The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and related notes included elsewhere in this Annual Report on Form 10-K. This Form 10-K contains certain forward-looking statements that are intended to be covered by the safe harbors created by The Private Securities Litigation Reform Act of 1995. See “Note on Forward-Looking Statements.”
We are a multinational specialty property and casualty insurer focused on generating consistent underwriting profits. We provide insurance coverage for small businesses and products with high volumes of insureds and loss profiles that we believe are predictable. We target lines of insurance that we believe generally are underserved by the market. We have grown by hiring teams of underwriters with expertise in our specialty lines, through acquisitions of companies and assets that, in each case, provide access to distribution networks and renewal rights to established books of specialty insurance business. We have operations in four business segments:
circumstances. Our reserves for loss and loss adjustment expenses incurred and unpaid are not discounted using present value factors. Our loss reserves are reviewed at least annually by our external actuaries. Reserves are based on estimates of the most likely ultimate cost of individual claims. These estimates are inherently uncertain. Judgment is required to determine the relevance of our historical experience and industry information under current facts and circumstances. The interpretation of this historical and industry data can be impacted by external forces, principally frequency and severity of future claims, length of time to achieve ultimate settlement of claims, inflation of medical costs and wages, insurance policy coverage interpretations, jury determinations and legislative changes. Accordingly, our reserves may prove to be inadequate to cover our actual losses. If we change our estimates, these changes would be reflected in our results of operations during the period in which they are made, with increases in our reserves resulting in decreases in our earnings.
In December 2012, AHL acquired all the issued and outstanding stock of Inter Re S.A., a Luxembourg domiciled captive insurance company, from USG People. The purchase price of Inter Re S.A. was approximately $40.6 million. We recorded approximately $44.8 million of cash, intangible assets of $8.5 million and a deferred tax liability of $12.7 million. Inter Re S.A. subsequently changed its name to AmTrust Re Epsilon.
In December 2012, AHL acquired all the issued and outstanding stock of Socare S.A., a Luxembourg domiciled captive insurance company, from Cactus S.A. The purchase price of Socare S.A. was approximately $119.3 million. We recorded approximately $130.5 million of cash, intangible assets of $26.2 million and a deferred tax liability of $37.4 million. Socare S.A. subsequently changed its name to AmTrust Re Theta.
In December 2011, AHL acquired all the issued and outstanding stock of Vandermoortele International Reinsurance Company SA, a Luxembourg domiciled captive insurance company, from NV Vandermoortele, Vandemoortele International Finance SA and NV Safinco. The purchase price of Vandermoortele International Reinsurance Company SA was approximately $66 million. We recorded approximately $71.4 million of cash, intangible assets of $10.6 million and a deferred tax liability of $16 million. Vandermoortele International Reinsurance Company SA subsequently changed its name to AmTrust Re Zeta.
In July 2012, we completed the acquisition of CNH Capital Insurance Agency Inc. and CNH Capital Canada Insurance Agency, Ltd., collectively known as "CNH Capital Insurance Agencies," from CNH Capital, the financial services business of CNH Global N.V. The acquisition allows us to enhance and expand CNH Capital Insurance Agencies' offering of equipment extended service contracts and other insurance products to Case IH, Case Construction, New Holland Agriculture and New Holland Construction equipment dealers in the United States and Canada. Additionally, we entered into service and license agreements with CNH Capital whereby we will make future payments based on gross revenues of the CNH Capital Insurance Agencies. In accordance with FASB ASC 805, Business Combinations, we recorded a purchase price of $34 million, which consisted primarily of goodwill and intangible assets of approximately $21.3 million and $19.4 million, respectively. The intangible assets consist of renewal rights and licenses and have asset lives of between 5 and 10 years and are included in our Specialty Risk and Extended Warranty segment. As a result of this transaction, we recorded approximately $10 million of fee income during the year ended December 31, 2012. Additionally, we recorded approximately $30 million of written premium for the year ended December 31, 2012 related to CNH.
In September 2008, we entered into a managing general agency agreement with Cardinal Comp, LLC (“Cardinal Comp”), a workers’ compensation managing general agent for which we paid the agency a commission for the placement of insurance policies. The agency operated in eight states and primarily in the state of New York. In September 2011, one of our subsidiaries entered into a renewal rights and asset purchase agreement with Cardinal Comp and Cook Inlet Alternative Risk LLC. The existing managing general agency agreement entered into in 2008 was terminated as part of the new agreement and will enable us to reduce commissions on written premium generated from the renewal rights agreement. In accordance with FASB ASC 805-10 Business Combinations, we recorded a purchase price of $30.4 million primarily for goodwill and intangible assets consisting of distribution networks, renewal rights and a trademark. The intangible assets have a life of between 2 and 16 years and are included as a component of the Small Commercial Business segment. We recorded approximately $91 million and $84 million of written premium related to Cardinal Comp for the years ended December 31, 2012 and 2011.
In accordance with FASB ASC 944-805 Business Combinations, we are required to adjust to fair value Majestic’s loss and LAE reserves by taking the acquired loss reserves recorded and discounting them based on expected reserve payout patterns using a current risk-free rate of interest. This risk free interest rate is then adjusted based on different cash flow scenarios that use different payout and ultimate reserve assumptions deemed to be reasonably possible based upon the inherent uncertainties present in determining the amount and timing of payment of such reserves. The difference between the acquired loss and LAE reserves and the our best estimate of the fair value of such reserves at acquisition date is amortized ratably over the payout period of the acquired loss and LAE reserves. We determined the fair value of the loss reserves to be $329 million. Accordingly, the amortization will be recorded as an expense on our income statement until fully amortized.
Pursuant to the Amended Stock Purchase Agreement, ACAC issued and sold to us for an initial purchase price of approximately $53 million, which was equal to 25% of the capital initially required by ACAC, 53,054,000 shares of Series A Preferred Stock, which provides an 8% cumulative dividend, is non-redeemable and is convertible, at our option, into 21.25% of the issued and outstanding common stock of ACAC (the “Preferred Stock”). We have pre-emptive rights with respect to any future issuances of securities by ACAC and our conversion rights are subject to customary anti-dilution protections. We have the right to appoint two members of ACAC’s board of directors, which consists of six members. Subject to certain limitations, the board of directors of ACAC may not take any action at a meeting without at least one of our appointees in attendance and ACAC may not take certain corporate actions without the approval of a majority of its board of directors (including both of our appointees).
We, the Trust and Michael Karfunkel, individually, each will be required to make its or his proportionate share of deferred payments payable by ACAC to GMACI pursuant to the GMACI Securities Purchase Agreement, the final payment of which is payable March 1, 2013, to the extent that ACAC is unable to otherwise provide for such payments. Our proportionate share of such deferred payments will not exceed $7.5 million. In addition, in connection with our investment, ACAC granted us a right of first refusal to purchase or to reinsure commercial auto insurance business acquired from GMACI. In February 2013, our obligation for any remaining deferred payment was eliminated.
In accordance with ASC 323-10-15, Investments-Equity Method and Joint Ventures, we account for our investment in ACAC under the equity method. We recorded $9.3 million, $4.9 million and $24.5 million of income during the years ended December 31, 2012, 2011 and 2010, respectively related to our equity investment in ACAC.
We manage the assets of ACAC and its subsidiaries for an annual fee equal to 0.20% of the average aggregate value of the assets under management for the preceding quarter if the average aggregate value for the preceding quarter is $1 billion or less and 0.15% of the average aggregate value of the assets under management for the preceding quarter if the average aggregate value for that quarter is more than $1 billion. We currently manage approximately $730 million of assets as of December 31, 2012 related to this agreement. As a result of this agreement, we earned approximately $1.5 million, $1.6 million and $1.5 million of investment management fees for the years ended December 31, 2012, 2011 and 2010, respectively.
settlement contracts. We have a 50% ownership interest in each of Tiger, AMT Alpha and AMTCH (collectively, the “LSC entities”). The LSC entities may also acquire premium finance loans made in connection with the borrowers’ purchase of life insurance policies that are secured by the policy, which are in default at the time of purchase. The LSC entities acquire the underlying policies through the borrowers’ voluntary surrender of the policy in satisfaction of the loan or foreclosure. A third party serves as the administrator of the Tiger life settlement contract portfolio, for which it receives an annual fee. The third party administrator is eligible to receive a percentage of profits after certain time and performance thresholds have been met. We provide for certain actuarial and finance functions related to the LSC entities. Additionally, in conjunction with our 21.25% ownership percentage of ACAC, we ultimately receive 60.625% of the profits and losses of Tiger and AMT Alpha. As such, in accordance with ASC 810-10, Consolidation, we have been deemed the primary beneficiary and, therefore, consolidate the LSC entities.
Ceding Commission Revenues. Ceding commission is a commission we receive from ceding gross written premium to third party reinsurers. We earn commissions on reinsurance premiums ceded in a manner consistent with the recognition of the direct acquisition costs of the underlying insurance policies, generally on a pro-rata basis over the terms of the policies reinsured. In connection with the Maiden Quota Share, which is our primary source of ceding commission, the amount we receive is a blended rate based on a contractual formula contained in the individual reinsurance agreements, and the rate may not correlate specifically to the cost structure of our individual segments. As such, we allocate earned ceding commissions to our segments based on each segment’s proportionate share of total acquisition costs and other underwriting expenses recognized during the period.
Product warranty registration and service - Our Specialty Risk and Extended Warranty business generates fee revenue for product warranty registration and claims handling services provided to unaffiliated third parties.
Management services - We provide services to insurance consumers, traditional insurers and insurance producers by offering flexible and cost effective alternatives to traditional insurance tools in the form of various risk retention groups and captive management companies, as well as management of workers’ compensation and commercial property programs.
Policy acquisition expenses comprise commissions directly attributable to those agents, wholesalers or brokers that produce premiums written on our behalf. In most instances, we pay commissions based on collected premium, which reduces our credit risk exposure associated with producers in case a policyholder does not pay a premium. We pay state and local taxes, licenses and fees, assessments and contributions to various state guaranty funds based on our premiums or losses in each state. Surcharges that we may be required to charge and collect from insureds in certain jurisdictions are recorded as accrued liabilities, rather than expense.
Premiums. We recognize insurance premiums, other than in our Specialty Risk and Extended Warranty segment, as earned on the straight-line basis over the contract period. Insurance premiums on Specialty Risk and Extended Warranty business are earned based on estimated program coverage periods. We base these estimates on the expected distribution of coverage periods by contract at inception, because a single contract may contain multiple coverage period options, and we revise these estimates based on the actual coverage periods selected by the insured. Unearned premiums represent the portion of premiums written that is applicable to the unexpired term of the contract or policy in force. We base premium adjustments on contracts and audit premiums on estimates made over the contract period. We also estimate an allowance for doubtful accounts based on a percentage of premium. We review our bad debt write-offs at least annually and adjust our premium percentage as required. Allowance for doubtful accounts were approximately $15.0 million and $11.7 million at December 31, 2012 and 2011, respectively.
In the event of a 5% increase in claims frequency as measured by our workers compensation insureds’ payroll, which we believe is the most important assumption regarding our business, our loss reserves as of December 31, 2012 would be understated by $16.7 million and would result in an after tax reduction in shareholders’ equity of $10.8 million. In the event of a 5% increase in claim severity, which is the average incurred loss per claim, our loss and loss adjustment expense reserves would be understated by $7.9 million and would result in an after tax reduction in shareholders’ equity of $5.1 million.
As of December 31, 2012, if the actual results of the future premiums audits were 1% lower than the historical results used in calculating EBUB, the result would be a decrease in EBUB and net earned premium of $5.4 million or $3.5 million after tax. If the actual results of the future premiums audits were 1% higher than the historical results used in calculating EBUB, the result would be an increase in EBUB, and net earned premium of $4.4 million or $2.9 million after tax.
Quarterly, our Investment Committee (“Committee”) evaluates each security that has an unrealized loss as of the end of the subject reporting period for other-than-temporary-impairment (“OTTI”). The Company generally considers an investment to be impaired when it has been in a significant unrealized loss position (in excess of 35% of cost if the issuer has a market capitalization of under $1 billion and in excess of 25% of cost if the issuer has a market capitalization of $1 billion or more) for over 24 months. In addition, the Committee uses a set of quantitative and qualitative criteria to review our investment portfolio to evaluate the necessity of recording impairment losses for other-than-temporary declines in the fair value of our investments. The criteria the Committee primarily considers include:
Based on guidance in FASB ASC 320-10-65, in the event of the decline in fair value of a debt security, a holder of that security that does not intend to sell the debt security and for whom it is not more than likely than not that such holder will be required to sell the debt security before recovery of its amortized cost basis, is required to separate the decline in fair value into (a) the amount representing the credit loss and (b) the amount related to other factors. The amount of total decline in fair value related to the credit loss shall be recognized in earnings as an OTTI with the amount related to other factors recognized in accumulated other comprehensive loss net loss, net of tax. OTTI credit losses result in a permanent reduction of the cost basis of the underlying investment. The determination of OTTI is a subjective process, and different judgments and assumptions could affect the timing of the loss realization. During 2012, 2011 and 2010, we recorded impairment write-downs of approximately $3.0 million, $4.4 million and $21.2 million, respectively after determining that certain of our investments were OTTI.
Life Settlements - When we become the owner of a life insurance policy either by direct purchase or following a default on a premium finance loan, the life insurance premium for such policy is accounted for as an investment in life settlements. Investments in life settlements are accounted for in accordance with ASC 325-30, Investments in Insurance Contracts, which states that an investor shall elect to account for its investments in life settlement contracts using either the investment method or the fair value method. The election is made on an instrument-by-instrument basis and is irrevocable. We have elected to account for these investments using the fair value method.
Deferred income taxes reflect the impact of “temporary differences” between the amount of assets and liabilities for financial reporting purposes and such amounts as measured by tax laws and regulations. The deferred tax asset primarily consists of book versus tax differences for premiums earned, loss and loss adjustment expense reserve discounting, policy acquisition costs, earned but unbilled premiums, and unrealized holding gains and losses on marketable equity securities. We record changes in deferred income tax assets and liabilities that are associated with components of other comprehensive income, primarily unrealized investment gains and losses and foreign currency translation gains and losses, directly to other comprehensive income. Additionally, the use of deferred tax liabilities related to equalization reserves are netted against related amortization expense and recorded as a decrease to other underwriting expense. Otherwise, we include changes in deferred income tax assets and liabilities as a component of income tax expense.
Gross Written Premium. Gross written premium increased $598.9 million, or 27.8%, to $2,749.3 million from $2,150.4 million for the years ended December 31, 2012 and 2011, respectively. The increase of $598.9 million was primarily attributable to growth in our Small Commercial Business and Specialty Program segments. The increase in Small Commercial Business resulted primarily from increases in workers' compensation policy counts, the acquisitions of Majestic in July 2011
and BTIS in December 2011 and rate increases in some of our key states. The increase in Specialty Program resulted primarily from programs developed from new underwriting teams hired in 2010 and 2011.
Net Written Premium. Net written premium increased $371.4 million, or 29.1%, to $1,648.0 million from $1,276.6 million for the years ended December 31, 2012 and 2011, respectively. The increase by segment was: Small Commercial Business - $118.7 million; Specialty Risk and Extended Warranty - $9.0 million; Specialty Program - $228.3 million; and Personal Lines - $15.4 million. Net written premium increased for the year ended December 31, 2012 compared to the same period in 2011 due to the increase in gross written premium in 2012 compared to 2011 and was partially offset by higher retention of premiums written on programs in our Specialty Program segment that are not covered by the Maiden Quota Share.
Net Earned Premium. Net earned premium increased $382.0 million, or 36.8%, to $1,418.9 million from $1,036.9 million for the years ended December 31, 2012 and 2011, respectively. The increase by segment was: Small Commercial Business - $96.3 million; Specialty Risk and Extended Warranty - $94.8 million; Specialty Program - $177.2 million; and Personal Lines - $13.7 million. The increase to Specialty Risk and Extended Warranty related to our change of reinsurers on April 1, 2011 for our European medical liability business, which resulted in an increase in our retention rate of net written premium on this business from 20% to 60% and the assumption of all remaining unearned premium on this business from the prior reinsurer on a cut off basis.
Service and Fee Income. Service and fee income increased $63.5 million, or 58.5%, to $172.2 million from $108.7 million for the years ended December 31, 2012 and 2011, respectively. The increase related to additional fee income of approximately $16.1 million and $9.9 million produced from the acquisitions of BTIS and CNH, respectively, higher technology fee income from ACAC of approximately $10.4 million, higher fee income of approximately $7.7 million from Warrantech from new programs and fees generated by becoming a servicing carrier for workers' compensation assigned risk plans in three additional states.
Acquisition Costs and Other Underwriting Expenses; Expense Ratio. Acquisition costs and other underwriting expenses increased $145.3 million, or 36.5%, to $543.7 million for the year ended December 31, 2012 from $398.4 million for the year ended December 31, 2011. The expense ratio increased to 24.4% in 2012 from 23.6% in 2011, and was driven by the Specialty Risk and Extended Warranty segment and Specialty Program segment. The increase in policy acquisition costs was the largest contributor to the increase in the expense ratio during the year ended December 31, 2012, which was the result of a change in business mix as well as the adoption of the new accounting standard for deferred acquisition costs during the first quarter of 2012.
Other. Other expenses increased $74.7 million, or 86.3%, to $161.3 million for the year ended December 31, 2012 from $86.6 million for the year ended December 31, 2011. The increase resulted primarily from the inclusion of BTIS's and CNH's operating costs for all of 2012 and six months of 2012, respectively.
Interest Expense. Interest expense for the years ended December 31, 2012 and 2011 was $28.5 million and $16.1 million, respectively. The increase was primarily related to the issuance of an aggregate of $200 million of 5.50% convertible senior notes during December 2011 and January 2012.
Net Written Premium. Net written premium increased $449.4 million, or 54.3%, to $1,276.6 million from $827.2 million for the years ended December 31, 2011 and 2010, respectively. The increase by segment was: Small Commercial Business - $112.6 million; Specialty Risk and Extended Warranty - $253.5 million; Specialty Program - $63.0 million; and Personal Lines - $20.3 million. Net written premium increased for the year ended December 31, 2011 compared to the same period in 2010 due to the increase in gross written premium in 2011 compared to 2010, as well as the reduction in the percentage of our European medical liability business ceded to reinsurers from 80% to 40%, which became effective April 1, 2011.
Net Investment Income. Net investment income increased $5.0 million, or 10.0%, to $55.5 million from $50.5 million for the years ended December 31, 2011 and 2010, respectively. In the year ended December 31, 2010, investment income benefited from the inclusion of $2.6 million of interest income related to a note receivable due from Warrantech before it was acquired during the third quarter of 2010. Absent this item, investment income increased $7.6 million as a result of a higher amount of invested assets period over period, which included the cash and investments acquired in the Majestic transaction.
Net Realized Gains (Losses) on Investments. Net realized gains on investments were $2.8 million, compared to net realized gains of $5.9 million for the years ended December 31, 2011 and 2010, respectively. The decrease in realized gains of investments related to lower trading activity of equity securities in 2011 as we have deemphasized equity investments in our overall investment portfolio. The net realized gains were inclusive of non-cash impairment writedowns of $4.4 million and $21.2 million in 2011 and 2010, respectively.
Other. Other expenses increased $30.2 million, or 53.5%, to $86.6 million for the year ended December 31, 2011 from $56.4 million for the year ended December 31, 2010. The increase was the result, primarily, of the inclusion of Warrantech’s results for all of 2011 compared to five months in 2010.
Interest Expense. Interest expense for the years ended December 31, 2011 and 2010 was $16.1 million and $12.9 million, respectively. The increase in interest expense was primarily attributable to higher average outstanding debt balances in 2011 compared to 2010. The increase in average debt balances for 2011 relate to our revolving credit facility we entered into during January 2011, which replaced our now terminated $40 million term loan, a secured loan agreement we entered into in February 2011 and the reduction of the principal amount of our $30 million promissory note.
Equity in Earnings of Unconsolidated Subsidiaries - Related Parties. Equity in earnings of unconsolidated subsidiaries - related parties decreased by $18.3 million for the year ended December 31, 2011 to $4.9 million. The majority of the decrease related to the initial acquisition gain on ACAC of $10.4 million we recognized during the year ended December 31, 2010 that was adjusted downward during the year ended December 31, 2011 by $3.6 million. Absent this adjustment for purchase price accounting, earnings related to ACAC decreased to $8.5 million in 2011 from $10.1 million in 2010 and resulted primarily from higher loss ratios on the GMACI Business.
Small Commercial Business Segment Results of Operations 2012 Compared to 2011
Gross Written Premium. Gross written premium increased $323.9 million, or 53.1%, to $933.7 million for the year ended December 31, 2012 from $609.8 million for the year ended December 31, 2011. The increase related primarily to an approximately 10.5 percent increase in policy issuance and rate increases in certain key states. In addition, approximately $104 million resulted from organic growth from Majestic, which was acquired in the third quarter of 2011. Approximately $70 million resulted from the acquisition of BTIS.
Ceding Commission. The ceding commission earned during the years ended December 31, 2012 and 2011 was $69.9 million and $62.1 million, respectively. The ceding commission increased period over period as a result of an increase in net
Acquisition Costs and Other Underwriting Expenses; Expense Ratio. Acquisition costs and other underwriting expenses increased $32.8 million, or 22.2%, to $180.8 million for the year ended December 31, 2012 from $148.0 million for the year ended December 31, 2011. The expense ratio decreased to 26.6% for the year ended December 31, 2012 compared to 26.8% for the year ended December 31, 2011. The decrease in the expense ratio resulted primarily from changes in business mix in 2012, partially offset by the adoption of the new accounting standard for deferred acquisition costs in 2012 on a prospective basis.
Small Commercial Business Segment Results of Operations 2011 Compared to 2010
Net Earned Premium. Net earned premium increased $67.9 million, or 26.9%, to $320.3 million for the year ended December 31, 2011 from $252.4 million for the year ended December 31, 2010. As premiums written earn ratably over a twelve month period, the increase in net premium earned resulted from higher net premium written for the twelve months ended December 31, 2011 compared to the twelve months ended December 31, 2010, as well as the assumption of $26 million of unearned premium from Majestic in the second quarter of 2011, for which we earned approximately $24.4 million during 2011.
Specialty Risk and Extended Warranty Segment Results of Operations 2012 Compared to 2011
Ceding Commission. The ceding commission earned during the years ended December 31, 2012 and 2011 was $65.1 million and $57.6 million, respectively. The increase related to the allocation to this segment of its proportionate share of our overall policy acquisition expense. Additionally, during 2012, we received a five percent ceding commission in connection with a 40% quota share arrangement with Maiden covering our European medical liability business. During the first three months of 2011, we ceded this business to another reinsurer and did not receive a ceding commission.
Acquisition Costs and Other Underwriting Expenses; Expense Ratio. Acquisition costs and other underwriting expenses increased $30.9 million, or 22.4%, to $168.3 million for the year ended December 31, 2012 from $137.4 million for the year ended December 31, 2011. The expense ratio increased to 19.1% for the year ended December 31, 2012 compared to 17.9% for the year ended December 31, 2011. The increase in the expense ratio resulted primarily from changes in business mix and the adoption of the new accounting standard for deferred acquisition costs in 2012 on a prospective basis.
Gross Written Premium. Gross written premium increased $308 million, or 41.1%, to $1,056.5 million for the year ended December 31, 2011 from $749 million for the year ended December 31, 2010. A majority of the increase related to growth in new and existing programs in our European business from warranty coverage of approximately $73 million, medical liability of approximately $61 million, general liability of approximately $19 million and professional liability of approximately $16 million. Additionally, the segment benefited from the underwriting of new programs in the U.S., and the assumption of unearned premium of $19 million from a new customer.
Net Earned Premium. Net earned premium increased $143.2 million, or 47.2%, to $446.8 million for the year ended December 31, 2011 from $303.6 million for the year ended December 31, 2010. As net premiums written are earned ratably over the term of a policy, which on average is 23 months, the increase resulted from growth in net written premium between 2010 and 2011. In addition, net earned premium increased as a result of our new reinsurance program for our European medical liability business.
Ceding Commission. The ceding commission earned during the years ended December 31, 2011 and 2010 was $57.6 million and $48.0 million, respectively. The increase related to the allocation to this segment of its proportionate share of our overall policy acquisition expense, which achieved proportionally more growth than certain other segments in 2011. Additionally, beginning on April 1, 2011, we entered into a 40% quota share reinsurance agreement with Maiden covering our European medical liability business by which we receive a five percent ceding commission. Prior to April 1, 2011, this business was ceded to another reinsurer.
Net Written Premium. Net written premium increased $228.3 million, or 112.6%, to $431.0 million for the year ended December 31, 2012 from $202.7 million for the year ended December 31, 2011. The increase in net written premium resulted from an increase of gross written premium for the year ended December 31, 2012 compared to the year ended December 31, 2011 as well as a reduction in the percentage of gross written premium ceded to reinsurers for programs that are not covered by in the Maiden Quota Share.
Net Earned Premium. Net earned premium increased $177.2 million, or 103.4%, to $348.6 million for the year ended December 31, 2012 from $171.4 million for the year ended December 31, 2011. As premiums written earn ratably over an annual period, the increase in net premium earned resulted from higher net written premium for 2012 compared to 2011.
Gross Written Premium. Gross written premium increased $117.4 million, or 44.5%, to $381.5 million for the year ended December 31, 2011 from $264.1 million for the year ended December 31, 2010. The increase in gross written premium related primarily to an increase in new and existing programs of approximately $192 million, including commercial auto and general liability programs, excess and surplus lines programs and public entity programs. The increases were offset by declines in other programs as a result of our maintenance of our pricing and administrative discipline, which resulted in the termination of certain programs representing approximately $73 million, of which three programs represented approximately 81% of this decrease. Additionally, we experienced a decrease of approximately $1.6 million in business we wrote on behalf of HSBC Insurance Company of Delaware pursuant to a 100% fronting arrangement we entered into in connection with our acquisition of WIC, which is now in run-off.
Ceding Commission. The ceding commission earned during the years ended December 31, 2011 and 2010 was $34.2 million and $24.0 million, respectively. The increase related primarily to an increase in earned premium and a shift in the mix of the programs written during the periods. The policy acquisition costs for certain programs that we wrote in 2011 are greater
relative to earned premiums from programs that were in place in 2010. Therefore, we allocated more ceding commission to the segment. In addition, this segment achieved proportionally more growth as compared to certain other segments.
Loss and Loss Adjustment Expenses; Loss Ratio. Loss and loss adjustment expenses increased $20.4 million, or 21.7%, to $114.7 million for the year ended December 31, 2011 compared to $94.3 million for the year ended December 31, 2010. The loss ratio for the segment was consistent year over year and was 66.9% compared to 67.2% for the years ended December 31, 2011 and 2010, respectively. Current accident year selected ultimate losses were similar to selected ultimate losses from the prior accident years, resulting in a flat loss ratio for the year ended December 31, 2011 as compared to the year ended December 31, 2010.
We assumed $118.1 million and $102.6 million of premium from the GMACI Insurers for the years ended December 31, 2012 and 2011, respectively. The increase in assumed premium in 2012 is due to increased premium writing by the GMACI Insurers. Net earned premium increased 13.9% in 2012 compared to 2011 due to the earning cycle of assumed premium written in 2011. Loss and loss adjustment expense increased 12.6% in 2012 compared to 2011 and increased proportionally with net earned premium. The decrease in the net loss ratio in 2012 from 2011 resulted primarily from lower actuarial estimates based on actual losses. The decrease in the net expense ratio in 2012 compared to 2011 resulted from the sliding scale commission structure with GMACI.
Our investment portfolio, including cash and cash equivalents but excluding life settlement contracts and other investments, increased $600.7 million, or 30.2%, to $2,589.1 million at December 31, 2012 from $1,988.4 million as of December 31, 2011. Our investment portfolio is classified as available-for-sale, as defined by ASC 320, Investments - Debt and Equity Securities. This increase is attributable to cash flow from operations in 2012 and the cash proceeds we received upon issuance of the overallotment of our convertible senior notes in January 2012. Our fixed maturity securities, gross, as of December 31, 2012, had a fair value of $2,065.2 million and an amortized cost of $1,947.6 million. Our equity securities are reported at fair value and were $20.5 million with a cost of $20.9 million as of December 31, 2012. Securities sold but not yet purchased represent our obligations to deliver the specified security at the contracted price and thereby create a liability to purchase the security in the market at prevailing rates. We account for sales of securities under repurchase agreements as collateralized borrowing transactions and we record these sales at their contracted amounts.
The table below summarizes the credit quality of our fixed maturity securities as of December 31, 2012 and 2011, as rated by Standard and Poor’s.
As of December 31, 2012, the weighted average duration of our fixed income securities was 4.7 years and had a yield of 3.9%.
Other investments represented approximately 0.4% and 0.7% of our total investment portfolio as of December 31, 2012 and 2011, respectively. At December 31, 2012, other investments consisted primarily of limited partnerships or hedge funds totaling $9.8 million and an annuity of $1.4 million. At December 31, 2011, other investments consisted primarily of limited partnerships or hedge funds totaling $13.2 million and an annuity of $1.4 million.
other items, including company management, media exposure, sponsors, marketing and advertising agreements, debt restructurings, regulatory changes, acquisitions and dispositions, pending litigation, distribution agreements and general industry trends.
Corporate bonds represent 65% of the fair value of our fixed maturities and 72% of the total unrealized losses of our fixed maturities. We own 529 corporate bonds in the industrial, bank and financial and other sectors, which have a fair value of approximately 20%, 43% and 2%, respectively, and 14%, 58% and 0% of total unrealized losses, respectively, of our fixed maturities. We believe that the unrealized losses in these securities are the result, primarily, of general economic conditions and not the condition of the issuers, which we believe are solvent and have the ability to meet their obligations. Therefore, we expect that the market price for these securities should recover within a reasonable time. Additionally, we do not intend to sell the investments and it is not more likely than not that we will be required to sell the investments before recovery of their amortized cost basis.
hold these investments until a recovery of fair value. We believe the gross unrealized losses of $1.2 million as of December 31, 2012 is not material to our financial position.
The table below summarizes the gross unrealized losses of our fixed maturity and equity securities by length of time the security has continuously been in an unrealized loss position as of December 31, 2012:
We may generate liquidity through a combination of debt or equity securities issuances, as well as financing through borrowing and sales of securities. During 2012 and 2011, we issued ten-year, $200 million convertible senior notes and in 2012 entered into a four-year, $200 million credit facility that was not utilized as of December 31, 2012.
The laws of the jurisdictions in which our Insurance Subsidiaries are organized regulate and restrict, under certain circumstances, their ability to pay dividends to us. As of December 31, 2012 and 2011, respectively, the Insurance Subsidiaries would have been permitted to pay dividends in the aggregate of approximately $403.1 million and $306.1 million, respectively. Our Insurance Subsidiaries paid dividends to us of $7.2 million, $5.8 million and $5.0 million of in 2012, 2011 and 2010, respectively. In addition, the terms of our debt arrangements limit our ability to pay dividends on our common stock, and future borrowings may include prohibitions and restrictions on dividends. Additional information regarding our dividends is presented in “Item 1. Business - Regulation”, in “Item 1A. Risk Factors” and in “Item 5. Market for Registrant’s Common Equity, Related Shareholder Matters and Issuer Purchase of Equity Securities - Dividend Policy” appearing elsewhere in this Form 10-K.
Net cash provided by operating activities was approximately $527.6 million for the year ended December 31, 2012, compared to $294.6 million for the same period in 2011. The increase in cash provided from operations resulted primarily from an increase in gross written premium written in 2012 compared to 2011. Additionally, we had increased cash collections in 2012 related to the earning of the tail end of premium written in 2011 for Specialty Risk and Extended Warranty segment policies that generally have a longer policy life and therefore a longer cash collection cycle.
In 2012, fixed maturities increased $671.0 million and resulted primarily from the used of cash generated from operations. Premium receivables increased $318.3 million as a result of the increase in premium writing in 2012, related primarily to growth in our Small Commercial Business and Specialty Program segments. Prepaid expenses and other assets increased $132.7 million and resulted primarily from our continued investment in life settlement contracts and an increase in miscellaneous accounts receivable due to growth in fee related businesses. Intangible assets increased $88.3 million as a result of acquiring FNC and CNH in 2012.
Loss and loss expense reserves increased $547.2 million and unearned premium increased $407.4 million in 2012 due primarily to higher premium writings in 2012 compared to 2011. Ceded reinsurance premium payable, increased by $190.8 million in 2012 as a result of ceding a higher amount of gross written premium to Maiden in 2012 compared to 2011. Deferred income taxes increased $107.1 million as a result of the acquisition of two Luxembourg captive insurance entities and the increase in deferred acquisition costs and intangible assets.
We structure our reinsurance programs by analyzing our threshold for risk in each line of business and on an overall consolidated basis, based on a number of factors, including market conditions, pricing, competition and the inherent risks associated with each business type. Based on our analysis of these factors, we may determine not to purchase reinsurance for some lines of business. We generally purchase reinsurance to reduce our net liability on individual risks and to protect against catastrophe losses and volatility. We retain underwriting risk in certain lines of business in order to retain a greater proportion of expected underwriting profits. We have chosen not to purchase any reinsurance on businesses where volatility or catastrophe risks are considered remote and limits are within our risk tolerance.
In our proportional reinsurance programs, we generally receive a commission on the premium ceded to reinsurers. This compensates our insurance companies for the direct costs associated with production of the business, the servicing of the business during the term of the policies ceded, and the costs associated with placement of reinsurance that benefits the proportional programs. In addition, certain of our reinsurance treaties allow us to share in any net profits generated under such treaties with the reinsurers. Various reinsurance brokers may arrange for the placement of this reinsurance coverage on our behalf and are compensated, directly or indirectly, by the reinsurers. We also enter reinsurance relationships with third-party captives formed by agents and other business partners as a mechanism for sharing risk and profit.
We monitor our financial exposure to the reinsurance market and take necessary actions in an attempt to mitigate our exposure to possible loss. We limit our liquidity exposure for uncollected recoverables by holding funds, letters of credit or other security, such that net balances due from reinsurers are significantly less than the gross balances shown in our consolidated balance sheets. We monitor the collectability of our reinsurance recoverables and record a reserve for uncollectible reinsurance when we determine an amount is potentially uncollectible. Our evaluation is based on our periodic reviews of our disputed and aged recoverables, as well as our assessment of recoverables due from reinsurers known to be in financial difficulty. In some cases, we make estimates as to what portion of a recoverable may be uncollectible. Our estimates and judgment about the collectability of the recoverables and the financial condition of reinsurers can change, and these changes can affect the level of reserve required.
The following table summarizes the top ten reinsurers that account for approximately 87% of our reinsurance recoverables on paid and unpaid losses and loss adjustment expenses as of December 31, 2012:
At the time of the Majestic loss portfolio transfer, these entities were reinsurers of Majestic. We currently hold collateral of approximately $34 million in a trust account related to cessions for Twin Bridges and Alterra, as well as approximately $29 million of funds held.
The following tables provide a summary of our primary reinsurance programs for 2012 for the United States and internationally:
If we incur catastrophe losses and loss settlement expenses that exceed the coverage limits of our reinsurance program, many of our property catastrophe programs have built in a fixed number of reinstatement of limits. For example, if we incur a property catastrophe loss, we are required to pay the reinsurers a reinstatement premium equal to the full amount of the original premium.
The Maiden Quota Share, which had an initial term of three years, was renewed through June 30, 2014 and will automatically renew for successive three-year terms unless either AII or Maiden Insurance notifies the other of its election not to renew not less than nine months prior to the end of any such three-year term. In addition, either party is entitled to terminate on thirty days’ notice or less upon the occurrence of certain early termination events, which include a default in payment, insolvency, change in control of AII or Maiden Insurance, run-off, or a reduction of 50% or more of the shareholders’ equity of Maiden Insurance or the combined shareholders’ equity of AII and the AmTrust Ceding Insurers.
As of December 31, 2012, we have no outstanding borrowings under this Credit Agreement. We have outstanding letters of credit in place under this Credit Agreement at December 31, 2012 for $95.8 million, which reduced the availability for letters of credit to $4.2 million as of December 31, 2012, and the availability under the facility to $104.2 million as of December 31, 2012.
Fees payable by us under the Credit Agreement include a letter of credit participation fee (which is the margin applicable to Eurodollar borrowings and was 1.50% at December 31, 2012), a letter of credit fronting fee with respect to each letter of credit 0.125% and a commitment fee on the available commitments of the lenders (a range of 0.20% to 0.30% based on our consolidated leverage ratio and was 0.25% at December 31, 2012).
In December 2011, we issued $175 million aggregate principal amount of our 5.50% convertible senior notes due 2021 (the “Notes”) to certain initial purchasers in a private placement. In January 2012, we issued an additional $25 million of the Notes to cover the initial purchasers' overallotment option. The Notes bear interest at a rate equal to 5.50% per year, payable semiannually in arrears on June 15 and December 15th of each year, beginning on June 15, 2012.
We separately allocated the proceeds for the issuance of the Notes to a liability component and an equity component, which is the embedded conversion option. The equity component was reported as an adjustment to paid-in-capital, net of tax, and is reflected as an original issue discount (“OID”). The OID of $41.7 million and deferred origination costs relating to the liability component of $4.8 million will be amortized into interest expense over the term of the loan of the Notes. After considering the contractual interest payments and amortization of the original discount, the Notes effective interest rate was
The agreement contains certain covenants that are similar to our revolving credit facility. Additionally, subsequent to February 25, 2012, but prior to payment in full, if the outstanding balance of this loan exceeds 90% of the fair value of the aircraft, we are required to pay the lender the entire amount necessary to reduce the outstanding principal balance to be equal to or less than 90% of the fair value of the aircraft. The agreement allows us, under certain conditions, to repay the entire outstanding principal balance of this loan without penalty.
In connection with the Majestic acquisition, we, through one of our subsidiaries, entered into a secured letter of credit facility with Comerica Bank during 2011. We utilize the letter of credit facility to comply with the deposit requirements of the State of California and the U.S. Department of Labor as security for our obligations to workers’ compensation and federal Longshore and Harbor Workers’ Compensation Act policyholders. The credit limit is for $75.0 million and was utilized for $49.6 million for the year ended December 31, 2012. We are required to pay a letter of credit participation fee for each letter of credit in the amount of 0.40%.
During the last three years, we did not engage in short-term borrowings to fund our operations. As discussed above, our Insurance Subsidiaries create liquidity by collecting and investing insurance premiums in advance of paying claims. Details about our investment portfolio can be found under “- Investment Portfolio” appearing elsewhere in this Form 10-K.
The following table sets forth certain of our contractual obligations as of December 31, 2012:
We currently own 256 life settlement contracts and 13 premium finance loans with a carrying value of $193.9 million. In order for us to derive the economic benefit of the face value of the policies, we are required to make these premium payments.
The interest related to the debt by period is as follows: $19.8 million - less than 1 year, $36.5 million - 1 - 3 years, $32.1 million - 3 - 5 years and $120.5 million - more than 5 years. In addition, included within debt and interest is $168 million related to the Maiden collateral loan and $1.9 million of associated interest.