Our corporate headquarters is a 44,000 square foot office building located in Westerville, Ohio. We lease this building pursuant to a lease agreement with an initial term of ten years, which expires in 2013. In addition, we have an option to renew the lease agreement for two five-year terms. In July 2006, we leased 11,000 additional square feet of office space in the same complex as our corporate headquarters. This space was leased with an initial term of five years and an option to terminate the lease after two years with one-month advance notice and payment of any unamortized leasehold improvements and brokerage cost.
We also lease an aggregate of 20,000 square feet of office space in Phoenix, Arizona. Our lease of this space has an initial term that expires in 2009. We also lease 1,200 square feet of office space in Conrad, Texas which has a three-year lease term, ending in April 30, 2010. Beginning in February 2008, we also lease 1,181 square feet of office space in Naples, Florida. This lease expires in 2011.
The amount received or to be received for insurance policies written by us during a specific period of time without reduction for acquisition costs, reinsurance costs or other deductions.
The following discussion of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and the notes to those statements included in this annual report on Form 10-K. This discussion and analysis includes forward-looking statements that are subject to risks, uncertainties and other factors described in “Risk Factors” and elsewhere that could cause our actual growth, results of operations, performance and business prospects and opportunities in 2008 and beyond to differ materially from those expressed in, or implied by, those forward-looking statements. See “Forward-Looking Statements”.
It is important to understand our accounting policies in order to understand our financial statements. Management considers certain of these policies to be critical to the presentation of our financial results, since they require management to make estimates and assumptions. These estimates and assumptions affect the reported amounts of assets, liabilities, revenues, expenses and related disclosures at the financial reporting date and throughout the period being reported upon. Certain of the estimates result from judgments that can be subjective and
complex and consequently actual results may differ from these estimates, which would be reflected in future periods.
Reinsurance Recoverables. Reinsurance recoverables on paid and unpaid losses, net, are established for the portion of our loss and loss expense reserves that are ceded to reinsurers. Reinsurance recoverables are determined based in part on the terms and conditions of reinsurance contracts which could be subject to interpretations that differ from our own based on judicial theories of liability. In addition, we bear credit risk with respect to our reinsurers that can be significant considering that certain of the reserves remain outstanding for an extended period of time. We are required to pay losses even if a reinsurer fails to meet its obligations under the applicable reinsurance agreement. See Note 4 to our audited consolidated financial statements included in this report.
Impairment of Investments. Impairment of investment securities results in a charge to income when a market decline below cost is deemed to be other-than-temporary. Under our accounting policy for equity securities and fixed-maturity securities that can be contractually prepaid or otherwise settled in a way that may limit our ability to fully recover cost, an impairment is deemed to be other-than-temporary unless we have both the ability and intent to hold the investment until the security’s forecasted recovery and evidence exists indicating that recovery will occur in a reasonable period of time.
stocks, are classified as “available-for-sale” and accordingly, are carried at fair value with the after-tax difference from cost or amortized cost, reflected in shareholders’ equity as a component of accumulated other comprehensive income, net of valuation allowances on deferred tax assets. Short-term investments are carried at amortized cost, which approximates fair value. The fair value for fixed maturity securities is largely determined by one of two primary pricing methods: third party pricing service market prices or independent broker quotations. Prices from third party pricing services are often unavailable for securities that are rarely traded or are traded only in privately negotiated transactions and as a result, certain of the Company’s securities are priced via broker quotations.
Additionally, for certain securitized financial assets with contractual cash flows (including asset-backed securities), FASB Emerging Task Force (EITF) 99-20, “Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets,” requires us to periodically update our best estimate of cash flows over the life of the security. If management determines that the fair value of a securitized financial asset is less than its carrying amount and there has been a decrease in the present value of the estimated cash flows since the last revised estimate, considering both timing and amount, then an other-than-temporary impairment is recognized.
For additional detail regarding our investment portfolio at December 31, 2007 and December 31, 2006, including disclosures regarding other-than-temporary declines in investment value, see “Investment Portfolio” below and Note 2 to our audited consolidated financial statements included in this report.
Deferred Policy Acquisition Costs. We defer commissions, premium taxes and certain other costs that vary with and are primarily related to the acquisition of insurance contracts. The acquisition costs are reduced by ceding commission income. The costs are capitalized and charged to expense in proportion to premium revenue recognized. The method followed in computing deferred policy acquisition costs limits the amount of such deferred costs to their estimated realizable value, which gives effect to the premium to be earned, related investment income, anticipated losses and settlement expenses and certain other costs expected to be incurred as the premium is earned. Judgments as to ultimate recoverability of such deferred costs are highly dependent upon estimated future loss costs associated with the written premiums. See Note 5 to our audited consolidated financial statements included in this report.
Our gross written premiums decreased 15.8% to $238.3 million for the year ended December 31, 2007 compared to $283.0 million for the same period in 2006. The decrease resulted from a 7.4% decline due to the impact of the change in the timing of recording gross written premiums in 2006 that increased our 2006 gross written premium by $20.9 million (discussed in more detail below), a 3.2% decline due to the termination of the auto physical damage program that began in 2006 and a 5.2% decline due to increased market competition. During 2007, we continued to experience increased competition across our product lines with indications of other carriers continuing to lower their rates and expand their risk profile. Despite this increase in competition, we maintained our underwriting discipline. We had moderate rate decreases in our core property and casualty lines during the year ended December 31, 2007. However, we experienced premium volume growth from our garage and ocean marine business during that period.
Net investment income increased by 14.0% for the year ended December 31, 2007 compared to the same period in 2006. This is due to continued positive cash flows from operations. Our tax equivalent yield for the year ended December 31, 2007 was 5.7%, compared to 5.8% 2006.
Total expenses decreased by $7.1 million to $202.1 for the year ended December 31, 2007 compared to $209.3 million for the year ended December 31, 2006. The combined ratio for the year ended December 31, 2007 was 91.7% compared to 94.5% for the same period in 2006. The loss and loss expense ratio was 57.9% and 61.9%, for the years ended December 31, 2007 and 2006, respectively. For the year ended December 31, 2007, total loss and loss expenses related to the 2007 accident year was $135.0 million, which was partially offset by $9.1 million of favorable reserve development on prior accident years. This compares to $136.6 million of current accident year loss and loss expenses and $1.1 million of favorable reserve development on prior accident years for the year ended December 31, 2006. The decrease in loss and loss expenses for the year ended December 31, 2007 for the current accident year is primarily due to the decline in earned premium, which was supplemented with a decline in the current accident year loss and loss expense ratio. The favorable development on prior accident years for the year ended December 31, 2007 primarily related to our claims made contractors casualty business written in 2005 and 2006 and our property business written in 2005 and 2006. This business continued to perform better than our original estimates.
The expense ratio for the years ended December 31, 2007 and for 2006 was 33.8% and 32.6%, respectively. The increase in the expense ratio in 2007 compared to 2006 is directly attributable to higher contingent commissions due to the favorable loss experience, lower growth in earned premium and $300,000 of professional fees and other costs incurred in the second quarter of 2007 related primarily to an aborted public equity offering. In addition, we incurred a higher blended commission rate due to a greater percentage of binding business that has a higher commission rate than that of brokerage business for the year ended December 31, 2007.
In addition, On September 13, 2006, the SEC staff released Staff Accounting Bulletin 108 (SAB 108) regarding the process of quantifying financial statement misstatements that were uncorrected in prior years. Following the release of SAB 108, we reviewed all of our accounting practices and did not identify any items that were considered to be a material misstatement of prior year financial statements. We did, however, make immaterial adjustments, one of which changed the timing of recording gross written premiums. In the past, we recorded premiums on a received and processed basis, which did not take into account premiums written by agents but not yet submitted to us. Under our revised accounting policy, which was implemented in the fourth quarter of 2006, we recorded an estimate of the policies that have been written by agents but not yet reported to us. These adjustments had the following impacts on the results for both the quarter and year ended December 31, 2006:
Premiums include insurance premiums underwritten by our insurance subsidiaries (which are referred to as direct premiums) and insurance premiums assumed from other insurers (which are referred to as assumed premiums). We refer to direct and assumed premiums together as gross premiums.
Year Ended December 31, 2007 Compared to Year Ended December 31, 2006. Gross written premiums decreased by $44.7 million to $238.3 million for the year ended December 31, 2007 from $283.0 million for the same period in 2006. As noted above, following the release of SAB 108 in 2006, we reviewed all of our accounting practices and did not identify any items that were considered to be a material misstatement of prior year financial statements. We did, however, make immaterial adjustments, one of which changed the timing of recording gross written premiums. In the past, we recorded premiums on a received and processed basis, which did not take into account premiums written by agents but not yet submitted to us. Under our revised accounting policy, which was implemented in the fourth quarter of 2006, we recorded a $20.9 million increase in gross written premiums to estimate policies that had been written by agents but not yet reported to us. In addition, due to the unfavorable underwriting results from our auto physical damage book written in 2006, gross written premiums for the program decreased by $9.0 million for year ended December 31, 2007 compared to the same period in 2006. The remainder of the decline in gross written premiums is due to the continued increase in competition with indications that we believe show other carriers are striving to increase their market share by reducing prices and providing broader coverage forms. These softening market conditions were most prevalent in our casualty market where we saw a decrease in premiums from our casualty book resulting from other carriers offering broader coverages at a lower price on certain classes of business.
Gross written premium for the other (including exited lines) segment increased $1.3 million for the year ended December 31, 2006 compared to the year ended December 31, 2005. This increase represents surety business written in order to maintain our U.S. Treasury listing.
Year Ended December 31, 2007 Compared to Year Ended December 31, 2006. Net written premiums decreased by $44.1 million to $203.8 million for the year ended December 31, 2007 compared to the year ended December 31, 2006. The decrease was due to lower gross written premiums and a higher percentage of ceded premium to gross written premium. The additional ceded premium in the year ended December 31, 2007 compared to the same period in 2006 is due to a change in the mix of business, specifically ocean marine, to the total business, which has a higher ceding rate than our other lines.
Year Ended December 31, 2006 Compared to Year Ended December 31, 2005. Net written premiums increased by 30.8% for the year ended December 31, 2006, respectively, compared to the same period in 2005 due to the growth in gross written premiums. Net written premiums represented 87.6% of gross written premiums for the year ended December 31, 2006, which is relatively the same as the relationship of net written premiums to gross written premiums for the year ended December 31, 2005. Our net written premiums for the year ended December 31, 2006, includes an adjustment of $18.2 million related to the initial booking of policies that have been written by agents but not yet reported to us, as discussed above.
Premiums earned increased by 23.3% to $219.0 million for the year ended December 31, 2006, compared to $177.6 million in 2005. Premiums earned as a percentage of net written premiums was 88.3% and 93.7% for the years ended December 31, 2006 and 2005, respectively. The relationship of premiums earned to net written premiums during the year ended December 31, 2006 was lower compared to the same period in 2005 as a result of the fact that beginning in 2006, we include an estimate of the premiums not yet received from our agents in our total gross and net written premium. As the majority of this premium was expected to have effective dates in December, the premiums were estimated to be less than a month earned, resulting in a lower overall relationship of premiums earned to net written premiums.
Year Ended December 31, 2006 Compared to Year Ended December 31, 2005. We realized net investment gains of $80,000 on the sale and write down of securities for the year ended December 31, 2006 compared to $326,000 of net realized losses for the year ended December 31, 2005. Other-than-temporary losses of $1.4 million were recorded during the year ended December 31, 2006. Other-than-temporary losses of $150,000 were included in the net realized investment losses for the year ended December 31, 2005.
We are liable for covered losses and incurred loss expenses under the terms of the insurance policies that we write. In many cases, several years may elapse between the occurrence of an insured loss, the reporting of the loss to us and our settlement of that loss We reflect our liability for the ultimate payment of all incurred losses and loss expenses by establishing loss and loss expense reserves as balance sheet liabilities for both reported and unreported claims. Loss and loss expenses represent our largest expense item and include (1) payments made to settle claims, (2) estimates for future claim payments and changes in those estimates for current and prior periods, and (3) costs associated with settling claims.
Loss and loss expense reserves represent our best estimate of ultimate amounts for losses and related expenses from claims that have been reported but not paid, and those losses that have occurred but have not yet been reported to us. Loss reserves do not represent an exact calculation of liability, but instead represent our estimates, generally utilizing individual claim estimates and actuarial analysis and estimation techniques at a given accounting date. The loss reserve estimates are expectations of what ultimate settlement and administration of claims will cost upon final
resolution. These estimates are based on facts and circumstances then known to us, a review of historical settlement patterns, estimates of trends in claims frequency and severity, projections of loss costs, expected interpretations of legal theories of liability, and many other factors. In establishing reserves, we also take into account estimated recoveries, reinsurance, salvage and subrogation. The reserves are reviewed regularly by our internal actuarial staff and annually reviewed by an outside independent actuarial firm primarily for the purpose of obtaining an opinion on our reserves for our statutory financial statements and for regulatory purposes.
Given the significant impact of the reserve estimates on our financial statements, we subject the reserving process to significant diagnostic testing. We have incorporated data validity checks and balances into our front-end processes. Leading indicators such as actual versus expected emergence and other diagnostics are also incorporated into the reserving processes.
Due to the inherent uncertainty underlying loss reserve estimates, including but not limited to the future settlement environment, final resolution of the estimated liability for a claim or category of claims will be different from that anticipated at the reporting date. Therefore, actual paid losses in the future may yield a materially higher or lower amount than currently reserved.
When a claim is reported, our claim department establishes a case reserve for the estimated probable ultimate cost to resolve a claim as soon as sufficient information is available to evaluate a claim. We open most claim files with a “formula reserve” (a nominal fixed amount) for the type of claim involved. Our formula reserve amounts are regularly reviewed but have not been changed during the three years ended December 31, 2007 in order to maintain stability in this aspect of the claim reserving process. We adjust the formula reserve to the probable ultimate cost for that claim as soon as sufficient information is available. It is our goal to reserve each claim at its probable ultimate cost no later than 30 days after the claim file is opened on property claims or 90 days following receipt of the claim on casualty claims. During the life cycle of a particular claim, more information may materialize that causes us to
We periodically review our reserves for loss and loss expenses, and based on new developments and information, we include adjustments of the probable ultimate liability in operating results for the periods in which the adjustments are made. In general, our initial reserves are based upon the actuarial and underwriting data utilized to set pricing levels and are reviewed as additional information, including claims experience, becomes available. The establishment of loss and loss expense reserves makes no provision for the broadening of coverage by legislative action or judicial interpretation or for the extraordinary future emergence of new types of losses not sufficiently represented in our historical experience or which cannot yet be quantified. We regularly analyze our reserves and review our pricing and reserving methodologies so that future adjustments to prior year reserves can be minimized. However, given the complexity of this process, reserves require continual updates and the ultimate liability may be higher or lower than previously indicated.
The following table presents our case reserves and IBNR reserves for loss and loss expenses (net of the effects of reinsurance) by segment and the effects of reinsurance for the periods included:
The favorable development during the year ended December 31, 2007 primarily relates to the 2004 through 2006 accident years. At the beginning of 2005, we began writing certain contractors’ liability business on a claims made form, replacing the occurrence form which had previously been utilized through 2004. We wrote a significant volume of claims made contractor liability business in both 2005 and 2006, and this business has continued to perform better than expected. We continue to write contractors’ liability business on an occurrence form, in certain jurisdictions and for certain classes of business. The ultimate loss ratios for the 2005 and 2006 accident years were reduced during 2007 due in part to the continued favorable experience on the claims made contractor liability business. In addition, management reduced its long-term loss ratio expectations and loss development factors for
Year Ended December 31, 2006 Compared to Year Ended December 31, 2005. Our gross reserves for loss and loss expenses were $250.7 million (before the effects of reinsurance) and $214.6 million (after the effects of reinsurance), as estimated through our actuarial analysis at December 31, 2006. At December 31, 2005, our gross reserves for loss and loss expenses were $211.7 million (before the effects of reinsurance) and $174.2 million (after the effects of reinsurance), as estimated through our actuarial analysis. In 2006, we determined that the December 31, 2005 net reserve for losses and loss expenses of $174.2 (after the effects of reinsurance) was redundant by $1.1 million. This favorable development is detailed in the chart above and further discussed in the segment information below.
Casualty. Our changes in the reserve estimates related to prior accident years for the years ended December 31, 2007, 2006 and 2005 for the casualty lines resulted in a decrease in incurred losses and loss expenses of $6.1 million and an increase in incurred losses and loss expenses of $6.2 million and $7.4 million, respectively. The favorable development during the year ended December 31, 2007 primarily relates to the 2004 through 2006 accident years. At the beginning of 2005, we began writing certain contractors’ liability business on a claims made form, replacing the occurrence form which had previously been utilized through 2004. We wrote a significant volume of claims made contractor business in both 2005 and 2006. Casualty reserves for accident years 2005 and 2006 were particularly difficult to initially estimate due to the magnitude and very limited experience for claims made contractor business. The ultimate loss ratios for the 2005 and 2006 accident years were reduced during the year due in part to the continued favorable experience on the claims made contractor liability business. We continue to write contractors’ liability business on an occurrence form, in certain jurisdictions and for certain classes of business.
In addition, during the year ended December 31, 2007, management reduced its long-term loss ratio expectations and loss development factors for other casualty business based on loss experience that emerged during the year that was more favorable than our initial expectations. Due to the reduction of these long-term loss ratio expectations and loss development factors, the indicated ultimate loss ratios produced by certain actuarial methods were lower as of December 31, 2007 than they were as of December 31, 2006. As a result, during the year, management reduced the selected ultimate loss ratios for casualty business for accident years 2004 through 2006. The reduction in losses for casualty business discussed above was partially offset by increases in legal costs and settlement costs related to litigation on construction defect claims.
In addition, we incurred increased legal expenses and internal restructuring costs to address related claims, which contributed to our continued adverse development in this area. During 2004, as a result of court decisions that further defined the legal environment in California, we decided to enhance our defense strategy for certain types of construction defect claims. As a result, the Company revised its construction defect defense team by retaining appellate and new trial counsel and restaffing the in-house team responsible for management of the litigation. Once the new legal teams were established late in 2004 and into 2005, it was determined that there were certain cases that should be settled and the defense budgets for the remaining cased had to be revised to reflect the added resources, resulting in higher than expected loss and defense costs in 2005. This strategy continued in 2006 and we incurred additional legal expenses when litigation discovery procedures yielded new information about the underlying claims. This new information required a reassessment of expected settlements or judgments and expenses on many suits that had been received in prior years.
With this continued development related to our construction defect claims in 2006 as well as a small amount of adverse development on our non-construction defect casualty claims, our internal actuaries continued to refine their actuarial reserving techniques concerning the weighting of reserve indications and supplemental information concerning claims severities. As a result, our casualty reserves moved to a higher point on the range of loss and loss expense reserve estimates. We also recorded $2.9 million of unfavorable development during the year ended December 31, 2006 related to estimated costs associated with possible reinsurance collection issues on two separate casualty claims.
As of December 31, 2007, the projected loss and loss expense ratios, after the effects of reinsurance, for the casualty lines were 60.8%, 56.0% and 54.2% for accident periods 2007, 2006 and 2005.
Our internal actuaries apply multiple traditional actuarial techniques to calculate loss and loss expense reserve estimates that use the following factors, among others:
economic inflation, coverage interpretations and jury determinations. In most instances, we rely on our historical experience or industry information to estimate values for the variables that are explicitly used in our reserve analyses. We assume that our historical experience reflects the effect of these unmeasured factors and is indicative of future effects of these factors. Where we have reason to expect a change in the effect of one of these factors, we perform analysis to quantify the necessary adjustments.
For claim liabilities other than construction defect, our internal actuaries apply multiple traditional actuarial techniques to determine loss and loss expense reserve estimates. Each technique produces a unique loss and loss expense reserve estimate for the line being analyzed. The set of techniques applied produces a range of loss and loss expense reserve estimates. From these estimates, the actuaries form a best estimate which considers the assumptions and factors that influence ultimate claim costs, including but not limited to those identified above as of December 31, 2007 for casualty lines, other than construction defect claims, the low end of the range of techniques was 20.9% below the actuarial best estimate, and the high end of the range of techniques was 4.0% above the actuarial best estimate. These low and high loss and loss expense reserve estimates reflect the fact that the methodologies applied do not produce identical estimates, and these estimates do not constitute the range of all possible outcomes. It is important to note that actual claim costs will vary from the selected estimate, perhaps by substantial amounts, due to the inherent variability of the business written, the potentially significant claim settlement lags and the fact that not all events affecting future claim costs can be estimated at this time period. The range presented herein represents neither the full range of reasonably likely outcomes nor the full range of possible outcomes.
For the construction defect reserving segment, the actuaries use one method to estimate IBNR reserves. The method is comprised of estimated IBNR claims by accident year, the percentage of claims expected to close with payment by accident year, and an expected average claim cost per claim closed with payment. The actuaries evaluate the impact of fluctuations above and below the expected levels for each of three components of the calculation on estimated IBNR. As of December 31, 2007, the range for construction defect claims was 12.8% below to 17.4% above the selected best estimate. The range presented herein represents neither the full range of reasonably likely outcomes nor the full range of possible outcomes.
At the high end of the range, the parameters of the IBNR estimate were varied as follows:
These factors produced IBNR estimates that, when added to case reserves, were 17.4% above the best estimate reserves. It is important to note that we do not believe that the fluctuations considered in these calculations represent the full range of reasonably likely outcomes. We believe the likely range extends beyond this range, particularly on the high end. The range presented herein represents neither the full range of reasonably likely outcomes nor the full range of possible outcomes.
Property. Our changes in estimates for the years ended December 31, 2007, 2006 and 2005 for the property lines resulted in decreases of $2.7 million, $9.3 million and $2.4 million, respectively.
When establishing our December 31, 2005 loss and loss expense reserves, we believed the accident year 2005 property loss ratio would be significantly impacted by claims activity resulting from Hurricanes Katrina, Rita and Wilma. In addition, due to the significantly higher claims per adjuster levels at the end of 2005 caused by the
As of December 31, 2007, the projected loss and loss expense ratios, after the effects of reinsurance, for the property lines were 68.0%, 66.0% and 61.2% for accident periods 2007, 2006 and 2005.
We began writing commercial automobile/trucking coverage for commercial vehicles and trucks in 1997. In 2000, we exited the commercial automobile line of business due to unsatisfactory underwriting results. Our net loss and loss expense reserves for commercial automobile as of December 31, 2007 and 2006 were $101,000 and $147,000, respectively.
We offered workers’ compensation coverage from 1997 through January 2002. We exited this line of business beginning January 1, 2002 due to unsatisfactory underwriting results and the lack of availability of acceptable reinsurance. Until July 2000, we purchased 100% quota share reinsurance on this book of business. Beginning in 2000, we started to retain some risk. No new policies have been written since the first quarter of 2002. In 2006, we recorded $2.9 million of unfavorable development related to estimated costs associated with reinsurance collection issues on our 1997 through 1999 workers’ compensation reinsurance treaties. Our net loss and loss expense reserves for workers’ compensation as of December 31, 2007 and 2006 were $3.0 million and $3.2 million, respectively.
Operating expenses include the costs to acquire a policy (included in amortization of deferred policy acquisition costs), other operating expenses (including corporate expenses) and interest expense. The following
table presents our amortization of deferred policy acquisition costs, other operating expenses and related ratios and interest expense for the periods indicated:
The increase in other operating expenses for the year ended December 31, 2007 is due to higher costs related to our agent contingent commission program and $300,000 of professional and other fees expensed, which related primarily to an aborted public equity offering. The increases were partially offset by recoveries received from our corporate insurance policy.
Interest expense increased on our variable rate Trust Preferred securities due to the increase in LIBOR during 2007. In addition, we incurred $324,000 of interest expense related to our line of credit for the year ended December 31, 2007, compared to $6,000 for the year ended December 31, 2006.
In response to the lower than expected performance of the auto physical damage program, we tightened the underwriting selection guidelines, and increased premium rates to yield a decrease in the loss and loss expense ratio.
Our insurance subsidiaries are restricted by statute as to the amount of dividends it may pay without the prior approval of regulatory authorities. Century and PIC may pay dividends without advance regulatory approval only from unassigned surplus and only to the extent that all dividends in the current twelve months do not exceed the greater of 10% of total statutory surplus as of the end of the prior fiscal year or statutory net income for the prior year. Using these criteria, the available ordinary dividend available to be paid from Century to ProCentury during 2008 is $27.4 million. The ordinary dividend available to be paid from PIC to Century during 2008 is $2.9 million.
Century paid ordinary dividends of $5.0 million in 2007, $2.5 million in 2006 and $2.5 million in 2005. PIC has not paid any dividends to Century in 2007, 2006 or 2005. Century’s ability to pay future dividends to ProCentury without advance regulatory approval is dependent upon maintaining a positive level of unassigned surplus, which in turn, is dependent upon Century generating net income in excess of dividends to ProCentury.
Consolidated net cash used in financing activities was $453,000 for the year ended December 31, 2007, compared to net cash provided by financing activities of $2.2 million for the same period in 2006. This decrease is primarily the result of lower net draws on the line of credit and higher dividends paid to shareholders, which were partially offset by $697,000 of proceeds from the exercise of share options during the year ended December 31, 2007 compared to the same period in 2006.
Line of Credit. We have a $10.0 million line of credit with a maturity date of September 30, 2009, and interest only payments due quarterly based on LIBOR plus 1.2% of the outstanding balance. All of the outstanding shares of Century are pledged as collateral. At December 31, 2007, the outstanding borrowings on the line of credit were $4.7 million. During the year ended 2007, the Company made draws totaling $650,000 on the line of credit for general corporate purposes. Interest expense for the year ended December 31, 2007 was $324,000. The Company had borrowings outstanding under the line of credit at December 31, 2006 of $4.0 million. Interest expense for the year ended December 31, 2006 was $6,000.
Consolidated net cash provided by financing activities was $2.2 million for the year ended December 31, 2006, compared to net cash used by financing activities of $1.1 million for the same period in 2005. This increase is primarily the result of additional draws on the line of credit in 2006 compared to 2005, which was contributed to Century to supplement Century’s capital base in response to the significant growth in gross written premium. The increase in net cash provided by financing activities was partially offset by an increase in dividends to $0.145 per share during year ended December 31, 2006 compared to $0.085 per share during the year ended December 31, 2005.
The timing for payment of our estimated losses is determined by our actuaries, using periods based on our historical claims payment experience. Due to the uncertainty in estimating the timing of such payments, there is a risk that the amounts paid in any period can be significantly different than the amounts disclosed above.
investment portfolio totaled $467.3 million as of December 31, 2007 and is summarized by type of investment as follows:
At December 31, 2007, our investment portfolio contained corporate fixed-maturity and corporate preferred equity securities with a fair value of $60.7 million. The following is a summary of these securities by industry segment at December 31, 2007:
Under our accounting policy for equity securities and fixed-maturity securities that can be contractually prepaid or otherwise settled in a way that may limit our ability to fully recover cost, an impairment is deemed to be other-than-temporary unless we have both the ability and intent to hold the investment for a reasonable period until the security’s forecasted recovery and evidence exists indicating that recovery will occur within a reasonable period of time.
Other-than-temporary impairment losses result in a permanent reduction to the cost basis of the underlying investment and are included in the net realized investment gains (losses) in the consolidated statements of operations. For the year ended December 31, 2007, 38 asset-backed securities were written down in accordance with EITF 99-20 and six preferred stocks were written down in the aggregate amount of $4.5 million. For the year ended December 31, 2006, eleven asset-backed securities were written down in accordance with EITF 99-20 in the aggregate amount of $1.4 million, which was included in net realized investment gains (losses) in the consolidated statements of operations. For the year ended December 31, 2005, two fixed maturity securities were written down in
At December 31, 2007, the Company had 141 fixed-maturity securities and seven equity securities that have been in an unrealized loss position for one year or longer. Of the fixed-maturity securities, 121 are investment grade, and 116 of these securities are rated A1/A or better (including 84 securities which are rated AAA). The 20 remaining non-investment grade fixed-maturity securities have an aggregate fair value equal to 65.2% of their book value as of December 31, 2007. The majority of this unrealized loss related to sub prime bonds, a sector which has experienced significant illiquidity and price dislocation. Each of these sub prime bonds was tested under the application of EITF 99-20 and it was determined none of these bonds was other than temporarily impaired. Three of the equity securities that have been in an unrealized loss position for one year or longer relate to investments in open ended bond funds. Each of these investments continues to pay its regularly scheduled monthly dividend and there have been no material changes in credit quality of any of these funds over the past twelve months. Finally, the four remaining equity securities that have been in an unrealized loss position for one year or longer relate to preferred share investments in issuers each of which has shown an improved or stable financial performance during the past twelve months. In addition, these four equity securities have an aggregate fair market value equal to 83.7% of their book value as of December 31, 2007. All 141 of the fixed income securities are current on interest and principal and all seven of the equity securities continue to pay dividends at a level consistent with the prior year. Management believes that it is probable that all contract terms of each fixed-maturity security will be satisfied. The unrealized loss position of the fixed-maturity securities is due to the changes in interest rate environment and the Company has the positive intent and ability to hold these securities until they mature or recover in value. The unrealized loss position in the equity securities is due to current market conditions and the Company has the positive intent and ability to hold these securities until they recover in value within a reasonable period of time.
Credit Risk. Credit risk is the potential economic loss principally arising from adverse changes in the financial condition of a specific debt issuer. We attempt to address this risk by investing in fixed-maturity securities that are either investment grade, which are those bonds rated “BBB-” or higher by Standard & Poor’s, or securities that although not investment grade, meet our credit requirements and targeted risk adjusted return. We also independently and through our outside independent investment managers, monitor the financial condition of all of the issuers of fixed-maturity securities in our portfolio. We utilize a rating change report, a rating watch report and a focus list as part of this process. Finally, we employ stringent diversification rules that limit our credit exposure to any single issuer.
Interest Rate Risk. We had fixed-maturity, preferred shares and bond mutual fund investments with a fair value of $448.1 million at December 31, 2007 that are subject to interest rate risk. We attempt to manage our exposure to interest rate risk through a disciplined asset/liability matching and capital management process. In the management of this risk, the characteristics of duration, credit and variability of cash flows are critical elements. These risks are assessed regularly and balanced within the context of our liability and capital position.
The table below summarizes our interest rate risk. It illustrates the sensitivity of the fair value of fixed-maturity, preferred share and bond mutual fund investments to selected hypothetical changes in interest rates at December 31, 2007. The selected scenarios are not predictions of future events, but rather illustrate the effect that such events may have on the fair value of the fixed-maturity, preferred share and bond mutual fund portfolio and shareholders’ equity.
See Note 1 to our audited consolidated financial statements included in this report for a discussion of recently issued accounting pronouncements.
We have audited the accompanying consolidated balance sheets of ProCentury Corporation and subsidiaries (the Company) as of December 31, 2007 and 2006, and the related consolidated statements of operations, shareholders’ equity and comprehensive income, and cash flows for each of the years in the three-year period ended December 31, 2007. In connection with our audits of the consolidated financial statements, we also have audited financial statement schedules I to VI. 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 and financial statement schedules based on our audits.
We have audited ProCentury Corporation and subsidiaries’ (the Company) internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control Over Financial Reporting contained in Item 9A(b). Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.
In our opinion, because of the effect of the aforementioned material weakness on the achievement of the objectives of the control criteria, the Company has not maintained effective internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.
ProCentury Corporation is a property and casualty insurance holding company that writes specialty insurance products for small and mid-sized businesses through Century Surety Company, or Century, and ProCentury Insurance Company, or PIC, our operating insurance subsidiaries. Century and PIC are both rated “A−” by the A.M. Best Company, or A.M. Best.
Reinsurance: The Company has entered into reinsurance contracts to cede a portion of its business. Total amounts recoverable under these reinsurance contracts include ceded reserves, paid and unpaid claims, and certain other amounts, which totaled $54.4 million as of December 31, 2007. The ceding of risk does not discharge the original insurer from its primary obligation to the contract holder. See Note 4.
In preparing the consolidated financial statements, management is required to make certain estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, expenses and related disclosures at the financial reporting date and throughout the period being reported upon. Certain of the estimates result from
judgments that can be subjective and complex and consequently actual results may differ from these estimates, which would be reflected in future periods.
Material estimates that are particularly susceptible to significant change in the near-term relate to the determination of loss and loss expense reserves, the recoverability of deferred policy acquisition costs, the determination of federal income taxes, the net realizable value of reinsurance recoverables and the determination of other-than-temporary declines in the fair value of investments. Although considerable variability is inherent in these estimates, management believes that the amounts provided are reasonable. These estimates are continually reviewed and adjusted as necessary. Such adjustments are reflected in current operations.
The consolidated financial statements include the accounts of ProCentury and its wholly owned subsidiaries. All significant intercompany balances and transactions have been eliminated.
For mortgage-backed securities, the Company recognizes income using a constant effective yield method based on prepayment assumptions and the estimated economic life of the securities. When estimated prepayments differ significantly from anticipated prepayments, the effective yield is recalculated to reflect actual payments to date and anticipated future payments. Any resulting adjustment is included in net investment income. All other investment income is recorded using the interest-method without anticipating the impact of prepayments.
The Company defers commissions, premium taxes and certain other costs that vary with and are primarily related to the acquisition of insurance contracts. The acquisition costs are reduced by ceding commission income. The costs are capitalized and charged to expense in proportion to premium revenue recognized. The method followed in computing deferred policy acquisition costs limits the amount of such deferred costs to their estimated realizable value, which gives effect to the premium to be earned, related investment income, anticipated losses and settlement expenses and certain other costs expected to be incurred as the premium is earned. Judgments as to ultimate recoverability of such deferred costs are highly dependent upon estimated future loss costs associated with the written premiums. The amounts that are not considered realizable are charged as an expense through amortization of deferred policy acquisition costs.
In the ordinary course of business, our insurance subsidiaries reinsure certain risks, generally on an excess-of-loss basis, with other insurance companies which primarily are rated “A” or higher by A.M. Best. Such reinsurance arrangements serve to limit the Company’s maximum loss.
Reinsurance does not discharge the Company from its primary liability to policyholders, and to the extent that a reinsurer is unable to meet its obligations, the Company would be liable.
impaired. During our annual analysis in 2007, we determined these assets had not been impaired. The indefinite-life intangible assets and goodwill are included in other assets in the Consolidated Balance Sheets.
ProCentury and its subsidiaries file a consolidated federal income tax return in accordance with a tax sharing agreement. The entities utilize a consolidated approach to the allocation of federal income taxes, whereas ProCentury’s tax sharing agreement with its subsidiaries allowed it to make certain code elections in its consolidated federal tax return. In the event such code elections are made, any benefit or liability is the responsibility of ProCentury and is not accrued or paid by the subsidiaries.
Investment securities - Fair values for fixed maturity securities are based on quoted market prices, where available. For fixed maturity securities not actively traded, fair values are estimated using values obtained from brokers’ quotes. Fair values for equity securities, consisting of preferred and common stocks and bond mutual funds, are based on quoted market prices or pricing services. Fair value disclosures for investments are included in Note 2.
In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities, Including an Amendment of FASB Statement No. 115” (“SFAS 159”). The objective of SFAS 159 is to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported net income caused by measuring related assets and liabilities differently. This statement permits entities to choose, at specified election dates, to measure eligible items at fair value (i.e., the fair value option). Items eligible for the fair value option include certain recognized financial assets and liabilities, rights and obligations under certain insurance contracts that are not financial instruments, host financial instruments resulting from the separation of an embedded nonfinancial derivative instrument from a nonfinancial hybrid instrument, and certain commitments. Business entities shall report unrealized gains and losses on items for which the fair value option has been elected in net income. The fair value option (a) may be applied instrument by instrument, with certain exceptions; (b) is irrevocable (unless a new election date occurs); and (c) is applied only to entire instruments and not to portions of instruments. SFAS 159 is effective as of the beginning of an entity’s first fiscal year that begins after November 15, 2007, although early adoption is permitted under certain conditions. Companies must report the effect of the first remeasurement to fair value as a cumulative-effect adjustment to the opening balance of retained earnings. We are currently evaluating the impact of adopting SFAS 159.
In September 2006, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements” (“SAB 108”). SAB 108 provides interpretive guidance on how the effects of prior-year uncorrected misstatements should be considered when quantifying misstatements in the current year financial statements. SAB 108 requires registrants to quantify misstatements using both an income statement (“rollover”) and balance sheet (“iron curtain”) approach and evaluate whether either approach results in a misstatement that, when all relevant quantitative and qualitative factors are considered, is material. If prior year errors that had been previously considered immaterial now are considered material based on either approach, no restatement is required so long as management properly applied its previous approach and all relevant facts and circumstances were considered. If prior years are not restated, the cumulative effect adjustment is recorded in opening accumulated earnings as of the beginning of the fiscal year of adoption. SAB 108 is effective for fiscal years ending on or after November 15, 2006, with earlier adoption encouraged. We adopted SAB 108 in the fourth quarter of 2006 and it did not have a material effect on our consolidated financial condition or results of operations.
SFAS No. 157; however, we do not expect it will have a material effect on our consolidated financial condition or results of operations.
In February 2006, the FASB issued Statement No. 155, “Accounting for Certain Hybrid Financial Instruments” (“SFAS No. 155”). Under current generally accepted accounting principles an entity that holds a financial instrument with an embedded derivative 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. We adopted SFAS No. 155 effective January 1, 2007 and it did not have a material effect on our consolidated financial condition or results of operations.
In September 2005, the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants (AICPA) issued Statement of Position (“SOP”) 05-1, “Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection with Modifications or Exchanges of Insurance Contracts” (SOP 05-1). SOP 05-1 provides guidance on accounting by insurance enterprises for deferred acquisition costs on internal replacements of insurance and investment contracts other than those specifically described in SFAS No. 97, “Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments,” issued by the FASB. SOP 05-1 defines an internal replacement as a modification in product benefits, features, rights or coverages that occurs as a result of the exchange of a contract for a new contract, or by amendment, endorsement or rider to a contract, or by the election of a new feature or coverage within a contract. SOP 05-1 is effective for internal replacements occurring in fiscal years beginning after December 15, 2006, with earlier adoption encouraged. Retrospective application of SOP 05-1 to previously issued financial statements is not permitted. Initial application of SOP 05-1 is required as of the beginning of an entity’s fiscal year. We adopted SOP 05-1 effective January 1, 2007 and it did not have a material effect on our consolidated financial condition or results of operations.
Other-than-temporary impairment losses result in a permanent reduction to the cost basis of the underlying investment and are included in the net realized investment gains (losses) in the consolidated statements of operations. For the year ended December 31, 2007, 38 asset back securities were written down in accordance with EITF 99-20 and six preferred stocks were written down in the aggregate amount of $4.5 million. For the year ended December 31, 2006, eleven of the asset-backed securities were written down in accordance with EITF 99-20 in the amount of $1.4 million. For the year ended December 31, 2005, the Company determined that two of the fixed maturity securities were other than temporarily impaired and were written down in the aggregate of $150,000, which were included as realized losses in the consolidated statements of operations.
The components of net investment income in 2007, 2006 and 2005 were as follows:
All investments in fixed-maturity securities were income producing during 2007, 2006 and 2005. Net realized investment gains (losses), including other-than-temporary impairments, were as follows:
For the years ended December 31, 2007, 2006 and 2005, net income tax (benefit) expense on net realized investment (losses) gains was $(258,000), $28,000, and $(114,000), respectively.
The change in unrealized appreciation on investments recorded in shareholders’ equity and in other comprehensive income is as follows:
At December 31, 2007 and 2006, Century maintained a trust fund (consisting of cash and investments) with a combined carrying value of $260,000 and $247,000, respectively. The assets of the trust are recorded as cash and investments and are held as security for unearned premiums and outstanding loss reserves under an assumed reinsurance contract.
interpretations of legal theories of liability, and many other factors. In establishing reserves, we also take into account estimated recoveries, reinsurance, salvage and subrogation. The reserves are reviewed regularly by our internal actuarial staff.
For the year ended December 31, 2006, the Company experienced favorable non-catastrophe property case reserve development producing a reduction in ultimate loss and loss expenses by $7.8 million primarily for the 2004 and 2005 accident years. The Company also changed its estimates during 2006 on catastrophe losses by reducing its estimates on Hurricane Wilma by $1.5 million due to actual incurred losses being lower than original estimates. This favorable development was offset by an increase of $2.5 million in casualty reserves during 2006 as a result of a small amount of adverse development in the casualty line and a result of a refinement to the internal actuarial reserving technique concerning the weighting of reserve indications and supplemental information concerning claims severities. The Company also incurred $2.8 million of adverse development during the year ended December 31, 2006 due to an increase in legal severities on construction defect claims that occurred when litigation discovery procedures yielded new information about underlying claims that enabled evaluation of expected settlements or judgment and expenses on suits that had been received in prior years. Additionally, the Company recorded $2.9 million of unfavorable development during the year ended December 31, 2006 related to estimated costs associated with possible reinsurance collection issues on two separate casualty claims and the 1998 and 1999 workers compensation reinsurance treaties.
For the year ended December 31, 2005, the Company experienced unfavorable casualty development. A significant portion of the loss and loss expenses attributable to insured events of prior periods for 2005 resulted from construction defect claims in the other liability line. As a result of court decisions that further defined the legal environment in California, the Company decided to enhance its defense strategy for certain types of construction defect claims. As a result, the Company revised the construction defect defense team by retaining appellate and new trial counsel and restaffing the in-house team responsible for management of the litigation. Once the new legal teams were established late in 2004 and into 2005, it was determined that there were certain cases that should be settled and the defense budgets for the remaining cases had to be revised to reflect the added resources, resulting in higher than expected loss and defense costs in 2005.
In the ordinary course of business, Century and PIC assumes and cedes reinsurance with other insurers and reinsurers. These arrangements provide greater diversification of business and limit the maximum net loss potential on large risks. Excess of loss contracts in effect through December 31, 2007 generally protect against individual property and casualty losses over $500,000. In addition, beginning in 2006, for casualty losses over $500,000 and under $1.0 million, the Company participates on a quota share basis on 50% of the $500,000 in excess of the $500,000 layer. This layer was ceded 100% to reinsurers in 2005. Excess of loss contracts in effect for workers’ compensation losses protect against individual losses over $200,000. Additionally, from January 1, 2001 through June 30, 2001, and from July 1, 2001 through December 31, 2002 the first $200,000 in workers’ compensation losses were 80% and 60% ceded on a quota share basis, respectively. Catastrophe and clash coverage is also maintained. In addition, effective January 1, 2004, Century entered into a loss portfolio transfer and quota share arrangement with Evergreen and Continental whereby Century assumed all of Evergreen and Continental’s
Of the total reinsurance recoverable on paid and unpaid losses at December 31, 2007, 64.4% was with reinsurance companies, which had an A. M. Best rating of A or higher at December 31, 2007. The amounts of ceded loss and loss expense reserves and ceded unearned premiums would represent a liability of the Company in the event that its reinsurers would be unable to meet existing obligations under reinsurance agreements.
We are closely monitoring the financial status of Gerling Global Reinsurance Corporation (which is not rated as it is no longer accepting new or renewal business). We are currently in arbitration with Gerling over a disputed claim.
On December 4, 2002, ProFinance Statutory Trust I (the “Trust”), a Connecticut statutory business trust formed by the Company, issued 15,000 floating rate capital securities (“Trust Preferred Securities”) generating gross proceeds of $15.0 million. Net proceeds were $14.5 million, after deducting offering costs of $454,000. In addition, on May 16, 2003, ProFinance Statutory Trust II (the “Trust”), a Connecticut statutory business trust formed by the Company, issued 10,000 floating rate capital securities (“Trust Preferred Securities”) generating gross proceeds of $10.0 million. Net proceeds were $9.7 million, after deducting offering costs of $300,000.
cumulative cash distributions accruing from the date of issuance and payable quarterly in arrears at a rate of 400 and 410 basis points, respectively, over the three-month London Interbank Offered Rates (“LIBOR”). The maximum distribution rate is 12.5% through December 4, 2007 and May 16, 2008, respectively. Under certain circumstances, the Company has the right to defer distributions and interest on the Trust Preferred Securities for up to five years. The obligations of the Trust are guaranteed by the Company with respect to distributions and payments of the Trust Preferred Securities. These distributions are recorded as interest expense in the accompanying consolidated statements of operations, as the Trust Preferred Securities are considered a debt instrument. Interest paid totaled $2.4 million, $2.4 million and $1.9 million in 2007, 2006, and 2005, respectively.
The income tax expense differed from the amounts computed by applying the U.S. federal income tax rate of 35% in 2007, 2006 and 2005 to income before income taxes as a result of the following:
The Company has recorded deferred tax assets and liabilities that result from temporary differences between the time income or expense items are recognized for financial statement purposes and for tax reporting. Such amounts are calculated using the enacted tax rates and laws that are expected to be in effect when the differences are expected to reverse. The determination of current and deferred income taxis is based on complex analyses of many factors including interpretation of Federal and state income tax laws, the difference between tax and financial reporting basis of assets and liabilities (temporary differences), estimates of amounts due or owed such as the timing of reversals of temporary differences and current financial accounting standards. A valuation allowance is established if, based upon the relevant facts and circumstances, management believes that some or all of certain tax assets will not be realized. The Company has open tax years that may in the future be subject to examination by federal and state taxing authorities. At December 31, 2007, the Company established a valuation allowance of $2.0 million related to unrealized losses on equity securities and other-than-temporary impairments that, upon realization, could not be offset by past or future capital gains. A portion of this valuation allowance, $1.5 million was recorded through other comprehensive income and the remainder was recorded through the statement of
A summary of the status of the option plan at December 31, 2007 and changes during the year then ended is presented in the following table:
Information on the range of exercise prices for options outstanding as of December 31, 2007, is as follows:
In September of 2006 and March of 2005, the Company granted 36,704 and 37,365, respectively of performance based restricted shares to certain executives that vest annually over a four-year period subject to the achievement of certain performance metrics. The Company accounted for these awards as fixed awards that were recorded at fair value on the date of grant.
Of the performance-based restricted share awards granted in March of 2005, an award for 17,659 shares was modified in accordance with the agreement entered into in connection with the termination of an executive officer’s employment in October 2005. As such, the award was treated as cancelled on October 1, 2005 due to a modification of the award to accelerate the vesting of the shares, change the vesting from annual vesting to monthly vesting and remove the performance based restrictions. As such, the award is treated as a variable award which is valued at the fair market value on the monthly vesting date. During 2005, the Company recorded $46,058 compensation expense related to the restricted shares. During the year ended December 31, 2006, the Company recorded $178,686 of compensation expense related to the restricted shares and all related shares were vested by September 30, 2006.
As of December 31, 2007, total compensation cost related to nonvested share options or restricted shares is $1.5 million, which is expected be recorded over 1.7 years. Total compensation cost for share based awards was $1.3 million, $1.3 million and $817,000 for the years ended December 31, 2007, 2006 and 2005, respectively. The tax benefit included in the accompany statements of operations related to the compensation cost was $338,000, $121,000, and $286,000 for the years ended December 31, 2007, 2006, and 2005, respectively. At December 31, 2007, the Company had $212,000 of compensation cost for share based awards capitalized with deferred policy acquisition costs.
In connection with the Company’s IPO in April 2004, the Company spun-off its subsidiaries, Evergreen and Continental, to the Company’s Class A shareholders. In connection with the spin-off, the Company entered into several agreements with Evergreen which facilitated the Evergreen and Continental transactions. The Company’s board of directors believes that these agreements were fair to the Company and its shareholders.
Quota Share Reinsurance Agreements. The Company entered into 100% quota share reinsurance contracts that provided for Century to reinsure Evergreen and Continental for property and casualty business that was written on Evergreen or Continental’s paper for Century in states that Century was not licensed and for Evergreen to reinsure Century in the same manner for bonding business. Under these contracts, the ceding company is entitled to receive a 5% commission and reimbursement of any premium taxes or other direct costs such as boards and bureaus fees. These fronting contracts were in force until December 31, 2007. During 2007, the Company assumed $905,000 of premiums and ceded $302,000 of premiums under this contract. The Company assumed $535,000 of premiums and ceded $406,000 of premiums under this contract during the year ended December 31, 2006.
Software License Agreement and Software Support and Maintenance Agreement. Century has entered into a software license agreement with Evergreen and Continental pursuant to which Century granted to Evergreen and Continental a fully paid-up, royalty free, non-exclusive perpetual license to use certain of Century’s proprietary software that relates to underwriting and claims processing and that has been developed for the mutual benefit of the Company, Evergreen and Continental. In addition, Century has entered into a software support and maintenance agreement with Evergreen and Continental, pursuant to which Century provides certain technical support and maintenance services for the software in return for an annual support and maintenance fee of $100,000. Evergreen and Continental may terminate the software support and maintenance agreement by providing 90 days prior written notice, and Century may terminate the agreement by providing twelve months’ prior written notice. On December 29, 2005, the software support and maintenance agreement was amended to adjust the Annual Fee effective January 1, 2006, to be at the rate of $50,000 per calendar quarter payable during the first month of each quarter. On October 18, 2006, the agreement was amended to adjust the Annual Fee retroactively to July 1, 2006 to $15,000 per calendar quarter. On April 25, 2007, the agreement was amended to adjust the Annual Fee retroactively to April 1, 2007 to $5,000 per calendar quarter. In all other respects, the agreement continues unchanged. The
Company received $30,000, $130,000, and $100,000 in Annual Fees respectively for the years ended December 31, 2007, 2006 and 2005, respectively.
In addition, the Company has entered into the following agreements with Evergreen. The Company’s board of directors believes that these agreements are fair to the Company and its shareholders.
On August 15, 2006, the Company became a participant on Evergreen’s Contract Bond Quota Share Treaty. The Company will assume 25% of all contract bonds written by Evergreen and Continental. The Company recorded assumed premium of $700,000 in 2007. The Company recorded assumed premium of $102,000 in 2006.
On October 1, 2007, the Company entered into 100% quota share reinsurance contract that provided for Century to reinsure Evergreen for contract surety business underwritten by Century employees that was written on Evergreen’s paper for Century in states that Century was not licensed. Under these contracts, the ceding company is entitled to receive a 10% commission. This fronting contract will remain in force until December 31, 2009. During 2007, the Company assumed $3,000 of premiums.
Rental expense on the operating leases on facilities for the years ended December 31, 2007, 2006 and 2005 was $1.5 million, $1.3 million, and $1.3 million, respectively.
premium finance agreements and other contracts and employment related disputes. The plaintiffs in some of these lawsuits have alleged bad faith or extra contractual damages and some have claimed punitive damages. The resolution of these legal actions is expected not to have a material adverse effect on the Company’s financial position or results of operations.
Ten of the Company’s 149 agents contributed, on a combined basis, 52.1% of the Company’s 2007 consolidated direct and assumed premiums written. One of the Company’s agents individually contributed an amount greater than 10% of the Company’s direct and assumed premiums written and represented 18.2% of the Company’s 2007 consolidated direct and assumed premiums written. There was no concentration of revenue with respect to geographic area as of December 31, 2007.
Our insurance subsidiaries are regulated by their states of domicile, Ohio and Texas, and the states in which they do business. Such regulations, among other things, limit the payment of dividends without prior regulatory approval. ProCentury is dependent on dividends from Century for operating expenses and interest and principal on long term debt and the Debentures. The maximum dividend that may be paid without prior approval of the Director of Insurance is limited to the extent that all dividends in the past 12 months do not exceed the greater of the statutory income of the preceding calendar year or 10% of total statutory surplus as of the prior December 31. As a result, the maximum dividend Century may pay to ProCentury in 2008 without prior approval is $27.4 million. Dividends paid to ProCentury from Century were $5.0 million, $2.5 million, and $2.5 million in 2007, 2006, and 2005, respectively.
The Company does not expect such regulatory requirements to impair its ability to pay operating expenses and interest and principal during 2008.
The National Association of Insurance Commissioners (NAIC) has developed property and casualty risked based capital (RBC) standards that relate an insurer’s reported statutory surplus to the risks inherent in overall operations. The RBC formula uses the statutory annual statement to calculate the minimum indicated capital level required to support asset and underwriting risk. The NAIC calls for various levels of regulatory action based on the magnitude of an indicated RBC capital deficiency, if any. The Company regularly monitors capital requirements along with the NAIC’s RBC developments. The Company has determined that the capital levels of its insurance subsidiaries are in excess of the minimum capital requirements for all RBC action levels as of December 31, 2007.
Our insurance subsidiaries maintain their accounts in conformity with accounting practices prescribed or permitted by the Ohio Department of Insurance and Texas Department of Insurance that vary in certain respects from GAAP. In converting from statutory to GAAP, typical adjustments include deferral of policy acquisition costs, the inclusion of statutory nonadmitted assets, and the inclusion of net unrealized holdings gains or losses in shareholders’ equity relating to fixed maturity securities. The statutory capital and surplus of Century as of December 31, 2007, 2006 and 2005 was $153.5 million, $137.5 million and $121.8 million, respectively. The statutory net income of Century for the years ended December 31, 2007, 2006 and 2005, was $27.4 million, $18.4 million and $7.8 million, respectively.
The Company’s Other Segment (including exited lines) includes the surety business and the Company’s exited lines, such as workers’ compensation and commercial auto/trucking. A limited amount of surety business is written in order to maintain Century’s U.S. Treasury listing.
Segment profit or loss for each of the Company’s segments is measured by underwriting profit or loss. The property and casualty insurance industry commonly defines underwriting profit or loss as earned premium net of loss and loss expenses and underwriting, acquisition and insurance expenses. Underwriting profit or loss does not replace operating income or net income computed in accordance with GAAP as a measure of profitability. Segment profit for the Investing operating segment is measured by net investment income and net realized gains or losses. The Company does not allocate assets, including goodwill, to the Property and Casualty and Other operating segments for management reporting purposes. The total investment portfolio and cash are allocated to the Investing operating segment.
On February 20, 2008, ProCentury Corporation (parent), pursuant to unanimous approval of its board of directors, entered into an Agreement and Plan of Merger (the “Merger Agreement”) with Meadowbrook Insurance Group, Inc. (“Meadowbrook”) and MBKPC Corp., a wholly-owned subsidiary of Meadowbrook (“Merger Sub”), whereby ProCentury will be merged with and into Merger Sub (the “Merger”). At the effective time of the Merger, shareholders of ProCentury will be entitled to receive, for each ProCentury common share, either $20.00 in cash or Meadowbrook common stock having a value of $20.00, subject to adjustment as described below. Each ProCentury shareholder will have the option to elect to receive cash or Meadowbrook stock, subject to proration so that the maximum total cash consideration will not exceed 45% of the total consideration paid in order to preserve the tax-free exchange of the stock consideration.
holders can either exercise such options and, in connection with the closing, elect to receive the form of merger consideration described above for the ProCentury shares acquired on exercise or agree to have their options cancelled in exchange for a per share cash payment equal to the difference between $20.00 and the exercise price of their options.