Management’s Discussion and Analysis provides a narrative of our financial performance and condition that should be read in conjunction with the accompanying Consolidated Financial Statements. It includes the following sections:
• The adequacy of our loss reserves established for Hurricane Katrina and Hurricane Rita, which are based on management estimates.
• Developments in domestic and global financial markets that could affect our investment portfolio and financing plans.
• Additional government and NASDAQ policies relating to corporate governance, and the cost to comply.
• The ability to maintain and safeguard the security of our data.
• The resolution of regulatory issues and litigation pertaining to and arising out of Hurricane Katrina.
We conduct our operations through two distinct segments: property and casualty insurance and life insurance. We manage these segments separately because they generally do not share the same customer base, and they each have different pricing and expense structures. We evaluate segment profit based upon operating and investment results. Segment profit or loss described in the following sections of the Management’s Discussion and Analysis is reported on a pre-tax basis. Additional segment information is presented in Part II, Item 8, Note 11 “Segment Information” to the Consolidated Financial Statements.
Our revenue is primarily composed of premiums and investment income. Major categories of expenses include losses and loss settlement expenses, changes in reserves for future policy benefits, operating expenses and interest on policyholders’ accounts. Through disciplined underwriting and strong agency relationships, we have traditionally emphasized writing good business at an adequate price, preferring quality to volume. Our goal of consistent profitability is supported by these business strategies.
An additional measure of our results is the combined ratio. The property and casualty insurance industry uses the combined ratio as a measure of underwriting profitability. The combined ratio is the sum of the loss ratio (losses and loss settlement expenses incurred as a percent of net premiums earned) plus the expense ratio (underwriting expenses as a percent of net written premiums, if calculated on a statutory basis, or net earned premiums, if calculated on a GAAP basis). A combined ratio below 100 percent generally indicates a profitable book of business. Our GAAP combined ratio was 81.3 percent, 87.9 percent and 111.3 percent in 2007, 2006 and 2005, respectively. Our statutory combined ratio was 82.1 percent, 89.7 percent and 112.5 percent in 2007, 2006 and 2005, respectively. The statutory combined ratio for the property and casualty industry is projected by A.M. Best to be 95.6 percent for 2007. The industry statutory combined ratio was 92.4 percent in 2006 and 101.2 percent in 2005.
In the wake of record losses related to Hurricane Katrina and Hurricane Rita, we disclosed in 2006 that we intended to reduce our property exposures in the Gulf Coast region, particularly in Louisiana, as a way to mitigate the catastrophe risk associated with this business. During 2007 we took steps to reduce our exposure in the Gulf Coast, including the implementation of stricter underwriting guidelines and policy terms, as well as significant premium rate increases in catastrophe-prone areas. These steps have reduced our probable maximum loss due to catastrophe in the Gulf Coast area by over 40 percent from pre-Hurricane Katrina levels. With the exposure reduction in Louisiana and increased catastrophe reinsurance protection, we believe that we would not exceed our catastrophe reinsurance coverage limits for any future catastrophes similar in magnitude and intensity to Hurricane Katrina, which was the costliest catastrophe in the history of our company.
The strong results and steady income produced by our life insurance segment has historically helped offset the volatility of our property and casualty insurance earnings due to the cyclical nature of the property and casualty insurance business. In order to maintain profitability within our life insurance segment we will continue to diversify our product offerings in response to industry needs. In 2007 we introduced a new universal life product that combined the most popular features of and replaced our two existing universal life products. Our new universal life product includes a disability income rider with an increased monthly disability income benefit from $1,500 to $2,500. During 2007 we continued to see annuity withdrawals exceed new annuity deposits - although at a slower rate than experienced during 2006. The current interest rate environment presents a challenge to maintaining a profitable interest rate spread for our annuity business. We will continue monitoring annuity withdrawals closely to determine if interest rate adjustments become necessary in the future. Despite these challenges, we remain optimistic about the future of our life insurance business.
In August 2007, we announced that our Board of Directors authorized us to repurchase up to an additional 600,000 shares of our common stock, bringing our total repurchase authorization to 687,167 shares. Under this share repurchase program, we may purchase our common stock from time to time through open market or privately negotiated transactions. The amount and timing of stock repurchases is determined at the discretion of management and depends on a number of factors, including the price of our common stock, general market and economic conditions, and corporate and regulatory requirements. The share repurchase program will be in effect for two years, but may be modified or discontinued by us at any time.
We are faced with the challenge of balancing the capital adequacy requirements established by A.M. Best with market expectations regarding returns on equity investment. We currently consider our stock to be undervalued and, therefore, a good investment opportunity for our capital resources. During the last two quarters of 2007, we repurchased 497,500 shares of our common stock and returned them to the status of authorized but unissued shares. For a more detailed accounting of the shares repurchased under this program, refer to Part II, Item 5 “Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.”
On February 15, 2008, our Board of Directors authorized us to repurchase up to an additional 500,000 shares of common stock. As of February 15, 2008, our remaining repurchase authorization is 689,667 shares.
During its meetings, the ERM committee discussed the risks that our company faces, as well as the controls that are in place to mitigate those risks. These are not new ideas - management has actively and successfully managed risks
ERM issues are discussed both during our quarterly Board of Directors meetings and at our semi-annual managers meetings. At these meetings, directors and managers are updated on ERM issues and the ongoing efforts of the ERM committee. The work of our ERM committee has led to the development of new tools designed to aid in the evaluation and mitigation of underwriting risks.
Fortunately, we have been successful in retaining a high percentage of our quality accounts, so despite pricing reductions on these accounts they have continued to be profitable. In addition, we have been able to write new business, which has also been profitable.
Net investment income has increased moderately since 2005. In the life segment, our investment portfolio has decreased due to an outflow of annuity funds. Cash generated from operating results in the property and casualty segment has led to an increase in investable funds. During 2006 and 2007 we shortened the duration of our portfolio due to the interest rate environment. Over the past two years, short-term rates of return have generally exceeded long-term rates. Despite this recent short-term emphasis, we have actively managed the duration of our portfolio to attain an appropriate matching of assets to liabilities.
(1) Please refer to the Non-GAAP financial measures section of this report for further explanation of this measure.
The property and casualty insurance segment reported pretax income of $139.0 million in 2007 and $103.6 million in 2006, compared with a pretax loss of $14.8 million in 2005. The improvement in the 2007 and 2006 results compared to 2005, was primarily due to the significant impact Hurricane Katrina and Hurricane Rita had on our loss experience during 2005. The financial impact from these hurricanes was realized largely on our homeowners, allied lines and commercial multiple peril lines of business.
Over the past three years, our commercial lines of business has accounted for over 90 percent of premium revenue. We do not anticipate that our current mix of business (commercial lines/personal lines) will change materially.
Since 2000, we have had only five active accounts in our assumed business and a number of assumed contracts that are in run-off. Late in 2006, we made the decision to cancel one of the largest remaining assumed contracts. This decision was made in response to an exposure base that was in excess of our risk tolerance levels as compared to the premium we were able to collect. In 2007, premium writings were down by 11.0 percent as a result of this decision. During 2008, there will be additional reductions in assumed business as the cancelled contract expires.
Net premiums earned are decreased by ceded premiums that we pay to reinsurers. In 2005, we paid an $8.0 million reinstatement premium for our catastrophe reinsurance coverage, due to the fact that we had exceeded our reinsurance limits of $125.0 million on Hurricane Katrina. In 2006, premium rates for our catastrophe and excess of
Each year, our results are impacted not only by losses that occur in the current year, but also by development on losses that have occurred in prior years. The development, which can have either a favorable or unfavorable impact on earnings, is due to paying losses at amounts different than what we reserved, or to changing loss reserve estimates based on new information that becomes available to us. For the past ten years, we have experienced a net redundancy due to losses that occurred in prior years. In 2007, we incurred losses of $245.8 million, of which $291.0 million were from losses that occurred in 2007. We had favorable development from prior years’ losses of $45.2 million. The redundancy was realized in each of our lines of business, with the exception of homeowners, which was attributable to Hurricane Katrina development.
The following table illustrates the primary components of the net loss redundancy we experienced in our reserves for 2007, 2006 and 2005.
Salvage is the sale of damaged goods, for which the insured has been indemnified for and for which the insured has transferred title to the insurance company. Salvage reduces the cost incurred for property losses. Subrogation also reduces the costs incurred for a loss by seeking payment from other parties involved in the loss and/or from the other parties’ insurance company. Alternative dispute resolution facilitates settlements and reduces defense and legal costs through processes such as mediation and arbitration. Workers’ compensation medical bill review is a system designed to detect duplicate billings, unrelated and unauthorized charges and coding discrepancies, as well as it ensures that we are billed for medical services according to the fee schedule designated by each state in which we have claims.
Our “other” redundancy is attributable to both the payment of claims in amounts other than the amounts reserved and changes in loss reserves due to additional information on individual claims that we received after the reserves for those claims had been established. The additional information we consider is unique to each claim. Such information may include facts that reveal we have no coverage obligation for a particular claim, changes in applicable laws that reduce our liability or coverage exposure on a particular claim, facts that implicate other parties as being liable on a particular claim and favorable court rulings that decrease the likelihood that we would be liable for a particular claim. Also, additional information relating to severity is unique to each claim. For example, we may learn during the course of a claim that bodily injuries are less severe than originally believed or that damage to a structure is merely cosmetic instead of structural.
Commercial fire and allied lines insurance covers losses to an insured’s property, including its contents, from weather, fire, theft or other causes. We provide this coverage through a variety of business policies. The net loss ratio for our commercial fire and allied lines was 56.0 percent in 2007, 85.6 percent in 2006 and 140.5 percent in 2005. The improvement in our 2007 results was due to a lower number of fires and storms occurring during the year as well as better catastrophe results than in prior years. The deterioration in the 2006 and 2005 results were a result of net catastrophe losses and loss settlement expenses from Hurricanes Katrina and Rita, which totaled $19.6 million and $126.1 million in this line of business during 2006 and 2005, respectively. Also, pricing in our commercial property lines of business decreased during 2007 and 2006, with the exception of catastrophe-prone areas along the Gulf Coast, primarily in Louisiana.
Our other liability line of insurance covers businesses for bodily injury liability and property damage arising from general business operations, accidents on their premises and products manufactured or sold. We reported a net loss ratio in this line of 40.5 percent in 2007, 29.7 percent in 2006 and 31.1 percent in 2005. The deterioration in the net loss ratio in 2007 was primarily related to increased severity. We had several large liability losses in 2007, but have detected no trends as to cause of loss or geographic location. We also experienced an increase in net premiums earned of 4.9 percent in 2007 over 2006, compared to an increase of 7.3 percent in 2006 over 2005, as a result of pricing initiatives in this particular line of business.
Our surety products guarantee performance and payment by our bonded principals. Our contract bonds protect owners from failure to perform on the part of our principals. In addition, our surety bonds protect material suppliers and subcontractors from nonpayment by our contractors. When surety losses occur, our loss is determined by estimating the cost to complete the remaining work and to pay the contractor’s unpaid bills, offset by contract funds due to the contractor, reinsurance and the value of any collateral to which we may have access. The net loss ratio in this line was 9.7 percent in 2007, 35.2 percent in 2006 and 46.3 percent in 2005. The improvement in 2007 as compared to 2006 was the result of stricter underwriting guidelines, as well as a decrease in frequency and severity. In 2007, there were no new claims that exceeded our $1.5 million reinsurance retention level, compared to three such claims in 2006 and four such claims in 2005. The 2006 and 2005 underwriting results were adversely impacted primarily by bonded principals that defaulted on their bonded obligations after a determination was made that they did not have the financial wherewithal to complete the bonded projects, which required us to pay the outstanding obligations associated with those projects. In response to the poor performance in the surety line of business, we continue to improve our underwriting discipline by, among other things, requiring principals to provide more frequent financial statements, requiring principals to maintain higher levels of capitalization, limiting bonding on those principals showing signs of inadequate cash flow and requiring additional indemnity and collateral. Our changes have resulted in a slight reduction in premium revenue in both 2007 and 2006.
Our assumed reinsurance line of business improved in 2007 and 2006, reporting net loss ratios of 36.0 percent and 57.5 percent, respectively. The improvement in 2007 results was due to improved catastrophe loss development during the year. In 2005, the net loss ratio was 137.8 percent. The improvement in our net loss ratio from 2005 to 2006 was primarily due to the impact Hurricane Katrina and Hurricane Rita had on our assumed loss experience during 2005. In recent years, we have significantly reduced the level of our assumed reinsurance business. This decrease in assumed reinsurance business continued in 2007 with premium writing decreasing by 11.0 percent as the result of the cancellation of a large assumed contract. We anticipate more reductions in 2008 and in the future as the cancelled contract expires. We continue to have exposure, primarily with respect to catastrophe coverage related to the runoff business, as well as to the small number of assumed reinsurance contracts that we have continued to underwrite.
1. Please refer to the Non-GAAP financial measures section of this report for further explanation of this measure.
The reduction in annuity balances was the primary contributor to the decrease in interest on policyholders’ accounts, each year since 2005, as well as a decline in credited interest rates on in force annuity contracts.
As of December 31, 2007, we recorded net unrealized gains, after tax, of $85.6 million, compared to $93.5 million in 2006 and $86.4 million in 2005. In each of the three years, our portfolio of equity securities was the largest contributor to net unrealized gains. In 2007, depressed stock prices resulted in the decrease in unrealized gains,
Refer to “Critical Accounting Estimates” in this section for a detailed discussion of our policy for recording other-than-temporary impairment charges.
Upon the purchase of American Indemnity Financial Corporation, we recorded a valuation allowance against the NOLs due to our determination that we may not be able to fully realize the benefits of the NOLs. At December 31, 2007 and 2006, the valuation allowance was $5.6 million and $6.2 million, respectively. Upon review each year, when we have determined that the benefit of the NOLs could be realized, the decrease in the valuation allowance has been recorded as a reduction to current federal income tax expense. The NOLs were not utilized in 2005 due to an operating loss caused by the losses from Hurricane Katrina. In future years, decreases to the valuation allowance will continue to be recognized as a reduction to current federal income tax expense.
At December 31, 2007, $1,812.8 million, or 98.5 percent, of our fixed maturities were classified as available-for-sale, compared with $1,808.2 million, or 97.6 percent, at December 31, 2006. We classify our remaining fixed maturities as held-to-maturity or trading. We record held-to-maturity securities at amortized cost. We record trading securities, primarily convertible redeemable preferred debt securities, at fair value, with any changes in fair value recognized in earnings. As of December 31, 2007, 95.1 percent of our fixed maturities were investment grade, as defined by the National Association of Insurance Commissioners’ Securities Valuation Office, with ratings of Class 1 or Class 2.
Our uses of cash include losses and loss settlement expenses, annuity withdrawals, commissions, premium taxes, income taxes, operating expenses, dividends, and investment purchases. Cash outflows may be variable because of the uncertainty regarding settlement dates for losses. In addition, the timing and amount of catastrophe losses are inherently unpredictable and could increase our liquidity requirements.
We invest funds available for short-term cash needs primarily in money market accounts, which are classified as cash equivalents. At December 31, 2007, our cash and cash equivalents included $110.5 million related to these money market accounts, compared with $48.6 million at December 31, 2006.
The insurance laws of the states and jurisdictions where we and our insurance subsidiaries and affiliate are domiciled restrict the timing and the amount of dividends we pay, or our subsidiaries and affiliate pay, without prior regulatory approval. In 2007, 2006 and 2005, United Fire received $4.0 million in dividends from its subsidiary, United Life Insurance Company. Pursuant to the sale of American Indemnity Company in May 2006, we implemented a plan of corporate reorganization. Part of this plan entailed the distribution of the majority of American Indemnity Company’s net assets to United Fire & Casualty Company. This distribution was recognized by United Fire as a $34.7 million intercompany dividend in 2006. Also, in 2007, United Fire received an $8.0 million dividend from American Indemnity Financial Corporation.
As of December 31, 2007, our cash and cash equivalents totaled $252.6 million, compared with $255.0 million at December 31, 2006. In 2007 and 2006, our cash position was higher than historical levels. This was attributable to the flat to inverted yield curve. As short-term rates were equal to or higher than long-term rates over the past two years, we shortened the duration of our portfolio and invested in short-term money markets.
Stockholders’ equity increased from $680.8 million at December 31, 2006, to $751.5 million at December 31, 2007, an increase of 10.4 percent, which resulted primarily from net income of $111.4 million. Decreases to stockholders’
(1) This projection of our obligation for future policy benefits considers only actual future cash outflows. The future policy benefit reserves presented on the consolidated balance sheet is the net present value of the benefits to be paid, less the net present value of future net premiums.
At December 31, 2007, we have no off-balance sheet obligations or commitments.
Critical accounting estimates are defined as those that are representative of significant judgments and uncertainties and that potentially may result in materially different results under different assumptions and conditions. We base our discussion and analysis of our results of operations and financial condition on the amounts reported in our Consolidated Financial Statements, which we have prepared in accordance with GAAP. As we prepare these
Upon acquisition, we classify investment securities as held-to-maturity, available-for-sale, or trading. We record investments in held-to-maturity fixed maturities at amortized cost. We record available-for-sale fixed maturities, trading securities, equity securities, short-term investments and other long-term investments at fair value. We record mortgage loans at amortized cost and policy loans at the outstanding loan amount due from policyholders.
We continually monitor the difference between our cost basis and the estimated fair value of our investments. Our accounting policy for impairment recognition requires us to record other-than-temporary impairment charges when we determine that it is more likely than not that we will be unable to collect all amounts due according to the contractual terms of the fixed maturity security or that the anticipated recovery in market value of the equity security will not occur in a reasonable amount of time. We include impairment charges on investments in net realized gains and losses based on the fair value of the investments at the measurement date. 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. As of December 31, 2007, we had a number of securities where fair value was less than our cost. The total unrealized depreciation on these securities totaled $17.6 million at December 31, 2007, compared with $14.2 million at December 31, 2006. At December 31, 2007, the largest unrealized loss, after tax, on any single fixed maturity or equity investment was $1.4 million. Our rationale for not recording other-than-temporary impairments on these securities is discussed in Part II, Item 8, Note 2, “Summary of Investments.”
Actual future results could differ materially from our current estimates, requiring adjustments to the recorded deferred policy acquisition cost asset. Such adjustments are recorded through income in the period the adjustments are identified. Due to changes in the estimated recoverability of our deferred policy acquisition costs, the premium deficiency charge calculated at December 31, 2006 decreased $7.3 million from the premium deficiency charge calculated at December 31, 2005. There was an immaterial change in premium deficiency between December 31, 2007 and December 31, 2006. A decrease in the premium deficiency charge allows us to defer comparatively more underwriting costs period over period, resulting in a relatively larger deferred acquisition cost asset. The changes in the estimated recoverability of our deferred policy acquisition costs are attributable to improvement in our underwriting experience over the recent past.
We defer policy acquisition costs related to non-traditional business and amortize these costs in proportion to the present value of estimated expected gross profits. The components of gross profit include investment spread, mortality and expense margins and surrender charges. We periodically review estimates of expected profitability and evaluate the need to “unlock” or revise the amortization of the deferred policy acquisition cost asset. The primary assumptions utilized when estimating future profitability relate to interest rate spread, mortality experience and policy lapse experience. The table below illustrates the impact that a reasonably likely change in our assumptions used to estimate gross profit would have on the deferred policy acquisition cost asset for our non-traditional business recorded as of December 31, 2007. The entire impact of the changes illustrated would be recognized through income as an increase or decrease to amortization expense.
The deferred policy acquisition costs in connection with our non-traditional business are adjusted with respect to estimated gross profits as a result of changes in the net unrealized gains or losses on available-for-sale fixed maturity securities allocated to support the block of fixed annuities and universal life policies. That is, because we carry fixed maturity securities available-for-sale at aggregate fair value, we make an adjustment to deferred policy acquisition costs equal to the change in amortization that would have been recorded if we had sold such securities at their stated aggregate fair value and reinvested the proceeds at current yields. We include the change in this adjustment, net of tax, as a component of accumulated other comprehensive income. This adjustment offset deferred policy acquisition costs by $8.0 million at December 31, 2007, compared with $4.1 million at December 31, 2006.
(1) “Fire and allied lines” includes fire, allied lines, commercial multiple peril and inland marine.
the circumstances and facts of the claim. Upon notice of a claim, we establish a reserve based on the claim information reported to us at that time. Subsequently, we conduct an investigation of each reported claim, which allows us to more fully understand the factors contributing to the loss and our potential exposure. This investigation may extend over a long period of time. As our investigation of a claim develops, and as our claims personnel identify trends in claims activity, we refine and adjust our estimates of case reserves. To evaluate and refine our overall reserving process, we track and monitor all claims until they are settled and paid in full, with all salvage and subrogation claims being resolved.
Our short-tail lines of business include fire and allied lines, homeowners, commercial property and inland marine. The amounts of the case-based reserves that we establish for claims in these lines depend upon various factors, such as individual claim facts (including type of coverage and severity of loss), company historical loss experience and trends in general economic conditions (including changes in replacement costs, medical costs and inflation).
The amounts of the case-based reserves that we establish for claims in long-tail lines depends upon various factors, including individual claim facts (including type of coverage, severity of loss and underlying policy limits), company historical loss experience, legislative enactments, judicial decisions, legal developments in the awarding of damages, changes in political attitudes and trends in general economic conditions, including inflation. As with the short-tail lines of business, we review and make changes to long-tail case-based reserves based on continually evolving facts as they become available to us during the claims settlement process. Our adjustments to case reserves are reflected in the financial statements in the period that new information arises about the claim. Examples of facts that become known that could cause us to change our case-based reserves include, but are not limited to: evidence that loss severity is different than previously assessed, new claimants who have presented claims and the assessment that no coverage exists.
For our short-tail lines of business, IBNR constitutes a small portion of the overall reserves. This is because claims are generally reported and settled shortly after the loss occurs. In our long-tail lines of business, IBNR constitutes a relatively higher proportion of total reserves, because, for many liability claims, significant periods of time may elapse between the initial occurrence of the loss, the reporting of the loss to us and the ultimate settlement of the claim.
The estimation of assumed and ceded reinsurance loss and loss settlement expense reserves is subject to the same factors as the estimation of loss and loss settlement expense reserves. In addition to those factors, which give rise to inherent uncertainties in establishing loss and loss settlement expense reserves, there exists a delay in our receipt of reported claims due to the procedure of having claims first reported through one or more intermediary insurers or reinsurers.
• Our case-basis reserves reflect the most up-to-date information available about the unique circumstances of each claim;
• No new judicial decisions or regulatory actions will increase our case-basis obligations;
• The historical patterns of claim frequency and claim severity utilized within our IBNR reserve calculation, without considering unusual events, are consistent and will continue to be consistent; and
• The company’s historical ratio of loss settlement expenses (“LAE”) paid to losses paid is consistent and will continue to be consistent.
Due to the inherent uncertainty in the loss reserving process, management believes that there is a reasonable chance that modification to the key assumptions listed above could individually, or in aggregate, result in reserve levels that are misstated either above or below the actual amount for which the related claims will eventually settle.
In 2007, we did not change our key assumptions. In estimating our 2007 loss and loss settlement expense reserves, we did not anticipate future events or conditions that were inconsistent with past development patterns.
Our reserve for other liability claims at December 31, 2007, is $176.3 million and consists of 3,000 claims, compared with $171.2 million, consisting of 3,016 claims at December 31, 2006. Defense costs are a part of the insured costs covered by other liability policies and can be significant; sometimes greater than the cost of the actual paid claims. Of the $176.3 million total reserve for other liability claims, $47.0 million is identified as defense costs and $16.6 million is identified as general overhead required in the settlement of claims. If our reserve for other liability loss and loss settlement expenses is overstated or understated by 10 percent, the potential impact to our Consolidated Financial Statements would be approximately $17.8 million, before federal income taxes.
Included in the other liability line of business are gross reserves for construction defect losses and settlement expenses. Construction defect is a liability allegation relating to defective work performed in the construction of structures such as commercial buildings, apartments, condominiums, single family dwellings or other housing, as well as the sale of defective building materials. These claims seek recovery due to damage caused by alleged deficient construction techniques or workmanship. At December 31, 2007, we established $10.5 million in construction defect loss and loss settlement expense reserves, consisting of 211 claims, compared with $11.2 million, consisting of 217 claims, at December 31, 2006. The reporting of such claims can be delayed, as the statute of limitations can be up to 10 years. Also, recent court decisions have expanded insurers’ exposure to construction defect claims. As a result, claims may be reported more than 10 years after a project has been completed, as litigation can proceed for several years before an insurance company is identified as a potential contributor. Claims have also emerged from parties claiming additional insured status on policies issued to other parties, such as contractors seeking coverage on a subcontractor’s policy.
Included in the other liability line of business are gross reserves for asbestos and other environmental losses and loss settlement expenses. At December 31, 2007, we had $5.0 million in direct and assumed asbestos and environmental loss reserves, compared with $3.5 million at December 31, 2006. In addition, we had ceded asbestos and environmental loss reserves of $1.9 million at December 31, 2007 compared to $.6 million at December 31, 2006. The estimation of loss reserves for environmental claims and claims related to long-term exposure to asbestos and other substances is one of the most difficult aspects of establishing reserves, especially given the inherent uncertainties surrounding such claims. Although we record our best estimate of loss and loss settlement expense reserves, the ultimate amounts paid upon settlement of such claims may be more or less than the amount of the reserves, because of the significant uncertainties involved and the likelihood that these uncertainties will not be resolved for many years.
Like the other liability line of business, workers’ compensation losses and loss settlement expense reserves are based upon variables that create imprecision in estimating the ultimate reserve. Estimates for workers’ compensation are particularly sensitive to assumptions about medical cost inflation, which has been steadily increasing over the past few years. Other variables that we consider and that contribute to the uncertainty in establishing reserves for workers’ compensation claims include: the state legislative and regulatory environments; trends in jury awards; and mortality rates. Because of these variables, the process of reserving for the ultimate loss and loss settlement expense requires the use of informed judgment and is inherently uncertain. Consequently, actual loss and loss settlement expense reserves may deviate from estimates reflected in our Consolidated Financial Statements. Such deviations may be significant. Our reserve for workers’ compensation claims at December 31, 2007, is $111.5 million and consists of 2,191 claims, compared with $103.7 million, consisting of 1,948 claims, at December 31, 2006. If our reserve for workers’ compensation loss and loss settlement expenses is overstated or understated by 10 percent, the potential impact to our Consolidated Financial Statements would be approximately $11.2 million, before federal income taxes.
• Establishing reserves that are appropriate and reasonable, but assuming a pessimistic view of potential outcomes.
We are required by state law, to engage an independent actuarial firm to render opinions as to the reasonableness of the statutory reserves we establish. There are no material differences between our statutory reserves and those established under GAAP. During 2007 and 2006, we engaged the services of Regnier Consulting Group, Inc. as our “independent actuarial firm” for the property and casualty insurance segment. We anticipate that this engagement will continue in 2008.
We establish reserves for amounts that are payable under traditional insurance policies, including traditional life insurance, disability income, and income annuities. Reserves are calculated as the present value of future benefits expected to be paid, reduced by the present value of future expected premiums. Our estimates use methods and underlying assumptions that are in accordance with GAAP and applicable actuarial standards. The key assumptions that we utilize in establishing reserves are mortality, morbidity, policy lapse, renewal, retirement, investment returns, inflation, and expenses. Assumptions are established when the policy is issued. If actual experience is less favorable than assumptions, we may need to increase our reserves, resulting in a charge to policyholder benefits and claims.
Refer to Part II, Item 8, Note 1 “Significant Accounting Policies” for a description of recently issued accounting pronouncements not effective for reporting purposes at December 31, 2007. We believe that the new accounting pronouncements, when adopted, will not materially affect our financial condition or results of operations.
We believe that disclosure of certain non-GAAP measures enhances investor understanding of our financial performance. The non-GAAP financial measures we utilize in this report are premiums written, catastrophe losses and combined ratio. These are statutory financial measures prepared in accordance with statutory accounting rules, as prescribed by the National Association of Insurance Commissioners’ Accounting Practices and Procedures Manual.
Premiums written is a measure of our overall business volume. Net premiums written are comprised of direct and assumed premiums written, net of what we are charged for reinsurance policies. Direct premiums written is the amount of premiums charged for policies issued during the period, Assumed premiums written is consideration or payment we receive in exchange for reinsurance we provide to other insurance companies. We report these premiums as revenue as they are earned over the underlying policy period. We report premiums written applicable to the unexpired term of a policy as unearned premium subject to reinsurance. We evaluate premiums written as a measure of business production for the period under review.
Catastrophe losses utilize the designations of the Insurance Services Office (“ISO”) and are reported with loss and loss settlement expense amounts net of reinsurance recoverables, unless specified otherwise. According to the ISO, a catastrophe loss is a single unpredictable incident or series of closely related incidents causing severe insured losses that cause $25.0 million or more in industry-wide direct insured losses to property and that affect a significant number of insureds and insurers (“ISO catastrophes”). We also include as catastrophes those events we believe are, or will be, material to our operations, either in amount or in number of claims made. The frequency and severity of catastrophic losses we experience in any year affect our results of operations and financial position. In analyzing the underwriting performance of our property and casualty insurance segment, we evaluate performance both including and excluding catastrophe losses. For the years ended December 31, 2007 and 2006 losses from non-ISO catastrophes totaled less than $.4 million and $.9 million, respectively. Portions of our catastrophe losses may be recoverable under our catastrophe reinsurance agreements. We include a discussion of the impact of catastrophes because we believe it is meaningful for investors to understand the variability in periodic earnings.
Combined ratio is a commonly used financial measure of underwriting performance. A combined ratio below 100 percent generally indicates a profitable book of business. The combined ratio is the sum of two separately calculated ratios, the loss and loss settlement expense ratio (referred to as the “net loss ratio”) and the underwriting expense ratio (the “expense ratio”). When prepared in accordance with GAAP, the net loss ratio is calculated by dividing the sum of losses and loss settlement expenses by net premium earned. The expense ratio is calculated by dividing non-deferred underwriting expenses and amortization of deferred policy acquisition costs by net premiums earned. When prepared in accordance with statutory accounting principles, the net loss ratio is calculated by dividing the sum of losses and loss settlement expenses by net premium earned; the expense ratio is calculated by dividing underwriting expenses by net premiums written.
(2) The adjustment of minimum pension liability is net of income taxes.
The accompanying Consolidated Financial Statements include United Fire & Casualty Company (“United Fire”) and its wholly owned subsidiaries: United Life Insurance Company, Lafayette Insurance Company, Addison Insurance Company, American Indemnity Financial Corporation, United Fire & Indemnity Company and Texas General Indemnity Company. United Fire Lloyds, an affiliate of United Fire, has also been included in consolidation. All intercompany balances have been eliminated in consolidation.
On whole life and term insurance (traditional business) premiums are reported as earned when due and benefits and expenses are associated with premium income in order to result in the recognition of profits over the lives of the related contracts. On universal life and annuity policies (non-traditional business), income and expenses are reported when charged and credited to policyholder account balances in order to result in the recognition of profits over the lives of the related contracts. We accomplish this by means of a provision for future policy benefits and the deferral and subsequent amortization of life policy acquisition costs. We do not write variable annuities or variable life insurance products.
The effect on deferred policy acquisition costs that results from the assumed realization of unrealized gains (losses) is recognized with an offset to unrealized investment appreciation (depreciation) as of the balance sheet dates. As of December 31, 2007, pre-tax adjustments decreased deferred policy acquisition costs by $3,831,000. As of December 31, 2006, pre-tax adjustments increased deferred policy acquisition costs by $9,188,000.
Liabilities for future policy benefits for traditional products are computed by the net level premium method, using interest assumptions ranging from 4.5 percent to 6.0 percent and withdrawal, mortality and morbidity assumptions appropriate at the time the policies were issued. Accident and health reserves are stated at amounts determined by estimates on individual claims and estimates of unreported claims based on past experience. Liabilities for universal life and investment contracts are stated at policyholder account values before surrender charges. Liabilities for traditional immediate annuities are based primarily upon future anticipated cash flows using statutory mortality and
interest rates, which produce results that are not materially different from GAAP. Liabilities for deferred annuities are carried at the account value.
Premiums earned and losses and loss settlement expenses incurred are reported net of reinsurance ceded. Ceded insurance business is accounted for on a basis consistent with the original policies issued and the terms of the reinsurance contracts. Refer to Note 5 “Reinsurance” in this item for a discussion of our reinsurance operations.
Our intangibles are composed entirely of agency relationships, which are being amortized by the straight-line method over periods of up to 10 years. We regularly review the carrying value of our intangibles for impairment in the recoverability of the underlying asset, with any impairment being charged to operations in the period that the impairment was recognized. We did not recognize an impairment write-down to the carrying value of our intangibles in 2007, 2006 or 2005.
Amortization expense totaled $60,000 for each of the three years ended December 31, 2007, 2006 and 2005.
We have been named as a defendant in various lawsuits, including actions seeking certification from the court to proceed as a class action suit and actions filed by individual policyholders, relating to disputes arising from damages that occurred as a result of Hurricane Katrina in 2005. As of December 31, 2007, there were in excess of 400 such cases pending, approximately 20 of which were styled as class actions. These cases have been filed in both Louisiana state courts and federal district courts. These cases involve, among other claims, disputes as to the amount of reimbursable claims in particular cases, as well as the scope of insurance coverage under homeowners and commercial property policies due to flooding, civil authority actions, loss of use and business interruption. Certain of these cases also claim a breach of duty of good faith or violations of Louisiana insurance claims-handling laws or regulations and involve claims for punitive or exemplary damages, while other cases claim that under Louisiana’s so-called “Valued Policy Law”, the insurers must pay the total insured value of a home that is totally destroyed if
We consider all of our other litigation pending at December 31, 2007, to be ordinary, routine, and incidental to our business.
Pursuant to our adoption of SFAS No. 123(R), “Share-Based Payment” on January 1, 2006, we recognize stock-based compensation expense on options granted under our stock option plans ratably over the underlying vesting period which is five years. This expense is based on the fair value of the respective stock award and is recognized ratably over the underlying vesting period. We utilized the modified-prospective method prescribed by SFAS No. 123(R) in transitioning to this new accounting treatment for stock-based compensation expense. This method requires that stock-based compensation expense be recorded for all stock options granted subsequent to January 1, 2006 and all unvested stock options that existed upon the adoption of SFAS No. 123(R) in 2006.
The table below displays the impact that SFAS No. 158 had on our Consolidated Financial Statements for December 31, 2006.
Proceeds from sales of available-for-sale securities during 2007, 2006 and 2005 were $3,689,000, $2,400,000 and $5,720,000, respectively. Gross gains of $929,000, $235,000 and $2,249,000 and gross losses of $0, $16,000 and $1,135,000 were realized on those sales in 2007, 2006 and 2005, respectively.
There were no sales of held-to-maturity securities during 2007, 2006 or 2005.
A summary of net realized investment gains resulting from sales, calls and other-than-temporary impairments and a summary of net changes in unrealized investment appreciation, less applicable income taxes, is as follows:
Net investment income for the years ended December 31, 2007, 2006 and 2005, is composed of the following:
(1) Includes an adjustment to reflect the change in the fair value of our limited partnership investments.
On the following pages are a summary of fixed maturity and equity securities that were in an unrealized loss position at December 31, 2007 and 2006. We have the ability and positive intent to hold the securities until such time as the value recovers or the securities mature. Further, we believe the deterioration in value of our fixed maturity portfolio is primarily attributable to changes in market interest rates and not the credit quality of the issuer. We attribute the deterioration in value of our equity security portfolio to usual market volatility and not to any permanent financial hardships encountered by the underlying companies in which we are invested. Therefore, we have concluded that our unrealized losses are temporary in nature.
In most cases, quoted market prices were used to determine the fair value of fixed maturities, equity securities, trading securities and short-term investments. Where quoted market prices do not exist, fair value is based upon estimated realizable value.
The fair value of the liabilities for annuity products that are in a benefit payment phase, guaranteed investment contracts and structured settlements is based on a discount rate of 5.75 percent at December 31, 2007 and 2006. The fair value of annuities currently in an accumulation phase is based on the underlying net cash surrender value.
A summary of the carrying value and estimated fair value of our financial instruments at December 31, 2007 and 2006, is as follows:
We maintain a $50,000,000 bank line of credit. Under the terms of the agreement, interest on outstanding notes is payable at the lender’s prevailing prime rate minus 1.0 percent. There was no outstanding loan balances at December 31, 2007 and 2006, nor did we borrow against this line of credit in 2007, 2006 or 2005. As of December 31, 2007, approximately $187,000 of the line of credit was allocated towards letters of credit we have issued as a result of our reinsurance operations.
(1) For 2006, $20.0 million of the property catastrophe reinsurance coverage applied only to specific named perils.
The ceding of insurance does not legally discharge us from primary liability under our policies and we must pay the loss if the reinsurer fails to meet its obligations. We believe all reinsurance receivables are collectable.
The ceding of insurance does not legally discharge United Life Insurance Company from primary liability under its policies. United Life Insurance Company must pay the loss if the reinsurer fails to meet its obligations. Approximately 91.9 percent of ceded life insurance in force as of December 31, 2007, has been ceded to four reinsurers. We believe all reinsurance receivables are collectable.
The table below provides an analysis of changes in our property and casualty loss and loss settlement expense reserves for 2007, 2006 and 2005 (net of reinsurance amounts). The favorable development in each year resulted from a re-estimation of loss reserves recorded at December 31 of the prior year. This re-estimation is primarily attributable to both the payment of claims in amounts less than the amounts reserved and from changes in loss reserves due to additional information on individual claims that we received after the reserves for those claims had been established. Another factor contributing to the redundancy recognized each year is the development of reserves for IBNR claims and loss settlement expenses at a level significantly less than anticipated at December 31 of the prior year. We attribute this favorable development to the fact that during recent years, we have experienced abnormally low levels of noncatastrophe claims frequency, due to improvements in our underwriting process. We have not altered our reserving process as of December 31, 2007.
We are directed by the state insurance departments’ solvency regulations to calculate a required minimum level of capital and surplus based on insurance risk factors. The risk-based capital results are used by the NAIC and state insurance departments to identify companies that merit regulatory attention or the initiation of regulatory action. At December 31, 2007, both United Life Insurance Company and United Fire and its property and casualty subsidiaries and affiliate had statutory capital and surplus in regards to policyholders well in excess of their required levels.
The State of Iowa Insurance Department governs the amount of dividends that we may pay to stockholders without prior approval by the department. Based on these restrictions, we are allowed to make a maximum of $105,083,000 in dividend distributions to stockholders in 2008 without prior approval. We paid dividends of $15,293,000, $13,196,000 and $11,818,000 in 2007, 2006 and 2005, respectively. Dividend payments by the insurance subsidiaries to United Fire are subject to similar restrictions in the states in which they are domiciled. In 2007, 2006 and 2005, United Fire received $4,000,000 in dividends each year from United Life Insurance Company. Also, in 2007, United Fire received an $8,000,000 dividend from American Indemnity Financial Corporation.
Pursuant to the sale of American Indemnity Company in May 2006, we implemented a plan of corporate reorganization. Part of this plan entailed the distribution of the majority of American Indemnity Company’s net assets to United Fire & Casualty Company. This distribution was recognized by United Fire in 2006 as a $34,700,000 intercompany dividend.
A reconciliation of income tax expense (computed at the applicable federal tax rate of 35 percent) to the amount recorded in the accompanying Consolidated Financial Statements is as follows:
As of December 31, 2007, we have a gross deferred tax asset for net operating loss carryforwards totaling $17,215,000, all of which was acquired as part of our purchase of American Indemnity Financial Corporation. Net operating loss carryforwards totaling $769,000 and $5,491,000 expire in 2010 and 2011, respectively, and can only be used to offset future income of our property and casualty insurance segment. We are required to establish a
valuation allowance for any portion of the gross deferred tax asset that we believe may not be realized. At December 31, 2007, we recorded a valuation allowance of $5,647,000. As we determine that the benefit of these net operating losses can be realized, the related reduction in the deferred tax asset valuation allowance will be recorded as a reduction to our current federal income tax expense.
We offer a noncontributory defined benefit pension plan in which all of our employees are eligible to participate after they have completed one year of service, attained 21 years of age and have met the hourly service requirements. Retirement benefits under our pension plan are based on the number of years of service and level of compensation. Our policy is to fund this plan on a current basis to the extent that the contribution is deductible under existing tax regulations. We estimate that we will contribute approximately $4,000,000 to the plan in 2008.
The following is a summary of the plan’s weighted average asset allocations at December 31, 2007 and 2006 by asset category:
Dividends on shares of United Fire common stock totaled $109,000 and $100,000 in 2007 and 2006, respectively. The annuity fund purchased from United Life Insurance Company is credited with compound interest on the average fund balance for the year. The interest rate will be equivalent to the ratio of net investment income to mean assets of United Life Insurance Company. It is our policy to structure our pension plan portfolio based upon a long-term, strategic outlook of the investment markets. We utilize historical and forward-looking return forecasts to establish future return expectations for our various asset categories. These investment return expectations are used to develop our asset allocation based on the specific needs of the pension plan. We utilize multiple investment managers in order to maximize the plan’s return while minimizing risk.
We offer a health and dental benefit plan to all of our eligible employees and retirees, which is composed of two programs: (1) the self-funded retiree health and dental benefit plan and (2) the self-funded employee health and dental benefit plan. The plan provides health and dental benefits to our employees and retirees (and covered dependents) who have met the service and participation requirements stipulated by the plan. The plan’s contract administrators are responsible for making medical and dental care benefit payments. Participants are required to submit claims for reimbursement or payment to the claims administrator within 12 months after the end of the calendar year in which the charges were incurred. An unfunded benefit obligation is reported for the plan, which relates primarily to our postretirement benefit program.
For measurement purposes of our health and dental benefit plan, a 10.0 percent annual rate of increase in the per capita cost of covered health care benefits is assumed for 2007. The rate is assumed to decrease gradually each year to a rate of 5.25 percent for 2013 and remain at that level thereafter. For dental claims, a 5.25 percent annual rate of increase was assumed for 2008 and thereafter.
We have an employee stock ownership plan for the benefit of eligible employees and their beneficiaries. All employees are eligible to participate in the plan upon completion of one year of service, meeting the hourly requirements with United Fire and attaining 21 years of age. Contributions to this plan are made at our discretion. These contributions are based upon a percentage of the total payroll and are allocated to participants on the basis of compensation. We make contributions in stock or cash, which the trustee uses to acquire shares of United Fire stock to allocate to participants’ accounts. As of December 31, 2007, 2006 and 2005, the employee stock ownership plan owned 244,386, 248,764 and 249,978 shares of United Fire common stock, respectively. Shares owned by the employee stock ownership plan are included in shares issued and outstanding for purposes of calculating earnings per share and dividends paid on the shares are charged to retained earnings. We made contributions to the plan of $275,000, $650,000 and $250,000 in 2007, 2006 and 2005, respectively.
We have a nonqualified employee stock option plan that authorizes the issuance of up to 1,000,000 shares of United Fire common stock to employees, with 310,908 options available for future issuance at December 31, 2007. The plan is administered by the Board of Directors. The Board has the authority to determine which employees will receive options, when options will be granted and the terms and conditions of the options. The Board may also take any action it deems necessary and appropriate for the administration of the plan. Pursuant to the plan, the Board may, at its sole discretion, grant options to any employees of United Fire or any of its affiliated companies. These options are granted to buy shares of United Fire’s common stock at the market value of the stock on the date of grant. The options vest and are exercisable in installments of 20.0 percent of the number of shares covered by the option award each year from the grant date. To the extent not exercised, installments shall accumulate and be exercisable by the optionee, in whole or in part, in any subsequent year included in the option period, but not later than 10 years from the grant date. Stock options have historically been granted free of charge to eligible employees as designated by the Board of Directors.
The analysis below details the activity of both of our stock option plans for the year ended December 31, 2007. Information on the options outstanding at December 31, 2007, is also presented.
The property and casualty insurance segment markets most forms of commercial and personal property and casualty insurance products, including surety bonds and reinsurance. The business is generated through 865 independent agencies and brokers in 42 states. The life insurance segment underwrites and markets life (primarily universal and traditional life) and annuity (primarily single premium annuity) products to individuals and groups through 927 independent agencies in 28 states.
(1)Fire and allied lines in this table includes fire, allied lines, homeowners, commercial multiple peril and inland marine.
(2)Other liability is business insurance covering bodily injury and property damage arising from general business operations, accidents on the insured’s premises and products manufactured or sold.
Basic earnings per share is computed by dividing net income or loss available to common shareholders (net income or loss less dividends to preferred shareholders and accretions of preferred stock issuance costs) by the weighted-average number of common shares outstanding during the period. Diluted earnings per share give effect to all dilutive common shares outstanding during the period. The dilutive shares we consider in our diluted earnings per share calculation relate to our convertible preferred stock outstanding as well as our outstanding stock options. During 2005, we redeemed all shares of preferred stock that were not previously converted into shares of common stock.
The components of basic and diluted earnings per share are displayed in the table below.
At December 31, 2007, we were obligated under noncancelable operating lease agreements for office space, vehicles, computer equipment and office equipment. Most of our leases include renewal options, purchase options or both. These provisions may be exercised by us upon the expiration of the related lease agreements. Rental expense under our operating lease agreements was $4,785,000, $4,714,000 and $4,558,000 for the years ended December 31, 2007, 2006 and 2005, respectively. Our most prominent lease arrangement is for office space through which we conduct the insurance operations of our Galveston, Texas, location. This lease was initiated in December 2004, with a lease term of 10 years. The annual lease payment for this office space is approximately $2,100,000.
At December 31, 2007, our future minimum rental payments are as follows:
We have audited the accompanying consolidated balance sheets of United Fire & Casualty Company (United Fire) as of December 31, 2007 and 2006, and the related consolidated statements of income, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2007. Our audits also included the financial statement schedules of United Fire listed in Item 15(a)(2). These financial statements and schedules are the responsibility of United Fire’s management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of United Fire’s 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 and our report, dated February 27, 2008, expressed an unqualified opinion thereon.