The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and the related notes included elsewhere in this report. The discussion and analysis below includes certain forward-looking statements that are subject to risks, uncertainties and other factors described in “Risk Factors” under Item 1A and elsewhere in this report that could cause actual results to differ materially from those expressed in, or implied by, those forward-looking statements. See “Forward-Looking Statements”.
Earning a profit from underwriting means that we intend for the premiums we earn in any period to be sufficient to pay all of the losses and loss adjustment expenses we incur during the period as well as all of the expenses associated with our operations. We use underwriting profit or loss as a basis for evaluating our underwriting performance. Our strategy is to operate at a lower expense ratio than many of our competitors; focus our efforts on the specialty insurance market where profits have historically been better than in the standard market; underwrite each risk individually in order to apply our expertise to each risk we underwrite; to use technology to provide our employees and managers with timely and accurate information about our business; and to actively manage claims in accordance with the terms of our insurance contracts. Our underwriting profit for the year ended December 31, 2006 was $35.9 million, an increase over the underwriting profit of $9.8 million reported for 2005. During 2005, the Company recorded $21.2 million (on a pre-tax basis) of costs, net of reinsurance, in connection with hurricanes, primarily Hurricane Katrina, including reinsurance reinstatements.
The Excess and Surplus Insurance segment offers commercial excess and surplus lines liability and property insurance in 48 states and the District of Columbia through James River Insurance Company (James River Insurance);
The Corporate and Other segment consists of management and treasury activities of our holding company and interest expense associated with our debt.
Workers’ Compensation Insurance segment. The favorable development from the Workers’ Compensation Insurance segment was offset by $696,000 of adverse development on prior accident years related to the Company’s initial allocation of the North Carolina involuntary workers’ compensation pool.
The 2006 premium amounts above reflect an increase in renewal business as well as penetration and growth in the Company’s broker and agency networks. The increase in our broker and agency network is as follows:
The number of brokers submitting business to the Excess and Surplus Insurance segment grew 15.3% from 209 in 2005 to 241 for 2006,
The number of agencies in the Workers’ Compensation Insurance network grew 6.6% from 137 as of December 31, 2005 to 146 as of December 31, 2006.
The ratio of net written premiums to gross written premiums is referred to as our net retention. For the years ended December 31, 2006 and 2005, our net retention was 76.6% and 58.3%, respectively.
Premiums are earned ratably over the terms of our insurance policies, generally twelve months, and net earned premiums were affected by the significant growth in written premiums over the prior year.
The combined ratio for the Excess and Surplus Insurance segment for the year ended December 31, 2006 was 79.0%, comprised of a loss ratio of 56.3% and an expense ratio of 22.7%.
The 2006 expense ratio of the Workers’ Compensation Insurance segment improved significantly over the prior year principally due to economies of scale achieved by this segment in its third full year of operations. Included in the expense ratio for 2006 was $310,000, or 0.8 percentage points, for anticipated guaranty fund assessments. This amount represents an improvement from the prior year’s assessments, which were $720,000, or 2.8 percentage points.
The combined ratio for the Workers’ Compensation Insurance segment for the year ended December 31, 2005 was 96.9%, comprised of a loss ratio of 62.7% and an expense ratio of 34.2%. The loss ratio for 2005 included $171,000 of favorable reserve development on direct business written by the Company on prior accident years offset by $696,000 of adverse development on prior accident years related to the Company’s initial allocation of the North Carolina involuntary workers’ compensation pool.
The Company’s gross reserve for losses and loss adjustment expenses at December 31, 2006 was $300.3 million. Of this amount, 74.8% relates to amounts that are incurred but not reported (IBNR). The Company’s gross reserves for losses and loss adjustment expenses by segment are summarized as follows:
During the fourth quarter of 2005, we concluded that one security in our portfolio which was not rated investment grade by Standard & Poor’s had experienced an impairment that was other-than-temporary, and accordingly, we took an impairment write-down of $92,000 on that security. We had also concluded that none of our other available-for-sale securities with unrealized losses at December 31, 2005 had experienced an other-than-temporary impairment.
The balance of our cash and cash equivalents was $40.3 million at December 31, 2006. The percentage of cash and cash equivalents to cash and invested assets at December 31, 2006 was 7.5% compared to 10.8% at December 31, 2005. We had a larger percentage of our cash and invested assets in cash and cash equivalents at December 31, 2005 to fund anticipated property insurance claim payments on hurricane losses.
Interest expense was $4.3 million and $2.7 for the years ended December 31, 2006 and 2005, respectively, related to the debt outlined below.
In May 2004, we issued $15.0 million of senior debt due April 29, 2034, with net proceeds to us of $14.5 million. The senior debt is not redeemable by the holder or subject to sinking fund requirements. Interest accrues quarterly and is payable in arrears at a floating rate per annum equal to three-month LIBOR plus 3.85%. The senior debt is redeemable prior to its stated maturity at our option in whole or in part, on or after May 15, 2009. The terms of the senior debt contain certain covenants, which, among other things, restrict our assuming senior indebtedness secured by our Common Stock or our subsidiaries’ capital stock or issuing shares of our subsidiaries’ capital stock. We are in compliance with all such covenants at December 31, 2006.
The following table summarizes the nature and terms of the junior subordinated debt and trust preferred securities outstanding at December 31, 2006:
We have provided a full, irrevocable and unconditional guarantee of the obligations of each of the trusts under the trust preferred securities. The indenture for the junior subordinated debt contains certain covenants with which we are in compliance as of December 31, 2006.
At December 31, 2006 and 2005, the ratio of total debt outstanding to total capitalization (defined as total debt plus total stockholders’ equity) was 21.4% and 17.6%, respectively. We use capital to support our premium growth. Accordingly, having debt as part of our capital structure allows us to generate higher earnings per share and book value per share results than we could by using equity capital alone. Our target debt to total capitalization ratio is 35.0% or less.
Our combined ratio for the year ended December 31, 2004 was 90.1% and was unaffected by any significant wind-related loss events. It did include the effects of $156,000 of favorable reserve development on prior accident years.
The number of brokers submitting business to the Excess and Surplus Insurance segment grew 40.3% from 149 to 209 for 2004 and 2005, respectively.
Stonewood Insurance did not receive its ‘‘A-’’ (Excellent) rating from A.M. Best until April 2004. Accordingly, the lack of a rating limited direct written premium production in the first quarter of that year. Gross written premiums for Stonewood Insurance for 2005 also included $4.4 million of assumed premiums from our initial allocation from the North Carolina involuntary workers’ compensation pool.
The combined ratio for the Workers’ Compensation Insurance segment for the year ended December 31, 2005 was 96.9%, comprised of a loss ratio of 62.7% and an expense ratio of 34.2%. The loss ratio for 2005 included $171,000 of favorable reserve development on direct business written on prior accident years offset by $696,000 of adverse development on prior accident years related to the Company’s initial allocation of the North Carolina involuntary workers’ compensation pool. Included in the expense ratio for 2005 was $720,000, or 2.8 percentage points, for guaranty fund assessments.
The combined ratio for the Workers’ Compensation Insurance segment for the year ended December 31, 2004 was 150.0%, comprised of a loss ratio of 73.5% and an expense ratio of 76.5%. The loss ratio for 2004 was negatively affected by claims administration expenses that were high relative to the low volume of claims activity during our first year of workers’ compensation insurance operations. Additionally, underwriting expenses, earned premium, and therefore, the expense ratio for 2004 were affected by the start-up nature of the business.
Interest expense was $2.7 million and $793,000 for the years ended December 31, 2005 and 2004, respectively. Interest expense related to the $15.0 million of senior notes and $22.7 million of junior subordinated notes that we issued in May and December 2004. Interest on these notes is paid at a floating rate based on three-month LIBOR. The increase in interest expense in 2005 is due to the fact that the notes were outstanding for the full year of 2005 and only portions of 2004 as well as a higher interest rate environment in 2005.
For the year ended December 31, 2005, income tax expense differs from the amounts computed by applying the Federal statutory income tax rate to income before taxes primarily due to interest income on tax-advantaged state and municipal securities. For 2005, our effective tax rate was 30.1%. State and municipal securities represented 28.9% of our fixed maturity security portfolio at December 31, 2005.
The Trust used the proceeds from the sale of its Trust Preferred Securities to purchase $20.6 million of the Company’s floating rate junior subordinated debentures (the Junior Subordinated Debt) issued to the Trust under an indenture (the Indenture). The Junior Subordinated Debt is the sole asset of the Trust, and the Trust Preferred Securities are the sole liabilities of the Trust. The Junior Subordinated Debt matures on June 15, 2036, unless accelerated earlier.
Interest on the Trust Preferred Securities and interest paid by the Company to the Trust on the Junior Subordinated Debt are payable quarterly in arrears. Through September 15, 2006, interest accrued at the per annum rate of 8.3%. On September 15,
The Indenture contains certain covenants with which the Company is in compliance as of December 31, 2006. For a description of the amounts outstanding and terms of our junior subordinated debt and senior debt see “Year Ended December 31, 2006 compared to Year Ended December 31, 2005 - Interest Expense.”
Our sources of operating funds consist primarily of premiums written, investment income and proceeds from offerings of debt and equity securities. We use operating cash flows primarily to pay operating expenses, losses and loss adjustment expenses and income taxes.
Net cash provided by operating activities was $133.2 million for 2006 compared to $106.8 million for 2005. Net cash provided by operating activities in both years is primarily attributable to cash received on written premiums exceeding the cash disbursed for operating expenses and losses and loss adjustment expenses. Net cash provided by financing activities for 2006 included the net proceeds of our offering of trust preferred securities in June 2006. Net cash provided by financing activities for 2005 included the net proceeds of $84.6 million from our initial public offering and the repayment of $2.0 million of notes receivable from directors and executive officers in April 2005.
The following is a summary of our casualty reinsurance in place at December 31, 2006:
(1) For policies with an occurrence limit of $1.0 million or higher, the quota share percentage is set such that our retention is $500,000. For all excess casualty policy limits in excess of $5.0 million, we purchase facultative reinsurance. For policies where we also write an underlying primary casualty policy, the quota share reinsurance reduces our excess casualty retention to $100,000, which when added to our retention on the primary casualty coverage, results in a total retention of $1.1 million on that risk.
We use catastrophe-modeling software to analyze the risk of severe losses from hurricanes and earthquakes. We model our portfolio of insurance policies in force each month and track our accumulations of exposed values geographically to manage our concentration in any one area. In the fourth quarter of 2005, we began reducing our exposure to hurricane losses by not writing any new or renewal primary property insurance with wind coverage within 100 miles of the Southeast and Gulf coasts of the United States or within 30 miles of the Northeast coast of the United States. We are reducing the concentration of exposed limits in any 50 mile area to $50.0 million or less on new and renewal policies.
were $36.5 million and reinsurance ceding commissions were $9.7 million. For 2006, the impact of this contract on pre-tax income was $234,000. This treaty was not renewed during 2006.
The following table illustrates our contractual obligations and commitments by due dates as of December 31, 2006:
James River Insurance and Stonewood Insurance each have a financial strength rating of “A-” (Excellent) from A.M. Best. A.M. Best assigns 16 ratings to insurance companies, which currently range from “A++” (Superior) to “F” (In Liquidation). “A-” (Excellent) is the fourth highest rating issued by A.M. Best. The “A-” (Excellent) rating is assigned to insurers that have, in A.M. Best’s opinion, an excellent ability to meet their ongoing obligations to policyholders. This rating is intended to provide an independent opinion of an insurer’s ability to meet its obligation to policyholders and is not an evaluation directed at investors.
For both methods, the expected loss ratio used is established using judgment, and is based primarily on industry data and the experience of our management team in writing similar insurance coverages. The expected loss ratio used in the loss ratio method is judgmentally adjusted up or down when the level of reported losses for a specific accident year for a specific statutory line of business leads us to conclude that the ultimate loss ratio will differ from our initial expected loss ratio. The expected loss ratio used in the incurred Bornhuetter-Ferguson method is typically not adjusted after it is initially set, because the mechanics of that method already incorporate departures from expected reported losses into the reserve calculations. The primary factor contributing to the difference between the methods is that the incurred Bornhuetter-Ferguson method incorporates assumptions regarding industry reporting patterns (the estimated percentage of the ultimate losses that have been reported at a particular valuation date) for losses and the level of our reported losses and loss adjustment expenses, which are not reflected in the loss ratio method. Since the incurred Bornhuetter-Ferguson method includes both our reported losses and estimates of future development patterns, it is more sensitive to our level of reported losses than the loss ratio method. We have generally selected the actuarial method that yields the highest reserve for each statutory line of business as our best estimate. We have consistently applied this methodology in 2006 and 2005.
We believe that generally selecting the higher of these two actuarial methods by statutory line of business as the basis for our best reserve estimates is appropriate at this early stage in our history. Given that our insurance companies have limited historical experience, that our two primary actuarial methods utilize industry data, that losses on our casualty business often take a number of years to develop and that we write difficult classes of business which typically do not meet the risk criteria of standard carriers, we believe that we do not have sufficient evidence at this time to conclude that our ultimate loss ratios will be significantly better than our expected loss ratios. Generally selecting the higher of the two primary actuarial methods as the basis for our best reserve estimates is consistent with that belief. In the future as more information becomes available to us and as we develop more experience, we may adjust or change our actuarial methods. Such future methods may not necessarily result in selecting the highest estimate of our actuarial methods.
At December 31, 2006, our aggregate reserve is the sum of the results from the selected estimates for each statutory line of business plus the reserve for losses and loss adjustment expenses associated with Hurricanes Katrina and Wilma that was estimated as described above. This aggregate reserve reflects our best estimate. Since we generally have selected the higher of the two actuarial methods at each financial statement date, the aggregate reserve includes components calculated using the incurred Bornhuetter-Ferguson method and components calculated using the loss ratio method. This combination of methods varies by statutory line of business and period.
The estimated net reserve at December 31, 2006 using the incurred Bornhuetter-Ferguson method was $181.9 million and using the loss ratio method was $194.3 million. In most instances, we have recorded the reserve estimate derived using the loss ratio method as our best reserve estimate because the expected loss ratio used in this method is derived from our management’s experience in the lines of business that we write and our current underwriting criteria. Generally, the expected loss ratios used in the loss ratio method decline as an accident year ages. As a result, our methodology gives more weight to the Bornhuetter-Ferguson method for more mature accident years. Each of these reserve estimates are individual point estimates and do not constitute an actuarial range. We record the reserve estimate derived from the incurred Bornhuetter-Ferguson method as our best estimate when the level of actual reported losses provides sufficient evidence that the ultimate loss ratio will exceed our expected loss ratio. When the level of actual reported losses provides sufficient evidence that the ultimate loss ratio will be less than our expected loss ratio, we generally reduce the expected loss ratio used in the loss ratio method.
Reserve estimates derived using the incurred Bornhuetter-Ferguson method are driven by our assumptions related to the expected loss ratio and the expected reporting pattern for losses, while reserve estimates derived using the loss ratio method are driven by our assumptions related to the expected loss ratio and are not sensitive to reporting patterns. The table below quantifies the impact that reasonably likely changes in these two variables, the expected loss ratio and the expected reporting pattern for losses, would have on the recorded reserve for losses and loss adjustment expenses at December 31, 2006. The reporting pattern scenarios below only apply to the incurred Bornhuetter-Ferguson analysis. In the table below, the expected loss ratio and the expected reporting pattern refer to assumptions related to those two variables that we made in calculating the net reserves that we recorded at December 31, 2006.
The sensitivity analysis above was based on the weighted-average assumptions presented in the following table. For the expected loss ratio assumptions, the expected loss ratio represents a weighted average of the expected loss ratios used for each of our statutory lines of business, with the expected loss ratio for each line weighted based on net earned premiums. For the expected reporting pattern assumptions, the expected reporting pattern represents a weighted average of the percentage of ultimate losses assumed to be reported to us at December 31, 2006 for each of our statutory lines of business. They have been weighted based on net earned premiums.
We believe that loss ratios 5% above or below our expected loss ratio constitute a reasonable range of expectations for each major line of business. In addition, we believe that the adjustments that we made to speed up or slow down the reporting patterns in the sensitivity analysis above are reasonably likely outcomes. Under the incurred Bornhuetter-Ferguson method, slowing the reporting pattern results in an increase in the estimate of reserves, because reported losses are seen as a smaller percentage of the ultimate reported losses, resulting in an increase in estimated unreported losses. Similarly, using a faster reporting pattern results in a decrease in the estimate of reserves. In determining the amounts by which to slow down or accelerate the reporting patterns for the sensitivity analysis presented above, we applied judgment to reflect the fact that the variability of reasonably likely reporting pattern outcomes varies by major line of business. There is little variability around our expected reporting patterns for our excess and surplus insurance property lines, because property claims are typically reported relatively quickly. Conversely, there is considerably more variability around our expected reporting patterns for our excess and surplus insurance casualty lines, because losses on casualty business often take a number of years to develop. Reporting patterns for workers’ compensation insurance are generally slower than reporting patterns for our excess and surplus insurance property lines and generally faster than reporting patterns for our excess and surplus insurance casualty lines. Accordingly, the variability around our expected reporting patterns for workers’ compensation insurance is greater than it is for our excess and surplus insurance property lines and less than it is for our excess and surplus insurance casualty lines. The impact of recording the net reserve for losses at the highest value from the sensitivity analysis above would be to reduce net income by $11.6 million and to reduce stockholders’ equity at December 31, 2006 by 5.4%. The impact of recording the net reserve for losses at the lowest value from the sensitivity analysis above would be to increase net income by $11.2 million and increase stockholders’ equity at December 31, 2006 by 5.2%. Such changes in the net reserve for losses and loss adjustment expenses would not have an immediate impact on our liquidity, but would affect cash flow in future periods as the incremental or reduced amount of losses are paid.
Our reserves are driven by a number of important assumptions including litigation and regulatory trends, legislative activity, social and economic patterns and claims inflation assumptions. Our reserve estimates reflect current inflation in legal claims settlements and assume we will not be subject to losses from significant new legal liability theories. Our reserve estimates also assume that we will not experience significant losses from mass torts and that we will not incur losses from future mass torts not known to us today. While it is not possible to predict the impact of changes in this environment, if new mass torts or expanded legal theories of liability emerge, our IBNR claims may differ substantially from our IBNR reserves. Our reserve estimates assume that there will not be significant changes in the regulatory and legislative environment. The impact of potential changes in the regulatory or legislative environment is difficult to quantify in the absence of specific, significant new regulation or legislation. In the event of significant new regulation or legislation, we will attempt to quantify its impact on our business.
IBNR reserve estimates are inherently less precise than case reserve estimates. A 5% change in net IBNR reserves at December 31, 2006 would equate to a $8.4 million change in the reserve for losses and loss adjustment expenses, a $5.5 million change in net income and a 2.5% change in stockholders’ equity at December 31, 2006.
Although we believe that our reserve estimates are reasonable, it is possible that our actual loss experience may not conform to our assumptions. Specifically, our actual ultimate loss ratio could differ from our initial expected loss ratio or our actual reporting patterns for losses could differ from our expected reporting patterns based on industry data. Accordingly, the ultimate settlement of losses and the related loss adjustment expenses may vary significantly from the estimates included in our financial statements. We regularly review our estimates and adjust them as necessary as experience develops or as new information becomes known to us. Such adjustments are included in current operations.
Losses and loss adjustment expenses for 2006 reflect $7.9 million of favorable development on the reserve for losses and loss adjustment expenses at December 31, 2005. This favorable development consisted of $7.7 million of favorable development in the Excess and Surplus Insurance segment (which are comprised of various statutory lines with both favorable and adverse development) and $235,000 of favorable development in the Workers’ Compensation Insurance segment.
Losses and loss adjustment expenses for 2004 reflect $156,000 of favorable development on the reserve for losses and loss adjustment expenses held at December 31, 2003 for the Excess and Surplus Lines Insurance segment.
we began recognizing the expense associated with awards issued on or after May 3, 2005 and for awards modified, repurchased or cancelled on or after that date in the income statement over the award’s vesting period using the modified prospective method. Compensation expense amounts related to options are recognized on a straight-line basis over each award’s vesting period in our income statement.
As a result of adopting Statement 123(R) on January 1, 2006, our income before income taxes and net income for 2006 are $986,000 and $640,000 lower, respectively, than if we had continued to account for share-based compensation under APB Opinion No. 25. Reported basic and diluted earnings per share for 2006 would have increased by $0.04 and $0.03, respectively, had we not adopted Statement 123(R). The adoption of Statement 123(R) did not have a material effect on our statement of cash flows.
In June 2006, the FASB issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109 (FIN 48). FIN 48 clarifies the accounting for uncertain tax positions. The interpretation prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 is effective for fiscal years beginning after December 15, 2006 with earlier adoption permitted. We are currently evaluating the impact of adopting FIN 48 on our financial statements, and we do not expect adoption of the interpretation to have a material impact on our financial position or results of operations.
In September 2006, the FASB issued Statement No. 157, Fair Value Measurement (Statement 157). Statement 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosures about fair value measurements. Statement 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007 with earlier application encouraged. We are currently evaluating the impact of adopting Statement 157 on our financial statements.
For 2007, we anticipate achieving an annual return on equity of at least 15% and growth in gross written premiums of between 10% and 20%.