We lease office space at One Bala Plaza, Bala Cynwyd, PA which serves as our headquarters location, we own office space in Pinellas Park, FL which serves as our home office for Liberty, and we also lease space at 45 offices throughout the country for our field and regional offices.
As of September 30, 2004, the Company’s four insurance subsidiaries were rated A+ (Superior) by A.M. Best Company. Effective October 1, 2004, the Company’s four insurance subsidiaries entered into a new intercompany reinsurance pooling arrangement. Two of the insurance subsidiaries, Philadelphia Indemnity Insurance Company and Philadelphia Insurance Company, entered into an intercompany reinsurance pooling arrangement which included substantially all the Company’s commercial and specialty lines business. The Company’s two other insurance subsidiaries, Liberty American Select Insurance Company and Liberty American Insurance Company, also entered into an intercompany reinsurance pooling arrangement which substantially included all the Company’s personal lines segment business. As a result of this arrangement, A.M. Best Company assigned an A- (Excellent) rating to these two companies. The rating of Philadelphia Indemnity Insurance Company and Philadelphia Insurance Company remained at A+.
Claims development and the adequacy of our liability for unpaid loss and loss adjustment expenses;
We do not intend to publicly update any forward looking statement, except as may be required by law.
We design, market, and underwrite specialty commercial and personal property and casualty insurance products for select markets or niches by offering differentiated products through multiple distribution channels. Our operations are classified into the following three reportable business segments which are organized around our three underwriting divisions:
We believe our product distribution marketing platform creates value added features not typically found in property and casualty products which contribute to generating premium growth above industry averages. Written premium information for our business segments for the years ended December 31, 2007 and 2006 is as follows:
Other key financial metrics that are regularly monitored in evaluating financial condition and operating performance include, but are not limited to:
The carrying amount of our investments approximates their estimated fair value. Our external fixed income investment manager provides pricing of our investments based on a pricing methodology approved by the investment manager’s pricing committee. Pricing is primarily obtained from market vendors based on a pre-established provider list.
For non-investment grade structured securities for which a vendor price is not available, broker pricing is obtained from either the lead manager of the issue or from the broker used at the time the security was purchased. Material assumptions and factors considered by the independent vendors and brokers in pricing these securities may include:
any market clearing activity and/or liquidity circumstances in the security or other benchmark securities that may have occurred since the prior month-end pricing period.
Cash flow assumptions for structured securities are obtained from a primary market provider of such information. These assumptions represent a market based best estimate of the amount and timing of estimated principal and interest cash flows based on current information and events. Prepayment assumptions for asset/mortgage backed securities consider a number of factors in estimating the prepayment activity, including seasonality (the time of the year), refinancing incentive (current level of interest rates), economic activity (including housing turnover) and burnout/seasoning (term and age of the underlying collateral).
Our total investments as of December 31, 2007 include $1.0 million in securities for which there is no readily available independent market price.
Our impairment review also includes an impairment evaluation for interests in securitized assets conducted in accordance with the guidance provided by the Emerging Issues Task Force of the Financial Accounting Standards Board. Gross unrealized losses for investments in securitized assets were $3.0 million as of December 31, 2007.
This assumption implies that historical claim reporting, handling, and settlement patterns are predictive of future activity and can thus be utilized to forecast ultimate liabilities on unpaid claims. Since the many factors that influence claim activity can change over time and are often difficult to isolate or quantify, the rate at which claims arose in the past and the costs to settle them may not always be representative of what will occur in the future. Key objectives in developing estimates of ultimate losses are to identify aberrations and systemic changes occurring within historical experience and to adjust for them so that the future can be projected on a more reliable basis. Various diagnostic tools are employed, (e.g., ratios of claims paid-to-claims incurred and analyses of average claim costs by age of development), and close communication is maintained among our actuarial, claims and underwriting departments to continually monitor and assess the validity of this assumption.
These methods, like historical paid loss development methods, assume that the ratio of losses in one period to losses in an earlier period will remain constant in the future. However, these methods use incurred losses (i.e., the sum of cumulative historical loss payments plus outstanding case reserves) over discrete periods of time to estimate future losses. Historical incurred loss development methods can be preferable to historical paid loss development methods because they explicitly take into account open cases and the claims adjusters’ evaluations of the cost to settle all known claims. However, historical incurred loss development methods assume that case reserving practices are consistently applied over time. Therefore, when there have been significant changes in how case reserves are established or material changes in the underlying loss exposures and/or circumstances which may lead to a claim being reported, using incurred loss data to project ultimate losses can be less reliable than other methods.
These methods are based on the assumption that ultimate losses vary proportionately with premiums. Expected loss ratios are typically developed based upon the information used in pricing, such as rate changes and trends affecting the frequency and/or severity of claims, and are multiplied by the total amount of premiums earned during a given accident period to calculate ultimate losses incurred during that same period. Expected loss ratio methods are useful for estimating ultimate losses in the early years of long-tailed lines of business, when little or no paid or incurred loss information is available, and in new or growing lines of business where historical information may lack predictive accuracy or otherwise not be representative of current loss exposures. Where expected loss ratio methods are employed, one or more of several traditional and accepted actuarial estimation methods are used to select expected loss ratios, including: loss ratios from mature years adjusted for trends in pricing and claim costs; permissible loss ratios underlying current rate levels; and projections of industry loss ratios in similar lines.
These methods combine estimates of ultimate claim counts and estimates of per claim ultimate loss severities to yield estimates of ultimate losses. Ultimate claim counts (frequency) are typically estimated using expected ratios of claims to a selected base (e.g., exposures or policy counts), with the expected ratios being based on historically observed experience. Adjustments for trends affecting claim occurrence or affecting the value of the base are also typically made. Ultimate loss severity estimates are typically based on historically observed per claim average losses and are adjusted for trends affecting the size of claims, most notably inflation. The Company has mainly used this method in the case of its residual value product.
This decrease in our actuarially determined reserve estimate would increase our net income and financial position by $68.5 million, which reflects the impact of reinsurance and federal income taxes. This change would not have a material impact on our liquidity.
This increase in our actuarially determined reserve estimate would decrease our net income and financial position by $57.5 million, which reflects the impact of reinsurance and federal income taxes. This change would not have a material impact on our liquidity.
The High end of the reasonably likely range of changes in expected loss ratios was judgmentally raised to reflect that the historical period over which the expected loss ratios were analyzed is widely recognized in the insurance industry as covering the hard market (i.e. most favorable pricing and coverage terms from the insurers’ perspective) portion of the current insurance cycle.
Reinsurance receivables from reinsurers under reinsurance contracts are subject to estimation. Reinsurance receivables may prove uncollectible if reinsurers are unable or unwilling to perform under our reinsurance contracts due to, but not limited to, such factors as the reinsurers’ financial condition or coverage disputes. In order to limit the risk of a reinsurer’s default, we:
principally contract with large reinsurers that are rated at least “A” (Excellent) by A.M. Best Company;
Effective January 1, 2006, we adopted on a modified prospective transition method Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment, (“SFAS 123(R)”). SFAS 123(R) requires the measurement and recognition of compensation expense for all share-based payment awards made to employees and directors, including stock options, stock settled stock appreciation rights (“SARS”), restricted stock and employee and director stock purchases related to the Employee Stock Purchase Plan, Nonqualified Employee Stock Purchase Plan, and Directors Stock Purchase Plan, based on fair values.
Share-based compensation expense recognized is based on the value of the portion of share-based payment awards that is ultimately expected to vest. Share-based compensation expense recognized in our Consolidated Statement of Operations and Comprehensive Income for the year ended December 31, 2007 includes compensation expense for:
Share-based payment awards granted prior to, but not yet vested, as of December 31, 2006 based on the grant date fair value estimated in accordance with the pro forma provisions of SFAS 123, and
See Note 13 to the Consolidated Financial Statements for additional information.
Upon adoption of SFAS 123(R), we elected to value share-based payment awards granted in 2006 and subsequent using the Black-Scholes option-pricing model, (“Black-Scholes model”) which was also previously used for the pro forma information required under SFAS 123. The determination of fair value of share-based payment awards on the date of grant using the Black-Scholes model is affected by our stock price, as well as the input of other subjective assumptions. These assumptions include, but are not limited to the expected term of stock options and SARS and our expected stock price volatility over the term of the awards. Options and the option component of the Employee and Directors Stock Purchase Plans shares have characteristics significantly different from those of traded options, and changes in the assumptions can materially affect the fair value estimates.
We have no off-balance sheet arrangements (as that term is defined in Item 303(a) (4) of Regulation S-K) that have or are reasonably likely to have a current or, future effect on our financial condition, changes in financial condition, revenue or expenses, results of operations, liquidity, capital expenditures or capital resources that is material to investors as of December 31, 2007.
An increase in our marketing personnel, as well as an increase in the number of our preferred agents.
The commercial lines segment in-force policy counts increased by 130.6% for the year ended December 31, 2007. The introduction of the antique/collector vehicle program accounted for 67.4% of the 130.6% total policy count increase for the period. The other factors discussed above accounted for the remaining 32.6% increase in the policy counts for the period.
Large commercial property-driven accounts located in non-coastal areas of the country;
Commercial package business with annual premiums in excess of $100,000; and
Realized average rate decreases on renewal business approximating 3.6% and 1.8% during 2007 for the commercial lines and specialty lines segments, respectively.
For our commercial lines segment, our property catastrophe costs were higher for the year ended December 31, 2007 compared to December 31, 2006. For our June 1, 2007 commercial lines segment property catastrophe reinsurance renewal, we experienced lower reinsurance rates, purchased increased catastrophe limits due to higher exposures primarily in the Northeast part of the country, and maintained the same catastrophe loss retention compared to our June 1, 2006 renewal.
Certain of our reinsurance contracts have reinstatement or additional premium provisions under which we must pay reinstatement or additional reinsurance premiums to reinstate coverage provisions upon utilization of initial reinsurance coverage. During the
Net Investment Income: Net investment income increased 27.8% to $117.2 million in 2007 from $91.7 million in 2006. Total investments grew by 23.9% to $3,015.2 million as of December 31, 2007 from $2,433.6 million as of December 31, 2006. The growth in investment income is primarily due to increased investments which arose from investing net cash flows provided from our operating activities. In addition, during 2007, there was a general decrease in interest rates, the impact of which was mitigated in part by our decision to increase the average duration of our portfolio.
The average duration of our fixed maturity portfolio was 5.0 years and 4.6 years as of December 31, 2007 and 2006, respectively. Our decision to increase the average duration of our fixed maturity portfolio was based upon enterprise risk management analyses completed during 2006 and 2007 which indicated the capacity to further refine the risk/return profile of our investment portfolio. Based upon the analyses, the following actions were implemented:
The total pre-tax return, which includes the effects of both income and price returns on securities, of our fixed income portfolio was 5.65% and 4.57% for the years ended December 31, 2007 and 2006, respectively, compared to the Lehman Brothers Intermediate Aggregate Bond Index (“the Index”) total pre-tax return of 7.02% and 4.63% for the same periods, respectively. We expect some variation in our portfolio’s total return compared to the Index because of the differing sector, security and duration composition of our portfolio as compared to the Index.
Net Realized Investment Gain (Loss): Net realized investment gains (losses) were $29.6 million and $(9.9) million for the years ended December 31, 2007 and 2006, respectively.
For the year ended December 31, 2007, we realized net investment gains of $0.8 million and $36.7 million from the sale of fixed maturity and equity securities, respectively, and $0.6 million and $7.3 million in non-cash realized investment losses for fixed maturity and equity securities, respectively, as a result of our impairment evaluations. The $36.7 million in net realized gains from the sale of equity securities included approximately $22.2 million of net realized gains as a result of the liquidation of one of our equity portfolios following our decision to change one of our common stock investment managers.
The increase in net loss and loss adjustment expenses was primarily due to:
Net reserve actions taken during the year ended December 31, 2007 decreased net estimated unpaid loss and loss adjustment expenses for accident years 2006 and prior by $85.8 million, as compared to net reserve actions taken during the year ended December 31, 2006 which decreased estimated net unpaid loss and loss adjustment expenses for accident years 2005 and prior by $91.4 million. Decreases in the estimated net unpaid loss and loss adjustment expenses for prior accident years during the year ended December 31, 2007 were as follows:
For accident year 2006, the decrease in estimated net unpaid loss and loss adjustment expenses was principally due to lower estimates for:
Commercial property, professional liability, and commercial automobile coverages due to better than expected case incurred loss development, primarily as a result of both claim frequency and severity emergence being less than anticipated, and
Professional liability, management liability and commercial property coverages due to better than expected case incurred loss development primarily as a result of claim severity being less than anticipated.
General liability and commercial automobile coverages due to better than expected case incurred loss development, primarily as a result of both claim frequency and severity emergence being less than anticipated.
An increase in the current accident year net ultimate loss and loss adjustment expense ratio for the year ended December 31, 2007 compared to 2006. During the year ended December 31, 2007, a net ultimate loss and loss adjustment expense ratio of
A $7.5 million net loss and loss adjustment expense estimate which we recognized for the October 2007 California wildfires during 2007. We incurred no such catastrophe losses during 2006.
An increase in the net ultimate loss and loss adjustment expense ratio for property business in the commercial lines segment due primarily to weather related losses, and a higher frequency of large fire losses during 2007 compared to 2006; and
Realized average rate decreases on renewal business approximating 3.6% and 1.8% for the commercial and specialty lines segments, respectively, for 2007 compared to 2006.
A $1.6 million increase in amortization expense of intangible assets for the renewal rights of insurance policies which we purchased during 2007 and 2006.
Premiums: Premium information for our business segments is as follows (dollars in millions):
A decrease in the lawyers professional liability gross written premium of $7.1 million as a result of non-renewing policies due to unacceptable underwriting results. Total 2006 gross written premium for the lawyers professional liability product was $11.8 million. We will continue to non-renew our remaining lawyers professional liability business in 2007.
The respective net written premiums, and net earned premiums for commercial lines, specialty lines and personal lines segments for the year ended December 31, 2006 vs. the year ended December 31, 2005, were as follows (dollars in millions):
Our decision to terminate our net liability cession under our quota share reinsurance agreement whereby we had ceded 10% of our commercial and specialty lines net written and earned premiums and loss and loss adjustment expenses for policies commencing during 2004. Pursuant to the agreement, during the year ended December 31, 2005, we ceded $43.7 million ($36.5 million for the commercial lines segment, $7.1 million for the specialty lines segment, and $0.1 million for the personal lines segment) of net earned premiums, which represented the unearned premium reserves as of December 31, 2004 on policies commencing during 2004. No earned premiums were ceded pursuant to this agreement during 2006 due to our decision to terminate the agreement on a run-off basis effective December 31, 2004.
We also experienced our higher property catastrophe reinsurance costs, increased catastrophe loss retentions, and decreased catastrophe coverage limits for our June 1, 2006 reinsurance renewal compared to the June 1, 2005 renewal as a result of the hardening property catastrophe reinsurance market.
Net Realized Investment Gain (Loss): Net realized investment gains (losses) were $(9.9) million and $9.6 million for the years ended December 31, 2006 and 2005, respectively. For the year ended December 31, 2006, we realized net investment gains (losses) of $(1.5) million and $0.4 million from the sale of fixed maturity and equity securities, respectively, and $4.6 million and $4.2 million in realized investment losses for fixed maturity and equity securities, respectively, as a result of our impairment evaluation. The $4.6 million in realized investment losses for fixed maturities resulting from our impairment evaluation included approximately $4.2 million of realized investment losses on available for sale fixed maturity investments that were recognized as of September 30, 2006 and subsequently sold during the fourth quarter of 2006 as a result of tax planning and investment portfolio management strategies.
The decrease in net loss and loss adjustment expenses was primarily due to:
Net reserve actions taken during the year ended December 31, 2006, wherein the net estimated unpaid loss and loss adjustment expenses for accident years 2005 and prior were decreased by $91.4 million, as compared to net reserve actions taken during the year ended December 31, 2005 wherein the estimated net unpaid loss and loss adjustment expenses for accident years 2004 and prior were decreased by $29.9 million. Decreases in the estimated net unpaid loss and loss adjustment expenses for prior accident years during the year ended December 31, 2006 were as follows:
Establishing loss reserve estimates is a necessarily complex and imprecise process. Our methodology is to employ several generally accepted actuarial methods to determine net unpaid loss and loss adjustment expenses. Over time, more reliance is placed on actuarial methods based on actual loss development, and accordingly, over time, less reliance is placed on actuarial methods based on expected loss development. The principal factor contributing to the decreases in the estimated net unpaid loss and loss adjustment expenses for prior accident years is the reconsideration of an assumption underlying previous estimates that loss ratio deterioration would result from the high growth rates we experienced in the most recent accident years. As actual losses experienced on these accident years have continued to be lower than anticipated, it has become more likely that the ultimate loss ratio will prove to be better than originally estimated. Over time, greater credibility has been given to this favorable trend by applying greater weight to actuarial methods based on actual loss development. The result is a reduction to these years’ net unpaid loss and loss adjustment expenses, which, in turn, leads to lower ultimate loss ratio expectations for the more recent accident years. As significant weight is given to actuarial methods based on expected losses for the more recent accident years, the result of lower expectations is a reduction to these years’ net unpaid loss and loss adjustment expenses.
A reduction in the current accident year net ultimate loss and loss adjustment expense ratio, excluding catastrophe losses, for the year ended December 31, 2006 compared to 2005. During the year ended December 31, 2006, a net ultimate loss and loss adjustment expense ratio, excluding catastrophe losses, of 47.6% was estimated for the 2006 accident year. During the year ended December 31, 2005, a net ultimate loss and loss adjustment expense ratio, excluding catastrophe losses, of 51.7% was estimated for the 2005 accident year.
These decreases to net loss and loss adjustment expenses incurred were partially offset by increases to net loss and loss adjustment expenses resulting from:
Acquisition Costs and Other Underwriting Expenses: Acquisition costs and other underwriting expenses increased $74.5 million (28.2%) to $338.3 million for the year ended December 31, 2006 from $263.8 million for the year ended December 31, 2005, and the expense ratio increased to 28.9% in 2006 from 27.0% in 2005. The increase in acquisition costs and other underwriting expenses was due primarily to the following:
These increases were partially offset by a $9.3 million change in net charges related to assessments from Citizen’s Property Insurance Corporation (“Citizens”). During 2006, we recognized a net reduction to expense of $3.4 million related to Citizens assessments, compared to a net increase to expense of $5.9 million related to Citizens assessments during 2005. The $3.4 million reduction to expense during 2006 is comprised of:
The $1.6 million reduction in expense related to the 2004 assessment is attributable to net policyholder surcharges related to premiums written during 2006. The $1.8 million reduction in expense related to the 2005 assessment is attributable to a reduction in the actual 2005 assessment paid to Citizens, compared to the amount that was estimated by Citizens and accrued by us as of December 31, 2005.
During the fourth quarter of 2005, Citizens announced that it was projecting the maximum ten percent regular assessment allowed under Florida law plus an additional emergency assessment of approximately one percent to be assessed during 2006 due to the hurricanes that struck Florida in 2005. During 2006, the Florida legislature approved a $715 million budget appropriation to be used to reduce the Citizens deficit and resulting assessments to insurers. This budget appropriation resulted in the $1.8 million reduction to our net assessment expense.
Our investment objectives are the realization of relatively high levels of after-tax net investment income with competitive after-tax total rates of return subject to established specific guidelines and objectives. We utilize external independent professional investment managers for our fixed maturity and equity investments. These investments consist of diversified issuers and issues, and as of December 31, 2007 approximately 87.8% and 10.7% of our total invested assets (total investments plus cash equivalents) on a cost basis consisted of investments in fixed maturity and equity securities, respectively, versus 86.0% and 10.4%, respectively, as of December 31, 2006.
Our impairment evaluation as of December 31, 2007 for fixed maturities available for sale excluding interests in securitized assets resulted in the following conclusions:
The unrealized losses on our long term investments in Corporate bonds which have ratings from Baa3/BBB to Aaa/AAA are generally caused by spread widening. Of the 73 investment positions held, approximately 79.5% were in an unrealized loss position. The contractual terms of the investments do not permit the issuer to settle the securities at a price less than the amortized cost of the investments.
Our impairment evaluation as of December 31, 2007 for interests in securitized assets resulted in the following conclusions:
The unrealized losses on our investments in Mortgage Pass-Through Securities which have ratings of Aaa/AAA are generally caused by spread widening. Of the 150 investment positions held, approximately 38.7% were in an unrealized loss position. The contractual terms of the investments do not permit the issuer to settle the security at a price less than the amortized cost of the investments.
The fair value of our structured securities investment portfolio (Asset Backed, Mortgage Pass-Through and Collateralized Mortgage Obligation securities) amounted to $1,143.3 million as of December 31, 2007. AAA rated securities represented approximately 99.8% of our December 31, 2007 structured securities portfolio. Approximately $947.7 million of our structured securities investment portfolio is backed by residential collateral, consisting of:
$21.6 million of structured securities backed by pools of ALT A loans (loans with low documentation and borrowers with FICO scores in the approximated range of 650 to the low 700’s); and
Our $27.6 million ALT-A and sub-prime overall AAA rated loan portfolio is comprised of 22 securities with net unrealized losses of $0.0 million as of December 31, 2007. These securities have the following characteristics:
have not experienced any ratings downgrades or surveillance issues as of December 31, 2007.
Given a combination of recent events in the housing and mortgage finance sectors and the issues surrounding the monoline financial guarantors, we believe that fixed income and equity markets, in general, may experience more volatility than during recent historical reporting periods. As of December 31, 2007, we had no impairments or surveillance issues related to these market conditions. However, we expect that ongoing volatility in these sectors, in particular, and in spread related sectors, in general, may impact the prices of securities held in our overall Aaa/AAA rated investment portfolio.
Our $1,389.1 million municipal bond overall AAA rated portfolio consists of $865.7 million of insured securities, or 62.3% of our total municipal bond portfolio. The weighted average underlying rating of the insured portion of our municipal bond portfolio is AA- and the weighted average rating of the uninsured portion of our municipal bond portfolio is AA+. The following table represents our insured bond portfolio by monoline insurer as of December 31, 2007:
Our impairment evaluation as of December 31, 2006 for fixed maturities available for sale, excluding interests in securitized assets, resulted in the following conclusions:
The unrealized losses on our investments in long term tax exempt securities which have ratings of A1/A+ to AAA/Aaa are generally caused by interest rate increases. Of the 736 investment positions held, approximately 49.3% were in an unrealized loss position. The contractual terms of the investments do not permit the issuer to settle the securities at a price less than the amortized cost of the investments. Therefore, it is expected that the securities would not be settled at a price less than the amortized cost of the investments.
The unrealized losses on our long term investments in corporate bonds which have ratings from Baa3/BBB to Aaa/AAA are generally caused by interest rate increases. Of the 114 investment positions held, approximately 87.7% were in an unrealized loss position. The contractual terms of the investments do not permit the issuer to settle the securities at a price less than the amortized cost of the investments. Therefore, it is expected that the securities would not be settled at a price less than the amortized cost of the investments.
The unrealized losses on our investments in Collateralized Mortgage Obligations which have ratings of Aa2/AA to Aaa/AAA are generally caused by interest rate increases. Of the 155 investment positions held, approximately 66.5% were in an unrealized loss position. The contractual terms of the investments do not permit the issuer to settle the security at a price less than the amortized cost of the investments. Therefore, it is expected that the securities would not be settled at a price less than the amortized cost of the investments.
Our impairment evaluation as of December 31, 2006 for equity securities resulted in the conclusion that we do not consider the equity securities to be other than temporarily impaired. Of the 3,555 investment positions held, approximately 14.8% were in an unrealized loss position.
Our financial instruments are subject to the market risk of potential losses from adverse changes in market rates and prices. The primary market risks to us are equity price risks associated with investments in equity securities and interest rate and spread risks associated with investments in fixed maturities. We have established, among other criteria, duration, asset quality and asset allocation guidelines for managing our investment portfolio market risk exposure. Our investments are classified as Available for Sale and consist of diversified issuers and issues.
We produced $26.5 million of net cash from financing activities during 2007. Cash provided from financing activities consisted of a
$5.9 million excess tax benefit from the issuance of shares pursuant to our stock based compensation plans; $8.0 million from our stock purchase plans; $6.6 million from the exercise of stock options issued under our performance based compensation plan and $6.0 million from the collection of notes receivable associated with our employee stock purchase plans.
Effective June 29, 2007, we amended our unsecured $50.0 million Credit Agreement (“the Credit Agreement”) to extend the maturity date to June 27, 2008. The Credit Agreement provides capacity for working capital and other general corporate purposes. The Credit Agreement contains various representations, covenants and events of default typical for credit facilities of this type. As of December 31, 2007, no borrowings were outstanding under the Credit Agreement.
Two of our Insurance Subsidiaries are members of the Federal Home Loan Bank of Pittsburgh (“FHLB”). A primary advantage of FHLB membership is the ability of members to access credit products from a reliable capital markets provider. The availability of any one member’s access to credit is based upon its FHLB eligible collateral. The borrowing capacity provides an immediately available line of credit. As of December 31, 2007, our Insurance Subsidiaries had no borrowings outstanding, and their unused borrowing capacity was $708.4 million.
We have certain contractual obligations and commitments as of December 31, 2007 which are summarized below:
Although there is typically no minimum contractual commitment with insurance contracts, the cash flows displayed in the table above represent our best estimate as to amount and timing of such.
As of December 31, 2007, we have recorded a $0.2 million liability for uncertain tax positions in accordance with FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109” (“FIN 48”). Due to the uncertain nature of the timing of future cash flows relating to the liability and the inability to make a reasonably
Property and casualty insurance premiums are established before the amount of losses and loss adjustment expenses, or the extent to which inflation may affect such amounts, is known. We attempt to anticipate the potential impact of inflation in establishing our premiums and reserves. Substantial future increases in inflation could result in future increases in interest rates, which, in turn, are likely to result in a decline in the market value of our investment portfolio and results in unrealized losses and/or reductions in shareholders’ equity.
In September 2006, the FASB issued Statement No. 157, “Fair Value Measurements” (“SFAS No. 157”), which clarifies that the term “fair value” is intended to represent a market-based measure, not an entity-specific measure, and gives the highest priority to quoted prices in active markets (Level 1 inputs) in determining fair value. SFAS No. 157 requires disclosures about (1) the extent to which companies measure assets and liabilities at fair value, (2) the methods and assumptions used to measure fair value, and (3) the effect of fair value measurements on earnings. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007. We are currently in the process of evaluating the impact of SFAS No. 157; however, we anticipate that SFAS No. 157 will primarily impact the fair value measurement and disclosures of our investments in equity securities and fixed maturities available for sale. Our initial assessment is as follows:
The fair value of our investments in the remainder of our fixed maturities available for sale is primarily measured using a market based valuation methodology using primarily vendor pricing (Level 2 inputs per SFAS No. 157).
In February 2007, the FASB issued Statement No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities,” (“SFAS No. 159”) which permits all entities the option to elect, at specified election dates, to measure eligible financial instruments at fair value. An entity must report unrealized gains and losses on items for which the fair value option has been elected in earnings at each subsequent reporting date, and recognize upfront costs and fees related to those items in earnings as incurred and not deferred. SFAS No. 159 applies to fiscal years beginning after November 15, 2007, with early adoption
Consolidated Statements of Operations and Comprehensive Income - For the Years Ended December 31, 2007, 2006 and 2005
Condensed Financial Information of Registrant As of December 31, 2007 and 2006 and For Each of the Three Years in the Period Ended December 31, 2007
Supplementary Insurance Information As of and For the Years Ended December 31, 2007, 2006 and 2005
The Company designs, markets, and underwrites specialty commercial and personal property and casualty insurance products for select target industries or niches including, among others, nonprofit and religious organizations; sports and recreation centers; the rental car, automobile leasing and the antique and collector car industries; special property for large commercial accounts; select classes of professional liability; and casualty insurance products for the homeowners and manufactured housing markets. All marketing, underwriting, claims management, investment, and general administration is provided by the underwriting manager and managing general agency.
For non-investment grade structured securities for which a vendor price is not available, broker pricing is obtained from either the lead manager of the issue or from the broker used at the time the security was purchased. Material assumptions and factors considered by the independent vendors and brokers in pricing these securities may include: cash flows, collateral performance including delinquencies, default, and recoveries and any market clearing activity and/or liquidity circumstances in the security or other benchmark securities that may have occurred since the prior month-end pricing period.
Cash flow assumptions for structured securities are obtained from a primary market provider of such information. These assumptions represent a market based best estimate of the amount and timing of estimated principal and interest cash flows based on current information and events. Prepayment assumptions for asset/mortgage backed securities consider a number of factors in estimating the prepayment activity, including seasonality (the time of year), refinancing incentive (current level of interest rates), economic activity (including housing turnover) and burnout/seasoning (the term and age of the underlying collateral).
The decision to purchase or sell investments is based on management’s assessment of various factors such as foreseeable economic conditions, including current interest rates and the interest rate risk, and the liquidity and capital positions of the Company.
Property and equipment are recorded at cost and depreciated using the straight-line method over the estimated useful lives of the respective assets. Costs incurred in developing information systems technology are capitalized and included in property and equipment. These costs are amortized over their useful lives from the dates the systems technology becomes operational. Upon disposal of assets, the cost and related accumulated depreciation are removed from the accounts, and the resulting gain or loss is reflected in earnings. The carrying value of property and equipment is reviewed for recoverability including an evaluation of the estimated useful lives of such assets.
Premiums are earned on a pro-rata basis over the terms of the policies. Premiums applicable to the unexpired terms of the policies in-force are reported as unearned premiums. The Company records an allowance for doubtful accounts for premiums receivable balances estimated to be uncollectible. As of December 31, 2007 and 2006, the allowance for doubtful accounts amounted to $0.5 million and $0.3 million, respectively.
Certain of the Company’s reinsurance contracts have reinstatement or additional premium provisions under which the Company must pay reinstatement or additional reinsurance premiums to reinstate coverage provisions upon utilization of initial reinsurance coverage. The Company accrues reinstatement and additional premiums based on ultimate loss estimates. During the years ended December 31, 2007 and 2006, the Company accrued $5.0 million and $5.3 million, respectively, of additional reinsurance premium under its casualty excess of loss reinsurance treaties as a result of changes in ultimate loss estimates.
Basic earnings per share has been calculated by dividing net income by the weighted-average common shares outstanding. Diluted earnings per share has been calculated by dividing net income by the weighted-average common shares outstanding and the weighted-average share equivalents outstanding.
Components of comprehensive income, as detailed in the Consolidated Statements of Operations and Comprehensive Income, are net of tax. The related tax effect of Holding Gains (Losses) arising during the year was $15.5 million, $11.4 million and $(8.8) million in 2007, 2006 and 2005, respectively. The related tax effect of Reclassification Adjustments was $(10.3) million, $3.5 million and $(3.4) million in 2007, 2006 and 2005, respectively.
In February 2006, the Financial Accounting Standards Board (“FASB”) issued Statement No. 155 “Accounting for Certain Hybrid Financial Instruments” (“SFAS No. 155”). Subsequently, SFAS No. 155 was modified. Under current generally accepted accounting principles, an entity that holds a financial instrument with an embedded derivative, subject to certain scope exceptions, must bifurcate the financial instrument, resulting in the host and the embedded derivative being accounted for separately. SFAS No. 155 permits, but does not require, entities to account for financial instruments with an embedded derivative at fair value thus negating the need to bifurcate the instrument between its host and the embedded derivative. SFAS No. 155 is effective as of the beginning of the first annual reporting period that begins after September 15, 2006. The Company adopted SFAS No. 155 on January 1, 2007. The adoption of SFAS No. 155 did not have a material effect on the financial condition or results of operations of the Company.
In September 2006, the FASB issued Statement No. 157, “Fair Value Measurements” (“SFAS No. 157”), which clarifies that the term “fair value” is intended to represent a market-based measure, not an entity-specific measure, and gives the highest priority to quoted prices in active markets (Level 1 inputs) in determining fair value. SFAS No. 157 requires disclosures about (1) the extent to which companies measure assets and liabilities at fair value, (2) the methods and assumptions used to measure fair value, and (3) the effect of fair value measurements on earnings. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007. The Company is currently in the process of evaluating the impact of SFAS No. 157; however, it anticipates that SFAS No. 157 will primarily impact the fair value measurement and disclosures of its investments in equity securities and fixed maturities available for sale. The Company’s initial assessment is as follows:
The fair value of its investments in government securities and equity securities is primarily measured using a market based valuation methodology primarily using quoted market prices in active markets (Level 1 inputs per SFAS 157).
In February 2007, the FASB issued Statement No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities,” (“SFAS No. 159”) which permits all entities the option to elect, at specified election dates, to measure eligible financial instruments at fair value. An entity must report unrealized gains and losses on items for which the fair value option has been elected in earnings at each subsequent reporting date, and recognize upfront costs and fees related to those items in earnings as incurred and not deferred. SFAS No. 159 applies to fiscal years beginning after November 15, 2007, with early adoption permitted for an entity that has also elected to apply the provisions of SFAS No. 157. An entity is prohibited from retrospectively applying SFAS No. 159, unless it chooses early adoption. SFAS No. 159 also applies to eligible items existing as of November 15, 2007 (or early adoption date). The Company is currently in the process of evaluating the impact of SFAS No. 159; however it does not currently anticipate electing the fair value option for any of its eligible financial instruments.
In December 2007, the FASB issued Statement No. 160, “Noncontrolling Interests in Consolidated Financial Statements. - an amendment of ARB No. 51” (“SFAS No. 160”), which establishes accounting and reporting standards for the non-controlling interests in a subsidiary and for the deconsolidation of a subsidiary. SFAS No. 160 requires that the ownership interests and the net income of the non-controlling interest be equally identified from that of the parent on the face of the financial statements. SFAS No. 160 also provides consistent accounting principles for changes in a parent controlling ownership interest in a subsidiary, and that any retained non-controlling financial interests in a deconsolidated subsidiary be measured at fair value. SFAS No. 160 applies to fiscal years beginning on or after December 15, 2008, and is applied prospectively, except for presentation and disclosure requirements, which are applied retrospectively for all periods presented. The Company is currently in the process of evaluating the impact of SFAS No. 160.
Under SAP, policy acquisition costs, such as commissions, premium taxes, fees, and other costs of underwriting policies are charged to current operations as incurred, while under GAAP, such costs are deferred and amortized on a pro-rata basis over the same period in which the related premiums are earned.
Under SAP, the costs and related policyholder surcharge receivables for guaranty funds and other assessments are recorded based on management’s estimate of the ultimate liability and related ultimate policyholder surcharge receivable, while under GAAP, such costs are accrued when the liability is probable and reasonably estimatable, and the related policyholder surcharge receivable is accrued as the related premium is written.
Under SAP, unpaid losses and loss adjustment expenses and unearned premiums are reported net of the effects of reinsurance transactions, under GAAP, unpaid loss and loss adjustment expenses and unearned premiums are reported gross of reinsurance.
Financial Information: The combined statutory capital and surplus of the Insurance Subsidiaries as of December 31, 2007 and 2006 was $1,298.8 million and $1,007.5 million, respectively. Combined statutory net income for the years ended December 31, 2007, 2006 and 2005 was $299.2 million, $270.9 million and $155.5 million, respectively. The Company made no capital contributions to the Insurance Subsidiaries during the years ended December 31, 2007 or 2006.
Dividend Restrictions: The Insurance Subsidiaries are subject to various regulatory restrictions which limit the maximum amount of annual shareholder dividends permitted to be paid. The maximum dividends which the Insurance Subsidiaries are permitted to pay to Philadelphia Insurance during 2008 without prior approval is $299.2 million. During 2007, PCHC received $3.5 million in dividend payments from its Insurance Subsidiaries. During 2006, PCHC received no dividend payments from its Insurance Subsidiaries.
insurer. The adequacy of a company’s actual capital and surplus is evaluated by a comparison to the risk-based capital results. Insurers failing to meet minimum risk-based capital requirements may be subject to scrutiny by the insurer’s domiciliary insurance department and ultimately rehabilitation or liquidation. As of December 31, 2007, the Company’s Insurance Subsidiaries exceeded their minimum risk-based capital requirements as follows (dollars in millions):
Estimated market values are based on quoted market prices or quotes from third party broker-dealers.
The Company’s impairment evaluation as of December 31, 2007 for fixed maturities available for sale excluding interests in securitized assets resulted in the following conclusions:
The unrealized losses on the Company’s investments in long term tax exempt securities which have ratings of A1/A+ to Aaa/AAA are attributable to the spread widening. Of the 873 investment positions held, approximately 32.8% were in an unrealized loss position. The contractual terms of the investments do not permit the issuer to settle the securities at a price less than the amortized cost of the investments. Therefore, it is expected that the securities would not be settled at a price less than the amortized cost of the investments.
The Company’s impairment evaluation as of December 31, 2007 for interests in securitized assets resulted in the following conclusions:
The unrealized losses on the Company’s investments in Asset Backed Securities which have ratings from A2/A to Aaa/AAA are attributable to the spread widening. Of the 116 investment positions held, approximately 40.5% were in an unrealized loss position. The contractual terms of the investments do not permit the issuer to settle the security at a price less than the amortized
The unrealized losses on the Company’s investments in U.S. Government Agency Issued Mortgage Pass-Through Securities which have ratings of Aaa/AAA are attributable to the spread widening. Of the 150 investment positions held the average rating was Aaa/AAA and approximately 38.7% were in an unrealized loss position. The contractual terms of the investments do not permit the issuer to settle the security at a price less than the amortized cost of the investments. Therefore, it is expected that the securities would not be settled at a price less than the amortized cost of the investments.
The fair value of the Company’s structured securities investment portfolio (Asset Backed, Mortgage Pass-Through and Collateralized Mortgage Obligation securities) amounted to $1,143.3 million as of December 31, 2007. AAA rated securities represented approximately 99.8% of the December 31, 2007 structured securities portfolio. Approximately $947.7 million of the structured securities investment portfolio is backed by residential collateral, consisting of:
$76.3 million of non-U.S. government agency Collateralized Mortgage Obligations backed by pools of prime loans (generally consists of loans made to the highest credit quality borrowers with Fair Isaac Corporation (“FICO”) scores generally greater than 720);
The Company’s $27.6 million ALT-A and sub-prime overall AAA rated loan portfolio is comprised of 22 securities with net unrealized losses of $0.0 million as of December 31, 2007. These securities have the following characteristics:
are spread across multiple vintages (origination year of underlying collateral pool); and
As of December 31, 2007, the Company holds no investments in Collateralized Debt Obligations or Net Interest Margin securities.
The Company’s $1,389.1 million municipal bond overall AAA rated portfolio consists of $865.7 million of insured securities, or 62.3% of our total municipal bond portfolio. The weighted average underlying rating of the insured portion of our municipal bond portfolio is AA- and the weighted average underlying ratio of the uninsured portion of our municipal bond portfolio is AA+. The following table represents our insured bond portfolio by monoline insurer as of December 31, 2007:
During 2007, the Company’s gross loss on the sale of fixed maturity and equity securities amounted to $0.3 million and $5.0 million, respectively. The fair value of the fixed maturity and equity securities at the time of sale was $33.7 million and $39.6 million, respectively.
The cost and estimated market value of fixed maturity securities as of December 31, 2007, by remaining contractual maturity, are shown below. Expected maturities may differ from contractual maturities because certain borrowers have the right to call or prepay obligations with or without call or prepayment penalties.
Estimated market values have been based on quoted market prices or quotes from third party broker-dealers.
The sources of net investment income for the years ended December 31, 2007, 2006 and 2005 are as follows (in thousands):
The Insurance Subsidiaries have investments, principally U.S. Treasury securities and Obligations of States and Political Subdivisions, on deposit with the various states in which they are licensed insurers. The carrying value of the securities on deposit was $15.7 million and $15.1 million as of December 31, 2007 and 2006, respectively.
The Company maintains investments in trust accounts under certain reinsurance agreements with unrelated insurance companies. These investments collateralize the Company’s obligations under the reinsurance agreements. The Company possesses sole responsibility for investment and reinvestment of the trust account assets. All dividends, interest and other income resulting from investment of these assets are distributed to the Company on a monthly basis. As of December 31, 2007 and 2006, the carrying values of these trust fund investments and cash balances were $1.3 million and $2.0 million, respectively.
As of December 31, 2007 and 2006, costs incurred for Property and Equipment not yet placed in service amounted to $2.7 million and $3.7 million, respectively. Amortization of costs incurred in developing or purchasing computer software amounted to $3.9 million, $4.1 million and $2.6 million for the years ended December 31, 2007, 2006 and 2005, respectively. Depreciation expense, excluding amortization of computer software, amounted to $4.2 million, $3.1 million and $2.1 million for the years ended December 31, 2007, 2006 and 2005, respectively.
The Company has no goodwill carried on its Consolidated Balance Sheets as of December 31, 2007 or 2006. During the fourth quarter of 2005, the Company recorded a $25.7 million impairment charge related to the write-down of goodwill arising from the acquisition of the Company’s personal lines segment. This loss, which was the same on a pre-tax and after-tax basis, was a result of the Company’s annual evaluation of the carrying value of goodwill. The write-down was determined by comparing the fair value of the Company’s personal lines segment and the implied value of the goodwill with the carrying amounts on the balance sheet. The write-down resulted from changes in business assumptions primarily due to the following: the unprecedented hurricane activity and associated catastrophe losses experienced in 2004 and 2005; the uncertainty of the 2006 catastrophe reinsurance renewal rates; the forecasted weather pattern of increased hurricane activity; the decision to change the personal lines segment business model to discontinue writing the mobile homeowners business and target new construction homeowners business; and the disruption in the Florida marketplace.
During the year ended December 31, 2006, net loss and loss adjustment expense payments for claims attributable to prior years are lower by $31.9 million due to the Company’s commutation of its 2004 Whole Account Net Quota Share Reinsurance Agreement.
During 2007, the Company increased/(decreased) the estimated net unpaid loss and loss adjustment expenses for accident years 2006 and prior by the following amounts:
Management liability coverages due to better than expected case incurred loss development primarily as a result of claim severity emergence being less than anticipated.
For accident year 2005, the decrease in estimated net unpaid loss and loss adjustment expenses was principally due to lower loss estimates for:
Professional liability, commercial general liability, rental leasing and management liability coverages due to better than expected case incurred loss development primarily as a result of claim severity emergence being less than anticipated.
For accident year 2003 and prior, the decrease in estimated net unpaid loss and loss adjustment expenses was principally due to lower loss estimates for:
For accident year 2005, the decrease in estimated net unpaid loss and loss adjustment expenses was principally due to lower estimates for commercial coverages due to better than expected case incurred loss development resulting from less than anticipated incurred frequency emergence on general liability coverages, and less than anticipated severity emergence on property and auto coverages.
For accident year 2004, the decrease in estimated net unpaid loss and loss adjustment expenses was principally due to lower estimates for commercial coverages due to better than expected case incurred loss development resulting from less than anticipated incurred frequency emergence on general liability coverages, and less than anticipated incurred severity emergence on auto coverages.
For accident year 2003, the decrease in estimated net unpaid loss and loss adjustment expenses was principally due to lower estimates for professional liability coverages and rental/leasing auto coverages due to better than expected case incurred loss development resulting from less than anticipated incurred severity emergence on professional liability E&O and D&O coverages, and less than anticipated incurred frequency emergence on leasing auto coverages.
During 2005, the Company increased/(decreased) the estimated total net unpaid losses and loss adjustment expenses for prior accident years by the following amounts:
For accident year 2002, the decrease in estimated net unpaid loss and loss adjustment expenses and prior was principally due to decreased loss estimates across most commercial and specialty lines of business due to better than expected case incurred loss development.
The composition of deferred tax assets and liabilities and the related tax effects as of December 31, 2007 and 2006 are as follows (in thousands):
Based on the Company’s federal tax loss and capital loss carryback availability, expected levels of future pre-tax financial statement income and federal taxable income, the Company believes that it is more likely than not that the existing deductible temporary differences will reverse during periods in which net federal taxable income is generated or have adequate federal carryback availability. As a result, no valuation allowance is recognized for deferred income tax assets as of December 31, 2007 or 2006.
As of December 31, 2007, the total amount of unrecognized tax benefits that, if recognized, would affect the effective tax rate was $0.2 million. The Company does not believe that it is reasonably possible that the $0.2 million of unrecognized tax benefits as of December 31, 2007 shown in the table above will significantly increase or decrease within the next twelve months.
The Company and its subsidiaries file Federal and State income tax returns as required, and is subject to Federal and State examinations for tax years 2002 through 2006, and 2004 through 2006, respectively.
Philadelphia Insurance has entered into tax sharing agreements with each of its subsidiaries. Under the terms of these agreements, the income tax provision is computed as if each subsidiary were filing a separate federal income tax return, including adjustments for the income tax effects of net operating losses and other special tax attributes, regardless of whether those attributes are utilized in the Company’s consolidated federal income tax return. As of December 31, 2007 and 2006, income taxes payable amounting to $0.9 million and $6.2 million, respectively were included in Other Liabilities in the Consolidated Balance Sheets.
During 2005, options to purchase 45,000 shares of the Company’s common stock, which were granted at an exercise price of $28.30 per share, were outstanding during the fourth quarter of 2005, but were not included in the computation of earnings per share for 2005 because the options’ price was greater than the average market price of the Company’s common shares for 2005. The options, which expire on October 3, 2015, were outstanding as of December 31, 2005.
The maximum number of shares of the Company’s common stock which may be subject to awards granted under the Plan is 18,750,000. The Plan permits (but does not require) the grant of restricted stock awards under conditions meeting the “performance based” compensation requirements of Section 162(m) of the Internal Revenue Code. The maximum number of shares includes all shares previously available for grants under the stock option plan prior to the adoption of this Plan. As of December 31, 2007, 4,467,018 shares of common stock remain reserved for future issuance pursuant to awards granted under the Plan. Under the Plan, the Company may grant stock options, SARS, restricted stock awards and restricted stock units to participants. Stock options, restricted stock awards and SARS have been granted to certain employees, and restricted stock awards have been granted to the Company’s non-employee directors pursuant to the Plan as of December 31, 2007.
During 2007, the Company granted SARS and restricted stock awards to certain employees and granted restricted stock awards to its non-employee directors. All stock options that have been granted have provided for the purchase of common stock at a price not less than the fair market value on the grant date. A SAR grant consists of a right that is the economic equivalent of a stock option that could have been granted under the Plan, except that on the exercise of a SAR, the employee receives shares of the Company’s common stock having a fair market value that is equal to the fair market value of the shares of common stock that would be subject to such hypothetical option, reduced by the amount that would be required to be paid by the employee as the purchase price upon exercise of such hypothetical option. All grants of SARS have provided for a hypothetical option purchase price of not less than the fair market value on the grant date. Stock options and SARS are generally exercisable after the expiration of five years following the
grant date and expire ten years following the grant date. Compensation expense for stock options and SARS is recognized ratably over the vesting period. Stock options and SARS are generally forfeited by participants who terminate employment prior to vesting.
Compensation expense for restricted stock awards is recognized ratably over the vesting period (“Restriction Period”). Stock subject to restricted stock awards granted to employees during 2007 become free of the risk of forfeiture (i.e., become vested) generally after the expiration of five years following the grant date (the applicable Restriction Period). Stock subject to restricted stock awards granted to the Company’s non-employee directors during 2007 become free of the risk of forfeiture after the expiration of three years following the grant date. Generally, if a participant terminates employment prior to the expiration of the Restriction Period, the award will lapse and all shares of common stock still subject to the restriction are forfeited.
There were no exercisable SARS outstanding as of December 31, 2007 or 2006. The aggregate intrinsic value of outstanding SARS as of December 31, 2007 and 2006 was $5.7 million, and $10.6 million, respectively. The weighted average remaining contractual life of SARS outstanding as of December 31, 2007 and 2006 was 8.5 years and 9.1 years, respectively.
The following table presents information regarding restricted stock award transactions for the years ended December 31, 2007 and 2006.
Employee Stock Purchase Plan (the “Stock Purchase Plan”): The aggregate maximum number of shares that may be issued pursuant to the Stock Purchase Plan, as amended, is 3,000,000. Shares may be purchased under the Stock Purchase Plan by eligible employees during designated one-month offering periods established by the Compensation Committee of the Board of Directors at a purchase price of the lesser of 85% of the fair market value of the shares on the first business day of the offering period or the date the shares are purchased. Shares purchased are restricted for a period of two years from the first day of the offering period. The purchase price of shares may be paid by the employee over six years pursuant to the execution of a promissory note. The promissory note(s) are collateralized by such shares purchased under the Stock Purchase Plan and are interest free. Under the Stock Purchase Plan, the Company issued 99,481 shares and 180,322 shares in 2007 and 2006, respectively. The weighted-average fair value per share of those purchase rights granted in 2007 and 2006 was $7.43 and $5.94, respectively.
period or the date the shares are purchased. Shares purchased are restricted for a period of five years from the first day of the offering period. The purchase price of shares may be paid by the employee over nine years pursuant to the execution of a promissory note. The promissory note(s) are collateralized by such shares purchased under the Nonqualified Stock Plan and are interest free. Under the Nonqualified Stock Plan, the Company issued 399,274 shares and 385,630 shares in 2007 and 2006, respectively. The weighted-average fair value per share of those purchase rights granted in 2007 and 2006 was $7.44 and $6.55, respectively.
Preferred Agents Stock Purchase Plan (“Preferred Agents Plan”): The Preferred Agents Plan has been established for the benefit of eligible Preferred Agents. The aggregate maximum number of shares that may be issued pursuant to the Preferred Agents Plan is 600,000. During designated offering periods, eligible Preferred Agents may either remit cash or have the Company withhold from commissions or other compensation amounts to be used for the purchase of shares under the terms of the Preferred Agents Plan at a purchase price of the lesser of 85% of the fair market value of the shares on the first business day of the offering period or the date the shares are purchased. Shares purchased are restricted for a period of two years from the first day of the offering period. During 2007, there were no shares issued under the plan. During 2006, the Company issued 60,492 shares under the plan. The weighted-average fair value of those purchase rights granted during 2006 was $5.80.
Effective January 1, 2006, the Company adopted Statement of Financial Accounting Standards No. 123 (revised 2004), “Share Based Payment” (“SFAS 123(R)”) using the modified prospective transition method, which requires the measurement and recognition of compensation expense for all share-based payment awards made to the Company’s employees and directors including stock options, stock settled appreciation rights (“SARS”), restricted stock and employee and director stock purchases related to the Employee Stock Purchase Plan, Nonqualified Employee Stock Purchase Plan, and Directors Stock Purchase Plan based on fair values. The Company’s financial statements as of and for the years ended December 31, 2007 and 2006 reflect the impact of SFAS 123(R). In accordance with the modified prospective transition method, the Company’s financial statements for prior periods have not been restated to reflect, and do not include, the impact of SFAS 123(R). Share-based compensation expense recognized is based on the value of the portion of share-based payment awards that is ultimately expected to vest. Share-based compensation expense recognized in the Company’s Consolidated Statement of Operations and Comprehensive Income for the years ended December 31, 2007 and 2006 included compensation expense for:
Compensation expense for the share-based payment awards granted subsequent to December 31, 2006 based on the grant date fair value estimated in accordance with the provisions of SFAS 123(R). In conjunction with the adoption of SFAS 123(R), the Company elected to attribute the value of share-based compensation to expense using the straight-line method, which was previously used for its pro forma information required under SFAS 123. Share-based compensation expense related to stock options and SARS was $9.9 million and $7.3 million, before income taxes for the years ended December 31, 2007 and 2006, respectively.
Share-based compensation expense related to restricted stock grants and employee and director stock purchase plans was $5.6 million and $2.7 million for the years ended December 31, 2007 and 2006, respectively.
As the share-based compensation expense recognized in the Consolidated Statement of Operations and Comprehensive Income for the years ended December 31, 2007 and 2006 is based on awards ultimately expected to vest, it has been reduced for estimated forfeitures. SFAS 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. Forfeitures were estimated based on historical experience.
SFAS 123(R) requires that share-based compensation cost is recorded in the financial statements in the same classifications as the related employees’ cash compensation. Accordingly, upon adoption of SFAS 123(R), a portion of the share-based compensation cost related to unvested awards and new awards has been capitalized as part of the Company’s Deferred Acquisition Costs. As of December 31, 2007 and 2006, approximately $2.7 million and $2.3 million, respectively, of share-based compensation cost is included in Deferred Acquisition Costs on the Consolidated Balance Sheet.
In the normal course of business, the Company has entered into various reinsurance contracts with unrelated reinsurers. The Company participates in such agreements for the purpose of limiting loss exposure and diversifying business. Reinsurance contracts do not relieve the Company from its obligation to policyholders. The loss and loss adjustment expense reserves ceded under such arrangements were $170.0 million and $187.8 million as of December 31, 2007 and 2006, respectively.
As of December 31, 2007, the Company did not have any aggregate unsecured reinsurance receivables due from a single reinsurer that exceeded 3% of shareholders’ equity. Unsecured reinsurance receivables include amounts receivable for paid and unpaid losses and loss adjustment expenses and unearned premium less reinsurance receivables secured by collateral.
The Company has a defined contribution Profit Sharing Plan, which includes a 401K feature, covering substantially all employees. Under the plan, employees may contribute up to an annual maximum of the lesser of 15% of eligible compensation or the applicable Internal Revenue Code limit in a calendar year. The Company makes a matching contribution in an amount equal to 75% of the participant’s pre-tax contribution, subject to a maximum of 6% of the participant’s eligible compensation. The Company may also make annual discretionary profit sharing contributions at each plan year end. Participants are fully vested in the Company’s contribution upon completion of four years of service. The Company’s total contributions to the plan were $2.3 million, $1.8 million and $1.3 million for the years ended December 31, 2007, 2006 and 2005, respectively.
The Company sponsors an unfunded nonqualified key employee deferred compensation plan. Under the plan, deferred compensation benefits are provided through deferrals of base salary and bonus compensation (“Employee Deferrals”) and discretionary contributions by the Company (“Employer Contributions”) for a select group of management and highly compensated employees of the Company and its subsidiaries. Each participant is permitted to specify an investment or investments from among permissible investments which shall be the basis for determining the gain or loss adjustment applicable to such participant’s plan deferral account. A participant’s interest in the portion of his or her plan deferral account that is attributable to Employee Deferrals are fully vested at all times. That portion of a participant’s plan deferral account attributable to Employer Contributions generally will vest over the course of a five year period beginning on the last day of the first year after the plan year for which the Employer Contribution was made. The amounts in each participant’s plan deferral account represent an obligation of the Company to pay the participant at some time in the future. The Company had a deferred compensation obligation pursuant to the plan amounting to $8.8 million and $6.8 million as of December 31, 2007 and 2006, respectively.
The Company also sponsors an unfunded nonqualified executive deferred compensation plan. Under the plan, deferred compensation benefits are provided by the Company through deferrals of base salary and bonus compensation for management and highly compensated executives designated by the Board of Directors. Each participant is permitted to specify an investment or investments from among permissible investments which shall be the basis for determining the gain or loss adjustment applicable to such participant’s plan deferral account. A participant’s benefit under the plan is the amount of such participant’s plan deferral amount. The
Effective June 29, 2007, the Company amended its unsecured Credit Agreement (the “Credit Agreement”) which establishes a revolving credit facility providing for loans to the Company of up to $50.0 million in principal amount outstanding at any one time. The amended Credit Agreement has a maturity date of June 27, 2008 and contains an annual commitment fee of 6.0 basis points per annum on the unused commitments under the Credit Agreement. Each loan under the amended Credit Agreement will bear interest at a per annum rate equal to, at the Company’s option, (i) Libor plus 0.35% or (ii) the higher of the administrative agent and lender’s prime rate and the Federal Funds rate plus 0.50%. As of December 31, 2007, no borrowings have been made by the Company under this Credit Agreement.
The Company continually monitors developments with respect to state insurance facilities. The Company is required to participate in various state insurance facilities that provide insurance coverage to individuals or entities that otherwise are unable to purchase such coverage from private insurers. Because of the Company’s participation, it may be exposed to losses that surpass the capitalization of these facilities and/or to assessments from these facilities.
Net Realized Investment Loss for the three months ended March 31, 2006, June 30, 2006, September 30, 2006 and December 31, 2006 includes non-cash realized losses of $0.7 million, $0.6 million, $5.7 million, and $1.8 million, respectively, as a result of impairment evaluations.
The Company’s operations are classified into three reportable business segments which are organized around its three underwriting divisions:
The Commercial Lines Underwriting Group which has underwriting responsibility for the commercial multi-peril package, commercial automobile, specialty property and inland marine, and antique/collector car insurance products;
Each business segment’s responsibilities include: pricing, managing the risk selection process, and monitoring the loss ratios by product and insured. The reportable segments operate solely within the United States and have not been aggregated.