In 2000, Savers purchased a building at 12641 East 116th Street, Cerritos, California, in which another subsidiary of ours has its operations, for $2.0 million. In July 2004, we entered into an agreement with an unaffiliated third party to sell this property and subsequently leaseback the property. The sale proceeds were $2.9 million and the net book value of the property was $1.9 million. Direct costs associated with the transaction were $158,000. In conjunction with the sale, a deferred gain of $880,000 was recorded and will be amortized over the ten-year term of the operating lease.
The GAAP combined ratio is the sum of the GAAP loss and loss adjustment expense ratio and the GAAP expense ratio. The GAAP loss and loss adjustment expense ratio is the unconsolidated net loss and loss adjustment expense in relation to net earned premium. The GAAP expense ratio is the unconsolidated policy acquisition and other underwriting expenses in relation to net earned premium.
The statutory combined ratio is the sum of the statutory loss and loss adjustment expense ratio and the statutory expense ratio. The statutory loss and loss adjustment expense ratio is the statutory net loss and loss adjustment expense in relation to net earned premium. The statutory expense ratio is the statutory policy acquisition and other underwriting expenses in relation to net written premium.
We are a publicly traded specialty risk management company, with an emphasis on alternative market insurance and risk management solutions for agents, professional and trade associations, and insureds of all sizes. The alternative market includes a wide range of approaches to financing and managing risk exposures, such as captives, rent-a-captives, risk retention and risk purchasing groups, governmental pools and trusts, and self-insurance plans. The alternative market developed as a result of the historical volatility in the cost and availability of traditional commercial insurance coverages, and usually involves some form of self-insurance or risk-sharing on the part of the client. We develop and manage alternative risk management programs for defined client groups and their members. We also operate as an insurance agency representing unaffiliated insurance companies in placing insurance coverages for policyholders. We define our business segments as specialty risk management operations and agency operations.
remaining proceeds from the issuance of the senior debentures may be used to support future premium growth through further contributions to our Insurance Company Subsidiaries and general corporate purposes.
We earn commission revenue through the operation of our retail property and casualty insurance agency, which was formed in 1955. The agency has grown to be one of the largest agencies in Michigan and, with acquisitions, has expanded into California. The agency operations produce commercial, personal lines, life, and accident and health insurance, for more than fifty unaffiliated insurance carriers.
Intersegment revenue is related to intercompany agency commission revenue, which represents commissions received by our agency operations from our Insurance Company Subsidiaries. This revenue is primarily related to the conversion of an existing west-coast commercial transportation program to one of our Insurance Company Subsidiaries.
Significant periods of time can elapse between the occurrence of an insured loss, the reporting of the loss to the insurer, and the insurer’s payment of that loss. To recognize liabilities for unpaid losses and loss adjustment expenses (“LAE”), insurers establish reserves as balance sheet liabilities representing estimates of amounts needed to pay reported and unreported net losses and LAE. We establish a liability for losses and LAE which represent (1) case basis estimates of reported unpaid losses and LAE on direct business, (2) actuarial estimates of incurred but not reported losses (“IBNR”) and LAE, and (3) estimates received from ceding reinsurers on assumed business. Such liabilities, by necessity, are based upon estimates and, while we believe the amount of our reserves are adequate, the ultimate liability may be greater or less than the amount provided.
As of December 31, 2004, we have accrued $378.2 million of gross loss and LAE reserves compared with $339.5 million at December 31, 2003.
Reinsurance recoverables represent (1) amounts currently due from reinsurers on paid losses and LAE, (2) amounts recoverable from reinsurers on case basis estimates of reported losses and LAE, and (3) amounts recoverable from reinsurers on actuarial estimates of IBNR losses and LAE. Such recoverables, by necessity, are based upon estimates. Reinsurance does not legally discharge us from our legal liability to our insureds, but it does make the assuming reinsurer liable to us to the extent of the reinsurance ceded. Instead of being netted against the appropriate liabilities, ceded unearned premiums and reinsurance recoverables on paid and unpaid losses and LAE are reported separately as assets in our consolidated balance sheets. Reinsurance recoverable balances are also subject to credit risk associated with the particular reinsurer. In our selection of reinsurers, we continually evaluate their financial stability. While we believe our reinsurance recoverables are collectible, the ultimate recoverable may be greater or less than the amount accrued. At December 31, 2004 and 2003, reinsurance recoverables on paid and unpaid losses were $169.1 million and $165.0 million, respectively.
uncollectibility of certain reinsurance balances due from some risk-sharing partners, some of which are in litigation. At the end of each quarter, an analysis of these exposures is conducted to determine the potential exposure to uncollectibility. At December 31, 2004, we believe this allowance is adequate. To date, we have not, in the aggregate, experienced material difficulties in collecting balances from our risk-sharing partners. No assurance can be given, however, regarding the future ability of any of our risk-sharing partners to meet their obligations.
Our investment portfolio is primarily invested in debt securities classified as available for sale, with a concentration in fixed income securities of a high quality. Our investment philosophy is to maximize after-tax earnings and maintain significant investments in tax-exempt bonds. Our policy for the valuation of temporarily impaired securities is to determine impairment based on analysis of, but not limited to, the following factors: (1) market value less than amortized cost for a six month period; (2) rating downgrade or other credit event (e.g., failure to pay interest when due); (3) financial condition and near-term prospects of the issuer, including any specific events which may influence the operations of the issuer such as changes in technology or discontinuance of a business segment; (4) prospects for the issuer’s industry segment; and (5) intent and ability to retain the investment for a period of time sufficient to allow for anticipated recovery in market value. We evaluate our investments in securities to determine other than temporary impairment, no less than quarterly. Investments that are deemed other than temporarily impaired are written down to their estimated net fair value and the related losses recognized in income. There were no impaired investments written down in 2004 and 2003. There were $75,000 in impaired investments written down in 2002. There can be no assurance, however, that significant changes in the above factors in relation to our investment portfolio, will not result in future impairment charges.
Results from operations improved $4.0 million from a net income of $10.1 million, or $0.35 per diluted share, in 2003 to net income of $14.1 million, or $0.48 per diluted share, in 2004. This improvement reflects an improvement in underwriting results, which is the result of the controlled growth of earned premium in profitable programs written in 2004, continued rate increases, growth in agency commission, control over expenses, and leveraging of fixed costs. In addition, this improvement in net income reflects an after-tax benefit of approximately $1.4 million from the acceleration of revenue recognition, net of expenses, relating to the termination of a specific multi-state claims run-off contract.
Revenues increased $59.5 million, or 28.2%, to $270.3 million for the year ended December 31, 2004, from $210.8 million for the comparable period in 2003. This increase reflects a $63.3 million, or 41.9%, increase in net earned premiums. The growth in net earned premiums primarily reflects the earning pattern of programs written in 2004, which include the conversion of an existing west-coast commercial transportation program to one of our insurance subsidiaries, the impact of a renewal rights contract for a select group of association-endorsed workers’ compensation programs which had over twenty years of profitable underwriting experience, the implementation of an excess liability program for public entities with a twenty-year profitable track record, the return of profitable programs, the impact of an overall 13.6% rate increase achieved in 2003, and an overall 8.4% rate increase in 2004, which consisted of 4.3% in the workers’ compensation line of business and 12.5% in all other lines of business combined. This increase was partially offset by the anticipated reduction in managed fee revenue from two limited duration or closed end administrative services and claims contracts.
During 2004, we accelerated the recognition of the deferred claim revenue related to a multi-state claims run-off service contract. The acceleration of this revenue was a result of an earlier than anticipated termination of our obligation under the contract. This contract was terminated by the Liquidator during the third quarter of 2004, after a Liquidation Order was entered against the entity for which we had serviced the claims. At the time of termination, we had $3.5 million of deferred revenue related to the claims contract. The revenue had been paid to us pursuant to an agreed upon schedule. However, in order to remain consistent with our historic claims handling pattern, we had previously adopted a more conservative revenue recognition pattern; therefore, resulting in the establishment of deferred revenue. At the termination of the contract, pursuant to the contract terms, we are no longer obligated to handle the related claims. The $3.5 million of deferred revenue related to the claims contract, was fully recognized as of September 30, 2004. Had the contract not been terminated, we would have received additional claims fee revenue for continued claims handling services. Of the $3.5 million, approximately $993,000 was expected to be recognized within the fourth quarter of 2004. Therefore, the pre-tax favorable impact for 2004 in relation to the acceleration of the deferred claim revenue, net of related expenses, would have been approximately $2.1 million. Refer to our revenue recognition accounting policy described in Note 1 - Summary of Significant Accounting Policies of the Consolidated Financial Statements.
Net earned premiums increased $63.3 million, or 41.9%, to $214.5 million in the year ended December 31, 2004, from $151.2 million in the comparable period in 2003. As previously mentioned, this increase primarily reflects the earning pattern resulting from the controlled growth of programs written in 2004.
Net investment income increased $1.4 million, or 10.5%, to $14.9 million in 2004, from $13.5 million in 2003. Average invested assets increased $57.1 million, or 19.0%, to $358.7 million in 2004, from $301.6 million in 2003. The increase in average invested assets reflects cash flows from underwriting activities and growth in gross written premiums during 2003 and 2004, as well as, net proceeds from capital raised through the issuance of debentures. The average investment yield for 2004 was 4.2%, compared to 4.5% in 2003. The current pre-tax book yield was 3.9% and current after-tax book yield was 2.9%. The decline in investment yield reflects the accelerated prepayment speeds in mortgage-backed securities and the reinvestment of cash flows in municipal bonds and other securities with lower interest rates. Over the past two years, the reinvestment of cash flows has shifted from maturing securities with higher yields being replaced by securities with lower yields in a declining interest rate environment. In addition, the decline in investment yield reflects the timing of investing the proceeds from the capital raised in 2004.
Specialty risk management operations generated pre-tax income of $16.6 million for the year ended December 31, 2004, compared to pre-tax income of $11.8 million for the comparable period in 2003. This increase in pre-tax income demonstrates the improvement in underwriting results and the further leveraging of fixed costs as we continue to experience controlled growth of premium volume. In addition, this improvement in pre-tax income reflects an approximate $2.1 million pre-tax favorable impact in relation to the previously mentioned acceleration of deferred claim revenue, net of related expenses, relating to the termination of a specific multi-state claims run-off contract. The GAAP combined ratio was 101.4% for the year ended December 31, 2004, compared to 104.4% for the comparable period in 2003.
Our expense ratio improved 0.8 percentage points to 33.5% for the year ended December 31, 2004, from 34.3% for the same period in 2003. This ratio is the unconsolidated policy acquisition and other underwriting expenses in relation to net earned premium. As mentioned above, the commutation and the reclassification had a favorable impact of 0.8 percentage points. Partially offsetting this favorable impact was the anticipated increase in gross outside commissions. This is a result of a shift in the balance between workers’ compensation and general liability. The general liability line of business has a higher commission rate and a lower loss ratio.
Management fees increased $6.0 million, or 46.9%, to $18.8 million from $12.8 million for the comparable period in 2002. This increase in management fees reflects revenue from new fee-for-service agreements of $5.6 million. The remaining increase is the result of an overall net increase in management fees within our existing managed programs.
Loss control fees decreased $287,000, or 11.1%, to $2.3 million from $2.6 million for the comparable period in 2002. This decrease is mainly the result of the previously mentioned conversion of an existing fee-based program into an insured program within one of our underwriting subsidiaries.
Specialty risk management operations generated a pre-tax income of $11.8 million for the year ended December 31, 2003 compared to a pre-tax loss of ($739,000) for the comparable period in 2002. This improvement reflects the favorable impact of the previously indicated fee-for-service agreements and improved underwriting results. The GAAP combined ratio was 104.4% for the year ended December 31, 2003, compared to 108.6% for the comparable period in 2002.
Net losses and LAE decreased $262,000, or 0.3%, to $98.5 million for the year ended December 31, 2003, from $98.7 million for the same period in 2002. Our loss and LAE ratio decreased by 2.0 percentage points to 70.1% for the year ended December 31, 2003, from 72.1% for the same period in 2002. This ratio is the unconsolidated net loss and LAE in relation to net earned premium. This improvement in the loss and LAE ratio reflects continued disciplined underwriting and rate increases. In addition, while we had adverse development of $2.9 million, or 1.5% of $193.1 million of net loss and LAE reserves at December 31, 2002, reserves continue to stabilize.
Our expense ratio improved 2.2 percentage points to 34.3% for the year ended December 31, 2003, from 36.5% for the same period in 2002. This ratio is the unconsolidated policy acquisition and other underwriting expenses in relation to net earned premium. The improvement reflects a reduction in gross commissions and leveraging of fixed costs.
Revenue from agency operations, which consists primarily of agency commissions, increased $2.7 million, or 18.3%, to $17.7 million for the year ended December 31, 2004, from $15.0 million for the comparable period in 2003. This increase is primarily the result of increases in new business, rate increases, higher retention levels, and profit sharing commissions.
Agency operations generated pre-tax income, before corporate overhead, of $8.9 million for the year ended December 31, 2004, compared to $6.9 million for the comparable period in 2003. The improvement in the pre-tax margin is primarily attributable to the overall increase in revenue.
Revenue from agency operations, which consists primarily of agency commission revenue, increased $624,000, or 4.4%, to $15.0 million for the year ended December 31, 2003, from $14.3 million for the comparable period in 2002. This increase was primarily the result of rate increases, increases in profit sharing commissions, and an increase in revenue from new producers. This increase was partially offset by $220,000 of commission revenue earned in 2002 related to the sale of a book of business, which was sold in 2002.
The key assumptions used in our selection of ultimate reserves included the underlying actuarial methodologies, a review of current pricing and underwriting initiatives, an evaluation of reinsurance costs and retention levels, and a detailed claims analysis with an emphasis on how aggressive claims handling may be impacting the paid and incurred loss data trends embedded in the traditional actuarial methods. With respect to the ultimate estimates for losses and LAE, the key assumptions remained consistent for the years ended December 31, 2004, 2003, and 2002.
For the year ended December 31, 2004, we reported an increase in net ultimate loss estimates for accident years 2003 and prior of $4.5 million, or 2.4% of $192.0 million of net loss and LAE reserves at December 31, 2003. The increase in net ultimate loss estimates reflected revisions in the estimated reserves as a result of actual claims activity in calendar year 2004 that differed from the projected activity. There were no significant changes in the key assumptions utilized in the analysis and calculations of our reserves during 2004. The major components of this change in ultimates are as follows:
The commercial multiple peril line and general liability line of business had an increase in net ultimate loss estimates of $3.0 million, or 7.2% of net commercial multiple peril and general liability reserves. The net increase reflects an increase of $1.9 million and $500,000 in accident years 2001 and 1999, respectively. The increase in the ultimate loss estimate for accident year 2001 reflects higher than expected emergence in claim activity in a general liability occurrence program within the Kansas City Branch. The increase in accident year
1999 reflects an increase in one claim in an excess professional liability program and a higher than expected increase in reserves on one discontinued program. These increases were partially offset by a reduction of $575,000 in the ultimate loss estimate for accident year 2000. The improvement in accident year 2000 reflects better than expected claims activity in two previously discontinued programs. The change in ultimate loss estimates for all other accident years was insignificant.
The projected net ultimate loss estimate for the commercial automobile line of business increased $1.2 million, or 4.3% of net commercial automobile reserves. This net overall increase reflects an increase of $1.8 million, $614,000 and $572,000 in accident years 2002, 2001 and 2000 respectively. These increases reflect the impact of the change in the case reserve for one claim in a California program and the impact of higher than expected emergence in claims activity in three previously discontinued or inactive programs. These increases were partially offset by a reduction of $1.3 million in the ultimate loss estimate for accident year 2003 related to automobile physical damage claim activity and better than expected emergence in other programs. The change in ultimate loss estimates for all other accident years was insignificant.
The workers’ compensation residual market line of business had a decrease in net ultimate loss estimates of $1.7 million, or 11.6% of net reserves on the workers’ compensation residual market line of business. The change reflects a reduction of $1.7 million in accident year 2003. We record loss reserves as reported by the National Council on Compensation Insurance (“NCCI”), plus a provision for the reserves incurred but not yet analyzed and reported to us, due to a two quarter lag in reporting. This 2003 change reflects a difference between our estimate of the lag incurred but not reported and the amounts reported by the NCCI in the quarter. The change in ultimate loss estimates for all other accident years was insignificant.
Salary and employee benefits increased $4.1 million, or 8.4%, to $52.3 million in 2004, from $48.2 million for the comparable period in 2003. This increase primarily reflects both merit increases and the accrual of anticipated variable compensation, which is directly tied to our performance and profitability. These increases were partially offset by a slight decrease in staffing levels.
underwriting results. Partially offsetting this decrease was a reduction in overall bad debt expense in 2004 as compared to increases in related allowances recorded in 2003 on previously discontinued programs.
Salary and employee benefits and administrative expenses include both corporate overhead and the holding company expenses included in the reconciling items of our segment information.
Interest expense for 2004, 2003, and 2002 was $2.3 million, $977,000, and $3.0 million, respectively. Interest expense is primarily attributable to our former term loan, in addition to our current lines of credit and debentures, which are described within the Liquidity and Capital Resources section of Management’s Discussion and Analysis. Interest expense increased $1.5 million as a result of the debentures. Offsetting this increase was a reduction in interest associated with our former term loan and our current lines of credit of $63,000, or 7.5%, to $777,000 in 2004, from $840,000 in 2003. This decrease reflects a reduction in the average outstanding balance, offset by an increase in the average interest rate. The average debt outstanding was $14.8 million, $26.0 million, and $44.0 million in 2004, 2003, and 2002, respectively. The average interest rate was approximately 5.2%, 4.0%, and 7.0%, in 2004, 2003, and 2002, respectively.
Income tax expense, which includes both federal and state taxes, for 2004, 2003 and 2002, was $6.4 million, $6.2 million, and $897,000, or 31.2%, 38.0% and 35.2% of income before taxes, respectively. Our effective tax rate differs from the 34% statutory rate primarily due to a shift towards increasing investments in tax-exempt securities in an effort to maximize after-tax investment yields, offset by state income tax. Our current statutory tax rate of 34% is based upon $6.8 million of taxable income after the utilization of $13.1 million of net operating loss carryforwards. At $18.3 million of taxable income, our statutory tax rate will increase to 35%.
Our principal sources of funds, which include both regulated and non-regulated cash flows, are insurance premiums, investment income, proceeds from the maturity and sale of invested assets, risk management fees, and agency commissions. Funds are primarily used for the payment of claims, commissions, salaries and employee benefits, other operating expenses, shareholder dividends, and debt service. Our regulated sources of funds are insurance premiums, investment income, and proceeds from the maturity and sale of invested assets. These regulated funds are used for the payment of claims, policy acquisition and other underwriting expenses, and taxes relating to the regulated portion of net income. Our non-regulated sources of funds are in the form of commission revenue, outside management fees, and intercompany management fees. These non-regulated sources of funds are used to meet debt service, shareholders’ dividends, and other operating expenses of the holding company and non-regulated subsidiaries. The following table illustrates net income, excluding interest,
Regulated subsidiaries’ cash flow provided by operations for the year ended December 31, 2003, was $29.6 million, compared to $6.0 million for the comparable period in 2002. The increase in regulated cash flow from operations primarily reflects growth in written premiums and overall improved underwriting results.
Non-regulated subsidiaries’ cash flow provided by operations for the year ended December 31, 2003, was $17.9 million, compared to cash used of $4.2 million for the comparable period in 2002. The increase in non-regulated cash flow from operations primarily reflects the inflow of cash related to the previously mentioned limited duration administrative services contract and a multi-state claims run-off contract entered into at the beginning of 2003. At inception, these contracts resulted in a higher inflow of cash during the first quarter of 2003. In addition, the increase in cash flow from operations is the result of intercompany tax payments made during 2002 to the regulated subsidiaries in accordance with the tax sharing agreement. These intercompany tax payments were made to compensate the regulated subsidiaries for the utilization of our net operating loss carryforward. These intercompany tax payments also contributed to the increase in regulated cash flow from operations.
On September 30, 2003, an unconsolidated subsidiary trust of ours issued $10.0 million of mandatory redeemable trust preferred securities (“TPS”) to a trust formed by an institutional investor. Contemporaneously, we issued $10.3 million in junior subordinated debentures, which includes our $310,000 investment in the trust. We received a total of $9.7 million in net proceeds, after the deduction of approximately $300,000 of commissions paid to the placement agents in the transaction. These issuance costs have been capitalized and are included in other assets on the balance sheet, which will be amortized over seven years as a component of interest expense. We contributed $6.3 million of the proceeds to our Insurance Company Subsidiaries and the remaining balance was used for general corporate purposes. The debentures mature in thirty years and provide for interest at the three-month LIBOR, plus 4.05%.
The revolving line of credit provides for interest at a variable rate based, at our option, upon either a prime based rate or LIBOR based rate. On prime based borrowings, the applicable margin ranges from 75 to 25 basis points below prime. On LIBOR based borrowings, the applicable margin ranges from 125 to 175 basis points above LIBOR. The margin for all loans is dependent on the sum of non-regulated earnings before interest, taxes, depreciation, amortization, and non-cash impairment charges related to intangible assets for the preceding four quarters, plus dividends paid or payable from our subsidiaries during such period (“Adjusted EBITDA”). As of December 31, 2004, the average interest rate for LIBOR based borrowings outstanding was 4.07%.
December 31, 2004, the LIBOR-based option was 4.09%. At December 31, 2003, the line bore interest at the Prime Rate of 4.00%. The line will expire on May 14, 2005. We expect to renegotiate this line of credit prior to its expiration.
As of December 31, 2004 and 2003, the recorded values of our investment portfolio, including cash and cash equivalents, were $402.2 million and $324.2 million, respectively. The debt securities in the investment portfolio, at December 31, 2004, were 95.4% investment grade A or above bonds as defined by Standard and Poor’s.
On September 17, 2002, our Board of Directors authorized management to repurchase up to 1,000,000 shares of our common stock in market transactions for a period not to exceed twenty-four months. On August 6, 2003, our Board of Directors authorized management to repurchase up to an additional 1,000,000 shares of our common stock under the existing share repurchase plan. The original share repurchase plan expired on September 17, 2004. At our regularly scheduled board meeting on November 3, 2004, our Board of Directors authorized management to repurchase up to 1,000,000 shares of our common stock in market transactions for a period not to exceed twenty-four months. We did not repurchase any common stock during the year ended December 31, 2004. For the year ended December 31, 2003, we repurchased and retired 569,100 shares of common stock for a total cost of $1.6 million. As of December 31, 2004, the cumulative amount we repurchased and retired was 764,800 shares of common stock for a total cost of approximately $2.0 million.
A significant portion of our consolidated assets represent assets of our Insurance Company Subsidiaries that at this time, without prior approval of the State of Michigan Office of Financial and Insurance Services (“OFIS”), cannot be transferred to us in the form of dividends, loans or advances. The restriction on the transferability to us from the Insurance Company Subsidiaries is dictated by Michigan insurance regulatory guidelines which, in general, are as follows: the maximum discretionary dividend that may be declared, based on data from the preceding calendar year, is the greater of each insurance company’s net income (excluding realized capital gains) or ten percent of the insurance company’s surplus (excluding unrealized gains). These dividends are further limited by a clause in the Michigan law that prohibits an insurer from declaring dividends except out of surplus earnings of the company. Earned surplus balances are calculated on a quarterly basis. Since Star is the parent insurance company, its maximum dividend calculation represents the combined Insurance Company Subsidiaries’ surplus. Based upon the 2004 statutory financial statements, Star may only pay dividends to us during 2005 with the prior approval of OFIS. Star’s earned surplus position at December 31, 2004 was negative $13.7 million. No dividends were paid in 2004 or 2003.
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 $151.2 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 $68.3 million, $54.0 million, $16.1 million, and $12.8 million, respectively, resulting in net losses and loss adjustment expenses of $102.6 million, $81.1 million, $24.0 million, and $19.2 million, respectively.
Insurance operations are subject to various leverage tests (e.g. premium to statutory surplus ratios), which are evaluated by regulators and rating agencies. Our targets for gross and net written premium to statutory surplus are 3.0 to 1 and 2.5 to 1, respectively. Our premium leverage ratios as of December 31, 2004, on a statutory consolidated basis, were 2.60 to 1 and 1.94 to 1 on a gross and net written premium basis, respectively.
requiring an insurance company to be placed under regulatory control in a rehabilitation or liquidating proceeding.
The “Authorized Control Level” is triggered if a company’s total adjusted capital is less than 100% but greater than or equal to 70% of its risk-based capital, at which level the regulatory authority may take any action it deems necessary, including placing the company under regulatory control.
At December 31, 2004, all of our Insurance Company Subsidiaries were in compliance with RBC requirements. Star reported statutory surplus of $120.7 million and $99.9 million at December 31, 2004 and 2003, respectively. The calculated RBC was $28.4 million in 2004 and $22.8 million in 2003. The threshold requiring the minimum regulatory involvement was $56.9 million in 2004 and $45.7 million in 2003.
The Estimated Current Reserve Deficiency to Surplus ratio measures the relationship between the current year’s net premium earned to cumulative net unpaid loss and loss adjustment expense reserves. Stated differently, this ratio compares balance sheet accounts (loss and loss adjustment expense reserves) for all years to an income statement account (net earned premium) for a single year. This ratio implicitly assumes that there is a constant relationship between premiums earned and reserves; that there is a constant level of rate adequacy; that there is a constant mix of business; and there are consistent reinsurance terms.
As the NAIC IRIS Instruction Manual states, the results of this ratio can be distorted by significant changes in premium volume. The unusual range reflects the impact of earned premium growth in Star of 59% which resulted from the reduction in premiums in 2002 and the subsequent controlled growth in 2003 and 2004. In addition, the cumulative rate increases since January 2000 were 80.3%. Finally, the workers’ compensation reinsurance program over the past five years has changed with the termination of the 2000 and 2001 surplus relief treaty and increases in net retentions from a low of $100,000 per occurrence in 2000 to $350,000 in 2004. A more accurate reflection of the values intended to be derived in the formula would utilize a weighted average premium approach. Three different approaches, using weighted premiums with a 50-50 split of current and prior premiums, weights based on current reserves by age, and weights based on percentages of reserves to ultimate incurred by age would result in a reduction of 47.1 percentage points, 34.1 percentage points, and 44.9 percentage points, respectively, all of which are within the normal range.
there can be no guaranty, we believe the underwriting efforts and rate increases that have occurred will return these programs to profitability.
In our risk-sharing programs, we are subject to credit risk with respect to the payment of claims by our clients’ captive, rent-a-captive, large deductible programs, indemnification agreements, and on the portion of risk exposure either ceded to the captives, or retained by the clients. The capitalization and credit worthiness of prospective risk-sharing partners is one of the factors we consider upon entering into and renewing risk-sharing programs. We collateralize balances due from our risk-sharing partners through funds withheld trusts
or letters of credit. At December 31, 2004, we had risk exposure in excess of collateral in the amount of $8.7 million, compared to $9.5 million at December 31, 2003, on these programs, of which we had an allowance of $6.3 million at December 31, 2004, compared to $6.4 million at December 31, 2003, related to these exposures. We have historically maintained an allowance for the potential uncollectibility of certain reinsurance balances due from some risk-sharing partners, some of which are in litigation. At the end of each quarter, an analysis of these exposures is conducted to determine the potential exposure to uncollectibility. At December 31, 2004, we believe this allowance is adequate. To date, we have not, in the aggregate, experienced material difficulties in collecting balances from our risk-sharing partners. No assurance can be given, however, regarding the future ability of any of our risk-sharing partners to meet their obligations. At December 31, 2004 and 2003, the exposure amount in litigation with former risk-sharing partners, which is not reserved or collateralized, is $1.2 million and $1.3 million, respectively.
On June 6, 2003, we entered into a Guaranty Agreement with a bank. We are guaranteeing payment of a $1.5 million term loan issued by the bank to an unaffiliated insurance agency. In the event of default on the term loan by the insurance agency, we are obligated to pay any outstanding principal (up to a maximum of $1.5 million), as well as any accrued interest on the loan, and any costs incurred by the bank in the collection process. In exchange for our guaranty, the president and member of the insurance agency pledged 100% of the common shares of two other insurance agencies that he wholly owns. In the event of default on the term loan by the insurance agency, we have the right to sell any or all of the pledged insurance agencies’ common shares and use the proceeds from the sale to recover any amounts paid under the guaranty agreement. Any excess proceeds would be paid to the shareholder. As of December 31, 2004, no liability has been recorded with respect to our obligations under the guaranty agreement, since no premium exists in excess of the guaranteed amount.
In December 2003, FIN No. 46 was revised as FIN No. 46(R) to address certain implementation issues and to defer full adoption into financial statements for periods ending after March 15, 2004, with earlier adoption permitted. In accordance with FIN No. 46(R), we performed an evaluation of our business relationships and determined that our wholly owned subsidiary, American Indemnity, did not meet the tests for consolidation, because neither us, nor Star are the primary beneficiaries of American Indemnity. Therefore, effective January 1, 2004, we deconsolidated American Indemnity on a prospective basis in accordance with the provisions of FIN No. 46(R). The adoption of FIN No. 46(R) and the deconsolidation of American Indemnity did not have a material impact on our consolidated balance sheet or consolidated statement of income.
At December 31, 2004 and 2003, respectively, we held an $868,125 and $885,794 note receivable, including $207,335 of accrued interest at December 31, 2004, from one of our executive officers. Accrued interest at December 31, 2003 was $225,005. This note arose from a transaction in late 1998 in which we loaned the officer funds to exercise 64,718 common stock options to cover the exercise price and the taxes incurred as a result of the exercise. The note bears interest equal to our borrowing rate and is due on demand any time after January 1, 2002. The loan is partially collateralized by 64,718 shares of our common stock under a stock pledge agreement. For the years ended December 31, 2004 and 2003, $42,000 and $3,500, respectively, have been paid against the loan. As of December 31, 2004, the cumulative amount that has been paid against this loan was $45,500. On June 1, 2001, the officer and us entered into an employment agreement which provides the note is a non-recourse loan and our sole legal remedy in the event of a default is the right to reclaim the shares pledged under the stock pledge agreement. Refer to Note 15 - Related Party Transaction for further information.
On December 3, 2003, we entered into a Development Agreement with an unaffiliated third party for the construction of our new corporate headquarters. The developer used a real estate consulting firm whose
principal is the son-in-law of our Chairman. This firm was paid approximately $240,000 by the developer, for its consulting work during the construction of the new building.
On December 4, 2003, we entered into a Purchase and Sale Agreement with an unaffiliated third party for the sale of 4.5 acres of land located adjacent to our new headquarters. In connection with this transaction, we executed an Exclusive Sale/ Lease Agency Agreement (“Agreement”) with the same real estate consultant, whereby will serve as the real estate broker for the sale of the land. Under the Agreement, the real estate consultant will be paid a five percent commission (approximately $105,800) of the sales price. The sale price is approximately $2.1 million.
In July 2004, we entered into an agreement with an unaffiliated third party to sell our property at 12641 East 116th Street, Cerritos, California. Refer to Note 14 - Sale-Leaseback Transaction for further information regarding this transaction. The real estate consulting firm described above was also used for this transaction. This firm received total commissions of $73,550, in relation to this transaction.
If our reserves for losses and loss adjustment expenses are not adequate, we will have to increase our reserves, which would result in reductions in net income and retained earnings.
Actual losses and the costs we incur related to the adjustment of losses under insurance policies may be different from the amount of reserves we establish. When we increase reserves, our net income for the period will decrease by a corresponding amount.
Our performance is dependent on the continued services and performance of our senior management and other key personnel.
Our future success also will depend on our ability to attract, train, motive and retain other highly skilled technical, managerial, marketing, and customer service personnel. Competition for these employees is intense and we may not be able to successfully attract, integrate or retain sufficiently qualified personnel. In addition, our future success depends on our ability to attract, retain and motivate our agents. Our failure to attract and retain the necessary personnel and agents could have a material adverse effect on our business, financial condition, and results of operations.
We transfer some of the risk we have assumed to reinsurance companies in exchange for a portion of the premium we receive in connection with the risk. Although reinsurance makes the reinsurer liable to us to the extent the risk is transferred, it does not relieve us of our original liability to the policyholders. Our reinsurers may not pay the reinsurance recoverables they owe us or they may not pay on a timely basis. If our reinsurers fail to pay us or fail to pay us on a timely basis, our financial results could be adversely affected.
Our results may fluctuate as a result of many factors, including cyclical changes in the insurance industry.
changes in loss reserves resulting from the general claims and legal environments as different types of claims arise and judicial interpretations relating to the scope of insurer’s liability develop;
We face competitive pressures in our business that could cause demand for our products to fall and adversely affect our profitability.
A number of new, proposed or potential legislative or industry developments could further increase competition in our industry. These developments include:
the enactment of the Gramm-Leach-Bliley Act of 1999 (which permits financial services companies such as banks and brokerage firms to engage in the insurance business), which could result in increased competition from new entrants to our markets;
the formation of new insurers and an influx of new capital in the marketplace as existing companies attempt to expand their business as a result of better pricing and/or terms;
These developments could make the property and casualty insurance marketplace more competitive by increasing the supply of insurance capacity. In that event, recent favorable industry trends could be reversed and may negatively influence our ability to maintain or increase rates. Accordingly, these developments could have an adverse effect on our business, financial condition and results of operations.
Because we are heavily regulated by the states in which we operate, we may be limited in the way we operate.
potential assessments for the provision of funds necessary for the settlement of covered claims under certain insurance policies provided by impaired, insolvent or failed insurance companies.
We could be forced to sell investments to meet our liquidity requirements.
Because our investment portfolio consists primarily of fixed income securities, our investment income could suffer as a result of fluctuations in interest rates.
We currently maintain and intend to continue to maintain an investment portfolio consisting primarily of fixed income securities. The fair value of these securities fluctuates depending on changes in interest rates. Generally, the fair market value of these investments increases or decreases in an inverse relationship with changes in interest rates, while net investment income earned by us from future investments in fixed income securities will generally increase or decrease with interest rates. Changes in interest rates may result in fluctuations in the income derived from, and the valuation of, our fixed income investments, which could have an adverse effect on our financial condition and results of operations.
We are subject to credit risk with respect to the obligations of our reinsurers and the payment of claims by our clients’ captive, rent-a-captive, large deductible programs, indemnification agreements, and on the portion of risk exposure either ceded to the captives, or retained by our clients. The inability of our risk-sharing partners to meet their obligations could adversely affect our profitability.
primary liability to its policyholder. If all or any of the reinsuring companies are unable to meet their obligations, we would be liable for such defaulted amounts. Therefore, we are subject to a credit risk with respect to the obligations of our reinsurers. In order to minimize our exposure to significant losses from reinsurer insolvencies, we evaluate the financial condition of our reinsurers and monitor the economic characteristics of the reinsurers on an ongoing basis.
The Michigan Business Corporation Act contains “anti-takeover” provisions. Chapter 7A and 7B of the Business Corporation Act apply to us and may have an anti-takeover effect and may delay, defer or prevent a tender offer or takeover attempt that a shareholder might consider in their best interest, including those attempts that might result in shareholders receiving a premium over market price for their shares.
Our articles of incorporation allow the Board of Directors to issue one or more classes or series of preferred stock with voting rights, preferences and other privileges as the Board of Directors may determine. Also, we have adopted a shareholder rights plan which if triggered would significantly dilute the stock ownership percentage of anyone who acquires more than fifteen percent of our shares without the approval of our Board of Directors. The existence of our shareholder rights plan and the possible issuance of preferred shares could adversely affect the holders of our common stock and could prevent, delay or defer a change of control.
Insurance companies are subject to financial strength ratings produced by external rating agencies. Higher ratings generally indicate greater financial stability and a stronger ability to pay claims. Ratings are assigned by rating agencies to insurers based upon factors they believe are important to policyholders. Ratings are not recommendations to buy, hold, or sell our securities.
placed on a company’s rating if its financial and market trends are favorable, relative to its current rating level. We believe that as a result of our improved balance sheet and operating performance our rating will remain at least at its current level, if not at an upgraded level. However, there can be no assurance that A.M. Best will not change its rating in the future. A rating downgrade from A.M. Best could materially adversely affect the business we write and our results of operations.
Most states assess our Insurance Company Subsidiaries to provide funds for failing insurance companies and those assessments could be material.
Our Insurance Company Subsidiaries are subject to assessments in most states where we are licensed for the provision of funds necessary for the settlement of covered claims under certain policies provided by impaired, insolvent or failed insurance companies. Maximum contributions required by law in any one year vary by state, and have historically been less than 1% of annual premiums written. We cannot predict with certainty the amount of future assessments. Significant assessments could have a material adverse effect on our financial condition and results of operations.
See list of Financial Statement Schedules on page 55 and Note 18 - Quarterly Financial Data (Unaudited) of the Notes to the Consolidated Financial Statements.