b) Litigation expense represents expense associated with the settlements of certain class action lawsuits.
Prior to the Quarterly Report on Form 10-Q that we filed with the SEC for the quarterly period ended September 30, 2005, we had employed trade ratio calculations (loss ratio, expense ratio and combined ratio) that were different from those used by other companies engaged in the private passenger automobile insurance business. We had calculated our loss and expense ratios with fee income and other income included in the divisor while the more widely used calculation includes fee income as a contra-expense in the dividend with the divisor consisting of earned premium only. Our methodology had caused our loss ratio to appear lower and expense ratio to appear higher than would have been the case had we employed the more widely used calculation.
In each of our filings that contained trade ratio calculations, we had described our methodology so that users of the documents would be cognizant of the methodology we employed. Beginning with the Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2005, we conformed our calculation to the more widely used methodology to make it easier for investors to compare and contrast our performance with that of other industry participants.
other income, which primarily represents commission income we earn on business written in Texas.
losses and loss adjustment expenses, including estimates for losses and loss adjustment expenses incurred during the period and changes in estimates from prior periods, less the portion of those insurance losses and loss adjustment expenses that we ceded to our reinsurers;
The market conditions in the states in which we operate are competitive to varying degrees. Some companies with which we compete, primarily in California, do not verify certain underwriting information or default to lower values, which has the effect of lowering the premium they charge, and thus attract more business. In addition, some companies with which we compete pay incentives to agents and brokers. Also, some competitors spend significant sums on advertising. We have not relaxed our underwriting standards, do not advertise, and do not pay incentive commissions.
We monitor the rate and underwriting activity of the other market participants in each state in which we do business. We have noted some indications that the competitive conditions in some states may be stabilizing. During the fourth quarter of 2005, we began noting some moderation in rate decreases and began to see an up tick in rate filings where companies are raising rates. Overall, we observed 97 competitor rate revisions and new product introductions during the quarter ended December 31, 2005. These included 46 rate increases, 26 rate reductions, 10 revenue-neutral filings, and 15 introductions of new products.
One aspect of our growth strategy is to increase the number of producers with which we do business. We attempt to target producers in geographic areas where we are under-represented and where we believe we can write profitable business. During 2005, we increased our total number of producers to approximately 7,720 and our total number of producer locations to more than 10,360.
Over time, it is our goal to increase our geographic diversification. California continues to be our largest state, and California, Florida and Michigan accounted for 75% of our volume for 2005. However, our mix of premium writings has become more geographically diverse as we derived 46% of our gross written premium from California in 2005, down from 56% in 2004. Year-to-year changes in gross written premium, as enumerated above, vary significantly by state and are dependent upon a variety of factors, including competitive conditions and regulatory environments within those states, our strategies with respect to product pricing and the number and location of producers.
In California, our premium writings declined by 30% in 2005 and by 4% in 2004, as we observed intensifying competitive conditions in that state. In our other states, in the aggregate, our premium writings grew by 4% in 2005 and by 30% in 2004. In California, competitors’ filed rates remain stable, however, many have relaxed underwriting standards by not verifying mileage bands and other underwriting information, such as driving experience. This behavior results in lower policy premium for some consumers, making it more difficult for companies not engaging
in such practices to attract and retain customers. We have not relaxed our underwriting standards and do not intend to do so in the future.
We have increased the number of producers in California to 1,099 with 1,896 locations as of December 31, 2005 from 917 producers with 1,602 locations at December 31, 2004. Our strategy remains to increase the number of producers, without over-saturating the market. We closely monitor the behavior of our new producers to ensure adherence to our underwriting standards.
New business application volume in California during the fourth quarter of 2005 was approximately 40% lower than the comparable quarter of 2004. This change gives us some indication that the market may be beginning to stabilize, as the rate of decline we experienced throughout the first three quarters of 2005 had been closer to 50%. In the latter part of 2005, we also noted improvement in our business retention, which offset some of the decline in our new business, resulting in our overall gross written premium declining by less than the decline in new business policies.
The table below shows our gross written premium by state and quarter for the twelve months ended December 31, 2005:
We continue to experience strong growth in Michigan where our premium volume increased 16% for the year ended December 31, 2005 compared to 2004. Our strategy in Michigan is to grow by increasing the number of producers in profitable geographic areas where we are under-represented. At December 31, 2005, we had 601 producers with 813 locations, up from 571 producers with locations at December 31, 2004. Over time, we have built strong producer relationships based on the competitiveness of our products and customer service. Due to the recent market entrants and rate filing activity, we believe conditions will become more competitive in the future. The Governor of Michigan recently proposed legislation that would decrease automobile insurance rates by 20%, eliminate the use of credit as a rating variable, and seek changes in the law to make it easier for claimants to file tort claims. We are closely monitoring this situation.
of 2005, during which we experienced a 9% decline in our premium volume compared to the same period of 2004. As with each state in which we do business, we are closely monitoring and analyzing our business in Texas.
We have an exclusive license to use OneStep in the non-standard automobile insurance industry through December 2009. OneStep and OneStep Raptor use technology to provide fast and accurate quotes by accessing third-party information at the point of sale, including an applicant's driving record, accident history and, where permitted by law, credit reports. This process reduces the frequency of uprates which may occur when an application is incomplete or inaccurate. Our point-of-sale application systems permit the producer to print the policy, the identification cards and the policy declaration page as soon as the verifications are complete, usually within minutes.
Accruals for Litigation. We continually evaluate potential liabilities and reserves for litigation using the criteria established by Statement of Financial Accounting Standards, or SFAS, No. 5, "Accounting for Contingencies." We have a quarterly monitoring process involving legal and accounting professionals. Legal personnel first identify outstanding corporate litigation and regulatory matters posing a reasonable possibility of loss. Legal personnel then review these matters to evaluate the facts and changes since the last review in order to determine if we should record or adjust a provision for loss, the amount that we should record, and any appropriate disclosure regarding the provision, and communicate such information to accounting personnel. We believe the current assumptions and other considerations we use to estimate our potential liability for litigation are appropriate. While it is not possible to know with certainty the ultimate outcome of these claims or lawsuits, we believe we have adequately reserved for our existing known litigation and that such litigation will not have a material effect on our future financial condition or results of operations. In view of the uncertainties regarding the outcome of these claims or lawsuits, as well as the tax-deductibility of related payments, it is possible that the ultimate cost to us of these claims or lawsuits could exceed the reserves we establish by amounts that would have a material adverse effect on our future financial condition or results of operations in a particular quarter or year.
Net Written Premium. Net written premium increased by 77% to $653.1 million for the twelve months ended December 31, 2005 from $369.0 million for the comparable period of 2004. Of the increase in net written premium, $313.2 million was due to the reduction in the cession percentage to 10% for 2005 business from 50% for business and $106.3 million is due to the termination and commutation of our 2002-2004 quota share reinsurance agreement effective January 1, 2005. As of January 2006, all of the material reinsurance agreements to which we had been a party had been terminated and commuted, and the reinsurers had been released from all future liabilities under the agreements. See “Business - Reinsurance” above.
Net Earned Premium. Net earned premium increased by 83% to $595.1 million for the twelve months ended December 31, 2005 from $325.3 million for the comparable period of 2004. Gross earned premium was down by 7% and our premium retention increased to 92% from 47% as a result of the reduction in the ceding percentage under our quota share reinsurance agreement. We had a quota share reinsurance agreement in 2004 under which we ceded 50% of 2004 policy premium; for 2005, we had a quota share reinsurance agreement under which we ceded 10% of 2005 policy premium.
Net Investment Income and Realized Losses and Gains on Investments. Net investment income was $17.2 million for the twelve months ended 2005 compared to $9.0 million for the same period of 2004. Most of the increase was attributable to a larger invested asset base on average during 2005 compared to 2004. Our initial public offering, which we completed in February 2004, provided $113.4 million of net proceeds and the termination and commutation of our 2002-2004 quota share reinsurance agreement resulted in our receipt of $196.6 million in January 2005. Excluding the proceeds from the reinsurance termination, cash flow from operations aggregated $56.3 million for the twelve months
ended December 31, 2005 compared to $45.9 million for the twelve months ended December 31, 2004. The increased cash flow also contributed to the growth in invested assets and increased net investment income. The average pre-tax equivalent investment yield on the portfolio increased to 4.52% as of December 31, 2005 from 4.30% as of December 31, 2004.
Net realized gains and losses on securities sales were insignificant for the twelve months ended December 31, 2005 and 2004.
Policy Service Fee Revenue. Policy service fee revenue for the twelve months ended December 31, 2005 was $62.5 million, equivalent to 10% of gross earned premium, compared to $74.1 million, equivalent to 11% of gross earned premium, for the same period of 2004. The most prominent factor affecting our level of fee income is the decline in our average policies in force. As noted above, the ratio of fees to gross earned premium has declined by 1 point, indicating that on a per policy basis, we are collecting lower fees on average than in the prior year. Approximately 40%, or 0.4 points, of the decline is due to a lesser proportion of our business emanating from California where the level of fees charged is greater related to premiums than in the other states in which we operate. While approximately 20% of new business has been written on electronic funds transfer (“EFT”) payment plans in recent months, and we charge approximately 50% lower installment fees on installments paid by EFT, this has not been a significant factor in the lower fee ratio for the full year, accounting for less than 25%, or 0.25 points, of the decline. Many other factors, none of which is individually significant, accounted for the remainder of the decline.
The following table displays our net incurred losses and loss adjustment expenses (“LAE”) related to the current accident year (losses and LAE occurring in the current fiscal year) and prior accident years (losses and LAE recognized in the current fiscal year related to accidents which took place in a prior fiscal year).
Commissions and Other Underwriting Expenses. Commissions and other underwriting expenses increased to $154.0 million for the twelve months ended December 31, 2005 compared to $58.4 million for the twelve months ended December 31, 2004, an increase of $95.6 million, or 164%. This category of expenses includes producers’ commissions, premium taxes and company expenses that relate to the production of and vary with premium, reduced by ceding commission income. Most of the increase is the result of the large decrease in the ceding percentage under our quota share agreements, which, in turn, reduced ceding commission income. During the twelve months ended December 31, 2005, we ceded 8% of our gross earned premium compared to 53% for the comparable period of 2004.
The decrease in premium taxes from 2004 to 2005 was the result of the decline in gross earned premiums, as the premium tax rate was little changed between years.
The change in deferred acquisition costs related to Company expenses contributed $4.8 million of the increase in other underwriting expenses. Net amortization was $3.8 million during the twelve months ended December 31, 2005 compared to net capitalization of $1.0 million during the twelve months ended December 31, 2004. Most of the remainder of the increase in other underwriting expenses emanates from the costs associated with increased use of technology principally related to point of sale underwriting.
Our gross expense ratio was 21.5% for the twelve months ended December 31, 2005 compared to 18.1% for the same period of 2004, an increase of 3.4 points (please see Note About Trade Ratios included in Item 6 above). Our lower fee income as a percentage of earned premium accounted for 0.9 points of the increase. The change in the net deferral of Company related underwriting expenses contributed 0.7 points to the increase. The following items accounted for the remainder of the increase: $2.7 million associated with responding to governmental investigations concerning our reinsurance agreements (0.4 points), increased consulting related to Sarbanes Oxley and technology initiatives (0.5 points), and increased software expenses (0.3 points).
Net Written Premium. Net written premium increased by 40.0% to $369.0 million for the twelve months ended December 31, 2004 from $263.0 million for the comparable period of 2003. The larger increase in net written premium as compared to gross written premium was due to a decrease in the percentage of premiums ceded under our quota share reinsurance agreement from 60% in 2003 to 50% in 2004. As of January 2006, all of the material reinsurance agreements to which we had been a party had been terminated and commuted, and the reinsurers had been released from all future liabilities under the agreements. See “Business - Reinsurance” above.
Net Earned Premium. Net earned premium increased by 18.7% to $325.3 million for the twelve months ended December 31, 2004 from $274.0 million for the comparable period of 2003. Gross earned premium was up by 13.4% and our premium retention increased from 44.7% to 46.7% as a result of the reduction in the ceding percentage under our quota share reinsurance agreement. We had a quota share reinsurance agreement in 2004 under which we ceded 50% of 2004 policy premium; for 2003, we had a quota share reinsurance agreement under which we ceded 60% of 2003 policy premium.
Net realized gains on securities sales were insignificant for the twelve months ended December 31, 2004 compared to $1.2 million for the twelve months ended December 31, 2003.
Losses and Loss Adjustment Expenses Incurred. Losses and LAE incurred increased to $219.4 million for the twelve months ended December 31, 2004 compared to $199.7 million for the comparable period of 2003. Our loss ratio fell to 67.4% for 2004 from 72.9% for 2003, a decline of 5.5 points (please see Note About Trade Ratios included in Item 6 above).
The following table displays our net incurred losses and LAE for the twelve months ended December 31, 2004 and 2003.
Other Operating and General Expenses. Other operating and general expenses were $31.4 million for the twelve months ended December 31, 2004 compared to $24.2 million for the same period of 2003, an increase of 29.8%. The costs of being a public company added approximately $4.0 million, including an increase of $1.9 million in our insurance premiums for errors and omissions and directors’ and officers’ liability coverage. Depreciation increased by $1.7 million and bank fees related principally to premium collections increased by $1.0 million.
Litigation Expense. For the twelve months ended December 31, 2003, our consolidated statement of operations included a charge in the amount of $13.8 million before tax related to two coordinated class actions that alleged, among other things, improper cancellations of our insurance. See “Note 9. Commitments and Contingencies - Litigation” to the Consolidated Financial Statements. Our 2003 consolidated statement of operations also included a charge in the amount of $3.6 million before tax for a separate class action lawsuit that alleged, among other things, improper classification of our claims adjusters, which increased the overall charge to $17.9 million. As of December 8, 2003, all claimants in that suit had settled. We recorded no litigation expenses for the twelve months ended December 31, 2004 related to these class action lawsuits.
Income Taxes. Income taxes for the twelve months ended December 31, 2004 were $34.8 million, or 36.25% of income before income taxes. Our effective tax rate of 36.25% for 2004 comprised 34% federal income taxes and 2.25% state income taxes. Income taxes for the twelve months ended December 31, 2003 were $20.5 million, or
In February 2004, we completed a refinancing of our secured credit facility, which had an outstanding balance of $71.5 million at the time of the refinancing. This bank agreement ("Bank Agreement") consists of: (1) a $50 million Secured Revolving Credit Facility, which includes up to $15 million for letters of credit and matures in 2009, (2) a $35 million Term A Loan, which matures in 2010, and (3) a $40 million Term B Loan, which matures in 2011. The variable interest rate on borrowings under the Bank Agreement is LIBOR plus a margin (1.0% to 2.25%), which is determined based on our consolidated total debt to consolidated total capitalization ratio, as defined in the Bank Agreement. We also pay certain commitment fees. The Bank Agreement is secured by a pledge of stock of certain of our subsidiaries. The Bank Agreement requires compliance with certain financial loan covenants related to leverage and debt service coverage. As of and for the twelve-month period ended December 31, 2005, we were in compliance with all such covenants.
Net purchases of investments, primarily fixed income securities, were $181.8 million, $146.4 million and $13.2 million for the years ended December 31, 2005, 2004 and 2003, respectively. The increase in investment purchases from 2003 to 2004 was due to the investment of proceeds from our initial public offering that we completed in February 2004. Property, software and equipment additions were $8.0 million, $11.0 million, and $6.7 million for the years ended December 31, 2005, 2004 and 2003, respectively. Capital expenditures during 2005 and 2004 were predominantly for computer equipment and software.
The termination and commutation resulted in significant increases/(decreases) in certain balance sheet accounts in 2005, as follows (in thousands):
In December 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 123, Share-Based Payments (revised 2004), (“SFAS No. 123R”). This statement eliminates the option to apply the intrinsic value measurement provisions of APB No. 25 to stock compensation awards issued to employees. Rather, SFAS No. 123R requires companies to measure the cost of employee services received in exchange for an award of equity instruments based on the grant date fair value of the award. That cost will be recognized over the period during which an employee is required to provide services in exchange for the award - the requisite service period (usually
Includes principal repayments only. We have not included future interest expense because the interest rate is tied to LIBOR and is variable. The effective interest rate as of December 31, 2005 was 6.0%.