The following discussion and analysis of financial condition and results of operations should be read together with “Selected Financial Data” and our financial statements and accompanying notes appearing elsewhere in this Annual Report on Form 10-K. This discussion contains forward-looking statements, based on current expectations and related to future events and our future financial performance, that involve risks and uncertainties. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of many important factors, including those set forth under “Risk Factors,” “Forward-Looking Statements” and elsewhere in this Annual Report on Form 10-K.
The following table summarizes our results of operations for the years ended December 31, 2006, 2005 and 2004, respectively:
Year Ended December 31, 2006 Compared to the Year Ended December 31, 2005
In 2006, we moved beyond the early stages of developing our operations. Insurance revenues and investment income were sufficient to absorb the company’s operating expenses, operating profits resulted and we began realizing benefits of tax losses generated in earlier years. In addition, our expense levels were more proportional to our earned premium.
Loss and loss adjustment expenses were $62.7 million for the year ended December 31, 2006, compared to $19.1 million for the year ended December 31, 2005. Amortization of deferred acquisition costs was $25.6 million for the year ended December 31, 2006, compared to amortization of deferred acquisitions costs of $6.1 million for
Tax expense of $0.3 million for the year ended December 31, 2006 resulted from deferred tax liabilities associated with our acquisition of Potomac, which have an indefinite life and therefore cannot be offset with deferred tax assets, which consist primarily of tax loss carryforwards. We did not incur tax expense in 2005 because we had a net loss for the year.
Our net loss and loss adjustment expense ratio has improved for the year ended December 31, 2006 compared to the year ended December 31, 2005. For 2006, our loss and loss adjustment expense ratio was 57.2% on a direct basis (before reinsurance) and 56.5% on a net basis (after reinsurance). We experienced favorable prior year loss development of $0.9 million. For 2005, our loss and loss adjustment expense ratio was 66.7% on a direct basis and 71.8% on a net basis. The improved loss and loss adjustment expense ratio in 2006 reflects more favorable terms under our reinsurance contracts, as well as our adherence to conservative pricing and underwriting and an improved unallocated loss adjustment expense ratio arising from increased earned premium. Our ratio of all other expenses to gross written premiums also improved due to increased premiums. The table below provides key operating statistics and ratios:
Our direct loss and loss adjustment expense ratios by statutory line of business for 2006 and 2005 were as follows:
Year Ended December 31, 2005 Compared to the Year Ended December 31, 2004 and for Potomac Insurance Company of Illinois (Predecessor) for the Period from January 1, 2004 to November 23, 2004
In 2004, we completed our acquisition of Potomac and our IPO. During the early stages of development, insurance revenues and investment income were not sufficient to absorb our operating expenses and operating losses resulted. Further, the benefits of tax losses generated would not be recognized until our operating results produced sufficient taxable income. In addition, due to the lower than expected premium volume in 2005, our expense levels were disproportionate to our earned premium.
Total revenues for the year ended December 31, 2005 consisted of earned premium of $26.6 million and investment income of $3.6 million. For the year ended December 31, 2004, revenue consisted solely of investment income of $0.3 million earned on capital from our initial funding date of November 23, 2004 through December 31, 2004.
For 2005, total expenses were $48.2 million, consisting of loss and loss adjustment expense of $19.1 million, amortization of deferred policy acquisition costs of $6.1 million, service company fees of $8.8 million and other operating expenses of $14.2 million. We were still in early stages of developing our operations and introducing our products through our partner agents to the insurance marketplace. Insurance revenues and investment income were not sufficient to absorb our operating expenses and operating losses resulted. Further, the benefits of tax losses generated would not be recognized until our operating results produced sufficient taxable income. Other operating expenses consisted of $5.2 million of salaries and benefit costs (excluding $2.9 million of salary and benefit costs classified as loss adjustment expenses and acquisition expenses), $3.0 million of professional and consulting fees, $1.8 million of depreciation and amortization and $4.2 million of other expenses. Total expenses for 2004 consisted of service company fees of $4.6 million and other operating expenses of $3.8 million, reflecting start-up costs for our insurance operations.
Cash used for investment activities was $66.4 million for the year ended December 31, 2006, principally representing purchases of investments and additions to equipment and capitalized software. For the year ended December 31, 2005, cash used in investment activities was $13.6 million also principally representing increases in investments and additions to equipment and capitalized software. Net cash used for investment activities during the twelve month period ended December 31, 2004 totaled $110.0 million and was primarily related to the acquisition of Potomac and subsequent purchases of investments with the proceeds from our initial public offering.
We had cash flows from financing activities of $3.1 million from sales of Class B Common Stock to partner agents for the year ended December 31, 2006. For the year ended December 31, 2005, cash flows from financing activities from sales of Class B Common Stock to partner agents was $1.5 million. For the year ended December 31, 2004, cash from financing activities was provided from the net proceeds of our initial public offering of $123.5 million and $3.2 million from term loans.
During 2004, Potomac declared and paid $18.6 million in cash dividends and capital distributions and distributed $13.3 million of net assets to OneBeacon.
Our investment portfolio consists of marketable fixed maturity and short-term investments. All fixed maturity investments are classified as available for sale and are reported at their estimated fair value based on quoted market prices. Realized gains and losses are credited or charged to income in the period in which they are realized. Changes in unrealized gains or losses are reported as a separate component of comprehensive income, and accumulated unrealized gains or losses are reported as a separate component of accumulated other comprehensive income in stockholders’ equity.
The aggregate fair market value of our fixed maturity investments at December 31, 2006 was $144.5 million, compared to amortized cost of $145.6 million. This amount compares to the aggregate fair market value of our fixed maturity investments of $94.1 million compared to amortized cost of $95.8 million, as of December 31, 2005.
The following table of contractual obligations includes information with respect to our known contractual obligations as of December 31, 2006:
We use quoted market prices in determining the fair value of fixed maturities and short-term investments in most cases. Where quoted market prices are unavailable, we base the estimate on recent trading. Unrealized appreciation or depreciation of available-for-sale investments carried at fair value are excluded from net income and credited or charged directly to accumulated other comprehensive income, a separate component of stockholders’ equity. The change in unrealized appreciation or depreciation is reported as a component of other comprehensive income.
We establish an asset for deferred policy acquisition costs such as up-front commissions, premium taxes and other variable costs incurred in connection with writing our lines of business. Deferred policy acquisition costs will be amortized over the period of coverage of the policies written which is 12 months. We assess the recoverability of
At December 31, 2006, deferred policy acquisition costs were fully recoverable.
We recorded an indefinite-life intangible asset for the value of insurance licenses acquired in connection with the acquisition of Potomac. Indefinite-lived intangible assets are not subject to amortization. If the aggregate fair value of insurance licenses declines to an amount less than their book value, impairment will be recorded as a realized loss.
Our general liability product line is generally considered a long-tail coverage, as it takes a relatively long period of time to finalize claims from a given accident year. General liability reserves are comprised primarily of bodily injury and, to a lesser extent, property damage. Bodily injury claims arise from physical injury as a result of the policyholder’s legal obligation arising from non-intentional acts such as negligence, subject to the insurance policy provisions. In some cases the damages can include future wage loss (which is a function of future earnings power and wage inflation) and future medical treatment. Property damage claims arise from damages to the claimant’s private property arising from the policyholder’s legal obligation for non-intentional acts. In most cases, property damage losses are a function of costs as of the loss date, or soon thereafter.
legal environment, such as theories of liability, amount of jury awards, propensity to sue, statutes of limitations, tort law, and settlement patterns;
The commercial automobile product line is mostly liability coverage which is primarily long-tail coverage. Claims that arise early on pertain to auto physical damage (property) and property damage (liability). Claims that take longer to formalize and are more difficult to estimate relate to bodily injury.
Because we have a limited operating history, and thus have limited historical loss development data, we rely on methodologies that focus on utilizing industry information and pricing expectations, such as the Bornhuetter-Ferguson methods and the expected loss ratio methods. Methods that utilize historical data to project ultimate losses, such as the loss development methods, are calculated and reviewed but are less relied upon. IBNR reserves represent our best estimate of ultimate losses after subtracting case incurred loss and loss adjustment expenses.
The following table shows for SUA Insurance Company the recorded reserves and the high and low ends of the range of reasonable loss and LAE reserve estimates at December 31, 2006.