We lease our headquarters in Chicago, Illinois. Our headquarters have approximately 24,987 square feet and our lease expires in 2020. We believe that our facility will support our future business requirements or that we will be able to lease additional space, if needed, on reasonable terms.
We were formed on April 3, 2003 for the purpose of achieving attractive returns in the specialty commercial property and casualty insurance business by using an innovative business model. Specialty insurance typically serve niche groups of insureds that require highly specialized knowledge of a business class to achieve underwriting profits. This segment has traditionally been underserved by most standard commercial property and casualty insurers, due to the complex business knowledge and the investment required to achieve attractive underwriting profits. Competition in this segment is based primarily on client service, availability of insurance capacity, specialized policy forms, efficient claims handling and other value-based considerations, rather than price.
to commence insurance operations generating an accumulated deficit of $8.7 million. Among these activities, we engaged consultants to assist us in our business selection process of partner agents, we contracted with a service company to assist us in reviewing the business of those agents and developing underwriting and pricing guidelines, we began the development of our key business processing systems with vendors and consultants, and we began work on the development of our offering documents together with our underwriter and legal counsel. Effective November 23, 2004, we completed our initial public offering and concurrent private placements and concurrently completed the acquisition of Potomac. Effective with the completion of our initial public offering, we are in a position to conduct our intended business activities. We plan to commence writing insurance in 2005 utilizing the core group of partner agents currently assembled. Because we are unlikely to seek to or obtain cancellations of existing policies produced by our partner agents prior to the end of their terms, we will seek to transition policies over a 12-month period following the commencement of our insurance operations. As of December 31, 2004, we had not underwritten any insurance business.
We expect to derive the majority of our revenues from net earned premiums from policies written by our insurance operations and investment income from our investment portfolios. The amount of our insurance premiums written will depend on the number and type of policies we write, as well as prevailing market prices. We will strive to focus on the profitability over time of our blocks of policies rather than amount of premiums. As a result, the volume of premiums written may not be indicative of our ultimate expected profitability.
Policy acquisition expenses are expected to consist principally of up-front commissions, fees, and tax expenses that are directly related to obtaining and writing insurance contracts. Typically, policy acquisition expenses are based on a certain percentage of the premiums written on contracts of insurance. Since our commission expense will include meaningful underwriting profit-based commission accruals, as well as up-front commissions, our commission expense is likely to be higher in periods of greater profitability and lower in periods with poorer underwriting results. We expect that these expenses will be a function of the number and type of insurance contracts written.
General and administrative expenses will consist primarily of personnel expenses, payments to providers of outsourced services, professional fees and other operating overhead. We expect to use various third-party service providers as necessary to administer and manage the insurance business that we underwrite.
We were formed April 3, 2003 and did not have any financial activity until our initial funding date of December 12, 2003. For the period April 3, 2003 to December 31, 2003, we reported a net loss of $0.6 million.
For the period from January 1, 2004 to December 31, 2004, we reported a net loss of $8.2 million as a result of initial start-up costs while recording no insurance revenues. We did have investment income and realized gains of $0.3 million. Total expenses of $8.4 million were primarily comprised of $4.7 million in service company fees, $1.5 million in consulting fees, $0.7 million in salaries and benefits, $0.6 million in legal expenses, interest expense of $0.3 million and $0.6 million of miscellaneous expenses.
As a holding company, we will have continuing funding needs for general corporate expenses, the payment of principal and interest on future borrowings, if any, taxes and the payment of other obligations. Funds to meet these obligations are expected to come primarily from dividends, interest and other statutorily permissible payments from our operating subsidiary. The ability of our operating subsidiary to make these payments will be limited by the applicable laws and regulations of Illinois. There will be restrictions on the payment of dividends by our insurance subsidiary to us.
As of December 31, 2004, we have made capital expenditures of $2.4 million related to information systems.
On November 23, 2004, we received the proceeds of our initial public offering and concurrent private placements. Total proceeds after underwriting discounts and offering expenses were $119.8 million. Concurrent with the offering we acquired Potomac from OneBeacon for $22.0 million, including transaction costs. On December 22, 2004 we received proceeds of $3.7 million from underwriter’s exercise of the over allotment option.
The proceeds of the loans were used to pay our operating expenses and pay some of our offering expenses.
For the period from January 1, 2004 to December 31, 2004, our increase in cash was $8.8 million. Cash was provided from the net proceeds of our initial public offering of $119.8 million and proceeds of $3.7 million from underwriter’s exercise of the over allotment option and $3.2 million from term loans. Net cash used for investment activities during the twelve month period ended December 31, 2004 totaled $110.0 million and was primarily related to the acquisition of Potomac and subsequent purchases of investments with the proceeds from the initial public offering. Net cash used for operating activities during the period from January 1, 2004 to December 31, 2004 totaled $7.9 million and was primarily related to our initial start-up costs.
While insurance regulation differs by location, each jurisdiction requires that minimum levels of capital be maintained in order to write new insurance business. Factors that affect capital requirements generally include premium volume, the extent and nature of loss and loss adjustment expense reserves, the type and form of insurance business underwritten and the availability of reinsurance protection from adequately rated reinsurers on terms that are acceptable to us.
If we cannot maintain or obtain adequate capital to manage our business strategy and expected growth targets, our business, results of operations and financial condition may be adversely affected.
Our significant accounting policies, as of December 31, 2003 and December 31, 2004, are described in the notes to our financial statements.
We use quoted market prices in determining the fair value of fixed maturities and short-term investments in most cases. Where quoted market prices are unavailable, we expect to base the estimate on recent trading. Unrealized appreciation or depreciation of available-for-sale investments carried at fair value are excluded from net income and credited or charged, net of applicable deferred income taxes, directly to accumulated other comprehensive income, a separate component of stockholders’ equity. The change in unrealized appreciation or depreciation is reported as a component of other comprehensive income.
We continually monitor the difference between our cost basis and the estimated fair value of our investments. Our accounting policy for impairment recognition for fixed maturities requires other-than-temporary impairment charges to be recorded when we determine that it is probable we will be unable to collect all amounts due according to the contractual terms of the investment. Impairment charges on investments are recorded based on the fair value of the investments at the balance sheet date, and are included in net realized gains and losses. Factors considered in evaluating whether a decline in value is other than temporary include: the length of time and the extent to which the fair value has been less than cost; the financial conditions and near-term prospects of the issuer; and our intent and ability to retain the investment for a period of time sufficient to allow for any anticipated recovery.
We recorded an indefinite-life intangible asset for the value of insurance licenses acquired in connection with the acquisition of Potomac. Indefinite-lived intangible assets are not subject to amortization. If the aggregate fair value of insurance licenses declines to an amount less than their book value, impairment will be recorded as a realized loss for the excess of book value over fair value
Our most significant estimates will likely relate to our reserves for property and casualty losses and loss adjustment expenses. We will be required to establish reserves for the estimated total unpaid cost of losses and loss adjustment expenses for events that have already occurred. These reserves should reflect our best estimates of the total cost of claims that were reported to us, but not yet paid, referred to as Case Reserves, and the cost of claims “incurred but not yet reported” to us, or IBNR, referred to as IBNR Reserves.
For IBNR losses, we will estimate the amount of reserves for each line of business on the basis of historical and statistical information. We plan to consider historical patterns of paid and reported claims, industry data and the probable number and nature of losses arising from claims that have occurred but have not yet been reported for a given accident year.
“Operating Lease Obligation” means a payment obligation under a lease classified as an operating lease and disclosed pursuant to FASB Statement of Financial Accounting Standards No. 13, “Accounting for Leases,” (November 1976), as may be modified or supplemented. All operating lease obligations are for facilities.
On February 3, 2005, we entered into a lease agreement for our office space that commences on May 1, 2005 and terminates on April 30, 2020. Our future net lease obligations are $1.43 million for years 1 through 5, $2.37 million for years 6 through 10 and $2.69 million for years 11 through 15.
Market risk can be described as the risk of change in fair value of a financial instrument due to changes in interest rates, creditworthiness, foreign exchange rates or other factors. We will seek to mitigate that risk by a number of actions, as described below.
Inflation could have a significant effect on our results of operations in some situations. The effects of inflation could cause the severity of claims to increase in the future. Our estimates for losses and loss adjustment expenses will include assumptions, including those relating to inflation, about future payments for settlement of claims and claims handling expenses. To the extent inflation causes these costs to increase above our estimated reserves that will be established for these claims, we will be required to increase reserves for losses and loss adjustment expenses with a corresponding reduction in our earnings in the period in which the increase is identified. The actual effects of inflation on our results cannot be accurately determined until claims are ultimately settled.
We also have other receivable amounts subject to credit risk, including reinsurance recoverables from our current reinsurer, OneBeacon. To mitigate the risk of counterparties’ nonpayment of amounts due under these arrangements, we will establish business and financial standards for reinsurer approval, incorporating ratings by major rating agencies and considering then-current market information.
Potomac’s pre-tax income was $1.0 million for the period from January 1, 2004 through November 23, 2004 and $2.1 million for the year ended December 31, 2003. As of January 1, 2004, Potomac ceased its participation in the OneBeacon Amended and Restated Reinsurance (Pooling) Agreement, or the Pool. As a result, net written premiums, net earned premiums, losses and underwriting expenses for the period from January 1, 2004 through November 23, 2004 were $0 and, therefore, are not comparable with 2003 results.
Potomac’s net investment income decreased by $0.8 million or 38% for the period from January 1, 2004 through November 23, 2004, primarily due to the continued run-off of loss reserves in the latter part of 2003, as well as reduced interest rates. Net realized gains increased by $0.9 million in the same period when compared to 2003.
Total expenses for 2003 declined by 34% compared to 2002, primarily as a result of reduced premium writings and improved underwriting performance. Improved underwriting performance resulted from continued efforts to improve premium adequacy through rate increases, aggressive rate pursuit actions and re-underwriting efforts, such as changes in business mix away from historically less profitable business lines and shifting away from certain classes of risks within business lines. Total expenses in 2003 also include net unfavorable prior accident year reserve development of $0.7 million primarily related to construction defect claims.
As of January 1, 2004, Potomac ceased its participation in the Pool and entered into a transfer and assumption reinsurance agreement whereby it transferred all of its direct insurance business written to OneBeacon. As a result, Potomac no longer has any insurance assets or liabilities on a net basis and will not share in any favorable or unfavorable development of prior year losses recorded by the Pool after January 1, 2004 unless OneBeacon fails to perform.
In 2004, Potomac’s sources of cash consisted primarily of net investment income and proceeds from sales and maturities of investments. Potomac’s uses of cash were primarily investing expenses and the purchase of
investments. Prior to January 1, 2004, the effective date of Potomac’s withdrawal from the Pool, its sources of cash also included premium collections and its uses included claim payments and operating expenses.
During 2004 Potomac declared and paid $18.6 million in cash dividends and capital distributions and distributed $13.3 million of net assets to OneBeacon. During 2002 Potomac declared and paid $3.0 million in cash dividends to OneBeacon and OneBeacon contributed $0.5 million in cash to Potomac.
Management believes that its critical accounting policies affect its more significant estimates used in the preparation of its financial statements. The descriptions below are summarized and have been simplified for clarity.
In a broad sense, loss and LAE reserves have two components: (i) case reserves, which are reserves established within the claims function for claims that have been reported to Potomac and (ii) IBNR. Case reserves are estimated based on the experience and knowledge of claims staff regarding the nature and potential cost of each claim. OneBeacon’s claims staff periodically adjusts case reserves as additional information becomes known or payments are made. Generally accepted actuarial methods are used to project estimates of IBNR. Actuaries use a variety of statistical and analytical methods to determine estimates of IBNR, which are based, in part, on historical claim reporting and payment patterns. In estimating IBNR, actuaries consider all available information, including reinsurance protections, inflation and the effects of legal, social and legislative trends on future claim payments. Management exercises judgment based upon its knowledge of its business, review of the outcome of actuarial studies, historical experience and other factors to record an estimate it believes reflects Potomac’s expected ultimate unpaid loss and LAE and related reinsurance recoverables.
Potomac was a net participant in the Pool through 2003. The Pool included several companies that had direct written business in those years when asbestos and environmental losses were not explicitly excluded by standard policy language. As a result, through 2003 Potomac did have net exposure to such losses as a result of its business assumed from the Pool.
Potomac has stopped writing business and virtually all its policies have expired. Potomac’s contingent direct liabilities were $97.3 million at November 23, 2004 which were fully reinsured by OneBeacon under the transfer and assumption agreement. Approximately 90% of such liabilities relate to accident years 1995 through 2000 and are principally risks written on Commercial Multi-Peril and Workers’ Compensation policies.
The collectibility of reinsurance recoverables is subject to the solvency and willingness to pay of the reinsurers. Potomac is selective in regard to its reinsurers, placing reinsurance principally with those reinsurers with strong financial condition, industry ratings and underwriting ability. Management monitors the financial condition and rating of its reinsurers on an ongoing basis.