With the ProCentury Merger, we assumed the lease of ProCentury’s corporate headquarters in Westerville, Ohio. The lease agreement for this building expired in 2013. We executed a new lease agreement for 60,000 square feet of office space in Westerville, Ohio commencing in 2013.
(1) The combined loss and expense ratio (or combined ratio), expressed as a percentage, is the key measure of underwriting profitability traditionally used in the property and casualty insurance business. The combined ratio is a statutory (non-GAAP) accounting measurement, which represents the sum of (i) the ratio of losses and loss expenses to premiums earned (loss ratio), plus (ii) the ratio of underwriting expenses to net premiums written (expense ratio). The combined ratios above have been modified to reflect GAAP accounting, as management evaluates the performance of our underwriting operations using the GAAP combined ratio. Specifically, the GAAP combined ratio is the sum of the loss ratio, plus the ratio of GAAP underwriting expenses (which include the change in deferred policy acquisition costs) to net premiums earned (expense ratio). When the combined ratio is under 100%, underwriting results are generally considered profitable; when the combined ratio is over 100%, underwriting results are generally considered unprofitable.
We establish a liability for losses and LAE, which represents case based estimates of reported unpaid losses and LAE and actuarial estimates of incurred but not reported losses (“IBNR”) and LAE. Such liabilities, by necessity, are based upon estimates and, while we believe the amount of our reserves is adequate, the ultimate liability may be greater or less than the estimate. As of December 31, 2013 and 2012, we have accrued $1,616.5 million and $1,456.0 million of gross loss and LAE reserves, respectively.
The following table sets forth our gross and net reserves for losses and LAE based upon an underlying source of data, at December 31, 2013 (in thousands):
All of these methods are consistently applied to each reserve category for which they are applicable and they create indications for each accident year. We use judgment selecting the best estimate from within these estimates or adjusted estimates. As such, no one method or group of methods is strictly used for any line of business or reserve category within a line of business. The individual selections by year are our best judgments based on the strengths and weaknesses of the method, indications, the inherent variability in the data and the specific modifications to selections for data characteristics.
Selection of the paid loss pattern requires analysis of several factors including the impact of inflation on claims costs, the rate at which claims professionals make claim payments and close claims, the impact of judicial decisions, the impact of underwriting changes, the impact of large claim payments, and other factors. Claim cost inflation itself requires evaluation of changes in the cost of repairing or replacing property, changes in the cost of medical care, changes in the cost of wage replacement, judicial decisions, legislative changes and other factors. Because this method assumes that losses are paid at a consistent rate, changes in any of these factors can impact the results. Since the method does not rely on case reserves, it is not directly influenced by changes in the adequacy of case reserves.
This method uses historical, cumulative reported loss dollars by accident year and develops those actual losses to estimated ultimate losses based upon the assumption that each accident year will develop to estimated ultimate cost in a manner that is analogous to prior years, adjusted as deemed appropriate for the expected effects of known changes in the claim payment and case reserving environment, and to the extent necessary supplemented by analyses of the development of broader industry data.
This is a method that assigns partial weight to the initial expected losses and partial weight to observed reported loss dollars (paid losses plus case reserves). The weights assigned to the initial expected losses decrease as the accident year matures.
The use of case incurred losses instead of paid losses can result in development patterns that are less variable than paid patterns. However, the inclusion of case reserves can lead to distortions if changes in case reserving have taken place, and the method requires analysis of all the factors that need to be reviewed for the expected loss ratio and incurred development methods.
Claims for short-tail lines of business settle quicker 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 typically 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 2% of our total reserves at December 31, 2013.
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.
This process assumes that past experience, adjusted for the effects of current developments and anticipated trends, is an appropriate basis for predicting future events. In particular, the development factor based methods all have as a key assumption that the development of losses in the future will follow a pattern similar to those measured by past experience and as adjusted either explicitly or by actuarial judgment. There is no precise method for subsequently evaluating the impact of any specific factor on the adequacy of reserves, because the eventual deficiency or redundancy is affected by multiple and varied factors. With respect to the ultimate estimates for losses and LAE, the key methods remained consistent for the years ended December 31, 2013 and 2012. We reviewed the key assumptions that underlie the actuarial standard methods and made the appropriate adjustments to reflect the emergence of claim activity.
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 $5.8 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.
Our range of loss and LAE reserves table shows that presently we estimate them as going from favorable development of 12.5% to unfavorable of 8.9%. The range was evaluated based on the ultimate loss estimates from the actuarial methods described above.
The range of loss and LAE reserves at December 31, 2013 had a minimum reserve estimate of $971.8 million and a maximum reserve estimate of $1,210.0 million.
The range of loss and LAE reserves at December 31, 2012 had a minimum reserve estimate of $953.3 million and a maximum reserve estimate of $1,164.4 million. At December 31, 2012 we recorded the loss and LAE reserves at 1,074.1 million. At December 31, 2013, re-estimated loss and LAE reserves for December 31, 2012 were $1,142.5 million which was within our 2012 loss and LAE estimated reserve range.
The sensitivity around the other lines of business primarily reflects the size of the underlying book of business. Our other reserves represent 3% of total reserves at December 31, 2013. A large portion of these reserves represent professional liability programs which tend to be claims-made and reinsured at lower limits, therefore reducing the volatility that is inherent in a smaller book of business. Another large portion represents property claims, which have a shorter reporting and payout pattern than liability and workers’ compensation claims.
The Company, and its subsidiaries, 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 as further disclosed in Note 15 ~ Commitments and Contingencies. Where appropriate, the Company vigorously defends 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 of insurance at issue. We account for such activity through the establishment of unpaid loss and loss expense reserves. We also maintain errors and omissions insurance and extra-contractual coverage under reinsurance treaties related to the policy of insurance at issue or other appropriate insurance. In terms of any retentions or deductibles associated with such insurance, the Company has established accruals for such retentions or deductibles, when necessary, based upon current available information. 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 reasonably estimable; then an accrual for the costs to resolve these claims is recorded by the Company in the accompanying consolidated balance sheets. Period expenses related to the defense of such claims are included in the accompanying consolidated statements of income. Management, with the assistance of outside counsel, adjusts such provisions according to new developments or changes in the strategy in dealing with such matters. On the basis of current information, the Company does not believe that there is a reasonable possibility that, other than with regard to the arbitration disclosed in Note 15 ~ Commitments and Contingencies, any material loss exceeding amounts already accrued, if any, will result from any of the claims, lawsuits and proceedings to which the Company is subject to, either individually, or in the aggregate.
Net Operating (Loss) Income and Net Operating (Loss) Income Per Share
Net operating (loss) income and net operating (loss) income per share are non-GAAP measures that represent net (loss) income excluding net realized gains or loss, net of tax. The most directly comparable financial GAAP measures to net operating (loss) income and net operating (loss) income per share are net (loss) income and net (loss) income per share, respectively. Net operating (loss) income and net operating (loss) income per share are intended as supplemental information and are not meant to replace net (loss) income nor net (loss) income per share. Net operating (loss) income and net operating (loss) income per share should be read in conjunction with the GAAP financial results. The following is a reconciliation of net operating (loss) income to net (loss) income, as well as net operating (loss) income per share to net (loss) income per share:
On February 21, 2014, A.M. Best Company, insurance industry rating agency, lowered Meadowbrook's issuer credit rating from BBB+ to BBB. While affirming the Company’s B++ financial strength rating A.M. Best lowered the outlook for this rating from “stable” to “negative.”
Effective July 1, 2013, certain of our Insurance Company Subsidiaries entered into quota share reinsurance agreement(s) with State National Insurance Company, National Specialty Insurance Company and United Specialty Insurance Company (collectively, “SNIC”), which will provide certain of our Insurance Company Subsidiaries the use of an “A” rated policy issuance carrier for a portion of the Company’s business where an “A” rated policy issuer is required. For the year ended December 31, 2013, we assumed $170.2 million, respectively, in direct written premium from SNIC. The impact of the Front Fee on the year ended December 31, 2013 expense ratios was 0.5%.
The net loss for the year ended December 31, 2013 was ($112.3 million), or ($2.25) per dilutive share, compared to net income of $11.7 million, or $0.23 per dilutive share, for the comparable period of 2012. Net operating loss, a non-GAAP measure, for the year ended December 31, 2013 was ($117.9 million), or ($2.36) per diluted share, compared to net operating loss of ($28.4 million), or ($0.57) per diluted share for the year ended December 31, 2012. The 2013 net operating loss, excluding the goodwill impairment, was ($16.3 million), or ($0.21) per diluted share. Total diluted weighted average shares outstanding for the year ended December 31, 2013, were 49,871,587, compared to 50,177,484 the comparable period in 2012. The decrease reflects the impact of our Share Repurchase Plan in 2012.
Net commission and fee revenue increased $5.5 million, or 16.0%, to $39.5 million for the year ended December 31, 2013, from $34.0 million for the comparable period in 2012. This increase was driven primarily by commission revenues generated from our subsidiary US Specialty Underwriters (“USSU”) that are no longer considered intercompany or eliminated in consolidation as they are now written by SNIC carriers. This increase did not impact the Company’s consolidated financial results as there is a corresponding increase in the expenses from net commission and fee operations.
The following table sets forth the components of expenses (in thousands):
Policy acquisition and other underwriting expenses decreased $48.6 million, to $225.5 million for the year ended December 31, 2013, from $274.1 million for the same period in 2012. Our expense ratio increased 0.2 percentage points to 32.3% for the year ended December 31, 2013, from 32.1% for the same period in 2012. The 2013 expense ratio, excluding the impact of the quota share reinsurance treaty, was 33.3% compared to 32.1% in 2012, or an increase of 1.2 percentage points. This increase reflects the effect of the arbitration award expense of 0.3 percentage points and 0.4 percentage points relating to a reallocation of corporate overhead costs from our fee-for-service operations to Insurance Company Subsidiaries' operations. The reallocation reflects a shift of corporate resources used to support capital and operating enhancements focused on strengthening statutory surplus and returning the Insurance Company Subsidiaries to an underwriting profit and a corresponding decrease to general selling and administrative costs. This reallocation had no net income effect. In addition, the expense ratio included a 0.4 percentage point increase relating to the use of an unaffiliated “A” rated insurance company for policy issuance purposes (“Front Fee’). The remaining 0.1 percentage point reflects the impact of deleveraging fixed costs.
Amortization expense decreased $3.1 million to $4.2 million for the year ended December 31, 2013, from $7.3 million for the same period in 2012. The decrease is primarily due to the $1.8 million write off of an intangible asset related to the public entity excess liability program that we terminated in the fourth quarter of 2012.
Goodwill impairment expense increased by $115.4 million from $0 in 2012 due to the $115.4 million impairment taken in the second quarter of 2013. Refer to Note 14 - Goodwill and Other Intangible Assets of the Notes to the Consolidated Financial Statements, for additional information specific to the goodwill impairment.
Interest expense increased by $4.5 million to $12.9 million for the year ended December 31, 2013 from $8.4 million for the same period in 2012. The increase is primarily due to the interest incurred on the $100 million cash convertible senior notes entered into in the first quarter of 2013.
The following table sets forth the components of revenues (in thousands):
Commission revenue increased $2.8 million, or 21.4%, to $15.9 million for the year ended December 31, 2012, from $13.1 million for the comparable period in 2011. This increase was driven primarily by commission revenues generated from the business of a Michigan agency that was acquired in the fourth quarter of 2011.
Net realized gains increased by $52.4 million, to $55.3 million for the year ended December 31, 2012, from a $2.9 million gain for the comparable period in 2011. The increase in realized gains relates to the fourth quarter 2012 sale of a portion of our bond portfolio in order to generate realized gains and enhance the statutory surplus of our Insurance Company Subsidiaries. We completed the reinvestment process of the proceeds during the first quarter of 2013, with the replacement of these bonds at lower re-investment rates.
Net loss and loss adjustment expenses (“LAE”) increased $182.3 million, to $677.7 million for the year ended December 31, 2012, from $495.4 million for the same period in 2011. Our loss and LAE ratio was 79.3% for the year ended December 31, 2012 and 66.3% for the year ended December 31, 2011. The loss and LAE ratio for the year ended December 31, 2012 includes a 10.0 percentage point increase from net ultimate loss estimates for accident years 2011 and prior, whereas the 2011 results include 1.0 percentage point change from net ultimate loss estimates for accident years 2010 and prior. The accident year loss and LAE ratio was 69.3% for the year ended December 31, 2012 up from 65.3% in the comparable period in 2011. The impact of Super Storm Sandy added 0.8 percentage points in 2012 as compared to 2011. In addition, the 2012 accident year loss and LAE ratio reflects the cumulative effect of an increase in our accident year forecasted 2012 loss and LAE ratio based upon the increase in net ultimate loss estimates for the 2009, 2010 and 2011 accident years.
In July 2009, our subsidiary, Star, purchased a 28.5% ownership interest in an affiliate, MFH, 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 equity earnings, net of tax, from MFH of $2.8 million, or $0.06 per dilutive share, for the year ended December 31, 2013, compared to $3.0 million, or $0.06 per dilutive share, for the comparable period of 2012, and $2.4 million, or $0.05 per dilutive share, for the comparable period of 2011. We received dividends from MFH in 2013, 2012 and 2011, for $2.0 million, $4.0 million and $3.4 million, respectively.
In November 2012, our subsidiary, Century, committed to a $10 million contribution to the Aquiline Financial Services Fund II L.P. as a strategic investment. As of December 31, 2013, approximately $6.4 million of the commitment had been satisfied with $3.6 million of unfunded commitment remaining. Our ownership interest is approximately 1.3% of the fund, which does not constitute “significant influence”. Therefore, we are accounting for this investment under the equity method of accounting. Century will recognize 1.3% of the Fund’s profits and losses as a result of this equity interest ownership. We recognized equity earnings, net of tax, from the Aquiline Financial Services Fund II L.P. of $0.6 million, or $0.01 per dilutive share for the year ended December 31, 2013.
Reserves are reviewed and established by our internal actuaries for adequacy and peer reviewed by our third-party actuaries. When reviewing reserves, we analyze historical data and estimate the impact of numerous factors such as (1) per claim information; (2) industry and our historical loss experience; (3) legislative enactments, judicial decisions, legal developments in the imposition of damages, and changes in political attitudes; and (4) trends in general economic conditions, including the effects of inflation. This process assumes that past experience, adjusted for the effects of current developments and anticipated trends, is an appropriate basis for predicting future events. There is no precise method for subsequently evaluating the impact of any specific factor on the adequacy of reserves, because the eventual deficiency or redundancy is affected by multiple factors.
For the year ended December 31, 2013, we reported an increase in net ultimate loss estimates for accident years 2012 and prior of $68.4 million, or 6.4% of $1.1 billion of beginning net loss and LAE reserves at January 1, 2013. At December 31, 2012 we recorded the loss and LAE reserves at 1,074.1 million. At December 31, 2013, re-estimated loss and LAE reserves for December 31, 2012 were $1,142.5 million which was within our 2012 loss and LAE estimated reserve range. The change in net ultimate loss estimates reflected revisions in the estimated reserves as a result of actual claims activity in calendar year 2013 that differed from the projected activity. The major components of this change in ultimates are as follows (in thousands):
The following table shows the re-estimated December 31, 2012 held reserves by line as of December 31, 2013 (in thousands):
For the year ended December 31, 2013, we reported an increase in net ultimate loss estimates for accident years 2012 and prior of $68.4 million, or $63.1 million, excluding the impact of an adverse arbitration award. Of the remaining $63.1 million increase, $36.3 million was related to business previously terminated that is now in run-off. Included in this $36.3 million increase is a $16.1 million year-to-date increase in an isolated California workers’ compensation territory, which developed in the second quarter of 2013. Since the second quarter of 2013 this territory has developed slightly favorably in the second half of the year. Excluding the isolated territory, the workers’ compensation line of business had a $1.6 million decrease in net ultimate loss estimates.
For the year ended December 31, 2013, the commercial multi-peril/general liability line of business increased $35.7 million, $27.7 million of which was related to the excess and surplus lines division, primarily on accident years 2011 and 2012. In addition to the $27.7 million of increase in excess and surplus lines, the commercial multi-peril/general liability line of business was impacted by an increase in older accident years of $12.0 million related to a terminated excess liability program, primarily on accident years 2004 - 2008. These increases were partially offset by a decrease of 4.0 million in the other liability line of business. Accident year combined ratios on the this line of business over the last 5 years, on a fully developed basis are between 94% and 97%, with the exception of 2011 with a 102.6% combined ratio, the only year above 100%.
The commercial automobile line of business had an increase in net ultimate loss estimates of $15.8 million, of which $7.3 million was due to terminated business. The dedicated claims team managing the run-off is taking the necessary actions to expeditiously run-off the remainder of the claims and has accelerated the process of reserving and closing claims.
The net ultimate loss estimates for accident years 2012 and prior in the workers' compensation line of business increased $14.6 million, or 3.2%. This was driven primarily by increases of $9.0 million and $6.8 million in 2011 and 2010, respectively. The increase in the net ultimate loss estimate for these accident years was due to greater than expected claim emergence, primarily in an isolated territory that was increased $19.2 million in the second quarter and since has had favorable development of $3.7 million. Cumulatively, in California’s workers’ compensation, we have achieved in excess of 60% rate increases since 2010 and in 2013 rate increases remained at over 20%.
This increase in ultimate loss estimates was partially offset by decreases of $1.9 million and $1.4 million in 2012 and 2007, respectively. These decreases reflect lower than expected claim emergence related to a California program, a New England program, and a countrywide program. Additional increases of $1.9 million, $2.2 million, and $1.3 million in accident years 2001, 2000, and 1999, respectively, were related to an adverse arbitration decision. The change in ultimate loss estimates for all other accident years was insignificant.
The net ultimate loss estimates for accident years 2012 and prior in the commercial multi-peril/general liability line of business increased $35.7 million, or 8.3%. This was driven partially by increases of $3.6 million, $4.2 million, $2.9 million, $2.2 million, and $1.9 million, in accident years 2008, 2007, 2006, 2005, and 2004, respectively, on a terminated excess liability program which had greater than expected claim emergence during the year.
The $15.8 million increase, or 11.4%, in net ultimate loss estimates for the commercial automobile line of business was primarily from increases of $10.7 million, and $3.1 million in accident years 2012 and 2011, respectively. These increases were primarily from greater than expected claim emergence in a transportation program, a California program, and a garage program. The transportation program, which was terminated in 2012, accounted for $3.7 million of the total increase in the year. The change in ultimate loss estimates for all other accident years was insignificant.
The $1.8 million increase, or 4.3%, in net ultimate loss estimates in other lines of business is primarily from increases of $1.1 million and $1.0 million accident years 2012 and 2011, respectively. This increase of $1.8 million in this line during the year was driven by $2.6 million of adverse development in our short tail business stemming from late reporting of 2012 storm occurrences. This was partially offset by a $1.1 million decrease related to lower than expected claim emergence in medical malpractice. The change in ultimate loss estimates for all other accident years was insignificant.
* Uses expense ratios originally reported in calendar year statement. These expense ratios have been adjusted in statement years 2012 and subsequent as a result of guidance retrospectively adopted on January 1, 2012. The impact on the expense ratio for any given year of the guidance was 0.2 points or less.
For the table above, the calendar year combined ratios increased to over 100% in calendar year 2012 and 2013, primarily driven by adverse development on prior accident year Loss & Loss Adjustment Expense (“LAE”). This prior year development is shown allocated to the related accident years in the following table:
The following table reconciles the originally reported accident year combined ratios to those with the ultimate evaluated at 12/31/13:
The developed (to ultimate) accident year combined ratio measurement allows management to observe profitability associated with business earned in each year and take appropriate actions. Management records its best estimate of reserves at each accounting date. The recent adverse development resulted in an upward adjustment in the prior accident year reserve levels to move up in the range of indications and is not necessarily indicative of an expected trend going forward.
Based on our subsidiaries’ membership in the Federal Home Loan Bank of Indianapolis (“FHLBI”), we have the ability to borrow on a collateralized basis at relatively low borrowing rates, providing a source of liquidity. As of December 31, 2013 and December 31, 2012, we had borrowed $30.0 million from the FHLBI. The proceeds were used to fund purchases of high quality bonds with maturities that match the maturity of the FHLBI credit facility. Due to the low cost of the FHLBI funding, the Company expects to generate returns of approximately 140 basis points in excess of its cost of borrowing under this strategy. We have the ability to increase our borrowing capacity through additional investments and pledging additional securities.
On August 29, 2012, we executed $130.0 million in senior credit facilities (the “Credit Facilities”). The Credit Facilities included a $30.0 million term loan facility and a $100.0 million revolving credit facility. On September 19, 2013, we amended the Credit Facilities pursuant to a second Amendment to Credit Agreement and Waiver (the “Amendment”).
The Credit Facilities replaced our former term loan of $65.0 million and revolving credit agreement of $35.0 million, entered into on July 31, 2008, which were terminated upon the closing of the Credit Facilities on August 29, 2012. At December 31, 2012, we had an outstanding balance of $28.5 million on our term loan and a $20.0 million outstanding balance on our revolving credit facility. There was $0.5 million in letters of credit that had been issued as of December 31, 2012.
Additionally, the Amendment revised the financial covenants applicable to the Credit Facilities that consist of: (1) minimum consolidated net worth of $365,697,000 as of the effective date of the Amendment, with quarterly increases thereafter of the sum of (a) seventy-five percent of positive net income and (b) seventy-five percent of increases in shareholders’ equity by reason of the issuance and sale of equity interests, if any, (2) minimum Risk Based Capital Ratio for all material Insurance Company Subsidiaries of 1.75 times Company Action Level, (3) maximum permitted consolidated leverage ratio of (i) 0.375 to 1.00 at any time prior to September 30, 2014, or (ii) 0.35 to 1.00 at any time on or after September 30, 2014, (4) minimum consolidated fixed charge coverage ratio of 1.25 to 1.00, and (5) minimum A.M. Best rating of “B++.” As of December 31, 2013, we were in compliance with these debt covenants.
On March 18, 2013, we issued $100.0 million of 5.0% cash convertible senior notes (the “Notes”), which mature on March 15, 2020. Interest on the Notes is payable semi-annually in arrears on March 15 and September 15 of each year, commencing September 15, 2013. Until the close of business on the second scheduled trading day immediately preceding the maturity date, holders may convert their Notes solely into cash at any time on or after September 15, 2019 or earlier under certain circumstances determined by: (i) the market price of the Company’s stock, (ii) the trading price of the Notes, or (iii) the occurrence of specified corporate transactions. The Notes are not convertible into our common stock or any other securities under any circumstances. The initial conversion rate is 108.8732 shares of common stock per $1,000 principal amount of the Notes (equivalent to an initial conversion price of approximately $9.18 per share), subject to adjustment upon the occurrence of certain events. Additionally, in the event of a fundamental change, the holders may require us to repurchase the Notes for a cash price equal to 100% of the principal, plus any accrued and unpaid interest. The proceeds from the issuance of the Notes were bifurcated into a debt component and an embedded conversion option component.
The following table shows the amounts recorded for the debt component of the Notes as of December 31, 2013 (in thousands):
Refer to Note 12 ~ Shareholders’ Equity of the Notes to the Consolidated Financial Statements.
The following table is a summary of our contractual obligations and commitments as of December 31, 2013 (in thousands):
(2) Relates to the proceeds received from the Federal Home Loan Bank of Indianapolis facility for which the Company used the full proceeds to purchase bonds. The Company achieves a margin on the assets above the cost of the debt and therefore treats this as operating leverage.
(3) Relates to the cash convertible senior notes, refer to Note 6 ~ Debt. The current carrying value on the Balance Sheet considering the original issue discount is $88.2 million. This will accrete to par value of $100 million due in 2020.
(4) 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 6 ~ Debt and Note 7 ~ Derivative Instruments.
(8) 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 $505.4 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 $87.7 million, $121.3 million, $73.7 million, and $222.7 million, respectively, resulting in net losses and loss adjustment expenses of $333.3 million, $380.1 million, $146.9 million, and $250.8 million, respectively.
(9) In November 2012, Century committed to a $10.0 million contribution to the Aquiline Financial Services Fund II L.P. as a strategic investment. As of December 31, 2013, approximately $6.4 million of the commitment had been satisfied with $3.6 million of unfunded commitment remaining. The remainder of the capital commitment will most likely be called in 2014; however, the exact date is not known as it is at the discretion of the fund managers based on the timing of the fund’s investments.
The LTIP is intended to provide an incentive to management to improve our performance over a period of time and remain with the Company, thereby increasing shareholder value. The LTIP is paid entirely in stock based upon the performance of the Company and the participant’s service during the one-year period. A participant’s target annual opportunity is established by the Compensation Committee and the Board of Directors in advance of any LTIP award.
Following the release of our 2013 fourth quarter results, on February 21, 2014, A.M. Best downgraded the issuer credit rating for our Insurance Company Subsidiaries to “bbb” from “bbb+” while affirming their financial strength rating of B++ (Good). A.M. Best also downgraded Meadowbrook’s issuer credit rating to “bb” from “bb+” and revised the outlook for the Insurance Company Subsidiaries to “negative” from “stable”. As a result of this recent development, we could experience a negative impact to our operations as described under “Risk Factors” above.
The National Association of Insurance Commissioners (“NAIC”) has a 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.
Insurance operations are subject to various leverage tests (e.g., premium to statutory surplus ratios), which are evaluated by regulators and rating agencies. As of December 31, 2013, on a trailing twelve month statutory consolidated basis, the gross and net premium leverage ratios were 1.9 to 1.0 and 1.4 to 1.0, respectively.
Departure from the “usual values” on four or more ratios, at an individual company, generally leads to inquiries or possible further review operations and financial condition from state insurance commissioners. In reviewing the financial information in the Statutory Annual Statements in coordination with the IRIS ratio results, a state regulator may determine that a company's departure from "usual values" is significant enough to indicate a strong concern with the financial condition of a company. When such a determination is made, state regulatory requirements may include but not be limited to: specific restrictions on premium writings and surplus levels of a company, additional analysis of other key financial ratios of a company, or requiring an action plan be filed by the Company with specific actions outlined to bring the ratios back into the usual range.
(1) The Two-Year Overall Operating ratio measures the overall profitability of an entity over a two-year period. For 2013, this ratio is above 100% for all six of the Insurance Subsidiaries. This was driven by the adverse prior year development experienced in calendar years 2012 and 2013.
(2) The Adjusted Liabilities to Liquid Assets evaluates an entity’s ability to meet obligations as they become due. While all liabilities are included in the ratio, only assets considered “liquid” by NAIC definition are included in the denominator of the ratio. For 2013, this ratio is outside the usual range on Star and Williamsburg, primarily as a result of our Intercompany Reinsurance Pooling Agreement. The Adjusted Liabilities include the gross amount of reinsurance payables related to the pool and does not allow an offset to those payables for any reinsurance recoverables related to the pool. In addition, the reinsurance recoverables are not included in the Liquid Assets portion of the formula. This causes the ratio results to appear much higher due to the timing of the settlement of the pool balances. Pool balances between the entities are settled subsequent to year-end. Once the balances are settled, the ratio is below 100% for both companies.
(3) Investment Yield is a measure of the return on invested assets. It is calculated on a pre-tax basis and includes statutory net investment income, but excludes realized and unrealized capital gains/(losses). Because pre-tax investment income is used in the calculation, the ratio does not take into account lower yield rates on tax-exempt bonds. Five of the six insurance subsidiaries generated unusual values for this ratio in 2013. In general, we believe our overall investment portfolio is conservatively invested. On a consolidated basis, our overall tax equivalent yield, excluding cash and cash equivalents was 3.7% at December 31, 2013, compared to 4.1% at December 31, 2012. As a comparison, the risk free rate on the 10 Year treasuries increased during 2013 from 1.9% to 3.0% although still reflecting historical lows. Approximately 99.8% of our fixed income investment portfolio is investment grade.
(6) The Gross Agents’ Balances to Policyholders’ Surplus measures receivable amounts currently due from agents or policyholders in relations to policyholders’ surplus, the results of which could indicate deficiencies in collections procedures that could result in future write-offs. On ProCentury, this ratio was above the usual range. Balances resulting from our Intercompany Reinsurance Pooling Agreement impact this ratio. As these balances are intercompany related, the results of this ratio is not an indicator of collection issues. Excluding the intercompany pooling, this ratio would have been well within the usual range as of December 31, 2013.
Effective December 31, 2012, we entered into a Multiple Line Quota Share Treaty with Swiss Reinsurance America Corporation (“Swiss Re”). This agreement was terminated on a run-off basis for business effective October 1, 2013 and after. Effective December 31, 2012, we ceded 50% of our unearned premium on a select portion of business. In return, we received a provisional ceding commission. The business included in the agreement was subject to specific limitations and ceded certain business based upon an in-force, new and renewal basis. We ceded 25% of direct written premium on this selected business commencing January 1, 2013, until the contract termination date of September 30, 2013, the remaining unearned premium and losses will continue to run-off. The ceded earned premium associated with this agreement was $145.5 million, ceded loss and LAE was $79.9 million and the ceding commission benefit was $55.4 million for the year ended December 31, 2013.