The selected financial data presented below should be read in conjunction with our consolidated financial statements and the notes thereto, which are included in Item 8. Financial Statements and Supplementary Data, herein. For additional information with respect to our business see
Our consolidated net income for the year ended December 31, 2006 increased 47% compared with the same period in 2005. Our consolidated net income for the year ended December 31, 2005 increased 24% compared with the same period in 2004.
During 2006, we sold our insurance management operations for $39.1 million in cash, which reflects a post-closing working capital adjustment of $0.9 million. In connection with the transaction, we also received a cash distribution of approximately $5.9 million from the operations prior to the sale. We recognized an $11.6 million after-tax gain on the disposition of these operations. During 2005, we sold our TPA operations and recognized a $1.7 million after-tax gain related to the sale.
Our net premiums written for the year ended December 31, 2006 declined 12%, compared with the same period in 2005 primarily as a result of a shift in business mix to lower risk specialties and to a lesser extent, a continued migration to lower policy limits for Florida-based physicians, a lower number of policyholders compared with the same period in the prior year and an effective rate decrease of 9.2% at First Professionals beginning December 1, 2006. Our net premiums written for the year ended December 31, 2005 increased 31% compared with the same period in 2004 primarily as a result of the termination of cessions under the Hannover Re net account quota share reinsurance agreement as of June 30, 2004.
We commuted our net account quota share reinsurance agreement with Hannover Re effective December 31, 2006, which resulted in the assumption of $84.0 million in loss and LAE reserves previously ceded under the agreement. Because of the commutation, we will no longer incur the finance charges previously associated with funds withheld under the agreement.
Our calendar year loss ratio improved to 67% for the year ended December 31, 2006, (compared to 74% and 84% for the years ended December 31, 2005 and 2004, respectively), as a result of favorable loss experience, including a significant reduction in reported claims and incidents for the year. The severity of our claims continued to be within our expectations.
For the year ended December 31, 2006, our expense ratio was 22% compared to 16% and 8% for the same periods in 2005 and 2004, respectively. Our other underwriting expenses for the year ended December 31, 2006 included two state guaranty fund assessments totaling $9.4 million ($5.8 million after-tax) related to the insolvency of the insurance subsidiaries of Poe Financial Group. No assessments were levied in 2005 or 2004.
Portfolio growth and a higher overall yield contributed to a 29% increase in our net investment income for the year ended December 31, 2006 compared to a 21% increase for the same period in 2005.
Our shareholders’ equity increased 14% and our insurance surplus increased 17% as of December 31, 2006 compared to the balances as of December 31, 2005.
We repurchased 683,955 shares of our common stock during 2006 at an average price of $38.05 per share; as of March 2, 2007, an additional 166,890 shares of our common stock have been repurchased, including 116,890 shares through our Rule 10b5-1 plan, at an average price of $39.48 per share; 437,635 shares remain available for repurchase under the current stock repurchase program.
During February 2007, our subsidiary, First Professionals, entered into an agreement with Physicians’ Reciprocal Insurers (“PRI”) to commute, effective January 1, 2007, all assumed reinsurance treaties with PRI where First Professionals acted as a reinsurer. These treaties covered excess of loss reinsurance and reinsurance for PRI’s death, disability and retirement risks. Under the terms of the agreements, First Professionals paid cash and delivered securities with an aggregate value of approximately $87.7 million to PRI as full settlement of all past and future obligations for policy risks previously reinsured by First Professionals. The corresponding net liabilities related to these agreements carried by First Professionals as of December 31, 2006 totaled $103.4 million. This transaction will be reflected in our first quarter 2007 financial statements.
On February 20, 2007, A.M. Best upgraded the financial strength rating of our insurance subsidiaries to “A-“ (Excellent) with a stable outlook from a financial strength rating of “B++” (Good) with a stable outlook.
Our discussion and analysis of financial condition, results of operations and liquidity and capital resources is based upon the consolidated financial statements, which have been prepared in accordance with GAAP. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues, expenses and related disclosures of contingent assets and liabilities. We generally base our estimates on historical experience or other appropriate assumptions that we believe are reasonable and relevant under the circumstances and evaluate them on an ongoing basis. The results of these estimation processes form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.
Our loss and LAE reserves represent management’s best estimate of the amounts we expect to pay out in the future on account of all insured events as of the end of the period. The liability comprises estimated case reserves on reported claims plus estimates of insured losses and LAE incurred but not yet reported (“IBNR”). Also implicit in our loss and LAE reserves is a provision for case reserve development, which represents an estimate of the aggregate difference between our individually estimated case reserves and the amount for which they will ultimately be settled. This provision, which is included in our total IBNR reserves, comprises the majority of such reserves given our claims-made only policy coverage.
Each technique has inherent benefits and shortcomings (i.e., biases), particularly when applied to company-specific characteristics and trends. For example, certain methods (e.g., the Bornhuetter-Ferguson methods) are more relevant to immature accident years, and other methods (e.g., the loss development methods) provide more meaningful information for years with a greater level of maturity. Because each method has its own set of attributes, we do not rely exclusively upon a single method. Rather, we evaluate each of the methods for the different perspectives that they provide. Each method is applied in a consistent manner from period to period and the methods encompass a review of selected claims data, including claim and incident counts, average indemnity payments, and loss adjustment costs.
Using internal actuarial staff, we analyze and develop projections of ultimate losses that are utilized in establishing our carried reserves. In performing our review, we separate reserves by line of business, coverage type, layer of coverage, geography, and accident year. By doing so, we are able to evaluate the unique patterns of development and trends for each line of business. We then select a point estimate for each line of business with due regard for the age, characteristics and volatility of the portion of the business, the volume of data available for review and past experience with respect to the accuracy of estimates for business of a similar type. This series of selected point estimates, along with other relevant quantitative and qualitative information, is then evaluated by management to produce our best estimate and our range of projected ultimate losses based upon the various methods discussed above. We develop our range by selecting and applying a factor to our best estimate in order to produce the upper end of our range, which is reflective of the outcomes of higher projections. A similar method is used to arrive at the low end of our range. In general, the width of a range reflects the level of variability in the underlying projections, and a typical range of reasonable values for MPL business is considered to be as wide as 15%. Therefore, in addition to the performance of the business itself, our financial condition, results of operations and cash flows are sensitive to our reserve estimates and judgments. The range developed for our loss and LAE reserves, net of reinsurance, at December 31, 2006 was $429.0 million to $498.6 million.
We also utilize and evaluate calculations contained in an actuarial study performed by an independent actuarial firm as an objective confirmation of the adequacy of our carried reserves. Our best estimate may differ from the selected reserve estimate of our independent actuary because of differences in evaluating such things as the impact of historical experience, legal and regulatory changes, expectations about future claim results and trends and certain other factors as discussed below. While our assessment may differ, our carried reserves remain within a reasonable actuarial range of the independent actuary’s selected reserve estimate. The independent review of our reserves plays an important role in our overall assessment of the adequacy of our reserves. The reserve opinions of our independent actuary for the years ended December 31, 2006 and 2005 have been filed with state insurance regulators along with the statutory financial statements of our insurance companies.
In 2006, we ended the year with 13,402 professional liability policyholders and paid a total of $53.0 million in loss payments (indemnity only) on 322 claims.
Given the magnitude of our reserves and these characteristics, even a relatively small change in the number of claims we expect to pay (i.e., frequency) or a relatively small percentage change in the average cost per claim (i.e., severity) could have a significant impact on our reserves and, correspondingly, our financial position, results of operations and cash flows. This is the case for other key assumptions as well, such as the frequency of reported claims and incidents that will ultimately close with an indemnity payment versus those that will close without an indemnity payment. In addition, due to the relatively small number of claims ultimately resulting in an indemnity payment and the average cost per claim, any change in the trends assumed in the ultimate values for these factors could result in a significant change in our reserve estimates. Because our aggregate loss and LAE reserves are so large, this also means that virtually any change in the level of our carried reserves will be material to results of operations and may be material to our financial position.
During November 2006, First Professionals entered into an agreement with CX Re to commute its ceded reinsurance agreement. Under the terms of the agreement, First Professionals assumed loss and LAE reserves previously ceded of approximately $2.4 million and received a comparable amount of assets in the form of cash and investments, resulting in no material gain or loss on the transaction.
During May 2005, First Professionals and APAC entered into agreements to commute their 25% quota share reinsurance ceded to American Professional Assurance, Ltd. (“APAL”). Under the terms of the agreement, First Professionals and APAC assumed loss and LAE reserves previously ceded of approximately $10.2 million and received a comparable amount of assets in the form of cash and investments, resulting in no material gain or loss on the transaction.
Losses and LAE related to the current year decreased approximately 6% for the year ended December 31, 2006 compared to 2005. As noted in our discussion of results of operations below, our net premiums earned remained flat for the year ended December 31, 2006 compared to 2005. Our loss ratio (defined as the ratio of net losses and LAE to net premiums earned) related to the current year decreased to 69% for the year ended December 31, 2006 compared to 74% for the same period in 2005. Our decline in losses and LAE for the current year reflects favorable claims trends, including a significant reduction in newly reported claims and incidents. Severity of claims also continued to be within our expectations.
Losses and LAE for claims related to prior years represent the total net change in estimates charged or credited to earnings in the current year with respect to liabilities established in prior years. Information regarding losses and LAE is accumulated over time and the estimates of the liability are revised accordingly, with the change recognized in the period revisions are made. As noted in the table above, our loss and LAE reserve estimates for prior years decreased approximately $5.1 million. The favorable prior year loss development reflects a decline in expected ultimate losses for years prior to 2006, primarily the 2004 and 2005 accident years, as a result of improved claim trends including lower frequency, a lower number of claims closed with indemnity payment and stable severity.
The following table sets forth on a calendar year basis, the development of our liability for losses and LAE, net of amounts recoverable under reinsurance arrangements, for the ten-year period preceding the year ended December 31, 2006, and the cumulative amounts paid with respect to such reserves. Development reflects the difference between the amount we previously established as loss reserves and the re-estimated liability as of the end of each succeeding year. Favorable development, or redundancy, means that we now believe we will have to pay less for related claims than we had previously set aside in reserves and have revised our reserve estimates accordingly. Adverse development, or deficiency, means that we now believe we will have to pay more for related claims and have increased our reserve estimates. The table also provides a reconciliation of our liability net of reinsurance to the gross liability before reinsurance, as it is shown on our consolidated statements of financial position.
As the table below indicates, our reserve estimates can vary over time based on actual results and our assessment of the impact of recent conditions and trends. For example, the cumulative net reserves carried at the end of calendar years 1996 through 1998 have been higher than subsequent payments and re-estimates and have developed downward (i.e., redundantly). In contrast, net reserves at the end of calendar years 1999 through 2003 have increased from the amounts initially carried and have developed upward (i.e., deficiently). Improvements in recent years have resulted in a redundancy in the cumulative net reserves carried at the end of 2006 as compared to our prior estimates. The following factors have contributed to the variation in our historical loss development:
Prior to 1998, reserves represented only those of First Professionals and were primarily related to MPL insurance business written in Florida. Claim results for this period were generally favorable and resulted in lower reserve estimates.
We experienced adverse development for accident years 1998 through 2002 because of higher than expected claim trends in Missouri.
We experienced adverse development for accident years 1998 through 2001 in our core Florida book primarily due to increases in ALAE for those report years as a result of the stricter claims handling philosophy implemented in 2001. This philosophy resulted in increases in ALAE costs for open claims including claims for prior accident years. Although our claims handling philosophy has decreased overall loss costs, it had an adverse affect on older report years where higher loss adjustment expenses were not entirely offset by lower indemnity expenses.
Accident years 2002 through 2005 have developed favorably overall, in particular accident years 2003 and 2004. We have experienced favorable development on these years because of improved claim trends, including lower frequency, a lower number of claims closed with indemnity payment, and stable severity, in part due to the strict claims philosophy adopted in 2001.
Data presented in the table above represents consolidated information of all our insurance subsidiaries commencing from their respective dates of acquisition. Data presented from 1996 to 1997 reflects only First Professionals’ liability for losses and LAE. The 1998 year reflects losses and LAE data for First Professionals and APAC. The data presented from 1999 to 2006 reflects all of our insurance subsidiaries.
Reserve for Extended Reporting Endorsements - A portion of the coverage that physicians purchase under claims-made policies is for an additional death, disability, and retirement (“DD&R”) insurance benefit. Coverage is provided to the physician for any prior incidents occurring during the claims-made policy period that are reported after his or her death, disability, or retirement. The loss exposure associated with this product is known as extended reporting endorsement claims. The reserve for extended reporting endorsement claims is recorded during the term of the original claims-made policy, based on the present value of future estimated benefits, including assumptions for morbidity, mortality, retirement, interest and inflation, less the present value of expected future premiums associated with this DD&R coverage. The reserves for these claims fluctuate based on the number of physicians who are eligible for this coverage and their age. These liabilities, which possess elements of both loss reserves and pension liabilities, are carried within unearned premiums. Once an endorsement is issued because of a triggering event, a liability is established as part of the reserve for losses and LAE. Any changes in the DD&R reserves are reflected as income or expense in the period in which we become aware that an adjustment is necessary. At December 31, 2006 and 2005, our carried DD&R reserves, which include assumed reserves pursuant to a reinsurance agreement established in the year 2000, were $81.0 million and $72.9 million, respectively, which include a discount related to the present value calculation of approximately $31.4 million and $29.4 million, respectively. A one percentage point change in our discount rate of 5% related to our DD&R reserves as of December 31, 2006, would result in an approximate addition or reduction in our reserve of approximately $8.6 million. Effective January 1, 2007, we commuted our assumed DD&R reserves. For additional information, see Item 8. Financial Statements and Supplementary Data, Note 19, Subsequent Events.
Issuer-specific considerations, including an issuer's short-term prospects and financial condition, recent news that may have an adverse impact on its results, and an event of missed or late payment or default;
We evaluate the financial condition of our reinsurers and monitor concentrations of credit risk with respect to the individual reinsurers that participate in our ceded programs to minimize our exposure to significant losses from reinsurer insolvencies. We hold collateral in the form of letters of credit or trust accounts for amounts recoverable from reinsurers that are not designated as authorized reinsurers by the applicable departments of insurance of the states that have jurisdiction over the underlying business.
The incremental effect of applying FAS 158 on individual line items in the consolidated statement of financial position is presented in the table below.
Deferred Policy Acquisition Costs and Deferred Ceding Commissions - Deferred policy acquisition costs consist primarily of commissions and premium taxes, which vary with and are directly related to the production of new and renewal insurance business. Acquisition costs are deferred and amortized over the period in which the related premium is earned. Deferred policy acquisition costs are reviewed to determine if they are recoverable from future income, including investment income. If such costs are estimated to be unrecoverable, they are expensed.
We previously had deferred ceding commissions under the Hannover Re net account quota share reinsurance agreement, which were deferred and earned over the period in which the related ceded premium was earned by the reinsuring company. We terminated cessions under the agreement effective June 30, 2004 and then commuted the agreement effective December 31, 2006. As a result of the termination of cessions under the agreement, there were no deferred ceding commissions reported in our consolidated statements of financial position as of December 31, 2006 and 2005. The amortization of the deferred ceding commissions, which was recorded as a reduction to other underwriting expenses, was $0.8 million and $11.7 million for the years ended December 31, 2005 and 2004, respectively.
Goodwill and Other Intangible Assets - In accordance with FAS 142, Goodwill and Other Intangible Assets, we make an annual assessment by reporting unit as to whether the value of our goodwill is impaired. We completed such assessments in 2006, 2005 and 2004 and concluded that the value of our goodwill was not impaired. We use both a market-based valuation analysis and a discounted cash flow analysis to estimate the fair value of each reporting unit. Changes to our assumptions could significantly lower our estimates of fair value and result in a determination that goodwill has suffered impairment in value. During 2006, we sold our insurance management operations, which included $8.0 million in goodwill, to a private investor.
As of December 31, 2005, we recognized an impairment charge of $0.4 million related to one of our intangible assets, which we believed did not have a remaining useful life. This impairment charge was incurred within our insurance reporting unit and is reported in other expenses in the consolidated financial statements. After the recognition of the impairment charge, there were no remaining intangible assets recorded in our consolidated statement of financial position as of December 31, 2005.
Consolidated net income was $51.6 million, or $4.83 per diluted common share, for the year ended December 31, 2006, an increase of 47% and 48%, respectively, compared with $35.0 million, or $3.26 per diluted common share, for the year ended December 31, 2005. Changes in net income are due to the factors discussed in the paragraph below with regard to consolidated income from continuing operations. In addition, consolidated net income for the year ended December 31, 2006 included discontinued operations of $18.6 million (including an $11.6 million gain on the disposal of our former insurance management operations and a $0.4 million gain on the disposal of our former TPA operations). Included in consolidated net income for the year ended December 31, 2005 was discontinued operations of $9.5 million (including a $1.7 million gain on the disposal of our former TPA operations).
Consolidated revenues were $259.8 million for the year ended December 31, 2006, an increase of 4%, from $250.7 million for the year ended December 31, 2005. The increase in consolidated revenues primarily resulted from higher net investment income, which reflects the growth in our investment portfolio and a higher overall yield.
Consolidated expenses were $212.7 million for the year ended December 31, 2006, a decrease of 1%, from $214.8 million for the year ended December 31, 2005. The decrease in consolidated expenses for the year ended December 31, 2006 is primarily due to a decline in net losses and LAE offset by higher other underwriting expenses and interest expense.
Consolidated net income for the year ended December 31, 2005 was $35.0 million, or $3.26 per diluted share, an increase of 24% and 21%, respectively, when compared with net income of $28.2 million, or $2.70 per diluted share, for the year ended December 31, 2004. Changes in net income are due to the factors discussed in the paragraph below with regard to consolidated income from continuing operations. In addition, consolidated net income for the years ended December 31, 2005 and included discontinued operations totaling $9.5 million and $10.3 million, respectively.
Consolidated revenues for the year ended December 31, 2005 were $250.7 million, an increase of 43%, from $174.8 million for the year ended December 31, 2004. The increase in consolidated revenues is primarily due to higher net premiums earned as a result of lower ceded premiums following the termination of the Hannover Re net account quota share reinsurance agreement as of June 30, 2004 and higher net investment income as a result of growth in our invested assets and improved yields. The growth in consolidated revenues for the year ended December 31, 2005 was offset to some extent by net realized investment losses, compared with net realized investment gains for the year ended December 31, 2004.
Our business is made up of our four insurance and certain other subsidiaries. Prior to the dispositions of our former TPA operations in June 2005 and our former insurance management operations in September 2006, we operated in multiple segments. Currently, we engage only in insurance operations. Financial and selected other data related to our continuing operations is summarized in the table below.
For the purpose of period over period comparisons, net paid losses and LAE do not take into account $84.0 million received in connection with the Hannover Re ceded reinsurance commutation effective December 31, 2006, which would be reflected as a reduction to reported net paid losses and LAE for 2006.
For the purpose of period over period comparisons, net paid losses and LAE do not take into account $10.2 million received in connection with the APAL ceded reinsurance commutation during the second quarter of 2005, which would be reflected as a reduction to reported net paid losses and LAE for 2005.
Hannover Re Net Account Quota Share Reinsurance Agreement - Our results include the effects of a net account quota share reinsurance agreement with the Hannover Re companies. Effective December 31, 2006, First Professionals commuted the agreement with Hannover Re. Under the terms of the agreement, First Professionals assumed loss and LAE reserves previously ceded of approximately $84.0 million and in exchange Hannover Re released to First Professionals the funds withheld under the agreement of $84.0 million. No gain or loss was recognized on the transaction. Amounts ceded under the Hannover Re net account quota share reinsurance agreement are summarized in the table below.
The decreases in direct and assumed premiums written and net premiums written for the year ended December 31, 2006 are primarily the result of a shift in business mix to lower risk specialties and to a lesser extent, a continued migration to lower policy limits in Florida, a lower number of policyholders compared with the same period in the prior year and an effective rate decrease of 9.2% at First Professionals beginning December 1, 2006. The number of professional liability policyholders was 13,402 at December 31, 2006, down 5% from 14,055 at December 31, 2005. The policyholder retention rate in our core Florida market was 94% for 2006 and 95% for 2005. National policyholder retention was 92% for 2006, compared to 94% for 2005.
Investment revenues, which are comprised of net investment income and net realized investment gains and losses, increased 29% and 108%, respectively, for the year ended December 31, 2006 compared to the same period in 2005. Net investment income increased primarily due to growth in our investment portfolio corresponding with increases in our insurance business in recent years and a higher overall yield, as well as the receipt of $45.9 million related to the disposition of our former insurance management segment. Net realized investment gains (losses) will vary depending on our cash needs and the management of our investment portfolio.
Net losses and LAE decreased approximately 9% for the year ended December 31, 2006 compared to the same period in 2005. Our calendar year loss ratio (defined as the ratio of net losses and LAE incurred to net premiums earned) decreased to 67% for the year ended December 31, 2006 compared to 74% for the same period in 2005. Our lower loss ratio reflects an improved current year loss ratio and favorable claims trends, including a significant reduction in newly reported claims and incidents during the year and favorable prior year loss development of $5.1 million, primarily as a result of lower expected ultimate losses for accident years 2004 and 2005. Severity of claims continued to be within our expectations.
Other underwriting expenses increased 40% for the year ended December 31, 2006 compared to the same period in 2005. The increase in other underwriting expenses during 2006 is primarily due to state guaranty fund assessments of $9.4 million related to the insolvency of the insurance subsidiaries of Poe Financial Group and a decrease in ceding commissions resulting from the termination of the Hannover Re net account quota share reinsurance agreement. In addition, during 2005, we received return management fees of $1.7 million because of a litigation settlement, which did not recur during 2006. Finally, share-based compensation increased $1.7 million during 2006, compared to the same period in 2005. Approximately $1.1 million of the increase in share-based compensation is the result of adopting FAS 123(R), effective January 1, 2006. For the year ended December 31, 2006, our expense ratio was 22% compared to 16% for the same period in 2005. Excluding the impact of the items discussed above, our expense ratio for the year ended December 31, 2006 was nearly unchanged compared to the same period in 2005.
The increase in interest expense was due to increases in the three-month LIBOR, which is the base rate used to determine the interest on our long-term debt. The increase in interest expense also reflects interest on our initial investment in trust-preferred securities and senior notes for which there is a corresponding amount reflected in net investment income as we earn interest on the amounts invested in the statutory capital trusts. The amortization of the initial cost of the hedging agreements also contributed to the increase in interest expense. The interest rates on our long-term debt ranged from 9.2% to 9.6% as of December 31, 2006. However, the hedging instruments that we have in place with maturity dates in 2008 essentially limited the maximum floating rate interest cost at 8.6% for those long-term debt arrangements where the interest rate was higher.
Other expenses are comprised primarily of finance charges associated with funds withheld under the Hannover Re net account quota share reinsurance agreement, which were $5.2 million for the year ended December 31, 2006, compared to $6.6 million for the same period 2005. The decrease in these finance charges corresponds with the decrease in the amount of funds withheld for business ceded under the agreement as we exercised our option to terminate future cessions as of June 30, 2004. We commuted our net account quota share reinsurance agreement with Hannover Re effective December 31, 2006. Because of the commutation, we will not incur finance charges related to funds withheld during 2007. In addition, other expenses for the years ended December 31, 2006 and 2005 include charges for compensation and benefits costs associated with the resignation of certain former officers in accordance with the terms of their respective employment agreements. Finally, during 2005, we recorded an impairment charge of $0.4 million related to one of our intangible assets.
Income tax expense for the year ended December 31, 2006 increased because of lower tax-exempt interest as a percentage of income before taxes. Our effective tax rate was 30% for the year ended December 31, 2006 compared to 29% for the same period in 2005. During 2005, we reached a settlement with the Internal Revenue Service (“IRS”) with regard to the examination of our income tax returns for the years ended December 31, 2000 and 2001. The settlement was approved by the Congressional Joint Committee on Taxation during the first quarter of 2006. We had previously accrued for income tax liabilities related to the examination, and consequently there was no income tax impact to our consolidated financial statements because of the settlement. During 2006, the IRS commenced an examination of our 2004 tax return. The examination was closed in February with no significant adjustments. Our income tax returns for 2003 and 2005 have not been examined by the IRS and remain open under the applicable statute of limitations.
Comparison of Results for the Years Ended December 31, 2005 and 2004
Net premiums earned increased 51% for the year ended December 31, 2005 compared to the same period in 2004 primarily as the result of the termination of cessions under the Hannover Re net account quota share reinsurance agreement, under which ceded earned premiums were $8.4 million and $75.7 million for the years ended December 31, 2005 and 2004, respectively. The decrease in ceded earned premiums earned under the agreement resulted in a corresponding increase in net premiums earned. Partially offsetting the increase in net premiums earned was the non-renewal, effective July 1, 2004, of the excess of loss reinsurance treaty under which First Professionals had previously assumed reinsurance from PRI.
Net losses and LAE increased 33% for the year ended December 31, 2005 compared to the same period in 2004. The growth in net losses and LAE is associated with the growth in premiums. Our loss and LAE ratios (defined as the ratio of net losses and LAE to net premiums earned) were 74% and 84% for the years ended December 31, 2005 and 2004, respectively. The smaller increase in our net losses and LAE relative to the net premiums earned and corresponding decrease in our loss ratio primarily reflect pricing and other improvements in our insurance business and the resulting improvement in our underwriting results. The improvement in our loss and LAE ratio for the year ended December 31, 2005 reflects the impact of pricing improvements and underwriting actions and favorable claims results, mainly lower numbers of newly reported claims and incidents and stable severity.
Interest expense increased 36% for the year ended December 31, 2005 compared to the same period in 2004. The increase is due to increases in the three-month LIBOR, which is the base rate used to determine the interest on our long-term debt. The interest rates on our long-term debt ranged from 8.09% to 8.61% as of December 31, 2005. We have hedging instruments in place, with maturity dates in 2008, which essentially limit the maximum floating rate interest cost at 8.6% for those long-term debt arrangements where the interest rate was higher.
Other expenses are comprised primarily of finance charges associated with funds withheld under the Hannover Re net account quota share reinsurance agreement, which were $6.6 million and $7.2 million for the years ended December 31, 2005 and 2004, respectively. As discussed elsewhere, we exercised our option to terminate future cessions under the agreement as of June 30, 2004. Other expenses for the year ended December 31, 2005 also includes a charge for compensation and benefits costs associated with the resignation of certain former officers in accordance with the terms of their respective employment agreements and an impairment charge associated with one of our intangible assets.
Our TPA operations were comprised of our former wholly owned subsidiary, Employers Mutual, Inc. (“EMI”). On May 9, 2005, EMI’s employee benefits administration business was sold effective April 30, 2005. An after-tax gain of $0.2 million was recognized on the sale. On May 31, 2005, the remaining TPA operations were sold to a private investor. An after-tax gain of $1.5 million was recognized on the sale. During the third quarter of 2006, we recorded an additional gain on the sale of discontinued operations of $0.4 million related to the finalization of our 2005 tax return, which reflected the sale of our former TPA operations. The results of operations and gain on sale of the former TPA operations are reported as discontinued operations.
As of December 31, 2006, we had cash and investments of $866.0 million. Included within cash and investments were cash and cash equivalents of $138.7 million and short-term investments and fixed income securities, available for sale, with a fair value of approximately $29.8 million and $27.5 million, respectively, with scheduled maturities during the next months. We believe that our cash and investments as of December 31, 2006, combined with expected cash flows from operating activities and the scheduled maturities of investments, will be sufficient to meet our cash needs for operating purposes for at least the next 12 months.
The securities are uncollateralized and bear floating interest rates equal to the three-month LIBOR plus spreads ranging from 3.85% to 4.20% (the interest rates ranged from 9.2% to 9.6% as of December 31, 2006). The floating interest rates are adjustable quarterly with changes in the three-month LIBOR, and in the case of two offerings, the maximum rate that may be charged under the securities within the first five years is 12.50%. We have also purchased interest rate collars designed to maintain the ultimate floating rate interest cost on all of these securities within a stated range for five years from closing. We have the option to call the trust-preferred securities and senior notes at par or its equivalent beginning five years from closing. The trust-preferred securities also contain features that allow us the option, under certain conditions, to defer interest payments for up to 20 quarters and to redeem the securities before the first optional call date in five years. In the case of the potential earlier call date, the redemption or call price payable by us may be different than par. The securities have stated maturities of 30 years and are due in May and October 2033.
We purchase reinsurance from a number of companies to mitigate concentrations of credit risk. Our reinsurance broker assists us in the analysis of the credit quality of our reinsurers. We base our reinsurance buying decisions on an evaluation of the then current financial strength and stability of prospective reinsurers. However, the financial strength of our reinsurers, and their corresponding ability to pay us, may change in the future due to forces or events we cannot control or anticipate. At December 31, 2006 our receivables from reinsurers totaled $176.9 million. We have not experienced difficulty in collecting amounts from reinsurers due to the financial condition of the reinsurers. Should future events lead us to believe that any reinsurer is unable to meet its obligation, adjustments to the amounts recoverable would be reflected in the results of current operations. We hold collateral in the form of letters of credit or trust accounts for amounts recoverable from reinsurers that are not designated as authorized reinsurers by the applicable departments of insurance of the states that have jurisdiction over the underlying business. The table below identifies our reinsurers from which our recoverables (net of amounts due to the reinsurer) are $5.0 million or more as of December 31, 2006.
(1) Derivative financial instruments - As noted above, we use interest rate collars as a hedge to maintain the total borrowing costs of our long-term debt (interest expense on the debt instruments, plus or minus cash flows under the interest rate collar instruments) to within specified ranges. Our total borrowing costs on long-term debt combined with the corresponding cash flows under the related interest rate collars, including the amortization of the initial costs of the hedging instruments, can fluctuate between $2.3 million and $4.4 million annually, until the interest rate collars expire. The interest rate collars are set to expire on dates corresponding with the first dates under the respective long-term debt agreements at which they can be retired by us at our option, which is five years from the date of issue in each case.
(2) Employee benefit plans - We provide pension benefits to eligible employees through various defined benefit plans that we sponsor. For additional information about our employee benefit plans, see Item 8. Financial Statements and Supplementary Data, Note 13, Employee Benefit Plans.
The following table illustrates the sensitivity to a change in the discount rate for our defined benefit plans as of December 31, 2006:
(3) Guarantees and contractual obligations of our trust-preferred securities - We guarantee the floating rate interest and principal obligations under the trust-preferred securities issued by three separately created, unconsolidated trusts. In addition, the indenture agreements relating to our junior subordinated debentures and trust-preferred securities contain limitations, under certain circumstances, as to (i) the declaration or payment of dividends, or distributions thereon, or the redemption, purchase, acquisition or liquidation with respect to any capital stock of FPIC or its affiliates; (ii) the payment, in certain circumstances, of principal, premium or interest on, or the repayment, repurchase or redemption of, debt securities of FPIC or its affiliates that rank in equal standing with or are junior in interest to the debentures; or (iii) the payment, in certain circumstances, under any guarantees of FPIC or its affiliates that rank in equal standing with, or are junior in interest to, capital securities guarantees relating to the issuance of the debentures. Circumstances that would result in such limitations include a continuing event of default, as defined by the indenture agreements, a default with respect to payment of any obligations under capital securities guarantees, or a continuing interest deferral election by FPIC. See Item 8. Financial Statements and Supplementary Data, Note 10, Long-term debt, for additional disclosures about our trusts and junior subordinated debentures.
All long-term debt is assumed to be settled at its contractual maturity.
Interest on long-term debt is calculated using implied forward rates for variable rate debt.
Employee benefit plan obligations are comprised of approved plan contributions and our unfunded obligation as of December 31, 2006.