We lease an aggregate of approximately 317,000 square feet of office space in numerous cities throughout the United States. Our most significant leased office spaces are located in Davie, Florida with approximately 100,000 square feet; Independence, Ohio with approximately 60,000 square feet; Orange, California with approximately 39,000 square feet; Phoenix, Arizona with approximately 24,000 square feet; and Centennial, Colorado with approximately 29,000 square feet. During 2006, we terminated the lease for a storage facility in Dania, Florida with approximately 10,000 square feet. We also opened an office in Southfield, Michigan with square footage of approximately 1,700 and expanded the existing office in North Charleston, South Carolina by approximately 1,500 square feet.
The following table presents our historical financial and operating data as of the dates or for the periods indicated. We derived the data as of and for each of the five years ended December 31, 2006 from our audited consolidated financial statements. The results of operations for past accounting periods are not necessarily indicative of the results to be expected for any future accounting periods. You should read this summary in conjunction with “
We have derived the following discussion and analysis of the results of operations for the three years ended December 31, 2006, and our financial condition as of each year-end, from the consolidated financial statements included elsewhere in this document. You should read this discussion and analysis in conjunction with such financial statements.
other income, which primarily represents commission income we earn for producing insurance policies written by an unrelated policy issuing county mutual insurance company in Texas, which policies we reinsure through a quota share reinsurance agreement.
On March 1, 2007, we entered into a Merger Agreement with Farmers Group, Inc. pursuant to which BWH Acquisition Company, a wholly owned subsidiary of Farmers (“Merger Sub”), will be merged with and into the Company, with the Company continuing as the surviving corporation and becoming a wholly-owned subsidiary of Farmers. Pursuant to the Merger Agreement, at the effective time and as a result of the Merger, each then outstanding share (each a “Share”) of Common Stock, including restricted stock (which vests upon a change in control), will be cancelled and converted into the right to receive $22.50 in cash per Share, without interest (the “Merger Consideration”). Each share of Common Stock that is subject to a then outstanding option and warrant that is vested or vests upon a change in control will be converted into the right to receive the Merger Consideration less the exercise price per Share for the option and warrant. Each Phantom Share under our Non-Employee Directors’ Plan also will be converted into the right to receive the Merger Consideration. Consummation of the Merger is subject to various customary closing conditions, including, but not limited to, (1) the expiration or termination of applicable waiting periods under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, (2) all insurance antitrust approvals and regulatory approvals from certain insurance departments, (3) absence of certain orders preventing the Merger, and (4) the approval of the Merger Agreement by our stockholders. We currently expect the Merger to close before the end of 2007.
We continuously monitor the profitability of our business at a highly detailed level. We seek rate changes based on indicated profitability related to our targets. We believe we can continue to improve our product structure by filing class plan changes that lower rates for certain market segments that produce favorable results relative to our average in a given state and raise rates for other poorer performing segments. We modified rates 64 times in 2006. Eighteen of such modifications were increases, 19 were revenue neutral, 14 were decreases, and 13 were new product introductions. The overall effect of these modifications was an increase to our overall rate level by 1.1%.
In the aggregate, we utilized point-of-sale underwriting to process over 99% of our new business applications in 2006. We have fully deployed OneStep, our browser-based point-of-sale underwriting system, in 12 states for both new business and endorsements.
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 (increases in premiums after issuance) 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, in certain cases, the policy declaration page, once the verifications are complete, usually within minutes.
Overall, average daily new business production in 2006 was stable compared to 2005 with less than 1% growth. However, average daily new business production began to improve significantly in the fourth quarter of 2006 with 23% growth compared to the fourth quarter of 2005. For the month of January 2007, we continued to see growth in average daily new business production, which increased 33% compared to January 2006 and 17% compared to the quarter ended December 31, 2006. Growth in new business is one component of gross written premium. Other components include renewal premium, rewrite premium, and positive endorsement premium, which increase our written premium, as well as cancellations, negative endorsement premium, and non-renewals, which reduce our written premium. The performance of these other components relative to prior periods, known as persistency, has a significant impact on our written and earned premium. In addition, new business production is a policy count metric. Average premium per policy also plays a large role in determining gross written premium. As an example, in California, we write predominantly twelve-month policies, which have twice the average premium of a six-month policy. An increase in twelve-month policies, or any higher average premium policy, would increase gross written premium, and a move to six-month polices, which we predominantly write in states other than California, would depress gross written premium, all other factors being equal.
We continue to emphasize productivity and efficiency by closely managing our staffing levels in relation to transaction volume in our claims and policy service divisions. At December 31, 2006, our staff count was 1,154 compared to 1,164 at September 30, 2006 and 1,213 at December 31, 2005. We employ various metrics to evaluate service performance so that we may ensure that service levels are meeting or exceeding our benchmarks.
Market conditions in the states in which we operate are competitive to varying degrees. We monitor the rate and underwriting activity of the other market participants in each state in which we do business. During the fourth quarter of 2006, we tracked 322 rate revisions by companies we monitor as detailed in the table below.
In California, gross written premium declined by 14% in 2006 and by 30% in 2005 due to continued competitive market conditions in this state. In our other states, in the aggregate, our gross written premium grew by 10% in 2006 and by 4% in 2005. While our competitors’ rates, as filed, remain stable, some have relaxed underwriting standards by not verifying miles driven, driving experience, or other underwriting information, which can significantly affect policy premiums. This practice has resulted in lower policy premiums for some drivers, making it more difficult for companies not engaging in such practices to attract new customers and retain those that seek alternative quotes at renewal. We have not relaxed our underwriting standards and do not intend to do so in the future. Recent California regulations require auto insurers to implement procedures to verify annual mileage.
In Texas, gross written premium grew by 38% in 2006 and by 35% in 2005. In June 2006, we introduced our Select 2.0 product in Texas. (See “Overview - Products and Services” above.) The new product has been well received, as much of the premium growth in 2006 came in the latter half of the year.
In South Carolina, gross written premium grew by 43% in 2006 and by 16% in 2005. We introduced our Select 2.0 product in South Carolina in September 2006. (See “Overview - Products and Services” above.) Since we introduced this product, we have seen an increase in the growth rate of our premium writings in this state.
(1) Amount represents the unearned premium previously ceded under our 2005 quota share resinsurance agreement, which we received as a result of the termination and commutation of this agreement.
Gross Written Premium. Gross written premium declined to $595.0 million for the twelve months ended December 31, 2006, or by 4%, compared to $617.9 million for 2005. The decline in gross written premium emanated primarily from California where written premium fell by $37.9 million, or 14%, for the twelve months ended December 31, 2006 compared to 2005. Our gross written premium in the other states in which we do business was higher in the aggregate by 10% for the twelve months ended December 31, 2006 compared to 2005. We provide for expected policy cancellations in order to adjust written premium to amounts we expect to ultimately collect and earn. (See “Operating Results - Key States” above.) We reduced the provision by $1.9 million in 2006, which added less than 1% to our reported gross written premium, and by $18.9 million in 2005, which added 3% to our reported gross written premium.
Net Written Premium. Net written premium declined by 8% to $604.0 million for the twelve months ended December 31, 2006 from $653.1 million for 2005. The decrease resulted primarily from the termination of quota share reinsurance agreements during the first quarters of both 2006 and 2005. Upon termination of the quota share reinsurance agreements, we “recaptured” the previously ceded unearned premium, which added to our net written premium. We recaptured $18.3 million in the first quarter of 2006 compared to $106.3 million in the first quarter of 2005, a decrease of $88.0 million. In addition, net written premium for the twelve months ended December 31, 2005 was reduced by $60.8 million ceded premium pursuant to a 10% quota share reinsurance agreement in place during that time. We had no quota share reinsurance agreement in effect during 2006.
Net Investment Income and Realized Gains and Losses on Investments. Net investment income increased by 25% to $21.5 million for the twelve months ended December 31, 2006 compared to $17.2 million for 2005. The tax equivalent book yield of our fixed maturity portfolio increased to 4.96% at December 31, 2006 from 4.52% at December 31, 2005. For the twelve-month period, approximately $2.4 million of the increase in net investment income was due to the larger size of the investment portfolio, and approximately $1.9 million related to a higher investment portfolio yield.
Net realized gains and losses on securities sales were insignificant for the twelve months ended December 31, 2006 and 2005.
Losses and LAE Incurred. Losses and LAE incurred declined to $394.1 million for the twelve months ended December 31, 2006 compared to $394.6 million for 2005. Our loss ratio increased by 1.5 points to 67.8% for 2006 from 66.3% for 2005.
The following table displays our incurred losses and 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).
The increase in the loss ratio was primarily attributable to an increase in adverse development on loss and LAE reserves for prior years, which was $5.3 million in 2006 compared to an insignificant amount in 2005, or 0.9 points of the increase. Adverse development occurs when loss and LAE reserves established for accidents that took place in years prior to the current year prove to be inadequate and management increases those reserves to reflect the revised estimate of the ultimate losses related to such accidents. Such increases result in a charge to loss and LAE incurred in the current year. The remainder of the increase in the loss ratio is attributed to a 0.6 point increase in the current accident year loss ratio, which is principally due to an increase in our LAE ratio. The LAE ratio has increased as premium volume has declined because a portion of our claims department’s costs are fixed or semi-fixed and cannot be adjusted immediately in response to changes in volume.
Commissions and Other Underwriting Expenses. Commissions and other underwriting expenses declined to $152.8 million for the twelve months ended December 31, 2006 compared to $154.0 million for 2005. 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.
Commissions and other underwriting expenses for the twelve months ended December 31, 2005 were reduced by ceding commission income of $12.3 million pursuant to a 10% quota share reinsurance agreement. We had no quota share reinsurance agreement in effect during 2006. Commissions and other underwriting expenses, excluding the effect of reinsurance, declined by 8% to $152.7 million from $166.3 million for the twelve months ended December 31, 2006 compared to 2005, which is consistent with the decline in gross earned premium of 9% for the same period.
Income Taxes. Income taxes for the twelve months ended December 31, 2006 were $22.1 million, or 34.4% of income before income taxes. This effective tax rate of 34.4% comprises 31.78% federal income taxes and 2.62% state income taxes. Income taxes for the twelve months ended December 31, 2005 were $29.7 million, or 35.17% of income before income taxes. This effective tax rate of 35.17% comprises 33.55% federal income taxes and 1.62% state income taxes.
Our combined ratio was 91.4% for the twelve months ended December 31, 2006 compared to 88.0% for 2005, an increase of 3.4 points. For the twelve-month period, the loss ratio increased 1.5 points (see “Losses and LAE Incurred” above) and the expense ratio increased 1.9 points. Approximately 2.1 points of the increase in the expense ratio was attributed to the absence of ceding commission income for the twelve months ended December 31, 2006 compared to 2005. In addition, 0.9 points of the increase in the expense ratio was due to lower fee and other income during the twelve months ended December 31, 2006 compared to 2005. These increases in the expense ratio were mitigated by a decrease in the direct commission ratio of 1.0 points.
Twelve Months Ended December 31, 2005 compared to Twelve Months Ended December 31, 2004
Gross Written Premium. Gross written premium decreased to $617.9 million for the twelve months ended December 31, 2005, or by 18%, compared to $752.9 million for 2004. The decline in gross written premium emanated primarily from California where written premium declined by 30% for the year. Generally, we observed increasingly competitive conditions during 2005 in the states where we did business. Because we exercised underwriting and pricing discipline, we saw our volume of business decline in several states, most notably, California and Florida, and grow more slowly in many other states compared to 2004. We provide for expected policy cancellations in order to adjust written premium to amounts we expect to ultimately collect and earn. (See “Operating Results - Key States” above.) During 2005, we reduced the provision by $18.9 million, which added 3% to our reported gross written premium for the 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 2004 business and $106.3 million was 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.
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 was the decline in our average policies in force. As noted above, the ratio of fees to gross earned premium 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 was due to a 30% decline in 2005 gross written premium in California where the level of fees charged has been greater related to premiums than in the other states in which we operate. While approximately 20% of new business was written on electronic funds transfer (“EFT”) payment plans in the last quarter of 2005, and we charged approximately 50% lower installment fees on installments paid by EFT, this was not a significant factor in the lower fee ratio for the full year, accounting for less than 25%, or 0.25 points, of the decline.
The decline in the loss ratio was primarily attributable to a reduction in adverse development on loss and LAE reserves for prior years, which was an insignificant amount in 2005 down from $2.5 million in 2004, or 0.8 points of the improvement. The remainder of the decrease in the loss ratio was due to a 0.3 point improvement in our claims experience for accident year 2005 compared to 2004. This improvement occurred despite $2.5 million of pre-tax losses related to Hurricanes Katrina, Rita and Wilma during the twelve months ended December 31, 2005 compared to $1.0 million of pre-tax losses related to Hurricanes Charley, Frances, Ivan and Jeanne during the twelve months ended December 31, 2004.
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 was 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. The premium tax rate was little changed between years.
Other Operating and General Expenses. Other operating and general expenses were $38.1 million for the twelve months ended December 31, 2005 compared to $31.4 million for the same period of 2004, an increase of $6.7 million. Costs associated with governmental investigations concerning our reinsurance agreements added $2.7 million before taxes during the twelve months ended December 31, 2005. Consulting, audit fees and regulatory examination fees increased by $3.5 million. Of this amount, Sarbanes-Oxley compliance accounted for approximately $1.8 million. Additionally, depreciation expense, principally related to enterprise software, was also $0.6 million higher during the twelve months ended December 31, 2005 than in the comparable period of 2004.
Interest Expense. Interest expense was $4.2 million for the twelve months ended December 31, 2005 compared to $3.0 million for the same period of 2004. Interest incurred pertains to debt we incurred pursuant to our credit facility, which we refinanced on February 18, 2004. The aggregate weighted average interest rate was 5.0% during the twelve months ended December 31, 2005 compared to 3.2% during the same period of 2004. The rate we paid on our debt under this credit facility was variable and tied to LIBOR. The average LIBOR rate was higher during the twelve months ended December 31, 2005 than in the comparable period of 2004. As of December 31, 2005, we had $69.9 million of outstanding debt compared to $73.4 million at December 31, 2004.
Our gross combined ratio for the twelve months ended December 31, 2005 was 88.2% compared to 84.6% for the same period of 2004. Our gross loss ratio was up 0.2 points to 66.7% for the twelve months ended December 31, 2005 compared to 66.5% for the comparable period of 2004. Our gross loss ratio, exclusive of $2.5 million of losses associated with Hurricanes Katrina, Rita, and Wilma in 2005 and $1.0 million of losses associated with Hurricanes Charley, Frances, Ivan, and Jeanne in 2004, was 66.4% for both 2005 and 2004.
We used a part of the proceeds of the term loan portion of the Senior Credit Facility to repay the remaining $68.0 million outstanding on the two pre-existing term loans. We contributed $25 million of the proceeds to our insurance subsidiaries as noted above. We have used the remaining $7 million of proceeds for general corporate purposes. Because we repaid the pre-existing term loans, we incurred a non-recurring non-cash pre-tax charge of $1.3 million for the write-off of deferred financing costs for the replaced facility. We have no immediate plans to take down any funding under the $25 million revolving credit portion of the Senior Credit Facility. The Merger Agreement with Farmers provides that, without Farmers’ prior written consent, we cannot incur additional indebtedness other than borrowings in the ordinary course under the Senior Credit Facility.
We have formed a new insurance subsidiary, Bristol West Preferred Insurance Company. We incorporated the new company on September 7, 2006, and capitalized it with $10 million. The new company is domiciled in Michigan, and it will only write Michigan business. This structure will provide certain advantages to us relative to potential exposures to claims for accidents occurring within the State of Michigan, as well as some premium tax savings.
Effective September 27, 2006, we re-domiciled Bristol West Casualty Insurance Company to Ohio from Pennsylvania. We employ a significant number of people in Ohio and have a greater presence there than in Pennsylvania. In addition, Bristol West Insurance Company, another of our insurance subsidiaries, is domiciled in Ohio. We anticipate that the re-domiciliation will provide us with some operating economies, as well as some premium tax savings.
On October 28, 2005, our Board of Directors authorized the repurchase of $20 million of our outstanding Common Stock. We completed this repurchase program during the year ended December 31, 2006 with the repurchase of 1,117,277 shares of our Common Stock at a cost of $19.0 million, or an average cost of $17.05 per share. During this repurchase program, we repurchased a total of 1,168,377 shares of our Common Stock at a total cost of $20 million, or an average cost of $17.11 per share. Under the Merger Agreement with Farmers, without Farmer’s prior written consent, we are not permitted to redeem or purchase our Common Stock other than in connection with the withholding of, or purchase of, shares of Common Stock to settle the exercise price of options and warrants and to reimburse us for withholding taxes that we may pay upon the exercise of options and the vesting of restricted stock under our 1998 Plan and our 2004 Plan.
On March 24, 2006, in connection with the exercise by Firemark Partners LLC (“Firemark”) of its vested options to purchase 110,823 shares of our Common Stock, Firemark used 22,662 of the shares of Common Stock subject to its option to settle the exercise price of $0.4 million for these options. We calculated the number of shares of Common Stock subject to Firemark’s option that we used to settle the exercise price using the last reported closing price per share of our Common Stock, as reported on the NYSE on the date of exercise ($18.73 on March 24, 2006).
We elected to terminate and commute our 2005 quota share reinsurance agreement on a cut-off basis effective January 1, 2006. The termination and commutation resulted in the reinsurer’s release from all future liability and settlement of the net balance due us of $11.0 million on January 31, 2006. We have invested these monies in high-quality fixed income securities.
The termination and commutation resulted in significant increases/(decreases) in certain balance sheet accounts in 2006, as follows (in thousands):
We have concluded that we no longer need quota share reinsurance because we have sufficient surplus to support our anticipated gross and net premium writings.
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, 2006 was 6.4%.
This table does not reflect any potential impact of the closing of the Merger.
As of December 31, 2006, we had $239.2 million of gross loss and LAE reserves, which represented our best estimate of ultimate losses and LAE. Our management believes the provision for unpaid losses and LAE is adequate to cover the ultimate cost of losses and LAE incurred to date. In 2006, we experienced $5.3 million of adverse development on loss and LAE reserves that we established at December 31, 2005. The increase in reserves for prior accident years was driven by a variety of factors, including higher than expected claim severity (dollars of loss per claim) in Michigan Personal Injury Protection claims, greater than expected litigation costs in Florida, and higher than expected claim severity in California, which includes a California extra-contractual claim verdict of $430,000.
For a discussion of the development of our loss and LAE reserves, net of reinsurance, for the calendar years 1996 through 2006, see “Item 1. Business - Loss and Loss Adjustment Expense Reserve Development.”
Establishing Loss and LAE Reserve Estimates. Quarterly, for each financial reporting date, we record our best estimate, which is a point estimate, of our overall reserve for both current and prior accident years of the remaining amounts that we expect to pay for all covered losses that occurred through the financial statement date and for all claim settlement expenses. The overall loss and LAE reserve estimate is the difference between (1) the sum of point estimates of ultimate loss and ultimate LAE, and (2) losses and LAE paid to date. The point estimates of ultimate loss consist of point estimates for case loss reserves and point estimates for IBNR losses. The point estimates of ultimate LAE consist of point estimates for adjusting and other expenses (“A&O”) and for defense and cost containment expenses (“DCC”). At December 31, 2006, our gross loss and LAE reserves were allocated approximately as follows: case loss reserves 63%, IBNR 21%, DCC 13%, and A&O 3%.
We use different processes to determine point estimates for case loss reserves and point estimates for IBNR losses and ultimate LAE. For reported claims where the claims adjuster believes that the settlement amount will be $50,000 or more, we establish a point estimate of case loss reserves for each claim based on the known facts regarding the claim, the parameters of the coverage that our policy provides and the experience and knowledge of claims staff regarding the nature and potential cost of each claim. We adjust these case loss reserve estimates as additional information becomes available to us. For reported claims where the claims adjuster believes that the settlement amount will be less than $50,000, we apply a system generated case loss reserve that varies by state, program and coverage and the length of time elapsed since the accident date. Using the actuarial methodologies described in the following paragraphs, we estimate additional amounts that may be required to meet the ultimate cost of these known claims. We reduce all case loss reserves as we make payments for reported claims. For coverage where partial payments are frequent, particularly PIP, we apply the partial payment to reduce the system generated case loss reserve and at the same time the adjuster may further manually reset the reserve. Our actuarial staff estimates IBNR losses and ultimate LAE quarterly using detailed statistical analyses and professional judgment after careful consideration of internal and external variables that may affect the resulting reserves. Because these underlying processes require the use of estimates and informed judgment, establishing loss and LAE reserves is an inherently uncertain and complex process.
We employ various statistical processes to estimate IBNR losses and ultimate LAE. Our actuarial staff performs quarterly analyses on approximately 150 homogenous data subsets that they expect to produce the most accurate estimates. We analyze the data separately (1) for each of the 22 states in which we write business, (2) for each type of coverage group written (for example, we analyze collision claims separately from bodily injury claims), (3) by the program in which the business is written (in some states, we have multiple programs where we use different structures to develop a premium rate, different policy limits and other policy attributes and that include, at times, different case loss reserves) and (4) by accident quarter. We perform these analyses for subsets of data rather than at an aggregated company level because it is important that there be homogeneity in the type of claims for which we are developing a best estimate of the liability. For example, the ratio of the number of claims closed with payment to the projected number of ultimate claims, when considered for a subset of homogenous data, does provide insight into the consistency of the rate of claim settlement over time for that data subset. Our actuarial staff estimates IBNR losses and LAE quarterly using up to 40 accident quarters depending on the applicable state, program and coverage group. These actuarial analyses generally estimate IBNR losses and LAE for each data subset gross of ceded reinsurance. We then apply the ceded reinsurance terms to the overall gross loss and LAE estimates to determine the ceded amounts that we apply to establish loss and LAE reserve estimates net of reinsurance.
Incurred development methods, like paid development methods, assume that the ratio of losses or LAE in one period to losses in an earlier period will be consistent over time. However, instead of using paid losses, incurred development methods use incurred losses (i.e., the sum of cumulative historical loss payments plus outstanding case loss reserves) over discrete periods of time to estimate future losses. Incurred development methods can be preferable to paid development methods because they explicitly take into account open cases and the evaluations of the cost to settle these cases. Since these methods use more data than paid development methods, the incurred development patterns may be less variable than paid patterns. However, incurred development methods necessarily assume that case loss reserving practices are consistently applied over time. Therefore, when there have been significant changes in how case loss reserves are established, using incurred data to project ultimate losses can be less reliable than other methods. Selection of the incurred development pattern requires analysis of the same factors analyzed for the paid development method. We typically apply incurred development methods to estimate incurred pure losses.
Bornhuetter-Ferguson incurred development methods are similar to the Bornhuetter-Ferguson paid development methods except that they use case incurred losses. The use of case incurred losses instead of paid losses can result in development patterns that are less variable than paid patterns. However, the inclusion of case loss reserves can lead to distortions if changes in case loss reserving have taken place and the analysis is not adjusted to account for the changes. These methods require analysis of all the factors that need to be reviewed for the expected loss ratio and incurred development methods. We typically apply Bornhuetter-Ferguson incurred development methods to estimate incurred pure losses and salvage and subrogation recoveries.
The run-off A&O method projects the number of claims adjusters, appraisers and managers necessary to run off the inventory of claims at year end given the volume of claims and the necessary infrastructure. This method utilizes the claim count projections from the loss and DCC reserve estimates and develops an estimate of ultimate A&O consisting of the staffing and other overhead costs necessary to support the projected levels of claim activity.
The historical information regarding claim frequency (ratio of the number of claims reported to the number of insured vehicles)
These key assumptions are themselves based on underlying assumptions regarding numerous internal and external factors, which often vary for different states, programs and coverage groups, for different accident periods and for different actuarial estimation methodologies. Internal factors include, but are not limited to, changes in product mix, changes in claims-handling practices, underwriting standards and rules, and loss cost trends. External factors include, but are not limited to, claim severity, claim frequency, inflation in costs to repair or replace damaged property, inflation in the cost of medical services, legislative activities, regulatory changes, judicial changes, and litigation trends.
Our actuarial staff selects one or more actuarial estimation methodologies to review for each data subset depending on the applicable state, program, coverage group and accident quarter as well as emerging issues relating to each. Our actuarial staff relies heavily on historical loss experience when determining loss reserve levels on the assumption that past loss experience is a good indicator of future loss experience. They most frequently utilize incurred development methods and Bornhuetter-Ferguson incurred development methods to estimate losses. Because historical DCC data is not as well developed, our actuarial staff most frequently uses a Bornhuetter-Ferguson paid development method to estimate DCC reserves.
In most cases, use of multiple methodologies produces a cluster of estimates with modest dispersion in the indicated possible outcomes. In a few cases, however, use of multiple methodologies produces conflicting results and wider bands of indicated possible outcomes. However, such bands do not necessarily constitute a range of outcomes, nor do management or our actuaries calculate a range of outcomes. If there is a significant variation in the results generated by different actuarial methodologies, our actuarial staff further analyzes the data using additional techniques. These processes could include analyzing individual claims to determine which method has the greatest credibility in order to establish the best estimate, making adjustments to the key assumptions underlying the methodologies, or using additional generally accepted actuarial estimation methodologies.
In order to provide an indication of the potential variability of our loss and LAE reserves, we have considered various alternatives for disclosing the effect that reasonably likely changes in the key assumptions underlying our loss and LAE reserves may have on our net income. Sensitivity analysis based on an evaluation of historical changes in key assumptions underlying loss and LAE reserves can provide an indication of the potential variability of the reserves. However, as we discuss in more detail below, we made the following conclusions:
It would not be cost effective for us to produce meaningful sensitivity analyses of the reasonably likely changes in the key assumptions underlying our aggregate loss and LAE reserves based on aggregated independent data relating to each such key assumption underlying each point estimate in each data subset. See the discussion below under the heading “Aggregated Company Data Analysis.”
We concluded that the only meaningful alternative for such sensitivity analysis that is available to management on a cost effective basis is a sensitivity analysis of potential variability in our loss and LAE reserves based on an evaluation of our historical loss and LAE reserve development. We describe this sensitivity analysis below under the heading “Loss and LAE Development Analysis.”
Data Subset Analysis. We concluded that it would not be meaningful for us to provide an indication of the potential variability of our aggregate loss and LAE reserves by disclosing separate sensitivity analyses indicating the potential variability of each significant point estimate in each data subset based on an evaluation of historical changes in the underlying key assumptions for each such point estimate.
for purposes of estimating our loss and LAE reserves, we assume that there is consistency or a discernable trend in the following:
The historical information regarding loss severity (dollars of loss per claim)
enhance our IT systems to house such a model and import into the model relevant data regarding each data subset that we currently collect in Excel spreadsheets;
determine the supplemental data that would be necessary to fully address the consistencies and trends on which our key assumptions and related underlying assumptions are based and to acquire and input such supplemental data;
expand the computing power of our IT systems to support the operation of such a stochastic model;
Any such stochastic model would need to determine, for each of over 150 data subsets covering different states, coverage groups, programs, and accident quarters, all probable changes in each of our key assumptions as well as in certain assumptions underlying the key assumptions. The model would then need to assign a reasonable probability to each outcome. After the model determined the probable outcomes and assigned probabilities to various assumptions in each data subset, it would need to estimate the impact of each of the various outcomes by performing simulations that utilize Monte Carlo computational algorithms. Monte Carlo simulations provide approximate solutions to mathematical problems by performing complex statistical sampling experiments on a computer. A Monte Carlo analysis of the relevant data would likely require hundreds of thousands, if not millions, of iterations. Monte Carlo algorithms can be expensive to construct and use, particularly if each simulation is to be performed relatively quickly. Also, the individuals with the specific expertise necessary to construct a stochastic model based on Monte Carlo simulations would be expensive to engage.
Further, we would need to make changes to the structure of our IT systems in order to be able to use a stochastic model to perform such macro analyses. The structure of our IT systems limits our ability to implement a stochastic model that performs such simultaneous simulations. Such a model would require an inordinate amount of time to perform the required iterations, given the recalculation time of our loss reserve spreadsheets. In addition, macro analysis of the impact of any key assumption would require the reserve spreadsheets for all related data subsets to be open simultaneously, which is currently impossible based on the size of the spreadsheets and the structure of our IT systems.
We estimate that the costs we would incur to take these necessary actions to construct a stochastic model and annually perform such macro sensitivity analyses would be material. From a cost-benefit perspective, we cannot justify these incremental costs. We do not currently anticipate that such a model or such sensitivity analyses would provide any significant benefits to our actuarial staff in estimating loss and LAE reserves or to our product staff in establishing premium levels or structures in any of the states in which we write business. Accordingly, we determined that such incremental costs would materially outweigh any such benefits that our business (and, as a result, our stockholders) would derive from such analyses.
Based on the historical loss and LAE reserve development recorded in our financial statements over the 10 and three year periods reflected below, our loss and LAE reserves at December 31, 2007, gross of all reinsurance except for loss and LAE ceded to MCCA, could ultimately vary from the loss and LAE reserves at December 31, 2006, gross of all reinsurance except for loss and LAE ceded to MCCA, as follows:
See “Item 1. Business - Loss and Loss Adjustment Expense Reserves Development.” We believe that the historical loss and LAE experience for this period may not provide the most appropriate illustration of future loss and LAE experience because of disproportionately high adverse development in certain years, particularly 2000 and 2001. The adverse development in our reserves for losses and LAE for 1999 (17%), 2000 (52%), 2001 (38%) and 2002 (21%) is due to a number of factors. Our reorganization of our claims department in 2000 resulted in an unanticipated increase in the average cost per closed claim and the number of claims primarily in California and Florida in 2000, 2001 and 2002. In addition, rate reductions in California between June 1998 and July 1999 and a poorly structured and priced product in Texas that we began offering in the first quarter of 1999 and discontinued in August 2002 also led to unfavorable development in reserves for unpaid losses and LAE.
See “Item 1. Business - Loss and Loss Adjustment Expense Reserves Development.” Because of changes we made in our actuarial department and to our systems and processes starting in 2003, we believe that the historical loss and LAE development experience for this period may provide a more appropriate illustration of potential loss and LAE development variability. However, the statistical sample is significantly smaller. In April 2003, with respect to each of the key assumptions underlying our loss and LAE reserve estimates, our actuarial staff started tracking the emergence of loss and LAE data by state, program, coverage group and accident quarter on a daily basis. We analyze this data using a browser-based reporting tool that compares the actual emergence of losses and LAE relative to the expected emergence over time. We use detailed mathematical models, which we continuously refine, to reduce the variability of our estimates of loss and LAE reserves. In August 2003, we deployed an Oracle-based data warehouse, which improves our actuarial staff’s ability to evaluate loss and LAE emergence relative to our expectations regarding loss and LAE reserves for the prior quarter. Our actuarial staff revises, as appropriate, the assumptions that they use to develop loss and LAE reserve estimates for the current quarter based upon actual loss and LAE emergence relative to our expectations as reflected in the reserve estimate for the prior quarter.
to estimate the risk of adverse or favorable development in such reserves; or
In June 2006, the FASB issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (“FIN 48”), an interpretation of SFAS No. 109, “Accounting for Income Taxes” (“SFAS 109”). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with SFAS 109. FIN 48 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 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, and disclosure.
In February 2006, the FASB issued SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments,” (“SFAS 155”), which amends portions of SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activity,” and SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.” SFAS 155 provides guidance for accounting for certain securities with embedded derivative instruments and was effective for financial instruments issued or acquired after an entity’s first fiscal year that begins after September 15, 2006. We do not expect that adoption of this statement as of January 1, 2007 will have a material effect on our Consolidated Financial Statements.
In September 2005, the AICPA issued Statement of Position 05-1, “Accounting by Insurance Enterprises for Deferred Acquisition Costs in connection with Modifications or Exchanges of Insurance Contracts” (“SOP 05-1”). SOP 05-1 provides guidance to insurance entities that incur deferred acquisition costs on internal replacements of insurance and investment contracts other than those specifically described in SFAS No. 97, “Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments.” SOP 05-1 defines internal replacements as modifications in product benefits, features, rights, or coverages that occur by the exchange of a contract for a new contract, or by amendment, endorsement, or rider to a contract, or by the election of a feature or coverage with a contract. The accounting treatment for such replacements depends on whether, under the provisions of SOP 05-1, the replacement contract is considered substantially changed from the replaced contract. A substantial change would be treated as the extinguishment of the replaced contract, and all unamortized deferred acquisition costs, unearned revenue liabilities, and deferred sales inducement assets from the replaced contract would no longer be deferred in connection with the replacement contract. A replacement contract that is substantially unchanged should be accounted for as a continuation of the original contract. SOP 05-1 will be effective for internal replacements occurring in fiscal years beginning after December 15, 2006, with earlier adoption encouraged. Adoption of SOP 05-1 as of January 1, 2006 did not have a material effect on our Consolidated Financial Statements.