In 1998, we purchased land in Southfield, Michigan for a cost of $3.2 million. In 2004, the construction of our corporate headquarters was completed on half of this land and in December 2004 we relocated to the new office building. Our corporate headquarters are approximately 72,000 square feet. The total construction cost of the building approximated $12.0 million, which was paid in full at the closing on January 19, 2005.
With the ProCentury merger, we assumed the lease of their corporate headquarters, an approximately 44,000 square foot office building located in Westerville, Ohio. The lease agreement for this building has an initial term of ten years that expires in 2013.
We are also a party to various leases, including other leases acquired from ProCentury, for other locations in which we have offices. We do not consider any of these leases to be material.
(1) During the first quarter of 2010, the Company made certain reclassifications to the expense classifications on the Consolidated Statement of Income. These reclassifications were made to enable the user of the financial statements to calculate the GAAP combined ratio directly from the Consolidated Statement of Income. As a result, the Consolidated Statement of Income for the years ended December 31, 2009, 2008, 2007, and 2006 have been reclassified to conform to this revised presentation. These reclassifications do not change total expenses or consolidated net income as originally reported.
We recognize revenue related to the services and coverages within the following categories: net earned premiums, management fees, claims fees, loss control fees, reinsurance placement, investment income, commission revenue, and net realized gains (losses).
We compete in the specialty insurance market. Our wide range of specialty niche insurance expertise allows us to accommodate a diverse distribution network ranging from specialized program agents to retail agents. In the specialty market, competition tends to place considerable focus on availability, service and other tailored coverages in addition to price. Moreover, our broad geographical footprint enables us to function with a local presence on both a regional and national basis. We also have the capacity to write specialty insurance in both the admitted and non-admitted markets. These unique aspects of our business model enable us to compete on factors other than price.
(2) Residual markets represent mandatory pooled workers’ compensation business allocated to individual insurance company writers based on the insurer’s market share in a given state.
The reserves referenced in the above table related to our direct and assumed business, which we directly manage and are established through transactions processed through our internal systems and related controls. Accordingly, the case reserves are established on a current basis, therefore there is no delay or lag in reporting of losses from a ceding company, and IBNR is determined utilizing various actuarial methods based upon historical data. Ultimate reserve estimates related to assumed business from residual markets are provided by individual states on a two quarter lag between the date of the evaluation and the receipt of the estimate from the National Council on Compensation Insurance (“NCCI”), and include an estimated reserve based upon actuarial methods for this lag. Assumed business, which is subsequently 100% retroceded to participating reinsurers, relates to business previously discontinued and now is in run-off. Relative to assumed business from other sources, we receive case and paid loss data within a forty-five day reporting period and develop our estimates for IBNR based on both current and historical data.
For the majority of claims, our claims personnel within our risk management subsidiary will establish a case reserve for the estimated amount of the ultimate payment for claims reported to one of our Insurance Company Subsidiaries. The amount of the reserve is primarily based upon a case-by-case evaluation of the type of claim involved, the circumstances surrounding each claim, and the policy provisions relating to the type of losses. The estimate reflects the informed judgment of such personnel based on general insurance reserving practices, which focus on the ultimate probable cost of each reported claim, as well as the experience and knowledge of the claims person. Until the claim is resolved, these estimates are revised as deemed necessary by the responsible claims personnel based on subsequent developments, new information or periodic reviews of the claims.
The standard actuarial methods that we use to project ultimate losses for both long-tail and short-tail exposures include, but are not limited to, the following:
Paid Bornhuetter-Ferguson Method. This is a method that assigns partial weight to initial expected losses for each accident year and partial weight to observed paid losses. The weights assigned to the initial expected losses decrease as the accident year matures.
Claims for short-tail lines of business settle more quickly than long-tail lines of business, and in general, loss development factors for short-tail lines are smaller than long-tail lines. For long-tail lines, we tend to rely on initial expected loss methods throughout the current accident year then move to development factor based methods for older accident years. Development methods on short-tail lines are generally reliable in the third and fourth quarter of the initial accident year and recorded loss ratios reflect a blend of the development and forecast methods. Short-tail lines represent 4% of our total reserves at December 31, 2010.
Each of the methods listed above requires the selection and application of parameters and assumptions. For all but the initial expected loss method, the key assumptions are the patterns with which our aggregate claims data will be paid or will emerge over time (“development patterns”). These patterns incorporate inherent assumptions of claims cost inflation rates and trends in the frequency of claims, both overall and by severity of claim. These are affected by underlying loss trends, rate changes, benefit changes, reinsurance structure and cost changes and other pertinent adjustments which are explicit key assumptions underlying the initial expected loss method. Each of these key assumptions is discussed in the following paragraphs.
An explicit assumption used in the analysis is the set of initial expected loss ratios (“IELRs”) used in the current accident year reserve projections and in some of the prior accident year ultimate loss indications. To estimate the sensitivity of the estimated ultimate loss to a change in IELRs, the actuarial department recasted the loss reserve indications using a set of IELRs all one percent higher than the final IELRs. The overall impact of a one percent change in IELRS would be a corresponding one percent change in reserve adequacy or a $4.8 million effect on after tax net income. Often the loss ratios by line of business will vary from the IELR in different directions causing them to partially offset each other. A variance of this type would typically be recognized in loss and settlement expense reserves and, accordingly, would not have a material effect on liquidity because the claims have not been paid.
Historic development as shown within the “Analysis of Loss and Loss Adjustment Expense Development” table has been nine percent or less in the last five years but was eleven percent in the year prior to the underwriting and reserving shift in 2002. At that time, we concentrated our efforts on eliminating underwriting relationships where we had substantial liabilities above an aggregate exposure retained by risk sharing associations and captives. For a large share of our business, we also accelerated the pace at which we brought the claim administration to our employees and away from outside third party administrators. This change enabled us to more rapidly recognize trends and underlying loss patterns, and establish more accurate reserves in a timely manner.
Reinsurance recoverables represent (1) amounts currently due from reinsurers on paid losses and LAE, (2) amounts recoverable from reinsurers on case basis estimates of reported losses and LAE, and (3) amounts recoverable from reinsurers on actuarial estimates of IBNR losses and LAE. Such recoverables, by necessity, are based upon estimates. Reinsurance does not legally discharge us from our legal liability to our insureds, but it does make the assuming reinsurer liable to us to the extent of the reinsurance ceded. Instead of being netted against the appropriate liabilities, ceded unearned premiums and reinsurance recoverables on paid and unpaid losses and LAE are reported separately as assets in our consolidated balance sheets. Reinsurance recoverable balances are also subject to credit risk associated with the particular reinsurer. In our selection of reinsurers, we continually evaluate their financial stability. While we believe our reinsurance recoverables are collectible, the ultimate recoverable may be greater or less than the amount accrued. At December 31, 2010 and 2009, reinsurance recoverables on paid and unpaid losses were $294.2 million and $274.5 million, respectively.
In our risk-sharing programs, we are subject to credit risk with respect to the payment of claims by our clients’ captive, rent-a-captive, large deductible programs, indemnification agreements, or on the portion of risk either ceded to the captives, or retained by the clients. The capitalization and credit worthiness of prospective risk-sharing partners is one of the factors we consider upon entering into and renewing risk-sharing programs. We collateralize balances due from our risk-sharing partners through funds withheld trusts or stand-by letters of credit issued by highly rated banks. We have historically maintained an allowance for the potential uncollectibility of certain reinsurance balances due from some risk-sharing partners, some of which may be in dispute. At the end of each quarter, an analysis of these exposures is conducted to determine the potential exposure to uncollectibility. At December 31, 2010, we believe this allowance is adequate. To date, we have not, in the aggregate, experienced material difficulties in collecting balances from our risk-sharing partners. No assurance can be given, however, regarding the future ability of our risk-sharing partners to meet their obligations.
We are subject at times to various claims, lawsuits and proceedings relating principally to alleged errors or omissions in the placement of insurance, claims administration, consulting services and other business transactions arising in the ordinary course of business. Where appropriate, we vigorously defend such claims, lawsuits and proceedings. Some of these claims, lawsuits and proceedings seek damages, including consequential, exemplary or punitive damages, in amounts that could, if awarded, be significant. Most of the claims, lawsuits and proceedings arising in the ordinary course of business are covered by the policy at issue, errors and omissions insurance or other appropriate insurance. In terms of deductibles associated with such insurance, we have established provisions against these items, which are believed to be adequate in light of current information and legal advice. In accordance with accounting guidance, if it is probable that an asset has been impaired or a liability has been incurred as of the date of the financial statements and the amount of loss is estimable; an accrual is provided for the costs to resolve these claims in our consolidated accompanying financial statements. Period expenses related to the defense of such claims are included in other operating expenses in the accompanying consolidated statements of income. We, with the assistance of outside counsel, adjust such provisions according to new developments or changes in the strategy in dealing with such matters. On the basis of current information, we do not expect the outcome of the claims, lawsuits and proceedings to which we are subject to, either individually, or in the aggregate, will have a material adverse effect on our financial condition. However, it is possible that future results of operations or cash flows for any particular quarter or annual period could be materially affected by an unfavorable resolution of any such matters.
Our results for the year ended December 31, 2010, include the positive impact from continued selective growth, coupled with our adherence to strict corporate underwriting guidelines as well as a focus on current accident year price adequacy and the benefits derived from leveraging of fixed costs. Our generally accepted accounting principles (“GAAP”) combined ratio was 95.0% for the year ended December 31, 2010, compared to 93.2% in 2009. Net operating income increased $4.7 million, or 8.8%, from $53.5 million for the year ended December 31, 2009, to $58.2 million for the year ended December 31, 2010.
Claim fees decreased $0.6 million, or 8.4%, to $6.8 million for the year ended December 31, 2010, from $7.4 million for the comparable period in 2009. This decrease is primarily due to the previously mentioned program above is now administering their claims in house and an anticipated decrease resulting from the termination of one unprofitable program.
Net realized gains (losses) improved by $2.0 million, to a $1.8 million gain for the year ended December 31, 2010, from a ($0.2) million loss for the comparable period in 2009. The loss in 2009 reflected both the realized losses on the sale of securities sold during the prior year and other-than-temporary impairments pertaining to certain corporate bonds, asset-backed and mortgage-backed securities, compared to the realized gains on the sale of securities sold in 2010.
Expenses increased $114.8 million from $554.5 million for the year ended December 31, 2009 to $669.3 million for the year ended December 31, 2010. This increase is reflective of the growth in our underwriting operations.
Interest expense for the year ended December 31, 2010, decreased $1.1 million, to $9.5 million, from $10.6 million for the comparable period in 2009. Interest expense is primarily attributable to our debentures, which are described within the Liquidity and Capital Resources section of Management’s Discussion and Analysis, as well as our term loan. The overall decrease reflects the decline in the average outstanding balance on our term loan to $43.8 million for the period ended December 31, 2010 from $55.1 million for same period in 2009. The decrease also reflects interest rate swaps that were entered into during the current year that replaced expiring swaps and had a lower fixed interest rate.
Net income for the year ended December 31, 2009, was $52.7 million, or $0.92 per dilutive share, compared to net income of $27.4 million, or $0.61 per dilutive share, for the comparable period of 2008. Net operating income, a non-GAAP measure, increased $14.7 million, or 37.9%, to $53.5 million, compared to net operating income of $38.8 million in 2008; this equates to an increase in operating income per share of 8.1% to $0.93 per diluted share, compared to $0.86 per diluted share in 2008. Total weighted average shares outstanding for the year ended December 31, 2009, were 57,413,391, compared to 44,995,712 for the comparable period in 2008. This increase in the weighted average shares is primarily the result of the equity issued in connection with the ProCentury merger.
Revenues for the year ended December 31, 2009, increased $189.8 million, or 43.4%, to $627.6 million, from $437.8 million for the comparable period in 2008. This increase primarily reflects a $169.9 million increase in net earned premiums, of which $114.2 million related to our Century operations and the remaining $55.7 million was primarily the result of overall growth within our existing programs and new business we implemented in 2008 and 2009.
Claim fees decreased $1.5 million, or 16.4%, to $7.4 million for the year ended December 31, 2009, from $8.9 million for the comparable period in 2008. This decrease is primarily the result of the fact that the previously mentioned program above is now administering their claims in house and an anticipated decrease resulting from the termination of one unprofitable program.
Net investment income increased $13.8 million, or 37.7%, to $50.4 million for the year ended December 31, 2009, from $36.6 million in 2008. This increase primarily reflects the increase in average invested assets from $0.9 billion in 2008 to $1.1 billion in 2009. This increase is in our average investment balance is due primarily to growth in underwriting profits and growth in investment income., and a slight lengthening of our loss and LAE reserve duration. The average investment yield for December 31, 2009 was 4.4%, compared to 4.2% in 2008. The current pre-tax book yield for December 31, 2009 and 2008, was 4.4%. The current after-tax book yield was 3.4%, compared to 3.3% in 2008. The duration of the investment portfolio is 5.1 years at December 31, 2009, compared to 4.8 years at December 31, 2008.
Expenses increased $160.5 million from $394.0 million for the year ended December 31, 2008 to $554.5 million for the year ended December 31, 2009.
Net loss and loss adjustment expenses (“LAE”) increased $98.2 million, to $327.4 million for the year ended December 31, 2009, from $229.2 million for the same period in 2008. Our loss and LAE ratio was 60.7% for the year ended December 31, 2009 and 62.0% for the year ended December 31, 2008. The accident year loss and LAE ratio was 66.0% for the year ended December 31, 2009 down from 66.5% in the comparable period in 2008. Additional discussion of our reserve activity is described below within the Other Items ~ Reserves section.
The accident year loss ratio is a non-GAAP measure and represents our net loss and LAE ratio adjusted for any adverse or favorable development on prior year reserves. The most directly comparable financial GAAP measure to the accident year loss ratio is the net loss and LAE ratio. The accident year loss ratio is intended as supplemental information and is not meant to replace the net loss and LAE ratio. The accident year loss ratio should be read in conjunction with the GAAP financial results. The following is a reconciliation of the accident year loss ratio to the net loss and LAE ratio, which is the most directly comparable GAAP measure:
In July 2009, our subsidiary, Star, purchased a 28.5% ownership interest in an insurance holding limited liability company for $14.8 million in cash. We are not required to consolidate this investment as we are not the primary beneficiary of the business nor do we control the entity’s operations. Our ownership interest is significant, but is less than a majority ownership and, therefore, we are accounting for this investment under the equity method of accounting. Star will recognize 28.5% of the profits and losses as a result of this equity interest ownership. We recognized after-tax equity earnings from MFH of $2.3 million, or $0.04 per dilutive share, for the year ended December 31, 2010, compared to $0.9 million, or $0.02 per dilutive share, for the comparable period of 2009. We had no equity earnings related to MFH for 2008. We received dividends from MFH in 2010 and 2009, for $1.0 million and $0.4 million, respectively. The gross earned premium from MFH for the years ended December 31, 2010 and 2009 was $118.4 million and $17.0 million, respectively. Additionally, the agent balances receivable from MFH for the years ended December 31, 2010 and 2009 was $39.0 million and $28.8 million, respectively.
The projected net ultimate loss estimate for the workers’ compensation line of business excluding residual markets increased $6.4 million, or 3.5% of net workers’ compensation reserves. This net overall increase reflects increases of $8.7 million and $686,000 for accident years 2009 and 2008, respectively. This increase in the net ultimate loss estimate for this accident year was because of greater than expected claim emergence in isolated states and classes of business. This increase was partially offset by decreases of $1.5 million and $1.3 million for accident years 2006 and 2004, respectively. This decrease was due to favorable development in a countrywide program and a Nevada program. The change in ultimate loss estimates for all other accident years was insignificant.
The commercial multiple peril line and general liability line of business had a decrease in net ultimate loss estimates of $20.7 million, or 6.2% of net commercial multiple peril and general liability reserves. The net decrease reflects decreases of $4.0 million, $8.7 million, $7.0 million, $3.9 million, $996,000, and $675,000 in the ultimate loss estimates for accident years 2009, 2008, 2007, 2006, 1997, and 1996, respectively. The decreases in the net ultimate loss estimates for these accident years were because of better than expected claim emergence in several excess and surplus lines programs. The decreases were offset by increases of $2.0 million, $738,000, $718,000, and $781,000 for accident years 2005, 2004, 2003, and 1999, respectively. This increase in the net ultimate loss estimates for this accident year was due to greater than expected claim emergence in a general liability program and two excess liability programs. The change in ultimate loss estimates for all other accident years was insignificant.
The projected net ultimate loss estimate for the other lines of business decreased $3.6 million, or 10.1% of net reserves. This net decrease reflects decreases of $1.1 million and $2.0 million in accident years 2009 and 2008, respectively. This decrease is primarily due to better than expected case reserve development during the calendar year in a professional liability program. The change in ultimate loss estimates for all other accident years was insignificant.
At December 31, 2010 and 2009, we had 108 and 127 securities that were in an unrealized loss position, respectively. Of the securities held at December 31, 2010, nineteen securities had an aggregate $12.3 million and $1.5 million fair value and unrealized loss, respectively, and have been in an unrealized loss position for more than twelve months. Of the securities held at December 31, 2009, forty-one had an aggregate $30.0 million and $2.3 million fair value and unrealized loss, respectively, and have been in an unrealized loss position for more than twelve months.
During the year ended December 31, 2010, in accordance with our OTTI policy, we recorded an OTTI credit loss of $0.5 million. For the year ended December 31, 2009, we recorded an OTTI loss of $5.2 million, of which a non-credit related OTTI loss of $1.7 million was recognized in other comprehensive income, resulting in a credit related OTTI loss of $3.5 million.
Refer to Note 3 ~ Investments, for additional information specific to OTTI and their fair value and amount of unrealized losses segregated by the time period the investment has been in an unrealized loss position.
We have a total revolving credit facility of $35.0 million, which may include up to $15.0 million in letters of credit. As of December 31, 2010, we had a zero outstanding loan balance on our revolving credit facility and $0.5 million in letters of credit issued. The undrawn portion of the revolving credit facility is available to finance working capital and for general corporate purposes, including but not limited to, surplus contributions to our Insurance Company Subsidiaries to support premium growth or strategic acquisitions.
On July 31, 2008, we executed $100 million in senior credit facilities (the “Credit Facilities”). The Credit Facilities included a $65.0 million term loan facility, which was fully funded upon the closing of our ProCentury Merger and a $35.0 million revolving credit facility, which was partially funded upon closing of the ProCentury Merger. The revolving credit facility includes a letter of credit facility with a sublimit. The total amount of credit available under the revolving credit facility is $35.0 million, which may include up to $15 million in letters of credit. As of December 31, 2010, the outstanding balance on our term loan facility was $37.8 million. We have a zero outstanding loan balance on our revolving credit facility as of December 31, 2010, and $0.5 million in letters of credit had been issued as of December 31, 2010. The undrawn portion of the revolving credit facility is available to finance working capital and for general corporate purposes, including but not limited to, surplus contributions to our Insurance Company Subsidiaries to support premium growth or strategic acquisitions. At December 31, 2009, we had an outstanding balance of $49.9 million on our term loan and had a zero outstanding balance on our revolving credit facility or any letters of credit issued.
As of December 31, 2010 and December 31, 2009, the recorded values of our investment portfolio, including cash and cash equivalents, were $1.3 billion and $1.2 billion, respectively.
At December 31, 2010, shareholders’ equity was $547.1 million, or a book value of $10.28 per common share, compared to $502.9 million, or a book value of $9.06 per common share, at December 31, 2009.
We paid dividends to our common shareholders of $7.0 million for the year ended December 31, 2010. For the year ended December 31, 2009, we paid dividends of $5.2 million to our common shareholders. On February 11, 2011, our Board of Directors declared a quarterly dividend of $0.04 per common share. The dividend is payable on April 5, 2011, to shareholders of record as of March 21, 2011.
When evaluating the declaration of a dividend, our Board of Directors considers a variety of factors, including but not limited to, cash flow, liquidity needs, results of operations, industry conditions, and our overall financial condition. As a holding company, the ability to pay cash dividends is partially dependent on dividends and other permitted payments from its Insurance Company Subsidiaries.
The following table is a summary of our contractual obligations and commitments as of December 31, 2010 (in thousands):
(2) Five year call feature associated with debentures, estimated seven year repayment. For a description of our debentures and related interest rate terms, as well as actual rates in accordance with our interest rate swap transactions, refer to Note 7 ~ Debt and Note 8 ~ Derivative Instruments.
(6) The loss and loss adjustment expense payments do not have contractual maturity dates and the exact timing of payments cannot be predicted with certainty. However, based upon historical payment patterns, we have included an estimate of our gross losses and loss adjustment expenses. In addition, we have anticipated cash receipts on reinsurance recoverables on unpaid losses and loss adjustment expenses of $280.9 million, of which we estimate that these payments to be paid for losses and loss adjustment expenses for the periods less than one year, one to three years, three to five years, and more than five years, to be $59.3 million, $77.8 million, $38.0 million, and $105.7 million, respectively, resulting in net losses and loss adjustment expenses of $241.8 million, $271.2 million, $107.6 million, and $163.5 million, respectively.
We maintain an investment portfolio with varying maturities that we believe will provide adequate cash for the payment of claims.
The LTIP is intended to provide an incentive to management to improve our performance over a three year period, thereby increasing shareholder value. The LTIP is not discretionary and is based upon a target for an average three year return on beginning equity. If the targets are met and all other terms and conditions are satisfied, the LTIP awards are paid. The LTIP is paid 50% in cash and 50% in stock. A participant’s percentage is established by the Compensation Committee and the Board of Directors in advance of any new three year LTIP award. The stock component of the LTIP is paid based upon the closing stock price at the beginning of the three year LTIP performance period, in accordance with the terms and conditions of the LTIP.
With the ProCentury merger our Compensation Committee and Board of Directors determined that our opportunity for successfully integrating the ProCentury merger would be heightened and shareholder value increased, if all participants were in the same equity-based plan beginning in 2009. As a result, our Compensation Committee approved the termination of our current 2007-2009 LTIP effective December 31, 2008 and established a new plan for 2009-2011 based on new performance targets. Based on this amendment, the current LTIP participants would receive their award based on a two-year performance period, rather than a three-year period. Therefore, the total award would be approximately two-thirds of the original three-year award. There were no accounting adjustments as a result of the amendment as there were no changes to the underlying plan, only an adjustment to the performance period.
The National Association of Insurance Commissioners (“NAIC”) has adopted a risk-based capital (“RBC”) formula to be applied to all property and casualty insurance companies. The formula measures required capital and surplus based on an insurance company’s products and investment portfolio and is used as a tool to evaluate the capital of regulated companies. The RBC formula is used by state insurance regulators to monitor trends in statutory capital and surplus for the purpose of initiating regulatory action. In general, an insurance company must submit a calculation of its RBC formula to the insurance department of its state of domicile as of the end of the previous calendar year. These laws require increasing degrees of regulatory oversight and intervention as an insurance company’s RBC declines. The level of regulatory oversight ranges from requiring the insurance company to inform and obtain approval from the domiciliary insurance commissioner of a comprehensive financial plan for increasing its RBC to mandatory regulatory intervention requiring an insurance company to be placed under regulatory control in a rehabilitation or liquidation proceeding.
At December 31, 2010, each of our Insurance Company Subsidiaries was in excess of any minimum threshold at which corrective action would be required.
In June 2009, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Codification (“ASC”) 810, Consolidation (previously SFAS No. 167, Amendments to FASB Interpretation No. 46(R)). ASC 810 contains consolidation guidance applicable to variable interest entities. The guidance further requires enhanced disclosures, including disclosure of significant judgments and assumptions as to whether a variable interest entity must be consolidated, and how involvement with the variable interest entity affects a company’s financial statements. The guidance is effective for annual periods beginning after November 15, 2009. We adopted ASC 810 in the first quarter of 2010. The adoption of ASC 810 did not have a material impact on our financial condition or results of operations.
Refer to list of Financial Statement Schedules and Note 19 ~ Quarterly Financial Data (Unaudited) of the Notes to the Consolidated Financial Statements.