The consolidated financial statements include the accounts of United America Indemnity and its wholly owned subsidiaries. All intercompany balances and transactions have been eliminated in consolidation.
The Company’s wholly-owned business trust subsidiaries, United National Group Capital Trust I (“UNG Trust I”), United National Group Capital Statutory Trust II (“UNG Trust II”), are not consolidated pursuant to Financial Accounting Standards Board (“FASB”) Interpretation No. 46(R), “Consolidation of Variable Interest Entities” (“FIN 46R”). The Company’s business trust subsidiaries have issued $30.0 million in floating rate capital securities (“Trust Preferred Securities”) and $0.9 million of floating rate common securities. The sole assets of the Company’s business trust subsidiaries are $30.9 million of junior subordinated debentures issued by the Company, which have the same terms with respect to maturity, payments and distributions as the Trust Preferred Securities and the floating rate common securities. The registration of the Company’s wholly owned business trust subsidiary, Penn-America Statutory Trust I (“Penn Trust I”), was cancelled effective January 15, 2008 as a result of the redemption of its $15.0 million issued and outstanding notes on December 4, 2007. The $15.0 million issued and outstanding notes of the Company’s wholly owned business trust subsidiary, Penn-America Statutory Trust II (“Penn Trust II”), were redeemed on May 15, 2008. The registration of Penn Trust II was cancelled effective February 2, 2009 as a result of this redemption.
the Company’s investments in bonds and stocks are determined on the basis of quoted market prices where available. If quoted market prices are not available, the Company uses third party pricing services to assist in determining fair value. In many instances, these services examine the pricing of similar instruments to estimate fair value. The Company purchases bonds with the expectation of holding them to their maturity; however, changes to the portfolio are sometimes required to assure it is appropriately matched to liabilities. In addition, changes in financial market conditions and tax considerations may cause the Company to sell an investment before it matures. In 2008 and 2007, the difference between amortized cost and fair value of these investments, excluding the Company’s convertible bond and preferred stock portfolios, net of the effect of deferred income taxes, is reflected in accumulated other comprehensive income in shareholders’ equity and, accordingly, has no effect on net income other than for impairments deemed to be other than temporary. The difference between amortized cost and fair value of the convertible bonds and preferred stocks is included in income. Prior to 2007, the difference between amortized cost and fair value of these investments, excluding the derivative components of the Company’s convertible bond and convertible preferred stock portfolios, net of the effect of deferred income taxes, was reflected in accumulated other comprehensive income in shareholders’ equity and, accordingly, has no effect on net income other than for impairments deemed to be other than temporary. The change in the difference between amortized cost and fair value of the options imbedded within the convertible bond and convertible preferred stock portfolios was included in income as a component of net realized investment gains and losses.
The Company adopted Statement of Financial Accounting Standards (“SFAS”) No. 155, “Accounting for Certain Hybrid Financial Instruments an amendment of FASB Statements No. 133 and 140” (“SFAS 155”) on January 1, 2007. As a result, the changes in the Company’s convertible bond and convertible preferred stock portfolios are included as components of net realized gains and losses. Prior to 2007, SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”), as amended, required that convertible instruments be bifurcated if they were classified as available for sale under SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities.” The change in the market value of the underlying security was included as a component of accumulated other comprehensive income, and the change in the value of the derivative component was included in income as a component of net realized investment gains and losses.
At December 31, 2008, the Company held $16.0 million of convertible bonds and $3.1 million of convertible preferred stock. The change in the difference between the amortized cost and the market value of the convertible portfolio is included in income as a component of net realized investments gains (losses). The Company realized a $5.2 million loss, a $2.6 million gain, and a $1.6 million loss for the years ended December 31, 2008, 2007, and 2006, respectively, due to market value changes related to convertibles.
The Company’s investments in other invested assets are comprised primarily of limited liability partnership interests. Partnership interests of 3% ownership or greater are accounted for using the equity method. The change in the difference between amortized cost and fair value of partnership interests of 3% ownership or greater, net of the effect of deferred income taxes, is reflected in income. Partnership interests of less than 3% ownership are carried at their fair value. The change in the difference between amortized cost and the fair value of partnership interests of less than 3% ownership, net of the effect of deferred income taxes, is reflected in accumulated other comprehensive income in shareholders’ equity and, accordingly, has no effect on net income other than for impairments deemed to be other than temporary.
On January 1, 2008, the Company adopted SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities,” (“SFAS 159”) which gives entities the option to measure eligible assets, financial liabilities and firm commitments at fair value (i.e., the fair value option), on an instrument-by-instrument basis. See Note 5 for a discussion of the adoption of SFAS 159. The Company’s investments in other invested assets, including investments in several limited partnerships, were valued at $46.7 million and $64.5 million as of December 31, 2008 and 2007, respectively. Of these amounts, $13.9 million and $15.0 million as of December 31, 2008 and 2007, respectively, were comprised of securities for which there is no readily available independent market price. Material assumptions and factors utilized in pricing these securities include future cash flows, constant default rates,
recovery rates, and any market clearing activity that may have occurred since the prior month-end pricing period. The remaining $32.8 million and $49.5 million were related to limited partnerships that invest mainly in securities that are publicly traded. Securities that are held by these partnerships are valued by obtaining values from Bloomberg, other external pricing sources, and managers that make markets for these securities. The Company obtains the value of the partnerships at the end of each reporting period; however, the Company is not provided with a detailed listing of the investments held by these partnerships. The Company receives annual audited financial statements from each of the partnerships it owns.
For bonds, the factors considered in reaching the conclusion that a decline below cost is other than temporary include, among others, whether (1) the issuer is in financial distress, (2) the investment is secured, (3) a significant credit rating action occurred, (4) scheduled interest payments were delayed or missed and (5) changes in laws or regulations have affected an issuer or industry. In addition, the Company considers its intent and ability to hold these securities until recovery or maturity.
The Company evaluates the collectibility of agents’ balances based on a combination of factors. In circumstances in which the Company is aware of a specific agent’s inability to meet its financial obligations to the Company, a specific allowance for bad debts against amounts due is recorded to reduce the net receivable to the amount reasonably believed by the Company’s management to be collectible. For all remaining balances, allowances are recognized for bad debts based on the length of time the receivables are past due. The allowance for bad debts was $3.6 million and $3.9 million as of December 31, 2008 and 2007, respectively. For 2008 and 2007, there were net bad debts written off of $0.0 million and $0.6 million, respectively.
Other intangible assets that are not deemed to have an indefinite useful life are amortized over their estimated useful lives. The carrying amount of intangible assets that are not deemed to have an indefinite useful life is regularly reviewed for indicators of impairments in value in accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” The Company’s annual impairment review of other intangible assets that are not deemed to have an indefinite useful life is performed at December 31. Impairment is recognized only if the carrying amount of the intangible asset is considered not to be recoverable from its undiscounted cash flows and is measured as the difference between the carrying amount and the estimated fair value of the asset. See Note 6 for details concerning the results of the Company’s 2008 impairment testing.
During 2008, the Company increased its uncollectible reinsurance reserve by $3.1 million due to an increase in the Company’s assessment of its risk of collecting from several individual reinsurers. During 2007, the Company decreased its uncollectible reinsurance reserve by $4.4 million due to a reduction in ceded loss reserves, including losses incurred but not reported, as a result of better than expected loss emergence. During 2006, the Company decreased its uncollectible reinsurance reserve by $8.6 million due to (i) an A.M. Best rating upgrade of one of the reinsurers included in the Company’s reserve, (ii) continued collections and reductions of receivables from other reinsurers included in the reserve, and (iii) better than expected loss emergence.
Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the
years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.
The costs of acquiring new and renewal insurance and reinsurance contracts include commissions, premium taxes and certain other costs that vary with and are primarily related to the acquisition of new and renewal insurance and reinsurance contracts. The excess of the Company’s costs of acquiring new and renewal insurance and reinsurance contracts over the related ceding commissions earned from reinsurers is capitalized as deferred acquisition costs and amortized over the period in which the related premiums are earned. In accordance with SFAS No. 60, “Accounting and Reporting by Insurance Enterprises,” the method followed in computing such amounts limits them to their estimated realizable value that gives effect to the premium to be earned, related investment income, losses and loss adjustment expenses, and certain other costs expected to be incurred as the premium is earned. The amortization of deferred acquisition costs for the years ended December 31, 2008, 2007, and 2006 was $108.9 million, $142.2 million, and $145.7 million, respectively. The Company determined that its acquisition costs of $34.7 million as of December 31, 2008 were deemed to be recoverable.
The carrying amounts reported in the balance sheet represent the outstanding balances.
The U.S. Insurance Subsidiaries are subject to various state guaranty fund assessments, which enable states to provide for the payment of covered claims or meet other insurance obligations from insurance company insolvencies. Each state has enacted legislation establishing guaranty funds and other insurance activity related assessments resulting in a variety of assessment methodologies. Expenses for guaranty fund and insurance-related assessments are recognized when it is probable that an assessment will be imposed, the obligatory event has occurred and the amount of the assessment is reasonably estimable. As of December 31, 2008 and 2007, included in other liabilities in the consolidated balance sheets were $0.8 million and $1.0 million, respectively, of liabilities for state guaranty funds and other assessments. As of December 31, 2008 and 2007, included in other assets in the consolidated balance sheets were $0.4 million and $0.6 million, respectively, of related assets for premium tax offsets or policy surcharges. The related asset is limited to the amount that is determined based upon future premium collections or policy surcharges from policies in force at the balance sheet date.
Basic earnings per share has been calculated by dividing net income available to common shareholders by the weighted-average common shares outstanding. Diluted earnings per share has been calculated by dividing net income available to common shareholders by the sum of the weighted-average common shares outstanding and the weighted-average common share equivalents outstanding, which include options and warrants and other equity awards. Basic and diluted per common share and related weighted average number of common share amounts are the same for 2008 since potential common shares were anti-dilutive and excluded from the computation due to the Company’s net loss for the year ended December 31, 2008. See Note 16 for details.
Accumulated comprehensive income as of December 31, 2008 and 2007 was as follows:
At December 31, 2008, the Company had 35 bonds that were in an unrealized loss position for greater than one year. The estimated fair value and amortized cost of these securities was $55.0 million and $62.6 million, respectively. The Company has analyzed these securities and has determined that they are not impaired. The Company has the ability to hold these investments until maturity or until recovery. 99.9% of these securities are investment grade.
The following table contains an analysis of the Company’s securities with gross unrealized losses, categorized by the period that the securities were in a continuous loss position as of December 31, 2007:
At December 31, 2007, the Company had 215 bonds that were in an unrealized loss position for greater than one year. The estimated fair value and amortized cost of these securities was $293.8 million and $297.7 million, respectively. The Company has analyzed these securities and has determined that they are not impaired. The Company has the ability to hold these investments until maturity or until recovery. 100% of these securities are investment grade.
The Company had approximately $3.5 million and $5.8 million worth of investment exposure through subprime and Alt-A investments as of December 31, 2008 and 2007, respectively. An Alt-A investment is one which is backed by a loan that contains insufficient documentation or background. As of December 31, 2008, approximately $1.2 million of those investments were rated AAA by Standard & Poor’s, $1.8 million were rated BBB- to AA, and $0.5 million were rated BB+. As of December 31, 2007, approximately $3.7 million of those investments were rated AAA by Standard & Poor’s, and the remaining $2.1 million were rated AA or A. Impairments on these investments was $0.5 million and $0.0 million during the year ended December 31, 2008 and 2007, respectively.
A summary of the Company’s insurance enhanced municipal bonds that are backed by financial guarantors, including the pre-refunded bonds that are escrowed in U.S. government obligations, is as follows:
The components of net realized investment gains (losses) on the sale of investments for the years ended December 31, 2008, 2007, and 2006 were as follows:
Proceeds from the sales of bonds classified as available-for-sale resulting in net realized investment gains (losses) for the years ended December 31, 2008, 2007, and 2006 were $222.3 million, $217.4 million, and $340.1 million, respectively.
The sources of net investment income for the years ended December 31, 2008, 2007, and 2006 were as follows:
The Company’s total investment return (loss) on an after-tax basis for the 2008, 2007, and 2006 were as follows:
Average of total cash and invested assets as of the beginning and ending of the period.
Certain cash balances, cash equivalents, and bonds available for sale were deposited with various governmental authorities in accordance with statutory requirements or were held in trust pursuant to intercompany reinsurance agreements. The estimated fair values of bonds available for sale and on deposit or held in trust were as follows as of December 31, 2008 and December 31, 2007:
As stated in Note 2, the Company adopted SFAS 159, which gives entities the option to measure eligible assets, financial liabilities, and firm commitments at fair value (i.e., the fair value option), on an instrument-by-instrument basis, with the change in fair value recorded in earnings. The Company elected to apply the fair value option within its limited partnership investment portfolio to those investments where the Company owns more than a 3% interest. The fair value of these investments was $7.5 million as of December 31, 2008. This limited partnership invests mainly in securities that are publicly traded. Securities that are held by the partnership are valued by obtaining values from Bloomberg, other external pricing sources, and managers that make markets for these securities. The Company obtains the value of the partnership at the end of each reporting period; however, the Company is not provided with a detailed listing of the investments held by the partnership. Accordingly, this investment is classified as level 3 within the SFAS 157 fair value hierarchy.
The Company’s invested assets are carried at their fair value. In accordance with SFAS 157, assets recorded at fair value are categorized based upon a fair value hierarchy:
Both observable and unobservable inputs may be used to determine the fair value of positions that the Company has classified within the Level 3 category. As a result, the unrealized gains and losses for invested assets within the Level 3 category presented in the tables below may include changes in fair value that are attributed to both observable (e.g., changes in market interest rates) and unobservable (e.g., changes in unobservable long-dated volatilities inputs).
The following table presents information about the Company’s invested assets measured at fair value on a recurring basis as of December 31, 2008, and indicates the fair value hierarchy of the valuation techniques utilized by the Company to determine such fair value.
The following table presents changes in Level 3 investments measured at fair value on a recurring basis for 2008:
The securities classified as Level 3 in the above table consist of $46.7 million related to our limited partnership investments. Of this amount, $13.9 million was comprised of securities for which there is no readily available independent market price. Material assumptions and factors utilized in pricing these securities include future cash flows, constant default rates, recovery rates, and any market clearing activity that may have occurred since the prior month-end pricing period. The remaining $32.8 million was related to limited partnerships that invest mainly in securities that are publicly traded. However, since we do not have the ability to see the invested asset composition of these limited partnerships on a daily basis, we have classified these investments within the Level 3 category.
For our fixed maturity and equity securities, which are valued as level 1 or level 2 in the SFAS 157 fair value hierarchy, our primary investment manager (the “Investment Manager”), receives prices from multiple sources, selects the most appropriate source for each of the Company’s securities, and provides the Company with one price for each of its securities which are non-binding.
The Investment Manager contracts with several vendors to provide investment pricing, but for each individual security, uses only one vendor at a time. The Investment Manager initially selects the vendor whose pricing of a security on the date of purchase is the most appropriate compared to the execution price for the security. The Investment Manager’s pricing committee (the “Pricing Committee”) then meets prior to each month end to examine the pricing data for each security. If the period over period vendor’s price for the security is outside of acceptable tolerance levels, the Pricing Committee will examine the pricing data of the other vendors for that security. As part of this process, the Pricing Committee may ask the Investment Manager’s traders for input as to which vendor is providing prices that the traders believe are reflective of fair value for the security. The Pricing Committee may also discuss the pricing variance with the vendor. Following this process, the Pricing Committee may decide to select a different vendor to price the security if it believes that vendor’s pricing is more reflective of the security’s value than the original vendor’s pricing. If a price cannot be obtained from a pricing vendor, the Pricing Committee will solicit prices from brokers. A negligible amount of securities in the Company’s portfolio requires broker pricing.
(1) select the vendor that will provide pricing for each new security purchased during that month;
(4) review any securities for which valuations had not been obtained;
In addition to the Investment Manager’s pricing validation process described above, the Company performs certain procedures to validate whether the pricing information received from the Investment Manager is reasonable, to ensure that the fair value determination is consistent with SFAS 157, Fair Value Measurements, and to ensure that its assets are properly classified in the fair value hierarchy. The Company’s procedures include, but are not limited to:
(3) Understanding and periodically evaluating the various pricing methods and procedures used by our Investment Manager to ensure that investments are properly classified within the fair value hierarchy.
During the year ended December 31, 2008, the Company has not needed to adjust quotes or prices obtained from the Investment Manager.
and partial impairment of the intangible assets related to the merger with Penn-America Group, Inc. was necessary. As a result, the Company recorded an impairment charge of $92.2 million, net of tax, in the fourth quarter of 2008 related to the Company’s 2005 merger with the Penn-America Group. The impairment charge of $92.2 million is comprised of a goodwill impairment of $84.3 million, an impairment of intangible assets with a definite life of $11.4 million pre-tax, $7.4 million after-tax, and an impairment of intangible assets with an indefinite life of $0.8 million pre-tax, $0.5 million after tax. An overview of the testing conducted during the fourth quarter of 2008 is as follows:
Step two of the goodwill impairment test, which determines the amount of the impairment loss, required the Company to determine the fair value of each asset and liability and to compare those values to the implied fair value of the reporting unit to determine the amount of goodwill. The excess of the fair value of the reporting unit over the amounts assigned to its assets and liabilities is the implied fair value of goodwill. Step two of the goodwill impairment test indicated the fair value of the Penn-America reporting unit was less than the amounts assigned to the assets and liabilities of the reporting unit, demonstrating that the entire amount of the Penn-America goodwill was impaired.
- Goodwill of $84,848 related to merger with Penn-America Group, Inc. and $17,006 related to the purchase of Penn Independent Corporation.
For intangible assets with indefinite lives, the impairment test consists of a comparison of the fair value of an intangible asset to its carrying amount. If the carrying amount of an intangible asset exceeds its fair value, an impairment loss shall be recognized in an amount equal to that excess. The Company’s intangible assets with indefinite lives are the Penn-America state insurance licenses and trade name, each having a pre-impairment carrying value of $5.0 million.
The Company worked with an independent valuation firm to determine the fair value of the intangible assets with indefinite lives. The valuation firm relied on the market approach to value the state licenses, which considers transactions for similar assets to determine value. The valuation firm appraised the state insurance licenses at a value higher than the carrying value of $5.0 million, which demonstrated there was no impairment. The valuation firm used the relief from royalty method to determine the fair value of the Penn-America trade name. The relief from royalty method calculates the present value of savings resulting from the right to manufacture or sell products that incorporate the intangible asset(s) without having to pay a license fee for its use. This method is commonly used to value trademarks, patents, developed technology, and base (core) technology. The assumed royalty rate under this approach was 0.5%, which yielded an estimated value of the trade name in the amount of $4.2 million, indicating that there was an impairment of $0.8 million pre-tax and $0.5 million after tax.
Impairment of indefinite lived intangible asset is the condition that exists when the carrying amount of an intangible asset with an indefinite life exceeds its fair value and is not recoverable. The carrying value of an intangible asset is not recoverable if it exceeds the sum of future undiscounted cash flows expected to result from the use and disposition of the asset.
The Company’s intangible assets with definite lives pertain to the Penn-America Group agency relationships that were in force at the time of the merger and internally developed software. The Company determined that the forecasted undiscounted cash flows related to the customer relationships, net of a capital charge equal to 16.0% of required capital, were negative, and therefore there was no value to the agency relationships. As a result, the Company recorded an impairment charge of $11.4 million pretax and $7.4 million after-tax, which was the total value of the agency relationships. The internally developed software related to the Penn-America Group does not directly generate cash flows; therefore, the Company worked with the independent valuation firm to determine the fair value of the software. The valuation firm used the cost approach, which estimates the cost to replicate the software, to determine the fair value of the internally developed software. The software was valued at $0.3 million, which is greater than the carrying value of $0.1 million, indicating there was no impairment.
The following tables present details of the Company’s intangible assets as of December 31, 2008:
Amortization expense related to the Penn-America Group, Inc. merger for the years ended December 31, 2008, 2007, and 2006 was $1.0 million, $1.0 million, and $1.0 million, respectively. Amortization expense related to the Penn Independent Corporation acquisition for the years ended December 31, 2008, 2007, and 2006 was $0.0 million, $0.0 million, and $0.5 million, respectively. Remaining amortization of the intangible assets is expected to be $0.07 million in 2009 and $0.04 million in 2010.
At December 31, 2008 and 2007, the Company carried reinsurance receivables of $679.3 million and $719.7 million, respectively. These amounts are net of a purchase accounting adjustment and an allowance for uncollectible reinsurance receivables. The purchase accounting adjustment is related to discounting the loss reserves to their present value and applying a risk margin to the discounted reserves. This adjustment was $17.5 million and $17.5 million at December 31, 2008 and 2007, respectively. The allowance for uncollectible reinsurance receivables was $13.7 million and $10.5 million at December 31, 2008 and 2007, respectively. The change is primarily due to an increase in the Company’s assessment of its risk of collecting from several individual reinsurers.
The Company reduced gross and ceded loss and loss adjustment expenses related to prior accident years by $176.2 million and $147.1 million, respectively, in 2007.
The Company reduced gross and ceded loss and loss adjustment expenses related to prior accident years by $114.1 million and $107.1 million, respectively, in 2006.
Property Catastrophe - The Company’s current property writings create exposure to catastrophic events. To protect against these exposures, the Company purchases property catastrophe coverage. In June 2008, the Company entered into a new property catastrophe reinsurance agreement that provides single event coverage for losses of $70.0 million in excess of $10.0 million. This coverage provides for one full reinstatement of coverage at 100% additional premium as to time and pro rata as to amount of limit reinstated. This replaces the contracts that expired on May 31, 2008, which provided single event coverage for losses of $100.0 million in excess of $10.0 million. The decline in coverage is due to reduced aggregate loss exposure to catastrophic events.
During the 2008, the Company ceded losses and loss adjustment expenses of $36.1 million due to Hurricane Ike, which occurred in September 2008. The Company recognized an additional $3.0 million of ceded written and earned premiums under its catastrophe reinsurance treaty as a result of the reinstatement of limits.
Property Excess of Loss - On January 1, 2008, the Company renewed its property excess of loss treaty. The Company’s retention remained unchanged at $1.0 million per risk. The Company’s property treaty covers losses of $14.0 million in excess of $1.0 million per risk.
Effective January 1, 2009, the Company renewed its property excess of loss treaty, retaining a $1.0 million per risk retention. The Company’s property treaty continues to cover losses of $14.0 million in excess of $1.0 million per risk.
Professional Liability Excess of Loss - On January 1, 2008, the Company renewed its professional liability excess of loss treaty. The Company’s retention remained unchanged at $0.5 million per occurrence. The Company’s professional liability excess of loss treaty through 2008 had limits of $9.5 million in excess of $0.5 million.
proportion to losses retained and ceded, remained unchanged at $0.75 million per occurrence. The Company’s general liability excess of loss treaty has limits of $2.25 million in excess of $0.75 million per occurrence.
The weighted average expected tax provision has been calculated using income (loss) before income taxes in each jurisdiction multiplied by that jurisdiction’s applicable statutory tax rate. The Company’s loss before income taxes in 2008 of $167.0 million is comprised of loss of $12.0 million from its foreign operations and loss of $155.0 million from its United States operations. The Company’s income before income taxes in 2007 of $118.1 million is comprised of income of $54.3 million from its foreign operations and income of $63.8 million from its United States operations. The Company’s income before income taxes in 2006 of $106.5 million is comprised of income of $43.2 million from its foreign operations and income of $63.2 million from its United States operations.
The Company recognized tax expense on discontinued operations of $0.05 million, $0.02 million and $4.8 million for the years ended December 31, 2008, 2007, and 2006, respectively.
The effective income tax benefit rate for 2008 was 17.5%, compared with an effective income tax expense rate of 15.8% for 2007 and 17.1% for 2006. The Company intends to carry back the net operating loss and net realized investment losses incurred in 2008. The effective rate differed from the weighted average expected income tax benefit rate of 32.4% for 2008 primarily due to investments in tax-exempt securities and the impairments of goodwill and intangible assets. The effective rates differed from the weighted average expected income tax expense rates of 19.0% and 21.0% for 2007 and 2006, respectively, primarily due to investments in tax-exempt securities.
Management believes it is more likely than not that the deferred tax assets will be completely utilized in future years. As a result, there is no valuation allowance at December 31, 2008 and 2007.
If recognized, the gross unrecognized tax benefits could lower the effective income tax rate in any future period. The provision for gross unrecognized tax benefits decreased $0.5 million during 2008 due to the expiration of the IRS statute of limitations on the Company’s 2003 and 2004 federal income tax returns. As a result, the effective income tax rate was reduced by 0.5% during 2008.
The Company classifies all interest and penalties related to uncertain tax positions as income tax expense. As of December 31, 2008, the Company has recorded $0.3 million in liabilities for tax-related interest and penalties on its consolidated balance sheet.
In 2007, the Company reduced its prior accident year loss reserves by $24.7 million and reduced its allowance for uncollectible reinsurance by $4.4 million. The loss reserves reduction of $24.7 million consisted of a net reduction of $42.5 million for primary liability, umbrella and excess, construction defect, and lines in run-off due to both lower than expected frequency and severity emergence, offset by a $17.8 million increase in net reserves for unallocated loss adjustment expenses and asbestos and environmental.
Loans payable of $0.9 million and $1.2 million as of December 31, 2008 and 2007 were comprised of a loan payable to a former minority shareholder. The current portion of these loans that will be payable in 2009 is $0.3 million. Interest expense related to loans payable was $0.03 million, $0.05 million, and $0.1 million for 2008, 2007, and 2006, respectively.
In November 2008, management fees of $1.5 million in the aggregate were paid to Fox Paine & Company pursuant to the Management Agreement. The management fees cover the period from September 5, 2008 through September 4, 2009 and will be recognized ratably over that period. In November 2007, management fees of $1.5 million in the aggregate were paid to Fox Paine & Company. The management fees covered the period from September 5, 2007 through September 4, 2008 and were recognized ratably over that period. In November 2006, management fees of $1.5 million in the aggregate were paid to Fox Paine & Company. The management fees covered the period from September 5, 2006 through September 4, 2007 and were recognized ratably over that period. The Company relies on Fox Paine & Company to provide management services and other services related to the operations of the Company.
The Company paid $0.2 million, $0.9 million, and $0.5 million in 2008, 2007, and 2006, respectively, in premium to Validus Reinsurance, Ltd. (“Validus”). Validus was a participant on the Company’s $100.0 million in excess of $10.0 million, $30.0 million in excess of $30.0 million, and $25.0 million in excess of $5.0 million catastrophe reinsurance treaties, all of which expired on May 31, 2007. No losses were ceded by the Company under these treaties
Total rental expense under operating leases for the years ended December 31, 2008, 2007, and 2006 were $3.7 million, $3.6 million, and $3.5 million, respectively. At December 31, 2008, future minimum payments under non-cancelable operating leases were as follows:
The Company is, from time to time, involved in various legal proceedings in the ordinary course of business. The Company purchases insurance and reinsurance policies covering such risks in amounts that it considers adequate. However, there can be no assurance that the insurance and reinsurance coverage that the Company
maintains is sufficient or will be available in adequate amounts or at a reasonable cost. The Company does not believe that the resolution of any currently pending legal proceedings, either individually or taken as a whole, will have a material adverse effect on the Company’s business, results of operations, cash flows, or financial condition.
On December 4, 2008, a federal jury in the U.S. District Court for the Eastern District of Pennsylvania (Philadelphia) returned a $24.0 million verdict in favor of United National Insurance Company (“United National”), an indirect wholly owned subsidiary of the Company, against AON Corp., an insurance and reinsurance broker. United National believes that it also is entitled to prejudgment interest, which, if the court agrees, could increase the judgment to in excess of $33.0 million. If United National is successful in being awarded the prejudgment interest, United National would expect to net, after payment of attorneys fees and other expenses, between $20.0 million and $22.0 million. AON has announced its intention to appeal the verdict. United National does not intend to recognize the gain contingency until the matter has been resolved through the appellate process.
As mentioned in Note 11 above, the Company has a remaining commitment of $3.8 million to the Fox Paine Capital Fund, II. The timing and funding of this remaining commitment has not been determined. As investment opportunities are identified by the partnerships, capital calls will be made.
The Company is party to a Management Agreement, as amended, with Fox Paine & Company, whereby in connection with certain management services provided to it by Fox Paine & Company, the Company agreed to pay an annual management fee of $1.5 million to Fox Paine & Company. The most recent annual management fee of $1.5 million was paid to Fox Paine & Company on November 21, 2008. The next annual management fee payment of $1.5 million is payable on November 1, 2009.
The Company allows employees to surrender the Company’s Class A common shares as payment for the tax liability incurred upon the vesting of restricted stock that was issued under the Company’s Share Incentive Plan. During 2008, the Company purchased an aggregate of 17,948 of surrendered Class A common shares from its employees for $0.3 million. All Class A common shares purchased from employees by the Company are held as treasury stock and recorded at cost.
On October 24, 2007, the Company announced that its Board of Directors authorized it to repurchase up to $50.0 million of the Company’s Class A common shares through a share repurchase program over the subsequent twelve months. This repurchase was completed in January 2008. All shares repurchased under this program are held as treasury stock and recorded at cost.
On February 11, 2008, the Company announced that its Board of Directors authorized the Company to repurchase up to an additional $50.0 million of its Class A common shares. This repurchase was completed in July 2008. All shares repurchased under this program are held as treasury stock and recorded at cost.
Purchased as part of the repurchase authorization announced in December 2007.
Includes 2,583 shares surrendered by employees as payment of taxes withheld on the vesting of restricted stock.
Includes 3,169 shares surrendered by employees as payment of taxes withheld on the vesting of restricted stock.
The adoption of SFAS 123R resulted in a cumulative benefit to equity of $0.4 million in 2006 due to recognition of expected forfeitures.
December 31, 2004. The Performance-Based Options were originally scheduled to vest in 25% increments and were conditioned upon the Company achieving various operating targets or Fox Paine & Company’s holdings in United America Indemnity achieving an agreed upon rate of return, and expire 10 years after the grant date. On December 31, 2005, the Company modified the 2003 grant of 566,661 Time-Based Options and the 2003 grant of 895,989 Performance-Based Options. Of the 2003 stock option grants, a total of 369,540 and 15,552 were forfeited and exercised, respectively, before the change. The Time Based Options were amended so as to modify the vesting schedule for the remaining unvested options to reflect vesting at the rate of 12% on December 31, 2006, 12% on December 31, 2007, and 36% on December 31, 2008. Also, the performance hurdle with respect to accelerated option vesting upon a change of control was eliminated. The Performance-Based Options were amended to eliminate the performance vesting criteria relating to the annual option vesting and catch-up vesting. Also, the performance hurdle with respect to accelerated option vesting upon a change of control was eliminated. The beginning balance of the table reflects a reclassification of 644,312 Performance-Based Options to Time-Based Options as a result of the removal of the performance based criteria. The remaining unvested options become exercisable at the rate of 10% on December 31, 2006, 10% on December 31, 2007, and 30% on December 31, 2008. As a result of these changes, the Company incurred an additional $2.5 million in stock option expense in 2005.
During 2004, the Company granted 10,000 Time-Based Options under the Plan. The Time Based Options vest in 20% increments over a five-year period, with any unvested options forfeited upon termination of employment for any reasons, and expire 10 years after grant date. The first vesting period ended on August 3, 2005.
outstanding options granted under the Plan. In 2006, the Company recorded $2.0 million of compensation expense for the 1,390,642 outstanding options granted under the Plan. The Company received $1.0 million, $1.9 million and $4.6 million of proceeds from the exercise of options during 2008, 2007 and 2006, respectively. Amortization expense related to options is anticipated to be $1.2 million in 2009, $1.2 million in 2010, and $1.2 million in 2011.
The weighted average fair value of options granted under the Plan was $7.57, $9.19, and $8.31 in 2008, 2007 and 2006, respectively, using a Black-Scholes option-pricing model and the following weighted average assumptions:
The following tables summarize the range of exercise prices of options outstanding at December 31, 2008, 2007 and 2006:
Decrease in weighted average remaining life from the prior year is due to terminations of employees with exercisable options that will expire in early 2009.
The Company recognized compensation expense for restricted stock of $1.4 million, $1.4 million and $2.5 million for 2008, 2007 and 2006, respectively. The total unrecognized compensation expense for the non-vested restricted stock was $3.7 million at December 31, 2008, which will be recognized over a weighted average life of 2.6 years. The weighted average fair value of the 109,453 Class A common shares, subject to certain restrictions granted to key employees of the Company under the Plan (“Restricted Shares”) that vested during the year ended December 31, 2008 was $16.42 per share.
employment and/or non-compete agreements. The related 42,500 Restricted Shares vest 331/3% on each subsequent anniversary date of the award for a period of three years.
During 2007, the Company granted an aggregate of 83,984 Restricted Shares to key employees of the Company and an aggregate of 19,332 fully vested Director Restricted Shares, at a weighted average fair value of $23.13 per share, to non-employee directors of the Company under the Plan. Included in the 83,984, the Company granted 2,500 Restricted Shares in exchange for a signed non-compete agreement. Of this award, 850 Restricted Shares vested immediately and the remainder vest 33% on October 24, 2008 and 2009. Also included, the Company granted 27,000 Restricted Shares to key executives of the Company in exchange for signed employment agreements. The shares vest 331/3% on each subsequent anniversary date of the award for a period of three years. Included in the 83,984 shares, the Company granted 54,484 Restricted Shares, as a result of the 2006 Board of Directors’ approval of the grant of Restricted Shares as described below.
First, the Compensation Committee revised the definition of the “Merger Price” from $15.375 per share to $17.89 per share. This change corrected a typographical error contained within the Integration Plan.
The Company maintains a 401(k) defined contribution plan that covers all eligible U.S employees. Under this plan, the Company matches 100% of the first 6% contributed by an employee. Vesting on contributions made by the Company for new employees occurs pro-rata over a three year period. Effective January 1, 2009, vesting on contributions made by the Company is immediate. Total expenses for the plan were $1.3 million for each of the years ended December 31, 2008 and 2007.
Through December 31, 2006, for employees, exclusive of employees of Penn Independent Corporation, Penn-America Group, Inc. and their respective subsidiaries, the Company matched 75% of the first 6% contributed by an eligible employee. Additionally, the Company contributed 1% of the employee’s salary regardless of whether an employee contributed to the plan. Eligible employees vested in the Company’s contribution and relative investment income after three years of service. Total expenses related to this plan for the year ended December 31, 2006 were $0.8 million.
Through December 31, 2006, for employees of Penn Independent Corporation, Penn-America Group Inc. and their respective subsidiaries, the Company matched 50% of the first 6% contributed by an eligible employee. Vesting in the Company’s contribution was immediate for eligible employees. Total expenses for this plan for the year ended December 31, 2006 were $0.4 million.
The Company’s U.S. insurance subsidiaries are required by law to maintain certain minimum surplus on a statutory basis, and are subject to regulations under which payment of a dividend from statutory surplus is restricted and may require prior approval of regulatory authorities. Applying the current regulatory restrictions as of December 31, 2008, the maximum amount of distributions that could be paid for 2009 by the United National Insurance Companies and the Penn-America Insurance Companies as dividends under applicable laws and regulations without regulatory approval is approximately $31.3 million and $18.9 million, respectively. The Penn-America Insurance Companies limitation includes $6.2 million that would be distributed to United National Insurance Company or its subsidiary Penn Independent Corporation based on the December 31, 2008 ownership percentages. For 2008, United National Insurance Companies and Penn-America Insurance Companies declared and paid dividends of $45.2 million and $19.8 million, respectively.
Based on the standards currently adopted, the Company reported in its 2008 statutory filings that the capital and surplus of the U.S. Insurance Companies are above the prescribed Company Action Level RBC requirements.
The following is selected information for the Company’s U.S. Insurance Subsidiaries, net of intercompany eliminations, where applicable, as determined in accordance with SAP:
Includes excise tax of $1,871 related to cessions from U.S. Insurance Companies to Wind River Reinsurance.
In the fourth quarter of 2008, the Company provided advance notice of its wish to liquidate all of its investment in two limited partnerships. In January 2009, the Company received a distribution from these partnerships in the amount of $24.1 million. This amount represents 95% of the estimated capital account balances for both partnerships as of December 31, 2008. The final distribution will be received when the partnerships’ audited financial statements for 2008 are finalized.
On January 26, 2009, the Company announced the appointment of Charles F. Barr as Senior Vice President and General Counsel, effective February 2, 2009.
On February 10, 2009, the Company announced that Messrs. Chad A. Leat and Robert S. Fleischer were appointed to the Board of Directors, effective as of that date. Mr. Leat was also appointed to serve as the Chair of the Audit Committee of the Board of Directors. The Company also notified the Listing Qualification Department of the NASDAQ Stock Market of Mr. Leat’s appointment.
An unaudited summary of the Company’s 2008 and 2007 quarterly performance is as follows: