The selected financial data herein has been derived from the consolidated financial statements of United Fire and its subsidiaries and affiliate. The data should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the “Consolidated Financial Statements and Related Notes.” The 2004 and prior amounts reflect the retroactive effects of our December 15, 2004, one-for-one stock dividend.
•Loss and Loss Settlement Expenses - Property and Casualty Insurance Segment
•Future Policy Benefits and Losses, Claims and Loss Settlement Expenses - Life Insurance Segment
This report may contain forward-looking statements about our operations, anticipated performance and other similar matters. The Private Securities Litigation Reform Act of 1995 provides a safe harbor under the Securities Act of 1933 and the Securities Exchange Act of 1934 for forward-looking statements. The forward-looking statements are not historical facts and involve risks and uncertainties that could cause actual results to differ materially from those expected and/or projected. Such forward-looking statements are based on current expectations, estimates, forecasts and projections about our company, the industry in which we operate, and beliefs and assumptions made by management. Words such as “expects,” “anticipates,” “intends,” “plans,” “believes,” “continues,” “seeks,” “estimates,” “predicts,” “should,” “could,” “may,” “will continue,” “might,” “hope” and variations of such words and similar expressions are intended to identify such forward-looking statements. These statements are not guarantees of future performance and involve risks, uncertainties and assumptions that are difficult to predict. Therefore, actual outcomes and results may differ materially from what is expressed in such forward-looking statements. Among the factors that could cause our actual outcomes and results to differ are:
•The resolution of legal issues pertaining to the World Trade Center catastrophe.
•The ability to maintain and safeguard the security of our data.
•The resolution of regulatory and legal issues pertaining to Hurricane Katrina.
Additional information concerning factors that could cause actual results to differ materially from those in the forward-looking statements is contained in Part II, Item 1A “Risk Factors” of this document.
We operate property and casualty and life insurance businesses, marketing our products through independent agents. Although we maintain a broad geographic presence that includes most of the United States, more than half of our property and casualty premiums and more than three-fourths of our life insurance premiums are written in five states. Our primary focus for our property and casualty insurance operations is on our core commercial lines business. 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.
Despite weather forecasters’ early predictions of a very active Atlantic hurricane season similar to that endured in 2004 and 2005, the 2006 season was relatively quiet by comparison - although average from a historic perspective. There were only nine named storms and five hurricanes (two major) during the 2006 season, with no hurricanes and only three tropical storms making landfall in the United States. Forecasters’ original predictions proved inaccurate in part due to the unexpectedly early and rapid development of the El Nino phenomenon in the Pacific Ocean. An El Nino happens when waters warm in the Pacific, affecting the atmosphere and increasing westerly winds across the North American continent. As a result, Atlantic hurricanes are weakened and pushed away from the United States
In the aftermath of Hurricane Katrina, United Fire & Casualty Company and our Louisiana property and casualty insurance subsidiary, Lafayette Insurance Company, along with many other insurers in the Louisiana market, were named as a defendant in litigation. Refer to Part I, Item 3 “Legal Proceedings” for a discussion of this litigation and its relationship to our operations.
Based on the experience of the 2004 and 2005 hurricane seasons, the two prominent catastrophe modeling companies made significant changes to their catastrophe models in 2006. These changes resulted in widely divergent results for the same or similar scenarios run through each company’s catastrophe model. Insurance companies, reinsurers, rating agencies and state insurance agencies all rely heavily on these models when assessing the adequacy of catastrophe reinsurance coverage. Divergent model results for the same or similar catastrophe scenarios make it more difficult for us to accurately assess our catastrophe reinsurance coverage needs. Despite the increased variability in catastrophe modeling results experienced during the year, the revised models have generally produced more severe estimates of the probable maximum loss generated by catastrophic events. This has generally led to an increased demand for catastrophe reinsurance coverage, resulting in increases in catastrophe reinsurance pricing and decreases in catastrophe reinsurance availability.
To reduce the financial impact of future catastrophes, we have increased our catastrophe reinsurance coverage and implemented revised underwriting guidelines and policy terms in the Gulf Coast region. For 2006 we increased our catastrophe reinsurance program limit from $125.0 million to $185.0 million. For 2007 we again increased our catastrophe reinsurance program limit from $185.0 million to $200.0 million. We increased our retention from $10.0 million in 2005 to $15.0 million in 2006 and to $20.0 million in 2007. Estimated premium for the program increased from approximately $6.0 million in 2005 to $14.0 million in 2006 and to $16.7 million in 2007. We also reduced our exposure by decreasing the number of policies we write in the Gulf Coast region and utilizing stricter underwriting standards, all while maintaining our overall level of premium volume in the region through significant rate increases.
Despite the lingering effects of the recent active hurricane seasons on the reinsurance market as a whole, we renewed our core reinsurance program for our property and casualty business for 2007 with very little change in pricing or coverage. Availability was not a significant issue for either our core or catastrophe reinsurance programs. Refer to the Reinsurance section in Part I, Item 1 “Business” for a more detailed discussion of our property and casualty reinsurance program.
Our property and casualty insurance segment performed well in 2006. We continued our emphasis on writing quality business - one of our company’s core objectives - and continued to have excellent results in our non-catastrophe business. This is the fifth year in a row of decreased non-catastrophe claims frequency. However, we did experience increased claims frequency and severity related to several large fires and Midwest storms that we experienced during the year. On a statutory basis, our combined ratio without catastrophes was 76.9 percent for 2006 compared with 67.4 percent for 2005. The insurance industry as a whole experienced non-catastrophe combined ratios of 91.6 percent (estimated) in 2006 and 94.1 percent in 2005.
reduce our exposure; including stricter underwriting guidelines and policy terms as well as significant premium rate increases in catastrophe prone areas. With the exposure reduction in Louisiana and increased catastrophe reinsurance protection, we believe that we are in a position where 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.
During 2006, we experienced an increase in policy retention for our core lines of business. We are optimistic that during 2007 we will achieve premium growth through a combination of new business and retention. However, we continue to experience pressure on pricing, particularly in non-coastal areas and with respect to premium accounts over $.1 million. We continue to look for opportunities with new and existing agencies where we can forge profitable business with substantial premium production. We also are working to increase our average agency size, in terms of premium volume, by adding new agencies and increasing premium volume in existing agencies.
Our life insurance segment produced strong results in 2006. Although we experienced statutory premium growth in our life insurance segment during the year, this growth was offset by an increase in annuity withdrawals. The current interest rate environment presents a challenge to maintaining a profitable interest rate spread. As a result, we lowered our annuity rates in January 2007 and will continue monitoring annuity withdrawals to determine if future rate adjustments are necessary. Despite these challenges, we are optimistic about the future of our life insurance business. In 2007, we are introducing a new universal life product. In an effort to address the evolving needs of the marketplace, this new product will combine the popular features of our two existing universal life products in addition to disability income riders, and increasing the disability income benefit from $1,500 to $2,500. We believe this new universal life product will allow us to further solidify our market position.
During the second quarter of 2006, we completed an offering of shares of our common stock priced at $28.00 per share. Pursuant to this offering, we issued 4.025 million shares of our $3.33? par value common stock, resulting in proceeds (net of $5.7 million in underwriting expenses) of $107.0 million.
Enterprise risk management (“ERM”) is a methodology that helps an organization assess and manage its overall exposure to risk. ERM has gained the attention of the insurance industry in recent years. ERM begins as a capital preservation process that helps insurers identify, quantify and manage risks from all sources that exist throughout the corporation, including risks arising from investments, underwriting, and operations. ERM considers the accumulation and diversification of risk and utilizes a company’s past experience to help evaluate future business plans and manage risk.
The property and casualty insurance segment reported pretax income of $103.6 million in 2006 and $98.4 million in 2004, compared with a pretax loss of $14.8 million in 2005. The deterioration in the 2005 results compared to 2004 and the improvement in net income from 2005 to 2006 was primarily due to the impact Hurricane Katrina and Hurricane Rita had on our loss experience during 2005. In 2006, we recorded $59.8 million in catastrophe losses, compared with $197.1 million in 2005 and $19.2 million in 2004. Hurricanes Katrina ($31.7 million) and Rita ($.3 million) contributed $32.0 million of the catastrophe losses in 2006. In contrast, Hurricanes Katrina ($178.2 million) and Rita ($10.9 million) contributed $189.1 million of the catastrophe losses in 2005. The financial impact from these hurricanes was realized largely on our homeowners, allied lines and commercial multiple peril lines of business.
Net investment income increased in 2006 over 2005 and 2004 primarily due to the funds received and invested from our May 2006 common stock offering.
In 2006, direct premiums written increased when compared with 2005, due to an increase in the amount of new business our existing agents produced, additional new business from agents who began writing with us during the year and from greater policy retention. In 2005, we experienced a decrease in direct written premiums compared to 2004 which was attributable to the rate decreases implemented in 2005 in response to the increased level of competition that existed in the property and casualty insurance market. In 2006 and 2005, we continued to de-emphasize our personal lines of business, which resulted in a reduction in personal lines premiums earned. We intend to continue growing our commercial lines of business, which is where we have historically been most profitable. Our focus on commercial lines is reflected in premiums written from our commercial lines of business, which accounts for over 90.0 percent of our direct premium writings for all years presented.
Ceded premiums written have increased considerably in both 2005 and 2006 in response to the severe hurricanes recently experienced in the Gulf Coast region. In 2005, we paid an $8.0 million reinstatement premium as a result of claims originating from Hurricane Katrina. In 2006, premium rates for our catastrophe reinsurance coverage increased considerably due to the 2005 hurricane season.
The property and casualty insurance segment in 2006 had loss and loss settlement expenses incurred of $278.5 million, with $303.5 million of loss and loss settlement expenses that occurred in 2005 and a redundancy of $25.0 million ($62.2 million without the adverse development on Hurricane Katrina claims) on losses that occurred prior to 2006, which resulted from settling or re-estimating claims for less than reserved for at December 31, 2005. Due to Hurricane Katrina, our homeowners, allied lines and commercial multiple peril lines of business experienced a reserve deficiency, while our remaining lines of business experienced reserve redundancies for the year.
Losses and loss settlement expenses incurred in 2004 totaled $256.2 million, reflecting losses and loss settlement expenses of $294.8 million on losses that occurred in 2004 and a redundancy of $38.6 million on losses that occurred prior to 2004. We experienced a redundancy in each of our lines of business, with the exception of other liability. The adverse development in our other liability line of business was affected by construction defect losses and related legal costs.
We discuss our reserving process, which contributed to the favorable development of loss reserves in 2006, 2005 and 2004, under “Critical Accounting Policies.” The majority of our business consists of short duration contracts. However, we consider our workers’ compensation and other liability lines of business to be long-tail lines of business due to the length of time that may elapse before claims are finally settled. Therefore, we may not know our
final development on individual claims for many years. Our estimates for losses, particularly in these long-tail lines, are dependent upon many factors, such as the legal environment, inflation and medical costs. We consider all of these factors, as well as others, in estimating our loss reserves. As conditions or trends with respect to these factors change, we change our estimate for loss reserves accordingly.
The following table illustrates the primary components of the net loss redundancy we experienced in our reserves for 2006, 2005 and 2004.
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 policies 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 35.2 percent in 2006, 46.3 percent in 2005 and 21.7 percent in 2004. The 2005 underwriting results were adversely impacted primarily by four bonded principals defaulting on their bonded obligations after a determination was made that they did not have the financial wherewithal to complete the bonded projects and to pay the outstanding obligations associated with those projects. In response to these losses, we have improved our underwriting discipline by, among other things, requiring principals to provide more frequent audited 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.
Net premiums earned from the surety line of business were $22.0 million in 2006, $25.2 million in 2005 and $25.3 million in 2004, while losses were $7.7 million in 2006, $11.7 million in 2005 and $5.5 million in 2004. The decreases in premiums earned are attributable to the more disciplined underwriting approach implemented in response to the severe losses incurred in 2005. The revision in our underwriting procedures is also evidenced by improvement in our loss experience in 2006.
In our personal lines business, the net loss ratio was 81.2 percent in 2006, 170.4 percent in 2005 and 56.0 percent in 2004. The 2005 and 2006 results were impacted by Hurricane Katrina and Hurricane Rita. Premium pricing in our personal lines business decreased on an aggregate basis during 2006 and 2005.
Pre-tax income recorded by the life insurance segment increased in 2006 due to a combination of factors. These factors include a decrease in interest on policyholders’ accounts, which is attributable to the impact of the net decrease in annuities in 2006; decreases in loss and loss settlement expenses, due to lower mortality rates; and a decrease in amortization of deferred policy acquisition costs, due to lower levels of deferrable expenses experienced in recent years. These results were somewhat offset by a decrease in premiums earned, due to a decrease in
As of December 31, 2006, we recorded net unrealized gains, after tax, of $93.5 million, compared to $86.4 million in 2005 and $103.7 million in 2004. The decline in 2005 was driven primarily by the decrease in the fair value of our available-for-sale fixed maturity portfolio, which resulted primarily from changes in interest rates, not from changes in the credit quality of the issuers of these securities. We consider any unrealized losses to be temporary, and we have the positive intent and ability to hold our fixed maturity securities for a period of time that is sufficient to allow for the recovery in fair value that we expect to occur. We also believe that the unrealized losses on our equity portfolio are temporary. The largest unrealized loss, after tax, on any single investment security at December 31, 2006 was $1.0 million.
Our effective federal income tax expense rate of 29.8 percent for 2006 and income tax benefit rate of 37.9 percent for 2005 were less than the applicable federal income tax expense rate of 35.0 percent, due primarily to our portfolio of tax-exempt securities and, in 2006, the utilization of a portion of the net operating loss related to American Indemnity Financial Corporation.
In September 2006, the FASB issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans,” which requires the recognition of the overfunded or underfunded status of pension plans and other postretirement plans as an asset or liability on the balance sheet, with changes occurring during future years reflected through the accumulated other comprehensive income portion of stockholders’ equity, net of tax, effective December 31, 2006. However, SFAS No. 158 does not change the amount of net periodic benefit cost to be recognized as a component of current period operations. SFAS No. 158 also requires the measurement of the funded status of a plan to match that of the date of our year-end Consolidated Financial Statements, eliminating the use of earlier measurement dates that were previously permissible; we currently utilize December 31 as the measurement date for plan assets and obligations and, therefore, comply with this requirement. The adoption of SFAS No. 158 resulted in the recognition of an after-tax charge of $10.2 million on our Consolidated Balance Sheets at December 31, 2006. Refer to Part II, Item 8, Note 1 “Significant Accounting Policies,” for a more detailed discussion of the impact of SFAS No. 158 on our Consolidated Financial Statements.
Our main objectives, while maintaining an acceptable level of risk, in managing our investment portfolio are to maximize both after-tax investment income and total investment returns. We develop our investment strategies based on a number of factors, including estimated duration of reserve liabilities, short- and long-term liquidity needs, projected tax status, general economic conditions, expected rates of inflation and regulatory requirements. We manage our portfolio based on investment guidelines approved by our management, which comply with applicable statutory regulations. The composition of our investment portfolio at December 31, 2006, is presented in the following table in accordance with GAAP.
(2) In connection with the sale of our subsidiary, American Indemnity Company, we disposed of $4.3 million in U.S. treasury notes.
At December 31, 2006, $1,808.2 million, or 97.6 percent, of our fixed maturities were classified as available-for-sale, compared with $1,777.1 million, or 96.1 percent, at December 31, 2005. We classify our remaining fixed
maturities as held-to-maturity, which are reported at amortized cost, or trading. 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, 2006, 93.7 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.
As of December 31, 2006, our cash and cash equivalents totaled $255.0 million, compared with $162.8 million at December 31, 2005. Net cash provided by operations varies with our underwriting profitability. As our profitability from insurance operations increased between 2005 and 2006, our net cash from operations increased from $53.7 million in 2005 to $104.5 million in 2006. Cash flows from underwriting operations, tax refunds received and reinsurance recoveries received related to Hurricanes Katrina and Rita contributed to the increase in cash and cash equivalents in 2006.
We invest funds available for short-term cash needs primarily in money market accounts, which are classified as cash equivalents. At December 31, 2006, our cash and cash equivalents included $48.6 million related to these money market accounts, compared with $44.3 million at December 31, 2005.
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 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.
offering and the issuance of stock from exercise of stock options of $107.4 million and an increase in net unrealized appreciation of $7.1 million. The increase in common stock is due primarily to the stock offering of 4,025,000 shares. Decreases to stockholders’ equity included dividends paid of $13.2 million and the after-tax charge to initially apply SFAS No. 158 at December 31, 2006, of $10.2 million. Book value per share at December 31, 2006, was $24.62, compared with $21.20 at December 31, 2005. As of December 31, 2006, we had authorization from the board of directors to repurchase 87,167 shares of our common stock.
The table below shows our contractual obligations and commitments, including our estimated payments due by period at December 31, 2006.
Payment amounts for future policy benefit reserves must be actuarially estimated and are not determinable from the contract. The projected payments illustrated above are based on the assumption that the holders of our annuities and life insurance policies will withdraw their account balances from our company upon the expiration of their contracts. Actual cash withdrawals could be significantly less than these amounts, depending upon the interest rate environment at the time of the contract expirations.
At December 31, 2006, we have no off-balance sheet obligations or commitments.
In most cases, we use quoted market prices to determine the fair value of fixed maturities, equity securities and short-term investments. Where quoted market prices were unavailable, we based fair value on estimated realizable value. For other long-term investments that primarily consist of holdings in limited partnership funds, we used the value determined by the various fund managers. We exclude unrealized appreciation or depreciation on investments carried at fair value from net income and report it, net of applicable deferred income taxes, as a component of accumulated other comprehensive income in stockholders’ equity.
To calculate the premium deficiency charge, we estimate expected losses and loss settlement expenses by using an assumed loss and loss settlement expense ratio which approximates that of the recent past. This is the only assumption we utilize to calculate the premium deficiency charge. Changes in this assumption can have a significant impact on the amount of premium deficiency charge calculated. We do not consider anticipated investment income in determining the recoverability of deferred costs.
The following table illustrates the hypothetical impact on the premium deficiency charge recorded at December 31, 2006 of reasonably likely changes in the assumed loss and loss settlement expense ratio utilized for purposes of this calculation. The entire impact of these changes would be recognized through income as other underwriting expenses. The base amount indicated below is the actual premium deficiency charge recorded as of December 31, 2006.
Sensitivity Analysis - Impact of Changes in Assumed Loss and Loss Settlement Expense Ratios
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 and the premium deficiency charge calculated at December 31, 2005 decreased $4.8 million from the premium deficiency charge calculated at December 31, 2004. These decreases in the premium deficiency charge allowed us to defer comparatively more underwriting costs period over period, resulting in relatively larger deferred acquisition cost asset balances. 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 establish reserves for property and casualty losses and loss settlement expenses for three basic categories: (1) case basis, (2) IBNR and (3) loss settlement expenses. Our reserves for each of these three categories of losses by line of business as of December 31, 2006, were as follows.
Our short-tail lines include fire and allied lines, homeowners, commercial property, inland marine and surety. The amounts of the case-based reserves that we establish for claims in these lines depend upon various factors, such as
Our long-tail lines of business include workers’ compensation and general liability. Certain product lines such as personal and commercial auto and commercial multi-peril include some long-tail coverages and some short-tail coverages. For many liability claims, significant periods of time, ranging up to several years, may elapse between the occurrence of the loss, the reporting of the loss to us and the settlement of the claim. As a result, loss experience in the more recent accident years for the long-tail liability classes has limited statistical credibility in our reserving process because a relatively small proportion of losses in these accident years are reported claims and an even smaller proportion are paid losses. In addition, long-tail liability claims are more susceptible to litigation and can be significantly affected by changing contract interpretations and the legal environment. Consequently, the estimation of loss reserves for long-tail classes is more complex and subject to a higher degree of variability than for short-tail classes.
The amounts of the case-based reserves that we establish for claims in these 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.
•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;
We are unable to reasonably quantify the impact of changes in our key assumptions utilized to establish individual case-basis reserves on our total reported reserve because the impact of these changes would be unique to each specific case-basis reserve established. However, based on historical experience, we believe that aggregate case-basis reserve volatility levels of five percent and ten percent can be attributed to the ultimate development of our case-basis reserves. The table on the following page details the impact of this development volatility on our reported case-basis reserves.
In 2006, we did not change our key assumptions. In estimating our 2006 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, 2006, is $171.2 million and consists of 3,016 claims. 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 $171.2 million total reserve for other liability claims, $46.7 million is identified as defense costs and $16.5 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 $17.1 million, before federal income taxes.
In addition to these issues, other variables also contribute to a high degree of uncertainty in establishing reserves for construction defect claims. These variables include: whether coverage exists; when losses occur; the size of each loss; expectations for future interpretive rulings concerning contract provisions; and the extent to which the assertion of these claims will expand geographically. In recent years, we have implemented various underwriting measures that may gradually mitigate the amount of construction defect losses experienced. These initiatives include increased
It is management’s policy to utilize staff adjusters to develop our estimate of case-basis loss reserves. IBNR and loss settlement expense reserves are established through various formulae that utilize pertinent, recent company historical data. The calculations are supplemented with knowledge of current trends and events that could result in adjustments to the level of IBNR and loss settlement expense reserves. In addition, management consults with its independent actuary, Regnier Consulting Group, throughout the year as deemed necessary. Management annually compares our estimate of total loss reserves to point estimates prepared by Regnier Consulting Group by line of business to ensure that our estimates are within the actuary’s acceptable range. Regnier Consulting Group performs
We calculate the reserves reported in our Consolidated Financial Statements in accordance with GAAP. We account for our annuity and universal life policy deposits in accordance with SFAS No. 97, “Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses on the Sale of Investments.” Under SFAS No. 97, a benefit reserve is established at the time of policy issuance in an amount equal to the deposits received. Subsequently, the benefit reserve is adjusted for any additional deposits, interest credited and partial or complete withdrawals. Reserves determined for statutory purposes are based upon mortality rates and interest rates specified by Iowa state law. Our life insurance subsidiary’s reserves meet or exceed the minimum statutory requirements. All of our reserves are developed and analyzed annually by Griffith, Ballard and Company, our independent consulting actuaries. At December 31, 2006, we recorded future policy benefits of $1,233.3 million, compared with $1,285.6 million at December 31, 2005.
State regulators have the authority to approve or deny our premium rates to ensure that they are not excessive or discriminatory. Because of this regulatory constraint, it is sometimes difficult to receive an adequate premium rate on our products, which can result in unsatisfactory underwriting results.
State insurance regulators also establish insurance funds to provide insurance coverage to those insureds unable to obtain insurance through the voluntary insurance market. In response to the hurricane activity during 2005 and 2004, several of these state insurance funds levied substantial assessments to insurers writing insurance in hurricane-affected areas. These state insurance funds assessed us over $8.1 million including Louisiana ($4.9 million), Mississippi ($2.6 million), Florida ($0.4 million) and Texas ($0.1 million), which increased our reported losses and loss settlement expenses during 2005. The terms of some of these assessments allowed us to recoup the amounts assessed through surcharges to policyholders applied to insurance policies written in the state over a one-year period. Through December 31, 2006 we have recouped $3.1 million of these 2005 assessments through policyholder surcharges. The $2.6 million assessment by the State of Mississippi did not allow us to recoup the amount assessed from policyholders. However, we did receive a $2.4 million refund on this assessment during 2006. The assessment amounts recouped and refunded positively impacted our 2006 operating results. During 2006, we paid another $0.4 million in hurricane assessments from state insurance funds. We anticipate being able to recoup all or part of these assessments through future surcharges to policyholders during 2007.
Our insurance companies are subject to state laws and regulations that require investment portfolio diversification and that limit the amount of investment in certain categories. Noncompliance may cause nonconforming investments to be nonadmitted in measuring statutory surplus and, in some instances; states may require us to sell the nonconforming securities.
The National Association of Insurance Commissioners annually calculates a number of financial ratios to assist state insurance regulators in monitoring the financial condition of insurance companies. A “usual range” of results for each ratio is used as a benchmark. Departure from the “usual range” on four or more of the ratios could lead to inquiries from individual state insurance departments as to certain aspects of a company’s business. None of our insurance companies had four or more ratios outside the “usual range” at December 31, 2006. In addition to the financial ratios, we are also required to calculate a minimum capital requirement for each of our insurance companies based on individual company insurance risk factors. These “risk-based capital” results are used to identify companies that require regulatory attention or the initiation of regulatory action. At December 31, 2006, all of our insurance companies had capital well in excess of the required levels.
Our family of property and casualty insurers has received a group rating of “A” (Excellent) from A.M. Best Company. Within the group, all of our property and casualty insurers have an “A” (Excellent) rating, except one insurance subsidiary that is in a runoff status, which A.M. Best has designated as NR-3 (Rating Procedure Inapplicable). Our life insurance subsidiary has received an “A-” (Excellent) rating from A.M. Best Company. According to A.M. Best Company, companies rated “A” and “A-” have “an excellent ability to meet their ongoing obligations to policyholders.”
Standard & Poor’s issued an “A-” rating to United Fire & Casualty Company, Addison Insurance Company, Lafayette Insurance Company, United Fire & Indemnity Company, United Fire Lloyds and United Life Insurance Company. According to Standard & Poor’s, an insurer rated “A” or “A-” has “strong financial security characteristics, but is somewhat more likely to be affected by adverse business conditions than are insurers with higher ratings.” A Standard & Poor’s Insurer Financial Strength Rating is Standard & Poor’s current opinion of the
creditworthiness of an insurer with respect to its ability to pay under its insurance policies and contracts in accordance with its terms.
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 net premiums written, catastrophe losses and statutory 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.
Statutory combined ratio: The combined ratio is a commonly used financial measure of underwriting performance. Generally, a combined ratio below 100 percent 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 nondeferred 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.
(1) The change in net unrealized appreciation is net of reclassification adjustments and income taxes (refer to Note 13).
(2) The adjustment of minimum pension liability is net of income taxes (refer to Note 13).
(3) Per share amounts reflect the retroactive effects of our December 15, 2004, one-for-one stock dividend.
(4) The recognition of the underfunded status of employee benefit plans is net of income taxes (refer to Note 13).
(5) The amounts reported are net of underwriting expenses (refer to Note 15).
In May 2006, we closed on the sale of our subsidiary, American Indemnity Company, a Texas domiciled property and casualty insurance company that is licensed in 26 states and the District of Columbia. The sale involved only American Indemnity Company and did not affect the business of any of our other Texas subsidiaries or operations at our Gulf Coast Regional Office in Galveston, Texas. American Indemnity Company had not written or renewed any policies of insurance since November 2003 and was sold as a “shell” company with no liabilities and only the capital assets necessary to maintain its licenses. The sale of American Indemnity Company resulted in a realized gain of $3,401,000, or $0.08 per share after-tax, which has been recorded in the 2006 results of our property and casualty insurance segment.
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the
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
Investments in held-to-maturity fixed maturities are recorded at amortized cost. We have the ability and positive intent to hold these investments until maturity. Available-for-sale fixed maturities, trading fixed maturities, equity securities and other long-term investments are recorded at fair value. Mortgage loans and short-term investments are recorded at cost. Policy loans are recorded at the actual amount loaned to the policyholder. Included in investments at December 31, 2006 and 2005, are securities on deposit with, or available to, various regulatory authorities as required by law, with carrying values of $1,389,654,000 and $1,439,783,000, respectively.
In 2006, 2005 and 2004, we impaired certain holdings in our investment portfolio as a result of other-than-temporary declines in market value and recorded a pretax realized loss of $406,000, $1,208,000 and $308,000, respectively. We continue to review all of our investment holdings for appropriate valuation on an ongoing basis. Refer to Note 2 “Summary of Investments” in this item for a discussion of our accounting policy for impairment recognition.
For purposes of reporting cash flows, cash and cash equivalents include cash, nonnegotiable certificates of deposit with original maturities of three months or less and money market accounts. Negative cash balances are reported as a component of accrued expenses and other liabilities.
We made payments for income taxes of $25,306,000, $37,903,000 and $32,714,000 during 2006, 2005 and 2004, respectively. In addition, we received refunds totaling $27,844,000 in 2006, due to an overpayment of 2005 tax. There were no significant payments of interest in 2006, 2005 and 2004, other than interest credited to policyholders’ accounts.
We file a consolidated federal income tax return. Deferred tax assets and liabilities are established based on differences between the financial statement bases of assets and liabilities and the tax bases of those same assets and liabilities, using the currently enacted statutory tax rates. Deferred income tax expense is measured by the year-to-year change in the net deferred tax asset or liability, except for certain changes in deferred tax amounts that affect stockholders’ equity and do not impact income tax expense.
Prior to the adoption of SFAS No. 123(R), we presented the tax benefit of stock option exercises as an operating cash flow. Upon the adoption of SFAS No. 123(R), tax benefits resulting from tax deductions in excess of compensation cost recognized for those options are classified as financing cash flows. This change in presentation did not have a material impact on the amounts reported in the accompanying consolidated statement of cash flows for the year ended December 31, 2006.
For the year ended December 31, 2006, we recognized stock-based compensation expense under SFAS No. 123(R) of $1,175,000, which resulted in a $.03 decrease in our basic and diluted earnings per share. As of December 31, 2006, we have approximately $3,553,000 in stock-based compensation that has yet to be recognized through our results of operations pursuant to SFAS No. 123(R). This compensation will be recognized as the underlying stock options vest over a term of five years. Prior to January 1, 2006, the reporting of pro forma stock-based compensation was limited to disclosure in the notes to the Consolidated Financial Statements. Pro forma net income was $8,653,000 and $78,590,000 for the years ended December 31, 2005 and 2004, respectively. These amounts include $391,000 and $227,000 in pro forma stock-based compensation expense (net of the related tax effects), which would have resulted in a $0.02 and $0.01 decrease in pro forma basic and diluted earnings per share for the years ended December 31, 2005 and 2004, respectively.
In September 2006, the FASB issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans,” which requires the recognition of the overfunded or underfunded status of pension plans and other postretirement plans as an asset or liability on the balance sheet, with changes occurring during future years reflected through the accumulated other comprehensive income portion of stockholders’ equity, net of tax, effective December 31, 2006. However, SFAS No. 158 does not change the amount of net periodic benefit cost to be recognized as a component of current period operations. SFAS No. 158 also requires the measurement of the funded status of a plan to match that of the date of our year-end Consolidated Financial Statements, eliminating the use of earlier measurement dates that were previously permissible; we currently utilize December 31 as the measurement date for plan assets and obligations and, therefore, comply with this requirement. The adoption of SFAS No. 158 resulted in the recognition of an after-tax charge of $10,168,000 on our consolidated balance sheet at December 31, 2006.
A reconciliation of the amortized cost (cost for equity securities) to fair values of investments in held-to-maturity and available-for-sale fixed maturity and equity securities as of December 31, 2006 and 2005, is as follows.
The amortized cost and fair value of held-to-maturity, available-for-sale and trading fixed maturities at December 31, 2006, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
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.
A summary of the carrying value and estimated fair value of our financial instruments at December 31, 2006 and 2005, 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, 2006 and 2005, nor did we borrow against this line of credit in 2006, 2005 and 2004. As of December 31, 2006, $200,000 of the line of credit was allocated towards letters of credit we have issued as a result of our reinsurance operations.
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. Historically, we have acted as a reinsurer, assuming both property and casualty reinsurance from other insurance or reinsurance companies. Most of the business we have assumed is property reinsurance, with an emphasis on catastrophe coverage. The majority of our assumed reinsurance business expired on or before December 31, 2000. We limit our exposure on our remaining assumed reinsurance contracts through selective renewal. However, we still have exposure related to the assumed reinsurance contracts that we have elected to continue writing and those that are in runoff status.
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 91.0 percent of ceded life insurance in force as of December 31, 2006, has been ceded to four reinsurers. We believe all reinsurance receivables are collectable. From 2002 to 2004, the life insurance segment assumed portions of credit life and accident and health insurance business from other insurance companies. We continue to have exposure related to our assumed reinsurance contracts that are in a runoff status.
Statutory capital and surplus in regards to policyholders at December 31, 2006, 2005 and 2004 and net income for the years then ended are as follows.
All states require domiciled insurance companies to prepare statutory-basis financial statements in conformity with the NAIC Accounting Practices and Procedures Manual, subject to any deviations prescribed or permitted by the applicable insurance commissioner and/or director. Statutory accounting practices primarily differ from GAAP in that policy acquisition and certain sales inducement costs are charged to expense as incurred, life insurance reserves are established based on different actuarial assumptions and the value of investments and deferred taxes are established on a different basis.
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 $71,564,000 in dividend distributions to stockholders in 2007 without prior approval. We paid dividends of $13,196,000, $11,817,000 and $12,654,000 in 2006, 2005 and 2004, respectively. Dividend payments by the insurance subsidiaries to United Fire are subject to similar restrictions in the states in which they are domiciled. In 2006 and 2005, United Fire received $4,000,000 in dividends from United Life Insurance Company. There were no intercompany dividends in 2004. 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 $34,700,000 intercompany dividend.
A portion of life insurance income earned prior to 1984 was not taxable unless it exceeded certain statutory limitations or was distributed as dividends. As of December 31, 2004, such income, accumulated in the policyholders’ surplus account, totaled $2,121,000. At current corporate income tax rates, the associated tax was $742,000. The American Jobs Creation Act (“AJCA”) suspended the tax on distributions from the policyholder surplus accounts of stock life insurance companies for the tax years beginning after December 31, 2004 and before January 1, 2007. AJCA also reversed the order of accounts from which distributions are deemed to occur during this time. Distributions occurring during 2005 and 2006 were deemed to come from the policyholder surplus accounts, then from the shareholder surplus accounts and then from other accounts, which allowed the distribution of the amount in our policyholders’ surplus account to be made on a tax-free basis in 2005 or 2006. During 2005, the $2,121,000 in the policyholders’ surplus account was distributed.
The two main employee benefit plans we offer are a noncontributory defined benefit pension plan and an employee/retiree health and dental benefit plan.
Dividends on shares of United Fire common stock totaled approximately $100,000 during 2006, as compared to $97,000 during 2005. 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 invest funds within the pension plan, primarily in common equity securities.
The preparation of financial statements in conformity with GAAP requires us to make various estimates and assumptions that affect the reporting of net periodic benefit cost, plan assets and plan obligations at the date of the financial statements. Actual results could differ from these estimates. One significant estimate relates to the calculation of the benefit plan obligations. We annually establish the discount rate used to determine the present value of the plan benefit obligations as of December 31. The discount rate is an estimate of the interest rate at which the plan benefits could be effectively settled. In estimating the discount rate, we look to rates of return on high-quality, fixed-income investments currently available and expected to be available during the period to maturity of the plan benefit obligations. Another significant assumption utilized is the expected long-term rate of return on the invested pension plan assets. The expected long-term rate of return is an assumption as to the average rate of earnings expected on the pension plan funds invested, or to be invested, to provide for the settlement of benefits included in the projected pension benefit obligation. Investment securities, in general, are exposed to various risks, such as fluctuating interest rates, credit standing of the issuer of the security and overall market volatility. Annually, we perform an analysis of expected long-term rates of return based on the composition and allocation of our pension plan assets and recent economic conditions.
The following actuarial assumptions were used at January 1 to determine our reported net periodic benefit costs for the year ended December 31.
The table below provides a reconciliation of the changes in both plans’ benefit obligations and fair value of plan assets and a statement of the plans’ funded status for 2006 and 2005.
The accumulated pension benefit obligation was $49,670,000 and $44,300,000 at December 31, 2006 and 2005, respectively.
For measurement purposes of our health benefit plan, a 9.0 percent annual rate of increase in the per capita cost of covered health care benefits is assumed for 2006. The rate is assumed to decrease gradually each year to a rate of 5.25 percent for 2011 and remain at that level thereafter. For dental claims, a 5.25 percent annual rate of increase was assumed for 2007 and thereafter.
The following table summarizes the expected benefit payments to be paid from our plans over the next 10 years.
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 486,908 available for future issuance at December 31, 2006. 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 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.
We also have a nonqualified nonemployee director stock option and restricted stock plan that authorizes United Fire to grant restricted stock and nonqualified stock options to purchase 150,000 shares of United Fire’s common stock, with 120,003 available for future issuance at December 31, 2006. The board has the authority to determine which nonemployee directors receive options, when options and restricted stock shall be granted, the option price, the
The following table summarizes information regarding the stock options outstanding and exercisable at December 31, 2006.
We have two reportable business segments in our operations: property and casualty insurance and life insurance. The property and casualty insurance segment has three domestic locations from which it conducts its business. All offices target a similar customer base, market the same products and use the same marketing strategies and are therefore aggregated. The life insurance segment operates from our home office. The accounting policies of the segments are the same as those described in Note 1. We analyze results based on profitability (i.e., loss ratios), expenses and return on equity. Because all of our insurance is sold domestically, we have no revenues allocable to foreign operations.
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 891 independent agencies and brokers in 41 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 899 independent agencies in 27 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.
We compute earnings per share in accordance with SFAS No. 128, “Earnings per Share.” Accordingly, we compute basic earnings per share 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 potentially dilutive common shares outstanding during the period. The potentially 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. We therefore have no shares of preferred stock outstanding at December 31, 2006 and 2005.
We determine the dilutive effect of our convertible preferred stock using the “if-converted” method. Under this method, we add to the denominator of the earnings per share calculation a number determined by multiplying the number of convertible preferred shares by the appropriate conversion rate. We also add the amount of preferred dividends and accretions back to the numerator of the earnings per share equation due to the assumed conversion of all the convertible preferred stock to common stock at the beginning of the reporting period. If the effect of the if-converted method is anti-dilutive, the effect on diluted earnings per share of our convertible preferred stock is disregarded. The preferred stock had an anti-dilutive effect in 2005 and a dilutive effect in 2004.
The effect of our preferred stock ($4,106,000 in preferred dividends and accretions and 1,142,000 potentially dilutive common shares) on our 2005 diluted earnings per share calculation was disregarded since the effect was anti-dilutive.
For the year ended December 31, 2006, we had 142,250 anti-dilutive options outstanding, which were excluded.
At December 31, 2006, our future minimum rental payments are as follows:
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of United Fire & Casualty Company at December 31, 2006 and 2005, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2006, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.
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, 2006, 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 28, 2007, expressed an unqualified opinion thereon.
As of December 31, 2006, United Fire & Casualty Company’s management assessed the effectiveness of internal control over financial reporting based on the criteria for effective internal control over financial reporting established in “Internal Control - Integrated Framework,” issued by the Committee of Sponsoring Organizations (COSO) of the Treadway Commission. Based on the assessment, United Fire & Casualty Company’s management determined that effective internal control over financial reporting is maintained as of December 31, 2006, based on those criteria.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with U.S. generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and