The following discussion and analysis of financial condition and results of operations should be read together with “Selected Financial Data” and our financial statements and accompanying notes appearing elsewhere in this Annual Report. Certain reclassifications have been made to prior period financial statement line items to enhance the comparability with prior years. This discussion contains forward-looking statements, based on current expectations and related to future events and our future financial performance, that involve risks and uncertainties. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of many important factors, including those set forth under “Risk Factors,” “Forward-Looking Statements” and elsewhere in this Annual Report.
We were formed on April 3, 2003 for the purpose of offering products in the specialty commercial property and casualty insurance market by using an innovative business model. Specialty insurance typically serves niche groups of insureds that require highly specialized knowledge of a business class to achieve underwriting profits. This market has traditionally been underserved by most standard commercial property and casualty insurers, due to the complex business knowledge and the investment required to achieve attractive underwriting profits. Competition in this segment is based primarily on client service, availability of insurance capacity, specialized policy forms, efficient claims handling and other value-based considerations, rather than just price.
The net loss and loss adjustment expense ratio and the acquisition expense ratio are calculated by dividing the respective expense amounts by net premiums earned. The other operating expense ratio is calculated by dividing other operating expenses by gross premiums written. Gross premiums written represents all premiums written by an insurance company during a specified period. Net premiums written is the difference between gross premiums written and premiums ceded to reinsurers. Premiums are earned over the terms of the related policies. At the end of each accounting period, the portions of premiums that are not yet earned are included in unearned premiums and are realized as revenue in subsequent periods over the remaining terms of the policies. Our policies have terms of 12 months. Thus, for example, for a policy that is written on July 1, 2008, one-half of the premiums would be earned in 2008 and the other half would be earned in 2009. Premiums earned represents the earned portion of our net premiums written.
Year Ended December 31, 2008 Compared to the Year Ended December 31, 2007
Net income for 2008 was $7.4 million, compared to net income of $12.6 million for 2007. Earnings per share on an undiluted basis for 2008 was $0.48 versus earnings per share of $0.82 for 2007. The decrease in our net income was due to a decrease in our pre-tax income and an increase in our taxes resulting from the full utilization of tax loss carry forwards which occurred in the second quarter of 2008. The decrease in our pre-tax income was due to several factors, most significantly, a decrease in our earned premiums, an other-than-temporary impairment
on certain of our investment securities resulting in a $0.8 realized loss, and an increase in our net loss and loss adjustment expense ratio, which amounts were partially offset by an increase in our investment income and decrease in our acquisition expense ratio. The decrease in earned premiums was due to several factors, most significantly, reductions in our workers’ compensation rates in Florida, increased competition and overall weak economic conditions.
Our written premiums are still concentrated in four of our nine partner agents, though there was continued diversification in the percentage of premiums written with the top four partner agents writing 85.8% of our business in 2008 as compared to 94.6% in 2007. We expect to see additional diversification as our relationship with these new partner agents mature. The breakdown of gross written premiums by partner agent for the years ended December 31, 2008 and 2007 was as follows:
While more diversified, our business written for the year ended December 31, 2008 was heavily weighted in workers’ compensation. Our gross written premiums by line of business for the years ended December 31, 2008 and 2007 were as follows:
Net investment income was $10.8 million for 2008 versus $9.5 million for 2007. The increase in net investment income is due to an increase in our invested assets. Our investment assets increased from $229.4 million at December 31, 2007 to $263.4 million at December 31, 2008 resulting from positive operating cash flow.
For the year ended December 31, 2008, our net loss and loss adjustment expense ratio was 62.3%, compared to 59.0% for the comparable twelve months in 2007. This increase was driven by higher loss ratios in our workers’ compensation book of business due primarily to lower rates and certain large losses in our commercial automobile and workers’ compensation lines, partially offset by favorable prior year loss development of $1.8 million principally in our general liability lines. For the year ended December 31, 2007 we experienced favorable prior year loss development of $2.2 million.
For the year ended December 31, 2008, other operating expenses were $23.1 million, which consisted of salaries and benefit costs of $8.5 million, $2.5 million of professional and consulting fees, $6.6 million of depreciation and amortization, $0.5 million of stock based compensation expense and $5.0 million of other expenses. Other operating expenses were $22.6 million for the year ended December 31, 2007, which consisted of salaries and benefit costs of $7.0 million, $3.2 million of professional and consulting fees, $5.0 million of depreciation and amortization expense, $1.1 million of stock based compensation expense and $6.3 million of other expenses. We remain committed to operating efficiently and increasing staff only as our business volume requires.
The increase in salaries and benefit costs in 2008 was offset by a decrease in professional and consulting services as we continued to bring previously outsourced services in-house.
Net income for the year ended December 31, 2007 was $12.6 million, compared to a net income for the year ended December 31, 2006 of $8.4 million. Earnings per share for 2007 were $0.82 versus $0.55 for 2006.
Net investment income was $9.5 million for 2007 versus $6.1 million for 2006. The increase in net investment income reflected a significant growth in our cash and invested assets from $164.1 million at December 31, 2006 to $229.4 million at December 31, 2007. The net investment yield for average invested assets for 2007 and 2006 was 4.6%. There were no realized gains in 2007 and $0.3 million in 2006. The increases in average invested assets primarily related to the cash flow from operations, including premium growth and favorable underwriting results.
Acquisition expenses were $36.6 million for the year ended December 31, 2007, compared to acquisition expenses of $26.0 million for the year ended December 31, 2006. The increase in acquisition expenses was driven primarily by the increase in earned premium as well as partner agent profit sharing from 2006 to 2007.
Loss and loss adjustment expenses were $90.0 million for the year ended December 31, 2007, compared to $62.7 million for the year ended December 31, 2006. The increase in loss and loss adjustment expenses was driven by the increase in earned premium. Our net loss and loss adjustment expense ratio increased in 2007 compared to 2006 primarily due to an increase in large losses in our commercial automobile line of business partially offset by improvements in workers’ compensation and general liability in prior years.
Our ratio of all other operating expenses to gross written premiums increased in 2007 as compared to 2006 primarily as a result of slowed growth in written premiums and increased depreciation expense resulting from information systems being fully deployed. The increase in depreciation expense was partially offset by a decrease in audit and tax services and stock option expenses. We have built an infrastructure that should allow for scalability for future premium growth.
We had cash flows from financing activities of $0.6 million resulting from sales of Class B Shares to our partner agents during the year ended December 31, 2008 partially offset by our repurchase of 275,000 shares of Common Stock during the second quarter of 2008. We had cash flows from financing activities of $1.3 million from sales of Class B Shares to our partner agents during the year ended December 31, 2007. For the year ended December 31, 2006, cash flows from financing activities from sales of Class B Shares to our partner agents was $3.1 million. The decrease from 2006 to 2007 to 2008 resulted from a substantial number of our partner agents having fulfilled their contractual obligation to purchase Class B Shares during 2006 and 2007 which was partially offset by our signing a new partner agent in 2008.
Our investment portfolio consists of marketable fixed maturity and short-term investments. All fixed maturity investments are classified as available for sale and are reported at their estimated fair value. Realized gains and losses are credited or charged to income in the period in which they are realized. Changes in unrealized gains or losses are reported as a separate component of comprehensive income, and accumulated unrealized gains or
The aggregate fair market value of our fixed maturity investments at December 31, 2008 was $216.7 million, compared to amortized cost of $220.7 million. The aggregate fair market value of our fixed maturity investments at December 31, 2007 was $177.7 million compared to amortized cost of $176.6 million. During 2008 we increased our investment in municipal bonds to $54.9 million from $4.3 million, at fair value, due to their favorable tax treatment. The average duration of our fixed maturity investments at December 31, 2008 was approximately 3.66 years.
The liquidity requirements of SUA relate primarily to the liabilities associated with its products and its operating costs. Historically, cash flows from earned premiums and investment income have provided sufficient funds to meet these requirements without requiring the sale of investments. If our cash flows change from our historical patterns, for example, as a result of a decrease in earned premiums or an increase in claims paid or operating expenses, we may be required to sell securities before their maturity, possibly at a loss. SUA generally holds a significant amount of highly liquid, short-term investments to meet its liquidity needs. Funds received in excess of SUA’s liquidity requirements are generally invested in additional marketable securities. The ability of our operating subsidiary to pay dividends or make other distributions to stockholders is subject to statutory and regulatory restrictions under Illinois law, including restrictions imposed as a matter of administrative policy, which are applicable generally to any insurance company in its state of domicile that limit such payments or distributions without prior approval by regulatory authorities. For information regarding restrictions on the payment of dividends by SUA, see the discussion under the heading "Item 1. Business - Insurance Regulation” in PART I of this annual report.
Capital Requirements of SUA Insurance Company. While insurance regulation differs by location, each jurisdiction requires that minimum levels of capital be maintained in order to write insurance business. Factors that affect capital requirements generally include premium volume, the extent and nature of loss and loss adjustment expense reserves, the type and form of insurance business underwritten and the availability of reinsurance protection from adequately rated reinsurers on acceptable terms. SUA is required to maintain certain minimum levels of capital and risk-based capital, the calculation of which includes numerous factors as specified by the respective insurance regulatory authorities and the related insurance regulations. We have capitalized our insurance operations in excess of the minimum regulatory requirements so that we may maintain adequate financial ratings. Our current level of capital is sufficient, but may need to be augmented to further expand our business strategy or to deal with significantly poorer than expected results.
The following table of contractual obligations includes information with respect to our known contractual obligations as of December 31, 2008:
(1) On November 23, 2004, Specialty Underwriters’ Alliance, Inc. acquired Potomac and subsequently renamed the company SUA Insurance Company. Prior to the acquisition, Potomac entered into a transfer and assumption agreement with OneBeacon, whereby all of its liabilities, including all direct liabilities under existing insurance policies, were ceded to and assumed by OneBeacon. We will not experience any gains or losses with respect to such legacy policies unless OneBeacon fails to honor its reinsurance obligation. To date, OneBeacon continues to handle, adjudicate and pay all claims that have arisen from such legacy policies.
estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the financial statements and the reported amounts of revenues and expenses during the reporting period.
Earned and Unearned Insurance Premiums. Premiums are recognized as revenue over the coverage period of policies written on a daily pro rata basis. Certain policies are subject to adjustment based on changes in exposure units over the period of coverage, such as payroll increases/decreases and changes in risk classifications and therefore the direct written premiums are estimated during the policies term until final audit of the policy occurs. Unearned insurance premiums represent the portion of premiums written relating to the remaining term of each policy.
Loss and LAE reserves, by line of business at December 31, 2008 and 2007 for our insurance operations were as follows:
inflation) and future medical treatment. Property damage claims arise from damages to the claimant’s private property arising from the policyholder’s legal obligation for non-intentional acts. In most cases, property damage losses are a function of costs as of the loss date, or soon thereafter.
Bornhuetter-Ferguson paid and incurred loss development methods combine the expected loss ratio method with the traditional historical paid and incurred loss development methods.
For additional information about our accounting practices and policies see the discussion under the heading “Item 8. Financial Statements - Note 2 - Summary of significant Accounting Policies” in PART II of this annual report.
In January 2009, the FASB issued FASB Staff Position No. 99-20-1, “Amendments to the Impairment Guidance of EITF Issue No. 99-20” (“FSP EITF 99-20-1”), which is effective for interim and annual ending after December 15, 2008. FSP EITF 99-20-1 amends EITF 99-2“Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets” (“EITF 99-20”), to align the impairment guidance in EITF 99-20 with the impairment guidance in FAS 115, “Accounting for Certain Investments in Debt and Equity Securities.” FSP EITF 99-20-1 amends the cash flows model used to analyze an other-than-temporary impairment under EITF 99-20 by replacing the market participant view with management’s assumption of whether it is probable that there is an adverse change in the estimated cash flows. The adoption of FSP EITF 99-20-1 in the fourth quarter did not have a material effect on the Company’s results of operations, financial position or liquidity.
The information required by this item is set forth beginning on page of this Annual Report on Form 10-K.