The summary financial data set forth below provides selected historical consolidated and combined financial and operating data of Republic Companies Group, Inc. and its predecessor operations for the periods indicated. In conjunction with the data provided in the following tables and in order to more fully understand our historical financial and operating data, you should also read
In our Commercial Lines segment, we underwrite commercial lines insurance distributed through our network of independent agents. Our farm and ranch products are distributed though independent agents and through an unaffiliated MGA. Our products target specific classes of business in service industries that we believe are generally underserved by the insurance industry, such as garages, family-owned restaurants and artisan contractors primarily within the Southwest region. These products currently include commercial package, auto, workers’ compensation, property, general liability, farm and ranch and commercial umbrella coverages.
In our Program Management segment, we distribute personal and commercial insurance policies through contractual programs established with unaffiliated MGAs. These MGAs provide the underwriting, claims handling and management for our products in targeted niche markets. We write the policies produced through these MGAs, retain all or a portion of the business and cede any remaining premiums to highly-rated reinsurers. We receive a fronting fee on programs where we have quota-share reinsurance in addition to participating in the underwriting results of each program. We require various contractual, operational, financial and oversight controls on the business of each MGA (including an audit at least every six months) to protect our surplus and reputation. These relationships are based on years of experience with the MGA principals and an understanding of the products, markets and distribution of the programs. Through these unaffiliated MGA programs, we currently underwrite commercial auto, light commercial casualty, prize indemnification, lender’s collateral protection, employers’ nonsubscriber policies and nonstandard personal auto.
In our Insurance Services segment, we provide fronting services primarily to national and regional carriers seeking to use our charters and licenses to access certain insurance markets primarily in Texas through our Texas county mutual insurance company, other insurance subsidiaries and a controlled affiliate. These companies establish programs whereby we underwrite risks that are entirely ceded to the carriers in exchange for a fronting fee. Our principal fronting programs are for personal and commercial auto policies. Our Insurance Services segment captures revenues and expenses that are not allocated to any particular segment, including corporate interest expense and general holding company corporate overhead expenses, and the equity in our share of the earnings of Seguros Atlas, S.A. (“Atlas”), our 30% owned unconsolidated foreign insurance company.
Our insured risks generally exhibit higher losses in the second and third quarters of the year due to a seasonal concentration of weather-related events in our geographic region. Although weather-related losses (including hail, high winds, tornadoes and hurricanes) can occur in any calendar quarter, the second quarter historically has experienced the highest frequency of these losses. For example, for the last five years, the contribution of weather-related catastrophes to the consolidated second quarter net loss ratio (i.e., after reinsurance recoveries) was, on average, approximately 8 points greater than the average contribution of catastrophes in the other three quarters. For 2005, our losses from Hurricanes Katrina and Rita (see next section-Recent Developments) were the first significant hurricane losses since Hurricane Lili in 2002 and were the most significant catastrophe losses for our Company since the Northridge earthquake in 1994, where we operated under a different ownership, territorial and organizational structure. Our Personal Lines segment has been most heavily impacted by this seasonality of weather events, with the contribution of weather-related catastrophes to its second quarter net loss ratio, on average, approximately 13 points greater than the average contribution of catastrophes in the other quarters over this same period. As described in Item 1. Business-Reinsurance, we purchase various levels of reinsurance to help protect us from the high frequency and severity of these events.
We believe that operating conditions in our market continue to be favorable in 2006 and we believe that premium levels are still attractive in the market segments in which we offer our products and services. We have seen a moderation in pricing increases and selected pricing decreases in certain segments of the market as a sustained period of favorable underwriting conditions has attracted new capital into the industry in spite of the recent hurricane activity.
The big story in the insurance industry in 2005 was the occurrence of three major hurricanes that struck the United States mainland. Hurricane Katrina is the most costly natural disaster to occur in the United States in modern times. Additionally, Hurricanes Rita and Wilma are also in the top 10 of the most costly storms to hit the U.S. We did not suffer any losses from Hurricane Wilma; however, Katrina and Rita significantly impacted our operating area and presented us with many challenges that we and other insurers had never seen before. Our initial estimates of ultimate losses were based on the best available data and assumptions regarding coverage, damage, demand surge and reinsurance, including claims received to date at the time of the estimates, industry loss estimates, estimates from industry and proprietary models, and contract language, among other factors. In developing our initial estimated losses, our exposure tracking tools allowed us to accurately estimate frequency by overlaying our risk locations over the path of both storms. In developing our initial estimate of the average severity, we increased our historical average severities for roof damage from wind and falling trees by a factor of 2 to 3 for potential increases in repair costs and other uncertainties associated with these large events. However, the impact of delayed access to some of the damaged areas, the impact of additional 2005 storms after Katrina and Rita and the impact of subsequent increases in the cost of materials and contractor repairs pushed the average severity on both storms higher than originally anticipated. Our initial estimate of $35.0 million gross loss and loss adjustment expenses (“LAE”) before reinsurance for Hurricane Katrina has been increased to $45.3 million due to the higher average severity. Our initial estimate of $31.0 million gross loss and LAE before reinsurance for Hurricane Rita has been increased to $47.2 million for the same reasons. Individually and collectively and before reinsurance recoveries, these two events were the most costly events in the Company’s history, excluding events in other states outside our current southwestern state territory under prior ownership (such as the 1994 Northridge earthquake in California).
premium that came due after the first event. Thus, our net retention on each event was $5.0 million and the $5.0 million recovery under our aggregate catastrophe treaty resulted in a total net loss of approximately $5.0 million related to the two storms.
Our reinsurance treaties include cash call provisions which provide ready access to cash to pay ceded losses and LAE based upon projected payment patterns. By closely monitoring the timing of loss payment patterns and coordinating these with the timing of reinsurance recoveries we have had adequate cash flow to pay losses without the need to liquidate securities held in our investment portfolio. This avoided the potential negative implications of liquidating long-term bond holdings during a period of rising interest rates. Our reinsurance recoverables at December 31, 2005 are higher than at December 31, 2004 primarily because of higher ceded recoverables for losses and LAE related to Hurricanes Katrina and Rita. We have experienced no collectibility issues regarding these recoverables and anticipate no uncollectible reinsurance recoverables associated with these storms.
Despite the severe damage suffered by our policyholders and agents in Louisiana and Texas, we are committed to writing insurance in these regions. Our regional and local perspective will help us focus on proper pricing, dispersion of risk and maintenance of appropriate reinsurance to facilitate a return to profitable underwriting operations in these areas.
We derive our revenue from net insurance premiums earned, net investment income, net realized gains from investments and other income.
Net investment income. We invest our statutory surplus and the funds supporting our insurance liabilities (including unearned premiums and unpaid losses and LAE) in cash, cash equivalents and fixed-income securities. Our net investment income includes interest earned on our invested assets.
Our expenses consist primarily of net losses and LAE incurred and underwriting, acquisition and operating expenses.
Interest expense. We pay interest on our senior secured credit facility and on our trust preferred securities.
We evaluate the performance of our business segments by monitoring key measures of growth and profitability. We generally measure our operating results by examining our net loss, net expense and net combined ratios, our underwriting leverage, our net income and our return on average equity. We measure our growth by examining our written and earned insurance premium growth rate. The following provides a further explanation of the key measures that we use to evaluate our results.
Net written premiums. Net written premium is the portion of gross written premiums that we retain after ceding premiums to reinsurers. For our independent agents segments, the cost of excess per risk, catastrophe and facultative reinsurance reduces gross written premiums to arrive at net written premium. In our Program Management segment, the non-retained portion of programs ceded under quota share arrangements to unaffiliated reinsurers and the cost of excess per risk on certain programs, represents ceded premium and is deducted from gross written premiums to arrive at net written premiums for our retained portion of this business.
Insurance premium growth rate. Insurance premium growth rate is the change (expressed as a percentage) in premiums written or earned from one period to another period. Our gross written premium growth rate is meaningful in evaluating sales of our insurance products. Due to the significant amount of gross written premiums ceded in our Insurance Services and Program Management segments from our fronting business, we also evaluate our growth based on the change in net written premiums. Our net written premium growth rate is meaningful in evaluating the sales of our insurance products after the effects of reinsurance, which includes removing the impact of our fronting business. Gross and net written premiums are also related to our ability to generate net insurance premiums earned.
Net loss ratio. Net loss ratio is the ratio (expressed as a percentage) of net retained losses and LAE incurred to net insurance premiums earned. Our net loss ratio is meaningful in evaluating the underwriting profitability of the insurance policies that are not ceded to reinsurers. Due in part to the significant amount of gross written premiums produced and ceded in our Insurance Services and Program Management segments from our fronting business, we calculate our loss ratio on a net basis (after the effect of ceded reinsurance). Among other factors, items that influence losses and LAE incurred and net loss ratio in a given period include (1) the adequacy of the premiums charged for risks assumed, (2) the number and size of exposures written, (3) trends in the frequency and severity of claims, (4) changes in the legal environment relating to coverage interpretations and jury awards, (5) the cost of adjusting claims and (6) the re-estimation of prior years’ liabilities for unpaid losses and LAE. Amortization of the fair value adjustment of the unearned premium, which was recognized in the application of Statement of Financial Accounting Standards (SFAS) No. 141, Business Combinations, in the 2003 Acquisition, affected the reported net insurance premiums earned. This impacted the net loss ratio in the 2004 and the period August 29 to December 31, 2003. Where appropriate, the impact of this adjustment has been disclosed.
Net ex-catastrophe loss ratio (expressed as a percentage) is the ratio of net losses and LAE incurred, not including losses from industry designated catastrophic events or other weather events with losses per event aggregating at least $400,000, divided by the net insurance premiums earned. This ratio is net of amounts ceded to reinsurers. This ratio is meaningful in evaluating the underwriting profitability of the insurance policies that are not ceded to reinsurers and that are not related to unpredictable catastrophic events.
Net expense ratio. Net expense ratio is the ratio (expressed as a percentage) of underwriting, acquisition and operating expenses to net insurance premiums earned and measures the cost of producing our insurance business through independent agents and MGAs and our operational efficiency in underwriting and administering our insurance business. Due in part to the significant amount of gross written premiums produced and ceded in our Program Management and Insurance Services segments from our fronting business, we calculate our expense ratio on a net basis (after the effect of ceded reinsurance). Among other factors, items that influence our net expense ratio include (1) agents’ and MGAs’ base commissions and profitability commissions, (2) salaries and benefits costs, (3) underwriting and risk selection costs, (4) premium taxes, fees and regulatory assessments, (5) infrastructure costs of buildings, fixed assets and systems, (6) write-offs of uncollectible premium receivables, and (7) amortization of deferred policy acquisition costs. Certain expenses that vary with and are primarily related to the acquisition of insurance policies are capitalized as deferred policy acquisition costs assets and amortized over the applicable policy period. Interest expense, income taxes, investment expenses, expenses associated with producing fronting revenues and certain holding company expenses are not included in the calculation of the net expense ratio. Certain expenses, such as depreciation of fixed assets, which are included in the net expense ratio, were impacted by purchase GAAP accounting. In particular, amortization of the fair value adjustment of the deferred policy acquisition cost asset, which was recognized in the application of the SFAS No. 141 in the 2003 Acquisition, affected our reported underwriting, acquisition and operating expenses. In addition, amortization of the fair value adjustment of the unearned premium, also recognized pursuant to SFAS No. 141, affected the reported net insurance premiums earned. This impacted the net expense ratios in 2004 and 2003. Where appropriate, the impact of these adjustments has been disclosed. Accordingly, net expense ratios for post-acquisition periods are not comparable with net expense ratios for pre-acquisition periods.
Net income and return on average equity. We use net income to measure our profits and we use return on average equity (expressed as a percentage) to measure our effectiveness in utilizing our shareholders’ equity to generate net income. This approach was adopted subsequent to the 2003 Acquisition.
In determining return on average equity for a given year, net income is divided by the average of the beginning and ending shareholders’ equity (including our Series A preferred stock for the 2003 Stub Period) for that year. Our return on average equity model allocates equity to the Personal Lines, Commercial Lines and Program Management segments using net underwriting leverage ratios. The difference between the sum of the equity allocated to those segments and the actual consolidated equity is reflected in the Insurance Services segment. The model evaluates various significant risks in determining the appropriate underwriting leverage for each line of business. The computed risk-adjusted leverage ratio is divided into the net written premiums by line of business within each segment to determine the amount of equity allocable to the segment. For each segment, we compute liabilities for losses and LAE, unearned premiums, deferred policy acquisition costs, premiums receivable and reinsurance recoverables. Our return on average equity model builds a balance sheet by segment using these computed assets and liabilities, the allocated equity and prorations of other assets, other liabilities and investments. Allocated assets include premiums receivable, reinsurance recoverables, deferred policy acquisition costs and estimates of deferred tax assets and other assets plus an allocation of invested assets sufficient for total assets to equal computed liabilities and allocated equity. Consolidated net investment income and consolidated net realized gains (losses) are allocated to segments based upon their allocated investments. Consolidated income tax expense (benefit) is allocated to segments based upon their relative share of income (loss) from continuing operations before income taxes. We do not allocate extraordinary income or equity in earnings of our unconsolidated foreign insurance company by segment.
Net underwriting leverage. Net underwriting leverage is the ratio of our net written premiums to our statutory surplus and measures our exposure to pricing errors in our book of business. Generally, the higher the ratio, the greater the potential adverse impact of pricing inadequacy on statutory surplus. However, certain short-tail lines of business, such as auto physical damage policies, are more predictable and less sensitive to pricing errors, and can operate with higher net underwriting leverage than long-tail lines of business. Generally, short-tail lines require lower amounts of capital to yield acceptable underwriting profit margins. We compute target net underwriting leverage ratios by line of business and develop a weighted average target net underwriting leverage ratio by segment based on the lines of business written in that segment. The target ratio for each segment is used in the return on average equity computation for that segment. Net underwriting leverage on a consolidated and combined basis is computed by dividing actual net written premiums by reported statutory surplus.
Revenue recognition. Our consolidated revenues are derived principally from insurance premiums earned, investment income and fronting fees. Insurance premiums are earned ratably over the policy term. Unearned premium liabilities are recorded for the portion of premium applicable to the unexpired portion of policy terms. Prepaid reinsurance assets are recorded for the portion of unearned premium liabilities ceded to reinsurers or other carriers. Fronting fees are earned over the policy period of the fronted policies. Unearned fronting fee liabilities are recorded for the portion applicable to the unexpired policy period. In each case the relevant policy period is generally one year. Investment income is recognized on an accrual basis of accounting.
Due to the inherent uncertainty associated with the estimation process, the ultimate liability for claims may differ, perhaps substantially, from the original estimate. Examples of factors we have experienced that have resulted in differences between the ultimate and the estimated liability for claims include:
lack of internal historical data on new lines of business, such as we experienced in the late 1990s and early 2000s when our new commercial book of business was rapidly growing;
unexpected regulatorily mandated premium rate rollbacks such as experienced in 2003 and 2004 on Texas personal property policies;
actuarial methodology to the dynamic set of variables existing at the time the liabilities are estimated, which variables individually may have the effect of increasing or decreasing such liabilities. The impact of these variables can reasonably be expected to cause total recorded liabilities to fluctuate between periods. Examples of the dynamic variables we have experienced that have impacted such liabilities include:
increased policy counts, such as we experienced in Texas personal property in 2001 and 2002 after competitors decreased policy writings due to the mold crisis, or such as we experienced in Texas personal auto in 2002 and 2003;
changes in policy forms and coverage limitations, such as higher policy deductibles for catastrophe losses applied in Texas and Louisiana personal property policies in 2002 and 2003, and stronger exclusions on mold losses in Texas personal property policies;
changes in participations in MGA driven programs. We increased our net retention in our largest MGA program from 10% to 20% in 2004, 20% to 40% in 2005, which resulted in a significant increase in the liabilities for this program during 2005 (for 2006, we increased our net retention from 40% to 50%);
We have no known liabilities for asbestos-related illnesses, toxic waste or other environmental remediation risks.
separately as assets, instead of being netted against the related liabilities in accordance with SFAS No. 113, Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts, since reinsurance does not relieve us of our legal liability to policyholders and ceding companies. We are required to pay losses even if a reinsurer fails to meet its obligations under our reinsurance agreement with them. Consequently, we bear credit risk with respect to our individual reinsurers and may be required to make judgments as to the ultimate recoverability of our reinsurance recoverables. Additionally, the same uncertainties associated with estimating liabilities for loss and LAE affect the estimates of the amount of ceded reinsurance recoverables. We continually monitor the financial condition and financial strength ratings of our reinsurers. We require unauthorized reinsurers and certain other reinsurers to collateralize their share of paid losses, ceded liabilities for losses and LAE and ceded unearned premiums either by placing funds in a trust account or by providing a letter of credit. Management regularly reviews the recoverability of our reinsurance recoverables and establishes an allowance when appropriate.
In accordance with GAAP, we defer commissions, premium taxes and certain other costs that vary with and are primarily related to the acquisition of insurance contracts. These costs are capitalized, recorded as an asset and charged to expense in proportion to insurance premium revenue earned. The method followed in computing deferred policy acquisition costs limits the amount of these deferred costs to their estimated realizable value, which gives effect to the premium to be earned, related investment income, anticipated losses and LAE and certain other costs expected to be incurred as the premium is earned. Judgments as to ultimate recoverability of the deferred acquisition cost assets are highly dependent upon estimated future loss costs associated with the written premiums. A premium deficiency and a corresponding charge to income is recognized if the sum of the expected losses and LAE, unamortized acquisition costs and maintenance costs exceed related unearned premiums and anticipated investment income. Management regularly reviews the categories of costs being deferred and the recoverability of the deferred costs. See Note 3 to our audited consolidated and combined financial statements included in this annual report. As described in more detail in Note 2 to our audited consolidated and combined financial statements included in this annual report, our deferred policy acquisition cost asset at the 2003 Acquisition date was adjusted to zero under purchase-GAAP. This adjustment decreased the commissions and other underwriting, acquisition and operating expenses in 2003 and 2004. We currently do not have a premium deficiency or an issue with recoverability of any deferred expenses.
Premium receivables are recorded for the portion of premiums written but not yet paid by policyholders. Estimates of uncollectible premiums are recorded based upon historical payment patterns and the aging of receivables. Management reviews the recoverability of premiums at least quarterly and records an expense for the estimated unrecoverable portion of the receivables.
Deferred taxes. We utilize the asset and liability method of accounting for income tax. Under this method, 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 and for operating loss, capital loss and tax credit carry-forwards. 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. Valuation allowances are established when necessary to reduce the deferred tax assets to the amounts more likely than not to be realized. See Notes 3 and 12 to our audited consolidated and combined financial statements included in this annual report. Deferred taxes are not recognized for differences that are permanent in nature (such as the difference between the carrying value and tax basis of our investment in Atlas (see note 5 to our consolidated and combined financial statements)).
Employee benefits. We account for our qualified noncontributory defined benefit pension plan in accordance with SFAS No. 87, Employers’ Accounting for Pensions. Our projected benefit obligation is dependent upon several future events, including the retirement dates and how long employees and any survivors live. We estimate the effects of such future factors and select benefit plan estimates, particularly the discount rate and expected long-term rate of return on pension plan assets. These selections can have a significant impact on the valuation of our projected benefit obligation and benefit expense, and thus on the consolidated results of operations and financial position.
We annually determine the assumptions used to calculate our benefit plan obligations. We establish a discount rate based upon published investment grade and long-term corporate bond yields, and consider the
duration of the employees’ service and retirement. In 2005, we lowered the discount rate to 5.50% from 5.75% in 2004 and 6.25% in 2003, which increased our minimum pension liability to $4.6 million before taxes.
No contribution to the plan was required in 2005 and none is projected in 2006. However, due to the reduction in the discount rate in each of the past two years, an additional minimum pension liability of $2.3 million and $0.8 million (after the related deferred tax effect) was recorded as a component of other comprehensive income for 2005 and 2004, respectively.
We have other employee benefit plans, including a 401(k) defined contribution plan, profit sharing and deferred compensation plans and group life and health plans. However, we do not have any other post-retirement benefit plans other than the ones described above.
As noted in Item 1. Business, Republic Companies Group, Inc. is an insurance holding company and did not have any operations prior to its acquisition of the operating companies of Republic Financial Services, Inc. (“Predecessor Company”) on August 29, 2003. As a result of the 2003 Acquisition, we were required under GAAP to adopt purchase accounting as prescribed by SFAS No. 141 and record our assets and liabilities at their fair market value at the time of the 2003 Acquisition. Since the price paid in the 2003 Acquisition was less than our net asset value, we recorded negative goodwill and wrote down the value of some of our assets. The resulting change in the book value of our assets limits the comparability of several income statement items from and after August 29, 2003 to those items in preceding periods and to those in succeeding periods after the amortization of certain items was completed. The financial information provided in this annual report for periods prior to August 29, 2003 was derived from the reported historical GAAP-based financial statements of the Predecessor Company may not be comparable to the purchase GAAP-based financial statements prepared after that date.
In connection with the 2003 Acquisition, we adjusted our unearned premium liability to fair value at the August 29, 2003 acquisition date pursuant to SFAS No. 141. The adjustment reduced the unearned premium liability to its fair value by $23.5 million, which was approximately equal to the historical deferred acquisition cost asset of $24.2 million. The fair value adjustment of the unearned premium liability was amortized over twelve months following the 2003 Acquisition. Thus, the results of operations involving net insurance premiums earned, commissions, underwriting, acquisition and operating expenses along with the net loss, net expense and net combined ratio reflect the impact of the amortization of the purchase GAAP fair value adjustment during the 2003 Stub Period and January through August 2004. Any comparison of the amounts between the 2003 Cutoff Period, 2003 Stub Period, 2003 Total and the years 2004 and 2005 must be viewed in light of the amortization of the purchase GAAP fair value adjustment. The following table reflects the impact of the amortization by segment of the fair value adjustment of the unearned premium liability as if it were an approximation of the historical deferred acquisition cost asset in the respective periods set forth below. There was no impact on the Insurance Services segment since there is no net retention of premiums, losses or underwriting and acquisition expenses. Amortization of this adjustment was completed in the third quarter of 2004 and there was no impact thereafter on our financial statements.
(1) These captions represent the consolidated or combined totals for the Company for the periods presented as reported in prior reports and as reported herein. The amounts for the reclassifications are the sum of the amounts described for each segment above.
The table below summarizes our results of operations on a consolidated and combined basis for the years ended December 31, 2005 and 2004 and the periods of August 29 to December 31, 2003 and January 1 to August 28, 2003, and illustrates certain operating results and key measures we use in monitoring and evaluating our operations. The information is intended to summarize and supplement information contained in our audited consolidated and combined financial statements included in this annual report and to assist the reader in gaining a better understanding of our results of operations. An analysis of the results of operations comparing the years 2005, 2004 and 2003 on a consolidated and combined basis follows this table. Following the consolidated company analysis are further analyses by segment comparing the results of operations for the years 2005, 2004 and 2003.
Premiums-Consolidated gross written premium in 2005 grew to $498.0 million from $465.8 in 2004, or an increase of 6.9%. The increase is largely attributable to growth of 17.6% in our Commercial Lines segment and 21.4% in our Insurance Services segment. Our commercial lines business grew in large part due to the addition of a farm and ranch program along with a concerted effort to develop new business in this segment after our re-underwriting initiatives in Commercial Lines in 2004. Our Insurance Services segment continues to grow from the success of several personal and commercial auto fronting programs which also provide fee income. Our Personal Lines segment also grew by 6.1% in 2005, reflecting the addition of our new low-value dwelling program. Growth in our standard personal property line was largely offset by declines in our nonstandard auto business. Our Program Management segment declined by 8.9% due to the runoff of older programs terminated in prior years. Consolidated gross written premiums of $465.8 million in 2004 were 1.4% lower than gross written premiums of $472.4 million in 2003 Total. The Personal Lines segment experienced a 14.5% decline largely due to a reduction in homeowner rates in Texas and reductions in our auto business. The Program Management segment experienced an 8.9% reduction in 2004 due to termination of three programs that were not meeting our underwriting and performance standards. The Insurance Services segment experienced a 37.1% increase in gross written premiums in 2004, primarily from the success of two personal auto fronting programs that started in 2003 and grew rapidly in 2004. Commercial lines gross written premium was essentially flat from 2003 to 2004 due to new business being offset by the loss of business that we intentionally eliminated as part of our effort to re-underwrite our commercial line book of business.
Consolidated net written premium in 2005 was $256.9 million compared to $231.7 million in 2004 with growth fueled primarily by the growth in our Commercial Lines segment of 18.8% and the Program Management segment of 24.6%. The commercial growth follows the reasons indicated preceding paragraph. The Program Management growth occurred primarily due to our increased retention in our largest MGA program and in the addition of our new nonsubscriber program. Net written premium in our Personal Lines segment grew a modest 2.2% in 2005. Net written premium was impacted by the purchase of additional catastrophe reinsurance during the fourth quarter of 2005 following Hurricane Katrina with the largest portion of the $4.1 million cost allocated to the Independent Agents-Personal Lines segment. Consolidated net written premiums of $231.7 million in 2004 were 12.6% lower than net written premiums of $265.1 million in 2003 Total. The 2004 decline was primarily the result of a 15.5% decline in the Personal Lines segment, a 5.5% decline in the Commercial Lines segment and a 13.1% decline in the Program Management segment. The changes in net written premium from 2003 to 2004 parallel the explanations for the change in gross written premium. The Insurance Services segment does not incur net written premiums since there is no retention of any underwriting risk.
Consolidated net insurance premiums earned increased 7.6% to $238.1 million in 2005 compared to $221.3 million in 2004. The increase was principally driven by growth in the Commercial Lines segment where net insurance premiums earned increased by 29.1%, with the largest portion of the growth coming from the new farm and ranch program. We acquired a book of farm and ranch business as of the last day of 2004. Our Personal Lines and Program Management segments had only modest increases of less than 2.0%. The purchase of additional catastrophe reinsurance after Hurricane Katrina reduced net insurance premiums earned by $4.1 million with most of the cost allocated to the Independent Agents-Personal Lines segment. Additionally, the earned premium impact of the growth in the low-value dwelling program will not be fully recognized until after 2005. Consolidated net insurance premiums earned of $221.3 million in 2004 were 13.5% lower than net insurance premiums earned of $255.7 million in 2003 Total. The 2004 decline was primarily the result of a 10.6% decline in the Personal Lines segment, an 18.1% decline in the Commercial Lines segment and a 15.5% decline in the Program Management segment. Net insurance premiums earned were reduced by the amortization of the fair value adjustment to the unearned premium liability from the 2003 Acquisition of $15.7 million and $7.8 million in 2004 and the 2003 Stub Period, respectively. There are no net insurance premiums earned in the Insurance Services and segment since there is no underwriting retention in this segment.
Net losses and LAE incurred-The consolidated net total loss ratio for 2005 was 56.8% and represented a 5.8 point improvement over the 62.6% from 2004. The loss ratio for 2005 also includes 5.9% for catastrophe
Underwriting income-Our consolidated net combined ratio was 93.7%, in 2005, 92.3% in 2004, 89.8% in the 2003 Stub Period and 112.2% in the 2003 Cutoff Period. Although our underwriting results declined slightly in 2005 due to higher reinsurance costs and higher catastrophe experience, we believe that our underwriting experience is reflective of continued improvement in the ex-catastrophe loss results, especially in the commercial lines area. The exceptionally positive results for the 2003 Stub Period stem from the fact that this period consists of the final four months of the year, which historically have considerably lower catastrophe claims than other times of the year. As mentioned earlier, 2003 was a year with high frequency and high severity of catastrophe losses; however, most of this activity occurred in the 2003 Cutoff Period. Additionally, the 2003 Cutoff Period included additional loss and loss expense development from prior periods based on outside actuarial estimates prior to the 2003 Acquisition.
Net investment income is included in the consolidated return on average equity and in the segment return on average equity computations. We allocate investment income to our segments based upon the assets and capital allocated to the segments.
than in prior years. The net realized gains of the 2003 Cutoff Period primarily resulted from the sale of equity investments and other affiliated investments under the direction of the prior ownership.
Our consolidated return on average equity for 2005 and 2004 was 13.6% and 13.8%, respectively. The return on average equity in 2005 was modestly lower than in 2004 despite a 3.6% increase in net income due to a higher average equity. Income from continuing operations and return on average equity increased significantly in 2004 primarily from improved underwriting results and increased investment income on our growing investment portfolio.
Average shareholders’ equity for purposes of our return on average equity calculation was $166.9 million in 2005. Average shareholders’ equity for 2004 for purposes of the return on average equity calculation was $158.5 million and included the redeemable preferred stock as shareholders’ equity prior to its reclassification as permanent equity.
Amounts due from reinsurers increased $52.1 million in 2005 to $217.2 million from $165.1 million in 2004 primarily because of higher ceded recoverables for losses and LAE related to Hurricanes Katrina and Rita. We have experienced no collectibility issues regarding these recoverables and anticipate no uncollectible reinsurance recoverables associated with these storms.
The amount of liabilities for reported claims (“case-based”), liabilities for incurred but not reported claims and incurred but underreported claims (“IBNR”) and liabilities for LAE by segment as of December 31, 2005 and 2004 were as follows:
(1) Reinsurance recoverables include estimated amounts for unpaid losses and LAE on reported and unreported claims. These do not include amounts recoverable for paid losses.
Premiums-Our Personal Lines segment performed well for the 2005 year. Gross written premiums of $140.9 million in 2005 were 6.1% higher than the comparable period in 2004. Growth in our high-margin low value dwelling initiative more than offset purposeful declines in the compressing-margin nonstandard auto line. Additional growth occurred in homeowners and dwelling fire, primarily in north Texas and Louisiana. The market for standard and nonstandard auto is highly competitive at present and we have maintained our underwriting and pricing discipline to allow an opportunity for underwriting profit, although in the near term that will likely mean a continuing decline in our auto books of business. Gross written premiums of $132.9 million in 2004 were 14.5% lower than the $155.4 million in 2003 Total. The decline primarily resulted from the implementation of a homeowners premium rate rollback mandated by the Texas Department of Insurance of 7%
in 2003, an additional 14% in 2004 and certain geographic and agency management actions. The impact of the rate rollbacks on net insurance premiums earned was accrued in 2003 and 2004. Personal property gross written premiums declined 14.9% in 2004 due to the Texas homeowners rate rollback, exposure reductions in higher catastrophe prone areas and the termination of certain historically unprofitable independent agent relationships. These reductions were partially offset by additional premiums from newly appointed agents in target growth areas of Texas and Louisiana. Personal auto gross written premiums declined 14.3% in 2004 primarily from our reduced emphasis on personal auto business due to increased competition.
Net written premiums in 2005 were $128.7 million compared to $125.9 million in 2004, or an increase of 2.2%. Net written premiums were impacted by the purchase of additional catastrophe reinsurance coverage following Hurricanes Katrina and Rita, with most of the premium allocated to the Personal Lines segment. Without this additional ceded premium, net written premium growth in 2005 would have been similar to the gross written growth described above. Net written premiums of $125.9 million in 2004 declined 15.5% from the $149.0 million net written premiums in 2003 Total. Personal property and personal auto 2004 net written premiums were lower by 16.6% and 14.4%, respectively, generally for the reasons described above for gross written premiums.
In the wake of Hurricanes Katrina and Rita, we have filed or will soon file for personal property rate increases with the departments of insurance in Texas and Louisiana. These rate increases will address higher modeled catastrophe losses as well as higher reinsurance costs associated with catastrophe-prone areas, including hail as well as coastal wind exposures. At the same time, we will lower our rates in less catastrophe-prone areas to remain competitive with other insurers. We have seen some aggressive pricing by some competitors in inland areas. Additionally, we are introducing a new homeowners form in the second quarter of 2006 that provides broader coverage and should be more competitive than other forms currently on the market and which should better position us to address market disruptions from certain competitors. Any rate increases are subject to varying degrees of regulatory reviews and approvals.
Net losses and LAE incurred-Our net loss experience in the Personal Lines segment improved noticeably despite the unusually significant weather activity in 2005. Catastrophe related losses comprised 9.7% of the loss ratio in 2005. As mentioned earlier, we incurred an estimated $92.5 million in gross losses, including LAE, before reinsurance recoveries from Hurricanes Katrina and Rita, with most of the losses occurring in the Personal Lines segment. However, due to reinsurance recoveries, our total net losses for these events were only $5.0 million. Catastrophe losses over the past five years on average accounted for 8.7 points of the loss ratio for this segment, and accounted for 10.0 points of the 2003 Total net loss ratio, but were only 4.5 points of the 2004 Personal Lines net loss ratio. Historically, our second and third quarters are most heavily impacted by weather-related catastrophes. The contribution of catastrophes to the second quarter net loss ratios over the past five years was on average 18.1 points while the contribution of catastrophes to the other three quarters was on average only 5.4 points. The third quarter net loss ratio over the past five years on average included 8.3 points for catastrophe events and is the quarter most exposed to hurricane events.
It should also be noted that the loss ratios in 2004 and 2003 Total were negatively impacted by the amortization of the fair value adjustment of the unearned premium from the 2003 Acquisition in the sense that the net insurance premium earned was reduced, thereby increasing the loss ratios. Excluding the impact of this adjustment would have resulted in total loss ratios of 57.8% and 51.0% in 2004 and 2003 Stub Period, respectively.
Other income represents installment billing fees-the largest portion of which involves the nonstandard auto business. These fees are down 13.3% in 2005, and in 2004 were down 13.7% compared to 2003 Total due to the decline in premium and policies in force in the nonstandard auto business.
Income from continuing operations before income taxes of $19.4 million for this segment in 2005 was only 2.1% lower than in 2004, despite the impact of higher catastrophe losses and higher reinsurance costs. Higher net
investment income also helped cushion the impact of higher catastrophe losses. The return on average equity for this segment was 15.0% for 2005. Income (loss) from continuing operations before income taxes was $19.8 million in 2004, $9.0 million for the 2003 Stub Period and ($8.9) million for the 2003 Cutoff Period. As described above, the pre- and post-acquisition periods are not comparable due to the differences in purchase GAAP compared to historical GAAP. Higher net income for 2004 resulted from increases in both the personal property and the personal auto lines of business and produced a return on average equity of 15.3%. The $9.0 million net income for the 2003 Stub Period reflects historically low-catastrophe months of the fourth quarter. The net loss for the 2003 Cutoff Period primarily resulted from loss development for prior periods.
Premiums-Gross written premiums of $82.8 million in 2005 were 17.6% higher than the $70.5 million in 2004, driven primarily by our farm and ranch initiatives and growth in targeted classes and regions. The farm and ranch program provided $8.9 million of gross written premiums in 2005 compared to $3.6 million in 2004 (the 2004 premium was from a book of business assumed at year-end). Additional growth occurred in commercial liability and commercial auto consistent with our growth plans. Gross written premiums of $70.5 million in 2004
Following is a list of initiatives that were taken in the period following the 2003 Acquisition and continuing through 2005 to improve the performance of the commercial book:
development of, and clearer communication to agents about, our defined target markets and target risks.
Net insurance premiums earned of $66.7 million were 29.1% higher in 2005 than in the $51.7 million in 2004. None of the assumed farm and ranch book of business impacted the 2004 earnings since we acquired the book at the end of the year. Our commercial book of business began to grow in late 2004 and the earned impact was significantly felt in 2005. Most of the cost for the additional catastrophe reinsurance protection acquired after Hurricanes Katrina and Rita was allocated to the Personal Lines segment; therefore, the Commercial Lines segment was not significantly impacted. Net insurance premiums earned of $51.7 million in 2004 were 18.1% less than the $63.1 million of 2003 Total, primarily due to the impact of the 2003 and 2004 changes described above for gross written premiums. Net insurance premiums earned for this segment included amortization of the fair value adjustment of the unearned premium liability of $4.5 million and $2.5 million in 2004 and the 2003 Stub Period, respectively.
It should also be noted that the loss ratios in 2004 and 2003 Total were negatively impacted by the amortization of the fair value adjustment of the unearned premium from the 2003 Acquisition in the sense that the net insurance premium earned was reduced, thereby increasing the loss ratios. Excluding the impact of this adjustment would have resulted in total loss ratios of 72.4% and 58.4% in 2004 and 2003 Stub Period, respectively.
Income from continuing operations before income taxes of $2.6 million for this segment in 2005 was substantially improved over the loss of ($3.1) million in 2004 primarily due to improving underwriting margins and higher investment income. The return on average equity for this segment was 4.2% for 2005. Income (loss) from continuing operations before income taxes was $2.1 million for the 2003 Stub Period and ($5.7) million for the 2003 Cutoff Period. As described above, the pre-acquisition losses included significant increases in liabilities for losses and LAE. The loss in 2004 was heavily impacted by the prior decisions to phase out certain classes of business and the agency management actions taken in 2003 and early 2004.
In the fourth quarter of 2005, TGA was acquired by Hallmark Financial Services, Inc. (“Hallmark”). On October 31, 2005, we reached a substantive agreement with Hallmark regarding an expanded relationship with TGA. The agreement provides for the continued participation by certain insurance subsidiaries of the Company as policy issuing carriers for TGA for a three-year period. The substantive agreement was previously filed by 8-K dated November 14, 2005 and is now evidenced by the Managing General Agency Agreement between various insurance subsidiaries of the Company and TGA effective January 1, 2006. A redacted version of the agreement is filed with this Form 10-K as Exhibit 10.14. Portions of this document were omitted pursuant to a confidential treatment request filed with SEC and have been provided separately to the SEC. In 2005, our net retention of the TGA business was 40%. Pursuant to the terms of the new agreement, we increased our retention to 50% in 2006. For 2007, our agreement provides that we will retain between 40% and 50% and in 2008 we will retain a minimum of 30%. We will continue to receive fronting fees in addition to our participation in the underwriting results of this program. Through 2005, the portion of TGA’s business not retained by us was ceded to unaffiliated reinsurers, including Folksamerica Reinsurance Co., Endurance Reinsurance Corp. of America and QBE Reinsurance Corp. Starting in 2006, an affiliate of Hallmark will assume the portion of TGA’s business not retained by us. Hallmark is rated “A-” (Excellent) by A.M. Best.
Underwriting income-When comparing the 2005 net combined ratios of 95.0% to the 2004 combined ratio of 83.0%, it is necessary to consider the approximately 5.0 point impact on the 2004 combined ratio of the favorable loss development and the amortization of the fair value of the unearned premium. Net insurance premiums earned and underwriting, acquisition and operating expenses included amortization of the fair value adjustment for the unearned premium in the 2003 Acquisition in the amounts of $1.6 million and $0.2 million for 2004 and the 2003 Stub Period, respectively. The 2005 net combined ratio was also negatively impacted by the cost of a new excess of loss reinsurance treaty purchased in 2005 to provide additional protection for the higher retention in our largest MGA program and by an increase in incurred losses on commercial auto business written by that program.
Net income from continuing operations before taxes of $7.1 million in 2005 was lower than the $12.1 million in 2004 primarily because of the above noted favorable loss development in 2004. The return on average equity for this segment was 15.0% in 2005 compared to 20.9% in 2004. Income from continuing operations before income taxes was $12.1 million for 2004, $2.5 million in the 2003 Stub Period and $3.4 million in the 2003 Cutoff. Our largest MGA has historically contributed the greatest profit for this segment. With the termination of unprofitable MGAs, the net income for this segment increased in 2004 due to the release of IBNR liabilities related to the favorable runoff of the terminated programs.
(1) We allocate assets to our segments through our return on average equity model. See “-Key Financial Measures” above.
As noted earlier, due to the fee-based nature of the business in this segment, there are no underwriting or acquisition expenses. However, operating expenses include the ordinary expenses for this segment, including corporate and holding company expenses and eliminations. Total expenses for this segment show as credits in 2005 and 2004 due to the nature of intercompany leasing arrangements of certain fixed assets which started in 2004. All intercompany transactions are eliminated in consolidation.
Interest expense on corporate debt, which is recorded in this segment, of $3.3 million in 2005 was 52.8% higher than the $2.2 million in 2004 due to the additional $20.0 million credit agreement in 2005 and to increases in the variable interest rate of an existing trust preferred security. Interest expense of $2.2 million for 2004 and $0.4 million for the 2003 Stub Period related to the two trust preferred securities issued in 2003 after the 2003 Acquisition. See Note 13 to our audited consolidated and combined financial statements included in this annual report.
The equity in earnings of our unconsolidated foreign insurance company includes our share of the income of Atlas of $4.2 million in 2005, $3.0 million in 2004, $0.7 million in the 2003 Stub Period, and $1.7 million in the 2003 Cutoff Period. The improvement in 2005 is largely attributable to Atlas’ improved investment results outpacing a decline in underwriting income for the year and to the fourth quarter 2004 true-up of $2.6 million. The improvement also resulted from a decline in the Mexican peso to U.S. dollar exchange rate during 2005. The Mexican insurance markets are experiencing rate softening due in part to price decreases from large foreign controlled insurers. These price decreases coupled with losses from multiple hurricanes (primarily life, accident and health, and auto losses) in 2005 negatively impacted Atlas’ underwriting results.
Republic Companies Group, Inc. operates as a holding company with no business operations of its own. Consequently, our ability to pay dividends to stockholders, meet debt payment obligations and pay taxes and administrative expenses is largely dependent on dividends or other distributions from our subsidiaries and affiliates.
Generally, there are no restrictions on the payment of dividends by our non-insurance company subsidiaries and controlled affiliates RHP, RG2, RDS and EGA other than state corporate laws regarding solvency and those imposed pursuant to the terms of our senior secured credit facility. As a result, our non-insurance company subsidiaries and affiliates should be able to generate revenues, profits and net cash flows that are generally unrestricted as to their availability for the payment of dividends, and we expect to use those revenues to service our corporate financial obligations, such as debt service and stockholder dividends. For the year ended December 31, 2005, our non-insurance company subsidiaries and affiliates produced cash flow sufficient to pay all dividend and debt service requirements. As of December 31, 2005, we had $5.4 million of cash and invested assets at our holding company and our non-insurance company subsidiaries and controlled affiliates.
Our insurance company subsidiaries are restricted by statute as to the amount of dividends that they may pay without the prior approval of their domiciliary state insurance departments. Generally, Texas-domiciled insurers may pay dividends without advance regulatory approval only from unassigned surplus and only to the extent that all dividends paid in the twelve months ending on the date in question do not exceed the greater of (1) 10% of their policyholders’ surplus as of December 31 of the preceding year or (2) 100% of their net income for the calendar year preceding the year in which the value is being determined and subject to available earned surplus, as defined by the domiciliary state insurance department. In addition, insurance companies are required by law to maintain a minimum level of surplus on a statutory basis. Statutory surplus is calculated by subtracting total liabilities from total admitted assets computed under accounting principles prescribed or permitted by the insurer’s state of domicile. As of January 1, 2006, the maximum dividend that RUIC can pay without prior approval was $16.9 million. Any dividend in excess of this amount would be considered an “extraordinary dividend,” which would require advance approval by the Texas Insurance Commissioner.
The National Association of Insurance Commissioners (“NAIC”) has a risk-based capital standard designed to identify property and casualty insurers that may be inadequately capitalized based on inherent risks of the insurer’s assets and liabilities and its mix of net written premiums. Insurers falling below a calculated threshold may be subject to varying degrees of regulatory action. As of December 31, 2005, the statutory surplus of our insurance subsidiaries and controlled affiliates was collectively $133.2 million in excess of the prescribed risk-based capital requirements that correspond to any level that would trigger regulatory action.
In 2005, Hurricanes Katrina and Rita resulted in considerable gross losses that required unusually higher payments to claimants following the storms. Our reinsurance treaties include cash call provisions which provide ready access to cash to pay ceded losses and loss adjustment expenses based upon projected payment patterns. By closely monitoring the timing of loss payment patterns and coordinating these with the timing of reinsurance recoveries we have had adequate cash flow to pay losses without the need to liquidate securities held in our investment portfolio. This avoided the potential negative implications of liquidating long-term bond holdings during a period of rising interest rates. Our reinsurance recoverables at December 31, 2005 are higher than at
Net cash provided by operating activities was $47.8 million for the year ended December 31, 2005 compared to $34.3 million for the year ended December 31, 2004 and net cash provided by operating activities of $22.5 million and $12.0 million for the 2003 Stub and 2003 Cutoff Periods, respectively. The increase in cash flow generated from operations for the year ended December 31, 2005 compared to the prior year was principally due to increases in cash flows due to the timing of collections and payments of losses and unearned revenue. Cash flows generated from operations were substantially similar in 2004 and 2003 Total. Our cash collection and payment processes have not changed materially and we do not expect changes to these procedures in the future.
Credit facility. Our subsidiary, Republic Companies, Inc., entered into a senior secured credit facility on February 23, 2005 with Frost National Bank, N.A. The credit facility is backed by our unconditional guarantee of our subsidiary’s payment and performance. The credit facility consists of a five-year term loan in the amount of $20.0 million. We used all of the proceeds of the term loan to fund a dividend to our preferred stockholders. Interest under the credit facility will equal, at our option, either one-, three- or six-month London Interbank Offered Rate (“LIBOR”) plus 2.0% or (2) the higher of the prime rate or the federal funds overnight rate plus 0.5%. The interest rate in effect at December 31, 2005 was 6.37%.
Our obligations under the credit facility are secured by a security interest in all of the issued and outstanding capital stock of our subsidiaries EGA, RG2 and RUIC. In addition, the credit facility is secured by our shares of common stock and preferred stock of RHP. Under the terms of the credit facility, an event of default will occur, among other things, upon:
our non-payment of any part of the principal or interest owing under the loan or other debt in excess of $2.5 million;
our failure to comply with certain covenants set forth in the senior secured credit facility including:
reducing our consolidated shareholders’ equity below $125 million at any time;
incurring additional debt or liens (except for certain permitted debts and permitted liens);
our becoming subject to intervention by state or federal insurance regulators;
our becoming subject to a judgment in excess of $2.5 million;
non-payment of all or any part of the principal of the trust preferred securities;
Our primary investment objectives are to preserve capital and manage for a total rate of return in excess of a specified benchmark portfolio. BlackRock Financial Management, Inc. (“BlackRock”) manages all of our fixed-income investments except certain short-term investments that are managed internally and are intended to meet near-term operating cash requirements.
We manage our fixed-income portfolio to a duration target related to the duration of our insurance liabilities. BlackRock has authority and discretion to buy and sell securities for us, subject to guidelines established by our Board of Directors. These guidelines employ stringent diversification rules and balance our investment credit risk and related underwriting risks to minimize total potential exposure to any one security or business sector. We review our investment portfolio with BlackRock monthly to ensure compliance with our investment guidelines.
The following table provides a breakdown of the amortized cost, aggregate fair value and net unrealized gains and losses by investment type as of December 31, 2005:
The following table presents information regarding our invested assets that were in an unrealized loss position at December 31, 2005 by amount of time in a continuous unrealized loss position:
In December 2004, the FASB issued SFAS No. 123 (Revised), Share Based Payment. SFAS No. 123R, which replaces SFAS No. 123, Accounting for Stock-Based Compensation, supersedes Accounting Procedures Board Opinion (“APB”) No. 25, Accounting for Stock Issued to Employees, and amends SFAS No. 95, Statement of Cash Flows. Generally, the approach in SFAS No. 123R is similar to the approach described in SFAS No. 123. SFAS No. 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statements based on their fair values (i.e., pro forma disclosure is no longer an alternative to financial statement recognition). SFAS No. 123R is effective for public companies at the beginning of the first annual period beginning after June 15, 2005. We adopted the provisions of SFAS No. 123 in 2004 and use the fair value method for expensing stock-based compensation for periods beginning on and after January 1, 2004. We do not believe the implementation of SFAS No 123R will have a material impact on our results of operations or financial position.
We have audited the accompanying consolidated balance sheets of Republic Companies Group, Inc. and subsidiaries (the Company) as of December 31, 2005, and 2004, and the related consolidated statements of operations, shareholders’ equity and comprehensive income (loss), and cash flows for the years ended December 31, 2005 and 2004, and the period August 29, 2003 to December 31, 2003. In connection with our audits of the consolidated financial statements, we also have audited the financial statement schedules as listed in the Index at Item 15(a). These consolidated financial statements and financial statement schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Republic Companies Group, Inc. and subsidiaries as of December 31, 2005 and 2004 and the results of their operations and their cash flows for the years ended December 31, 2005 and 2004, and the period August 29, 2003 to December 31, 2003, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein.
Years ended December 31, 2005 and 2004, and the period August 29, 2003 to December 31, 2003
Prior to August 29, 2003 and the acquisition described in note 2 below, EGA, RG2, RUIC and its wholly owned insurance subsidiaries and controlled affiliates (Subject Companies) were owned by Republic Financial Services, Inc., an indirect subsidiary of Winterthur Swiss Insurance Company (Winterthur) and the Credit Suisse Group. The financial statements presented herein reflect the combined results of operations, changes in net assets and cash flows for the Subject Companies for the period January 1, 2003 through August 28, 2003 on a combined GAAP historical cost basis (hereafter referred to as Predecessor Basis) rather than the purchase accounting basis described in note 2. Shareholders’ equity for the Subject Companies is not meaningful as the Subject Companies are presented on a combined basis.
The Company completed an initial public offering (IPO) of 6,000,000 new common shares to the public effective August 8, 2005 and now trades on the NASDAQ exchange under the symbol RUTX (see note 9).
RCGI was formed as a Delaware corporation on December 12, 2002. There were no operations of the Company prior to the acquisition described below.
Short-term investments consist primarily of treasury bills, money market funds and commercial paper and are carried at cost, which approximates fair value due to their short maturity.
Prior to August 29, 2003, the Company owned its home office building and treated the building as a long-lived asset. Depreciation was provided on a straight-line method based upon a life of 30 years. The cost of repairs and maintenance on real state was charged to expense when incurred.
Concurrent with the Acquisition, the Company’s investment in home office real estate was reclassified as an asset held for sale. As part of purchase accounting, the carrying value of the real estate was adjusted to current appraised value less costs to sell, with such value reallocated between the land and building to follow the appraisal methodology of valuing these components. Depreciation was not recorded since the property was available for sale. The cost of repairs and maintenance on real estate were charged to expense when incurred. The property was sold to an unrelated third party in August 2004. The Company currently leases its home office property (see note 16).
Other investments represent principally participation in trust preferred securities and are recorded at fair value.
Management reviews investments for impairment on a quarterly basis. A decline in the market value of any available for sale security below cost that is deemed to be other-than-temporary results in a reduction in the carrying amount of the security to fair value. The impairment is charged to earnings and a new cost basis for the security is established.
For purposes of the consolidated statement of cash flows, the Company considers certain highly liquid investments purchased with an original maturity of three months or less to be cash equivalents.
Policy acquisition costs such as commissions, salaries, premium taxes and certain other underwriting expenses, which vary with and are directly related to the production of business, are deferred and amortized over the effective periods of the related insurance policies. The recoverability of deferred policy acquisition costs is reviewed for any potential deficiency on a quarterly basis. A premium deficiency represents future estimated losses, loss adjustment expenses and amortization of deferred policy acquisition costs in excess of the related unearned premiums and related future investment earnings. If a premium deficiency is determined to exist, the amount thereof is deducted from the Company’s deferred policy acquisition cost asset in respect of the relevant business and is charged to earnings as an expense in the period it is determined that deficiency exists. To the extent the amount of the premium deficiency exceeds the related deferred policy acquisition cost balance, the deficiency is recorded as a liability and is charged to net income in the same period. No such deficiency was determined to exist during the periods ended December 31, 2005, 2004, or 2003. As part of the purchase accounting at Acquisition, the deferred policy acquisition cost asset and related unearned premium liability were
In prior years, certain policy installment billing fees received from policyholders were recorded as a reduction of expenses associated with installment billing and uncollectible receivables. In 2005, we elected to reclassify these fees to Other income and to reclassify the presentation in prior years to be consistent with the 2005 presentation. The impact is to increase Underwriting, acquisition and operating expenses and to increase Other income. The reclassification has no impact on net income.
In the normal course of business, the Company enters into transactions involving various types of financial instruments, including investments in debt and equity securities. All investment transactions have credit exposure to the extent that a counter party may default on an obligation to the Company. Credit risk is a consequence of carrying, trading and investing in securities. To manage credit risk, the Company focuses on higher quality fixed income securities, reviews the credit strength of all companies in which it invests, limits its exposure in any one investment and monitors the portfolio quality, taking into account credit ratings assigned by recognized statistical rating organizations.
In prior years, policy fees received from various fronting programs in the Program Management and Insurance Services and Corporate segments were included in gross and net written premiums and net insurance
Other income primarily represents fronting fee income associated with the Company’s Program Management and Insurance Services and Corporate segments, reduced by the expenses associated with the generation of this income.
The Company’s insurance subsidiaries charge fronting fees to insurance carriers for whom they provide fronting services. Fronting fees are also charged to unaffiliated MGAs in connection with the policies that they underwrite on the Company’s behalf. Fronting fees are earned over the terms of the underlying policies. Gross fees included in other income were $5,752,000, $6,153,000, $1,950,000, and $5,185,000, for the years ended December 31, 2005 and 2004, the period August 29, 2003 to December 31, 2003, and the period January 1, 2003 to August 28, 2003, respectively. Such fees were reduced by related expenses of $1,404,000, 1,811,000, $572,000, and $1,269,000 for the same periods.
Loss and loss adjustment expenses (LAE), net of salvage and subrogation, are provided for as claims are incurred. Our estimation of the ultimate liability for unpaid losses and LAE is based on projections developed by our actuaries using analytical methodology commonly used in the property and casualty insurance industry. Liabilities for losses and LAE are based upon (1) the accumulation of case basis estimates for losses on claims reported, (2) estimates of losses and loss adjustment expenses incurred but not reported based upon historical experience, (3) estimates of expenses for investigating and adjusting claims based upon past experience, and (4) estimates of salvage and subrogation collections. We periodically adjust our liability for losses and LAE for changes in product mix, underwriting standards, loss cost trends and other factors.
As noted in note 2, in conjunction with the Acquisition, the assets and liabilities acquired were valued at fair value. Accordingly, estimated liabilities for losses and LAE and related reinsurance recoverables on unpaid losses as of August 29, 2003 were recorded at estimated fair value. The fair value of the Company’s liabilities for losses and LAE and related reinsurance recoverables was estimated based on the present value of the expected underlying cash flows of the liabilities for losses and LAE and reinsurance recoverables, and included a risk premium and a profit and risk margin. In determining the fair value estimate, management adjusted the Company’s historical GAAP undiscounted net liabilities for losses and LAE to present value assuming a rate, which approximated the U.S. Treasury rate on the date of the Acquisition. The discounting pattern was actuarially developed from the Company’s historical loss data. A profit and risk margin and a risk premium were applied to the discounted liability for losses and LAE, to reflect management’s estimate of the cost the Company would incur to reinsure the full amount of its net liability for losses and LAE with a third party reinsurer. This margin was based upon management’s assessment of the uncertainty inherent in the net liability for losses and LAE and their knowledge of the reinsurance marketplace and was confirmed by reinsurers and reinsurance intermediaries. The discount on liabilities for losses and LAE is being amortized to expense over the duration of the acquired liabilities (approximately 4 years). The reinsurer’s profit and risk margin and risk premium are being amortized to income approximately in proportion with the amortization of discount.
Comprehensive income encompasses all changes in shareholders’ equity (except those arising from transactions with shareholders) and includes net income, change in net unrealized gain or loss on fixed-maturity investments classified as “available for sale” and equity securities, net of income tax, change in foreign currency translation gains or losses, net of income tax, and change in additional minimum pension liability, net of income tax.
Basic net income per common share has been computed based on the weighted average number of common shares outstanding during the period, including restricted shares vested under the Company’s Stock Plan (see note 18). Diluted income per share assumes the issuance of common shares for all potentially dilutive restricted stock awards granted during the reporting period. The dilutive effect of stock options and unvested restricted stock awards are considered in net income per share calculations using the treasury stock method.
The Company owns 80% of RHP and the 20% portion not owned by the Company is recorded as “Minority interest in consolidated subsidiary” in the consolidated balance sheet and “Minority interest in earnings of consolidated subsidiary” in the consolidated statement of operations.
Fair values for fixed maturities and equity securities are based on quoted market prices. In cases where quoted market prices are not available, fair values are based on estimates using present value or other assumptions, including the discount rate and estimates of future cash flows.
For cash and cash equivalents and short-term investments, the carrying amounts approximate fair value because of the short maturity of such financial instruments.
Fair value of investment securities changes based primarily on market rates. Losses shown in the tables below are believed to be temporary. Additionally, the Company intends to and has the ability to hold all securities to maturity. The Company demonstrated its ability to meet its obligations to policyholders and claimants without having to liquidate any of its long-term investment portfolio following two of the most severe hurricanes in history in 2005. At December 31, 2005, the Company’s fixed maturity portfolio had seventy-eight (78) securities with gross unrealized losses totaling $2,875,000 that were in excess of 12 months. No single issuer had a gross unrealized loss position greater than $173,000 or 5.0% of its original cost. At December 31, 2004, the Company’s fixed maturity portfolio had thirty-seven (37) securities with gross unrealized losses totaling $844,000 that were in excess of 12 months. No single issuer had a gross unrealized loss position greater than $96,000 or 3.8% of its original cost.
Investment expenses include portfolio management and advisory and banking fees plus internal investment management expenses. Prior to 2005, investment income and expense also included leasing income and the related costs of managing the Company’s investment in real estate.
The investment in unconsolidated foreign insurance company represents the Company’s 30% interest in Atlas. The Company records its equity in the earnings of Atlas on the basis of estimated GAAP income as of September 30 as that is the most recently available financial information on a GAAP basis. The equity in the earnings of Atlas also includes a true-up of the prior year results based on final GAAP amounts available in the subsequent period. The equity in the earnings of Atlas in 2005 includes a true-up adjustment from the fourth quarter of 2004 of $2,665,000. Summarized financial information for Atlas as of and for the periods ended December 31, 2005, 2004 and 2003 presented below represents year-end balances reported by Atlas, adjusted on the basis of GAAP information available at September 30:
The exchange rate used to convert the balance sheet information as of December 31, 2005, 2004 and 2003 was 10.633 pesos, 11.135 pesos and 11.202 pesos, respectively, to one dollar. For 2005 and 2004, net income was converted using an average exchange rate of 10.894 pesos to one dollar and 11.29 pesos to one dollar, respectively. Net income for the period August 29, 2003 to December 31, 2003 was converted using an average exchange rate for the period of 11.13 pesos to one dollar. Net income for the period January 1, 2003 to August 28, 2003 was converted using an average exchange rate for the period of 10.62 pesos to one dollar. The Company recorded $4,161,000 (including a true-up adjustment of $2,665,000 from the fourth quarter of 2004), $2,982,000, $727,000 and $1,675,000 as equity in the earnings in Atlas for the years ended December 31, 2005 and 2004, the periods August 29 to December 31, 2003 and January 1 to August 28, 2003, respectively. This represents an estimate of the Company’s share of Atlas’ earnings adjusted for estimated differences between Mexican statutory accounting requirements and GAAP.
The Company has not recognized a deferred tax liability for the excess of the carrying value over the tax basis of its investment in Atlas. The unrecognized deferred tax liability is treated as a permanent difference as prescribed by SFAS No. 109, Accounting for Income Taxes, which is consistent with the criteria of indefinite reversal described in APB No. 23, Accounting for Income Taxes-Special Areas. Accordingly, approximately $2.5 million of deferred tax expense and deferred tax liability are not recognized in the accompanying consolidated and combined financial statements.
The cost and carrying value for other invested assets on the consolidated balance sheet at December 31, 2005 and 2004 were:
The reinsurance recoverable balances as of December 31, 2005 include amounts related to ceded incurred losses and loss adjustment expenses for Hurricanes Katrina and Rita. Gross losses and loss adjustment expenses before reinsurance were approximately $92.5 million for these two events (see note 8).
Our loss and loss adjustment expenses estimates from hurricane losses are calculated in accordance with the coverage provided in the respective policies. The Company’s homeowners policies specifically exclude coverage for losses caused by flood, but generally provide coverage for damage caused by wind and wind driven rain. The estimates for homeowners losses, therefore, do not include estimates for losses caused by flood. Also see note 16 regarding contingent liabilities.
The Company’s catastrophe reinsurance treaties combined to significantly reduce the net loss retained. The liabilities for loss and loss adjustment expenses include estimates for the hurricane-related catastrophe losses. Further, the balances due from reinsurance companies include estimates for the portion of the catastrophe losses expected to be recovered from reinsurers according to the treaty provisions. Management believes that the liabilities for losses and loss adjustment expenses, net of reinsurance recoverables, at December 31, 2005 have been appropriately established in the aggregate and are adequate to cover the ultimate net cost of reported and unreported claims arising from losses which had occurred by that date. The Company’s combined retention on the two major hurricanes after consideration of reinsurance recoveries is approximately $5.0 million.
The development of claims related to prior periods in 2004 represents an increase in loss adjustment expenses related to prior years principally related to commercial liability claims. The development of liabilities related to prior years for the period ended August 28, 2003 was related to the increase in liabilities related to commercial general liability, personal and commercial auto liability, and personal property (mostly related to mold/accidental discharge losses) prior to the Acquisition.
In the opinion of the Company’s management, there are no exposures for asbestos, toxic waste or other environmental remediation risks.
In July 2005, the Company’s Board of Directors and shareholders approved an amendment of its Amended and Restated Certificate of Incorporation to change the capitalization of the Company upon an IPO. The amendment provided for a 5.5:1 stock split of common stock and addressed other matters in anticipation of completing an IPO, such as increasing the number of authorized shares of Common Stock to 200,000,000 shares and Preferred Stock to 10,000,000 shares. The amendment provided that upon the consummation of an IPO each issued and outstanding share of the Company’s Class A Common Stock and Class B Common Stock shall be converted into one share of newly authorized Common Stock (Converted Common Stock) without any action on the part of the holder. The amendment also provided that upon the consummation of an IPO, after the payment of
The Company was initially capitalized with cash of $1,000 and the issuance of 5,500 shares of common stock. On May 7, 2003, RCGI declared a stock dividend of 415.754185 shares of Class A Common Stock (accounted for as a stock split) and .272727 shares of Series A Preferred Stock (see paragraph 9(b) below) for each common share outstanding. After the stock dividend, there were 421,251 shares of Class A Common Stock outstanding. As part of the sale of the Series A Preferred Stock described below, the purchasers received 3,057,830 shares of Class A Common Stock and 1,327,898 shares of Class B Common Stock. After the Acquisition date and as of December 31, 2003, there were 3,479,080 and 1,327,898 shares of Class A and Class B Common Stock, respectively, issued and outstanding. At December 31, 2004, there were 3,580,286 and 3,567,977 shares of Class A Common Stock issued and outstanding, respectively, and 1,796,883 and 1,794,133 shares of Class B Common Stock issued and outstanding, respectively.
The Class A Common Stock was voting stock and the Class B Common Stock was nonvoting. However, in all other respects, Class A and Class B Common Stock had the same powers, preferences, rights, and qualifications with regard to dividends, liquidation or dissolution.
The holders of a majority of the outstanding Series A Preferred Stock could have required the Company to redeem all of the Series A Preferred Stock at the $1,000 liquidation value, but only after i) the Company commenced a bankruptcy or insolvency action, ii) the initial public offering and sale of the equity securities of the Company, or iii) an uncured breach of representations or covenants in the initial capitalization agreement. Additionally, prior to December 2004, holders of more than 25%, or 10% of the outstanding shares of Series A Preferred Stock could elect to require the Company to redeem their shares after the second or fifth anniversary of the Acquisition, respectively. This latter provision was eliminated in the Amended and Restated Certificate of Incorporation adopted in December 2004.
In May 2003, the FASB issued SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity which established standards for how an issuer assesses certain financial instruments with characteristics of both liabilities and equity and classifies them in its balance sheets. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances) when that financial instrument embodies an obligation of the issuer. For nonpublic companies, the effective date for this statement was deferred until periods beginning after December 15, 2004. Accordingly, the Series A Redeemable Preferred Stock was presented as mezzanine financing at December 31, 2003. However following the amendment of the Certificate of Incorporation in December 2004, the Series A Redeemable Preferred Stock was reclassified as permanent equity at December 31, 2004.
In connection with the Acquisition, the Company also issued $22 million of temporary capital (Series B Preferred Stock). This transaction was rescinded on October 31, 2003 and the Certificate of Incorporation was amended to delete this as an authorized series of stock. No dividends were paid or accrued for the temporary capital and none of this capital is outstanding.
Statutory net income and capital and surplus differ from amounts reported as net income and shareholders’ equity in accordance with GAAP primarily because under statutory accounting, policy acquisition costs are expensed when incurred, certain assets designated as “nonadmitted” for statutory purposes are charged to surplus, fixed income securities are reported primarily at amortized cost or fair value based on their rating by the NAIC, and income tax expense reflects only taxes paid or currently payable, and any change in the admitted net deferred tax asset is offset to surplus.
The dividends that the Company’s insurance subsidiaries may pay are restricted by law and subject to insurance regulatory approval in certain instances. On January 1, 2006, the maximum amount of dividend that RUIC can pay without prior approval is $16.9 million.
The Company’s insurance subsidiaries are subject to various risk-based capital (RBC) requirements imposed by the NAIC and state insurance departments. The RBC calculation serves as a benchmark for the regulation of insurance companies. At December 31, 2005, 2004, and 2003, all insurance subsidiaries were above the minimum policyholders’ surplus equivalent under the RBC calculation.
Basic net income per share is computed by dividing net income available to common shareholders by the weighted average number of shares outstanding for each period, including all restricted shares vested under the Stock Plan (see note 18). Diluted net income per share includes the potential dilution that could occur if outstanding contracts to issue common stock were exercised and converted to common stock, including the unvested shares issued under the Stock Plan. Per share information for the periods prior to August 29, 2003 is not meaningful due to the predecessor basis of presentation.
Total components of income tax expense are as follows for the years ended December 31, 2005 and 2004 and the periods August 29 to December 31, 2003 and January 1 to August 28, 2003:
A reconciliation of normal federal income tax expense (computed by applying the United States federal income tax rate of 35% to income from continuing operations before income taxes) to the federal income tax expense in the consolidated statements of operations follows:
The Company (excluding SCM) has a regular tax and alternative minimum tax net operating loss carryforward of approximately $9.9 million. SCM has a regular tax net and alternative minimum tax net operating loss carryforward of approximately $6.9 million. These net operating loss carryforwards are available to offset future taxable income and will expire from 2020 to 2024.
On September 30, 2003, the Company completed the private placement of 10,000 floating rate capital securities (the Capital Securities) with an aggregate liquidation value of $10 million through its newly formed Delaware statutory business trust, RIG Capital Trust I (the Trust). The Trust invested the proceeds from the sale of the Capital Securities, together with the proceeds from the sale by the Trust of its common securities to the Company, in an equivalent amount of the Company’s Floating Rate Junior Subordinated Debt Securities (the Debentures). The Debentures will mature on September 30, 2033, which date may be shortened to a date not earlier than September 30, 2008 if certain conditions are met, including any required regulatory approvals. The Debentures, which are the only assets of the Trust, are subordinate and junior in right of payment to all present and future senior indebtedness (as defined in the Indenture dated September 30, 2003) of the Company. The Debentures accrue interest at a floating rate equal to the three-month LIBOR plus 4.00%, payable quarterly on March 31, June 30, September 30 and December 31 of each year. The quarterly distributions on the Capital Securities are paid at the same rate that interest is paid on the Debentures. At December 31, 2005, the interest rate was 8.02%.
equal to the three-month LIBOR plus 3.85%, payable quarterly on January 29, April 29, July 29, and October 29 of each year. The quarterly distributions on the Capital Securities II are paid at the same rate that interest is paid on the Debentures.
The Company has fully and unconditionally guaranteed the payment by the Statutory Trust of distributions and other amounts under the Capital Securities II to the extent that the Statutory Trust has funds available for such payments. The Statutory Trust must redeem the Capital Securities II when the Debentures are paid at maturity or upon any earlier prepayment of the Debentures. The Debentures may be prepaid if certain events occur, including a change in the tax status or regulatory capital treatment of the Capital Securities II or a change in existing laws that require the Statutory Trust to register as an investment company. Under the provisions of the Debentures, the Company has the right to defer payment of interest on the Debentures at any time, or from time to time, for up to twenty consecutive quarterly periods. If interest payments on the Debentures are deferred, the distributions on the Capital Securities II will also be deferred. Interest of $1,587,663 was paid and expensed in 2005.
On February 23, 2005, the Company entered a credit agreement to secure $20 million of senior bank debt, the proceeds of which were used to pay accrued dividends on the Company’s Series A Preferred Stock. The Company pledged all of the capital stock of EGA, RUIC, RHP and RG2 as collateral pursuant to the Credit Agreement. The principal on the loan is due and payable on the maturity date of February 23, 2010. Interest is determined by the using the Eurodollar rate plus 2% or the prime rate as quoted by the Wall Street Journal on the date of the Company’s interest period election. With the interest period election, the Company locks in the rate for a one, three or six month time frame paying interest either monthly or quarterly depending on the length of the interest period. During 2005 interest rates pursuant to the credit agreement ranged from 4.65% to 6.37%. As of December 31, 2005, the interest rate was 6.37%. Interest expense in 2005 under the agreement totaled $948,218. The credit agreement contains certain financial covenants including a minimum consolidated net worth and a risk based capital requirement and other restrictive covenants limiting the creation, assumption or incurrence of certain types of debts or liens, restriction on the issuance of stock and the acquisition of certain assets. As of December 31, 2005, the Company is in compliance with all of the financial and other restrictive covenants.
Pension cost for the pension plan for employees of the Company and certain affiliates for the years ended December 31, 2005 and 2004, the period from August 29 to December 31, 2003, and the period from January 1 to August 28, 2003 includes the following components:
Since the decision to freeze the plan was made at the time of the Acquisition, $3,619,000 of the $3,475,000 in net pension cost was recorded as a purchase accounting adjustment and the remaining $(144,000) was a credit to the pension expense for the period August 29, 2003 to December 31, 2003.
The plan asset allocation as of December 31, 2005 and 2004 and the target asset allocation, presented as a percentage of total plan assets, are shown in the following table. None of the assets are invested in employer securities.
Asset allocations and investment performance are formally reviewed quarterly by the Company’s Benefits Advisory Committee. The expected long-term rate of return is estimated based on many factors including the expected forecast for inflation, risk premiums for each asset class, expected asset allocation, current and future financial market conditions, and diversification and rebalancing strategies. Historical return patterns and correlations and other relevant factors are analyzed to check for reasonableness and appropriateness.
At the time of the Acquisition, the Company assumed and froze a noncontributory nonqualified defined benefit pension restoration plan for a select group of management employees of the Company and its subsidiaries. This plan restores the benefit lost by these employees because of cap limits of the qualified plan. The plan may be terminated at any time by the RCGI board of directors.
Pension cost for the pension restoration plan for employees of the Company and its subsidiaries for the years ended December 31, 2005, 2004, and 2003 includes the following components:
Since the decision to freeze the plan was made at the time of the Acquisition, $81,000 of the $124,000 in net pension cost was recorded as a purchase accounting adjustment and the remaining $43,000 was a pension expense for the period August 29, 2003 to December 31, 2003. The curtailment reported in the period January 1, 2003 to August 28, 2003 was due to the transfer of a portion of the accrued benefits covering certain employees of Winterthur affiliates to a Winterthur affiliate prior to the Acquisition.
Major economic assumptions were selected based on input from the plan sponsor. Additional economic and demographic assumptions were chosen to be consistent with actuarial valuation assumptions. The weighted average assumptions used in determining the actuarial present value of the projected benefit obligation and the net periodic benefit cost were as follows:
The Company maintains a Nonqualified Deferred Compensation Plan for certain employees designated by the Board of Directors. Under this plan, participants can defer up to 50% of their base salary and up to 100% of their incentive compensation. The Company matches 50% of a participant’s deferred contribution up to 6% of their base salary and 6% of their incentive pay not matched under the 401(k) Profit Sharing Plan due to government restrictions. The Company had approximately $41,000 and $14,000 in matching contributions in 2005 and 2004, respectively, and none for 2003.
Effective January 1, 2004, the Company established a profit sharing plan covering substantially all employees. Contributions to the plan are at the discretion of the Company and generally represent a percentage of employees’ salaries. In 2005 and 2004, the Company contributed approximately $1.0 million and $1.5 million to this plan.
There may be issues that arise in the wake of the storms that could create uncertainties in the future and may negatively impact our operations in future quarters. These could include changes in the regulatory or legal environment impacting traditional policy contract terms, including the flood exclusion. The Company is unable to determine the impact, if any, of such issues on future operations, particularly if the flood exclusion is altered or deemed not applicable by regulators and upheld by the courts.
We have substantial reinsurance recoverables associated with losses from the recent hurricanes. The Company has experienced no collectibility issues regarding its reinsurance recoverables and anticipates no uncollectible reinsurance associated with these storms. However, reinsurance does not discharge or diminish the Company’s primary liability to insureds and claimants. To the extent that reinsuring companies are unable to meet obligations arising under reinsuring agreements, the company would remain liable.
The Company makes available property and casualty insurance products to U.S. businesses and residents in several states. Accordingly, we could be adversely affected by economic downturns, natural disasters, and other conditions that may occur from time to time in these states, which may not as significantly affect more diversified competitors.
The maximum aggregate number of shares of the Company’s common stock that may be reserved in connection with awards under the 2005 Plan is 1,000,000. As described below, awards representing 43,972 options have been granted under the 2005 Plan as of December 31, 2005.
In April 2004, the Company’s shareholders approved the Republic Companies Group, Inc. Stock Plan (the Stock Plan). The Stock Plan authorized the issuance of up to 693,000 shares of common stock pursuant to restricted stock awards and the exercise of stock options. As of December 31, 2005, there were 448,256 shares of vested and unvested restricted stock awards outstanding under the Stock Plan. Additionally at December 31, 2005, there were vested and unvested options outstanding to acquire an aggregate of 58,124 shares of common stock that will count against shares available under the Stock Plan. As of December 31, 2004, there were 512,056 vested and unvested restricted stock awards and no options for shares outstanding under the Stock Plan. Any awards or shares granted on or after July 12, 2005 under the Stock Plan will be counted against the shares available under the 2005 Plan. No awards of restricted stock were granted in 2005 under the Stock Plan.
Shares issued as restricted stock awards are held by the Company and vest to each grantee generally at the rate of 20% per year provided that the grantee is still employed by the Company or its affiliates. However, certain shares totaling 50,600 vested immediately upon their grant and 165,000 shares vest over a 2.5 year period.
In May 2005, the Company’s shareholders adopted the Incentive Bonus Plan (Bonus Plan) of its subsidiary, Republic Underwriters Insurance Company. The purpose of the Bonus Plan is to promote excellent performance and results by rewarding the teamwork and efforts of the Company’s officers, and employees that contribute to the Company’s success. The Bonus Plan provides that 25% of bonus awards may be paid in restricted common stock after the IPO. No awards of restricted stock were granted in 2005.
In July 2005, the Board of Directors authorized the grant of options to certain employees totaling 30,250 common shares with an exercise price equal to the closing price of the Company’s common stock on the closing date of the IPO, which was $14.13. In addition, in July 2005, the Board of Directors of the Company approved the grant of options to certain members of management totaling 12,375 common shares contingent on the closing of the Company’s IPO. The exercise price of these options was to equal the price of the Company’s common stock on the closing date of the IPO, which was $14.13. These options vest ratably over five years and expire ten years from the date of grant.
For the year ended December 31, 2005, the Company recorded $60,000 in stock compensation expense related to stock options.
Additional information with respect to the option activity is as follows:
The following tables summarize information for stock options outstanding at December 31, 2005:
The following is a summary of our unaudited quarterly consolidated results of operations for 2005 and 2004:
In January, 2006, shares totaling 3,652 at a market value of $14.98 per share on the date of grant were awarded to an independent director as compensation for service. Additionally, an award of 1,818 shares was granted to the same director, whereupon an election was made to defer receipt of these shares pursuant to the Deferred Compensation Plan for Directors
In February 2006, options to purchase 162,419 shares of the Company’s common stock were granted to certain officers at an exercise price of $15.25 per share. The value of each option at the time of grant was $5.77 and vest ratably over three to five years and expire ten years from the date of grant.
In February 2006, the Company issued 66,043 shares of restricted stock with a value of $15.25 per share as of the date of grant representing the 25% portion of bonus awards to be issued under the Bonus Plan. These shares vest ratably over three years from the date of grant.
The Company declared a quarterly dividend of $0.12 per common share on March 10, 2006 for stockholders of record on March 31, 2006, payable on April 14, 2006.
The Condensed Financial Information of Parent Company includes the financial information for Republic Companies Group, Inc. (RCGI). RCGI’s sole direct subsidiary is Republic Companies, Inc. (RCI). RCGI was formed in December 2002 for the purpose of acquiring Republic Underwriters Insurance Company and its wholly owned subsidiaries and certain affiliates (Subject Companies) through RCI in 2003 as described in note 2 to the Consolidated and Combined Financial Statements of Republic Companies Group, Inc. RCGI did not have any operations prior to the acquisition of the Subject Companies.