We lease approximately 61,525 square feet of office space in Bala Cynwyd, Pennsylvania, which serves as the headquarters location for our United National Insurance Companies, pursuant to a lease that expires on December 31, 2013. Penn-America Group, Inc. and Penn Independent Corporation lease approximately 50,000 square feet of office space in Hatboro, Pennsylvania that was recently purchased by American Insurance Service, Inc., one of our indirect wholly owned subsidiaries. Penn-America Group, Inc. and Penn Independent Corporation have entered into month-to-month leases with American Insurance Service, Inc. In addition, we lease additional office space in other locations in the United States, Bridgetown, Barbados, and Hamilton, Bermuda.
We intend to combine our Bala Cynwyd and Hatboro operations into one location. We have hired a real estate consultant to help us locate a suitable property.
The extraordinary gains of $1.4 million in 2005 and $1.2 million in 2004 represent the recognition of tax benefits derived from acquisition costs incurred in connection with the Acquisition, which are currently considered deductible for federal tax purposes. The $46.4 million excess of the estimated fair value of net assets over purchase price was recognized as an extraordinary gain in the consolidated statement of operations for the period September 6, 2003 to December 31, 2003.
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the consolidated financial statements and accompanying notes of United America Indemnity and Wind River Investment Corporation included elsewhere in this report. Some of the information contained in this discussion and analysis or set forth elsewhere in this report, including information with respect to our plans and strategy, constitutes forward-looking statements that involve risks and uncertainties. Please see “Cautionary Note Regarding Forward-Looking Statements” at the end of this Item 7 and “Risk Factors” in Item 1A above for more information. You should review “Risk Factors” in Item 1A above for a discussion of important factors that could cause actual results to differ materially from the results described in or implied by the forward-looking statements contained herein.
On January 23, 2006, we announced that our Board of Directors had selected Joseph F. Morris as our President. We also announced that we will consolidate our U.S. Insurance Operations under a single United America Insurance Group management structure, to be led by William F. Schmidt, as its President and Chief Executive Officer. We expect that this consolidation will be completed by year-end 2006.
As previously announced, Robert A. Lear resigned from Penn Independent Corporation on January 31, 2006. Robert Cohen has been appointed President and Chief Executive Officer of Penn Independent Corporation.
Our Insurance Operations segment offers two general classes of insurance products: property and general liability insurance products and professional liability insurance products. Our insurance products target very specific, defined, homogenous groups of insureds with customized coverages to meet their needs. Our products include customized guidelines, rates and forms tailored to our risk and underwriting philosophy.
Our expenses include losses and loss adjustment expenses, acquisition costs and other underwriting expenses, corporate and other operating expenses, interest, and other investment expenses. Losses and loss adjustment expenses are estimated by management and reflect our best estimate of ultimate losses and costs arising during the reporting period and revisions of prior period estimates. We record losses and loss adjustment expenses based on an actuarial analysis of the estimated losses we expect to be reported on insurance policies written. The ultimate losses and loss adjustment expenses will depend on the actual costs to resolve claims. Acquisition expenses consist principally of commissions that are typically a percentage of the premiums on insurance policies written, net of ceding commissions earned from reinsurers. Other underwriting expenses consist primarily of personnel expenses and general operating expenses. Agency commissions and operating expenses include commissions retained by agents and producers on policies bound by our Agency Operations. Other agency operating expenses include personnel expenses and general operating expenses. Corporate and other operating expenses are comprised primarily of outside legal fees, other professional fees, directors’ fees, and management fees. Interest expense consists of interest paid on funds held on behalf of others, senior notes payable and junior subordinated debentures.
We are directly liable for losses and loss adjustment expenses under the terms of the insurance policies that we write. In many cases, several years may lapse between the occurrence of an insured loss, the reporting of the loss to us, and our payment of that loss. We reflect our liability for the ultimate payment of all incurred losses and loss adjustment expenses by establishing loss and loss adjustment expense reserves as balance sheet liabilities for both reported and unreported claims.
The table below illustrates the sensitivity to a hypothetical change to our net loss and loss adjustment expense reserves as of December 31, 2005. The selected scenarios are not predictions of future events, but rather illustrative of the effect that such events may have on shareholders’ equity.
We regularly review the collectibility of our reinsurance receivables, and we include adjustments resulting from this review in earnings in the period in which the adjustment arises. A.M. Best ratings, financial history, and payment history with the reinsurers are several of the factors that we consider when judging collectibility. Changes in loss reserves can also affect the valuation of reinsurance recoverables if the change is related to loss reserves that are ceded to reinsurers. Certain amounts may be uncollectible if our reinsurers dispute a loss or if the reinsurer is unable to pay. If our reinsurer does not pay, we are still legally obligated to pay the liability.
For equity securities, a decline in value is other than temporary if an unrealized loss has either (1) persisted for more than 12 consecutive months or (2) the value of the investment has been 20% or more below cost for six continuous months or more. For securities with significant declines in value for periods shorter than six months, the security is evaluated to determine whether the cost basis of the security should be written down to its fair value.
Effective July 1, 2001, we adopted the provisions of SFAS No. 141, “Business Combinations” and SFAS No. 142, “Goodwill and Other Intangible Assets” (“SFAS 142”). On January 24, 2005, we recorded $102.0 million and $32.5 million of goodwill and intangible assets, respectively, as a result of the acquisition of Penn Independent Corporation and the merger with Penn-America Group, Inc. In determining these amounts, certain estimates and assumptions were made regarding the estimated realizable value of the assets acquired.
We used several techniques to value our intangible assets. Discounted cash flow and cost to replace methods were used to value agency relationships, customer contracts, and insurer relationships. State licenses were valued by comparing our licenses to comparable companies. Software was evaluated based on the cost to build and the cost to replace exiting software.
Other intangible assets that are not deemed to have an indefinite useful life are amortized over their useful lives. The carrying amount of intangible assets that are not deemed to have an indefinite useful life is regularly reviewed for indicators of impairments in value in accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (“SFAS 144”). The carrying amount of intangible assets
We provide for income taxes in accordance with the provisions of SFAS 109, “Accounting for Income Taxes” (“SFAS 109”). Deferred tax assets and liabilities are recognized consistent with the asset and liability method required by SFAS 109. Our deferred tax assets and liabilities primarily result from temporary differences between the amounts recorded in our consolidated financial statements and the tax basis of our assets and liabilities.
At each balance sheet date, management assesses the need to establish a valuation allowance that reduces deferred tax assets when it is more likely than not that all, or some portion, of the deferred tax assets will not be realized. The valuation allowance is based on all available information including our assessment of uncertain tax positions and projections of future taxable income from each tax-paying component in each jurisdiction, principally derived from business plans and available tax planning strategies. The $13.0 million deferred tax asset for the alternative minimum tax (“AMT”) carryforward is analyzed regularly by management. Based on these analyses, we have determined that our AMT carryforward is recoverable. Projections of future taxable income incorporate several assumptions of future business and operations that are apt to differ from actual experience. If, in the future, our assumptions and estimates that resulted in our forecast of future taxable income for each tax-paying component prove to be incorrect, a valuation allowance could become necessary. This could have a material adverse effect on our financial condition, results of operations, and liquidity.
We evaluate the performance of our Insurance Operations and Agency Operations segments based on gross and net premiums written, revenues in the form of 1) net premiums earned and 2) agency commissions and fees, and expenses in the form of 1) net losses and loss adjustment expenses, 2) acquisition costs, 3) other underwriting expenses, and 4) other operating expenses. See “Business Segments” in Item 1 of this Report for a description of our segments. The following table sets forth an analysis of financial data for our segments during the periods indicated:
Our insurance combined ratios are non-GAAP financial measures that are generally viewed as indicators of underwriting profitability. The net losses and loss adjustment expense ratio is the ratio of net losses and loss adjustment expenses to net premiums earned. The underwriting expense ratio is the ratio of acquisition costs and other underwriting expenses to net premiums earned. The combined ratio is the ratio of the sum of net losses, loss adjustment expenses, acquisition costs, and other underwriting expenses to net premiums earned.
Investment expenses were $5.9 million for 2005, compared with $4.2 million for 2004, an increase of $1.7 million or 41.0%. The increase was largely due to additional investment expenses in 2005 from the merger with Penn-America Group, Inc. and an increase in reinsurance trust maintenance fees.
Net losses and loss adjustment expenses were $288.1 million for 2005, compared with $133.8 million for 2004, an increase of $154.3 million or 115.3%. The calendar year loss ratio for 2005 was 60.6% compared with 58.2% for 2004. The loss ratio is calculated by dividing net losses and loss adjustment expenses by net premiums earned. Excluding the impact of purchase accounting adjustments in 2005 and 2004, the loss ratio for 2005 was 58.0% compared with 59.2% for 2004. The increase in the loss ratio was primarily driven by Hurricanes Katrina, Rita, and Wilma, which caused net losses to increase $8.0 million and the loss ratio to increase 1.9 points.
Katrina made landfall as a Category 1 hurricane just north of Miami, Florida on August 25, 2005, then again on August 29, 2005 along the Central Gulf Coast near New Orleans, Louisiana as a Category 4 storm. Our reinsurance coverage aggregates events from the same storm if they occur within 72 hours of each other. Four days elapsed between events; therefore, the second landfall was treated as a separate catastrophe event under the United America Insurance Group Catastrophe Reinsurance Treaty (“UAIG Catastrophe Reinsurance Treaty”).
America Catastrophe Reinsurance Treaty. Additional reinstatement coverage was not available on the Penn-America Catastrophe Reinsurance Treaty after the second event.
The UAIG Catastrophe Reinsurance Treaty provides $25.0 million in excess of $5.0 million of property coverage. We ceded catastrophic losses of $22.2 million on this treaty as a result of Katrina’s second landfall. The UAIG Catastrophe Reinsurance Treaty has first event coverage of $2.8 million still available. We accrued a total of $1.8 million towards the purchase of reinstatement coverage under the UAIG Catastrophe Reinsurance Treaty and the Penn-America Catastrophe Reinsurance Treaty. We ceded $1.9 million in losses to the UAIG Catastrophe Reinsurance Treaty as a result of Wilma. We have not purchased reinstatement coverage. As a result, if a third catastrophe event occurs between now and June 30, 2006, we would retain the first $6.9 million of losses. In addition, to protect us from property catastrophe exposures, we have purchased an additional $30.0 million in excess of $30.0 million of property catastrophe coverage for events occurring in 2006.
Agency commissions and operating expenses generated by our Agency Operations segment were $40.6 million and $39.3 million before and after intercompany eliminations, respectively, for 2005. Included in these amounts is a charge for severance pay of $0.7 million. Prior to the acquisition of Penn Independent Corporation, we had no agency commission and operating expenses.
Our expense ratio, which is calculated by dividing the sum of acquisition costs and other underwriting expenses by premiums earned, was 31.9% for 2005, compared with 32.4% for 2004. Excluding the impact of purchase accounting adjustments, the expense ratio for 2005 was 34.8% compared with 34.5% for 2004. The expense ratio for 2005 was impacted by the changes in acquisition costs and other underwriting expenses described above.
Interest expense was $9.4 million for 2005, compared with $5.5 million for 2004, an increase of $3.9 million. This increase is primarily due to additional interest expense, which resulted from borrowing an additional $90.0 million at an interest rate of 6.22%, the merger with Penn-America Group, Inc., the acquisition of Penn Independent Corporation, and the increase in market interest rates, which increased interest expense on our variable rate trust preferred securities, partially offset by paying off the $72.8 million in senior notes held by the Ball family trusts, which had an interest rate of 5.00%.
Income tax expense was $2.7 million for 2005, compared with $2.0 million of income tax benefit for 2004. During 2005, we recorded $1.4 million in tax expense associated with an increase in estimated U.S. ceding commission income earned by the United National Insurance Companies under a quota share arrangement with Wind River Bermuda and Wind River Barbados. In addition, the increase in income tax expense was attributable to additional income from Penn-America Group and Penn Independent Group, offset by an increase in federal tax deductions for interest on notes payable to our Non-U.S. Subsidiaries of $6.3 million as a result of the merger with Penn-America Group, Inc. and the acquisition of Penn Independent Corporation. Our effective tax rate for 2005 was 4.0%, compared with an effective tax benefit rate of 6.2% for 2004. The effective rates differed from the 11.6% weighted average expected rate due in part to investments in tax-exempt securities. We have an alternative minimum tax credit carryover of $13.0 million as of December 31, 2005 that, subject to statutory limitations, can be carried forward indefinitely. We are limited by Internal Revenue Code section 383 on the amount of our income that can be offset by an alternative minimum tax carryover following the Wind River Acquisition. The section 383 limitation is an amount equal to the value of the purchase price of the Wind River Acquisition less stock redemptions multiplied by the long-term tax-exempt rate. The limitation applies until the carryforward is fully utilized. The income limitation as a result of the Wind River Acquisition is $8.3 million per year.
Property and general liability gross premiums written were $322.6 million for 2004, compared with $577.9 million for 2003, a decrease of $255.3 million or 44.2%. This decrease primarily resulted from the termination of 17 products during 2003 and 13 products during 2002, combined with a reduction in gross premiums written of $71.3 million relative to our umbrella and excess business, exclusive of the terminated products, offset by rate increases of approximately 6% (as measured against expiring rates) on other products.
Property and general liability net premiums written were $217.2 million for 2004, compared with $165.7 million for 2003, an increase of $51.5 million or 31.1%. The ratio of net premiums written to gross premiums written was 67.3% for 2004, compared with 28.7% for 2003. The increase in net premiums written was largely due to our increasing our retention relative to individual products and due to rate increases of approximately 7%. These increases in net premiums written were partially offset by decreases in net premiums written due to the termination of the products previously mentioned. Net premiums written relative to the terminated products were $2.6 million for 2004, compared with $20.7 million for 2003.
The average duration of our fixed income investments approximated 3.8 years as of December 31, 2004, compared with 3.1 years as of December 31, 2003. Our book yield on our fixed income investments was 4.16% at December 31, 2004, compared with 4.0% at December 31, 2003.
Investment expenses were $4.2 million for 2004, compared with $2.8 million for 2003, an increase of $1.4 million or 50.0%. The increase was largely due to an increase in investment management fees.
Net realized investment gains were $2.7 million for 2004, compared with $5.8 million of net realized investment gains for 2003, a decrease of $3.1 million or 53.4%. The net realized investment gains for the current period consist of net gains of $2.0 million relative to our equity portfolio and net gains of $0.7 million relative to our bond portfolio. The net realized investment gains in 2003 consist of net gains of $6.4 million relative to our equity portfolio, net gains of $0.3 million relative to our bond portfolio and net losses of $0.9 million relative to other invested assets.
Net losses and loss adjustment expenses were $133.8 million for 2004, compared with $123.7 million for 2003, an increase of $10.1 million or 8.2%. The loss ratio for 2004 was 58.1% compared with 68.6% for 2003. The loss ratio is calculated by dividing net losses and loss adjustment expenses by net premiums earned. The loss ratio for 2004 and 2003, excluding the impact of purchase accounting adjustments, would have been 57.1% and 66.0%, respectively. The improvement in the loss ratio was attributable to continuing rate increases in 2004 and the termination of products that did not meet our profitability targets in 2003. These improvements were offset by $1.7 million of net losses related to Hurricanes Charley, Frances, Ivan, and Jeanne for 2004, which had the impact of increasing our loss ratio by 0.7 percentage points.
Acquisition costs and other underwriting expenses were $74.7 million for 2004, compared with $43.4 million for 2003, an increase of $31.3 million. This increase can be primarily attributed to a $35.7 million increase in acquisition costs and $4.4 million decrease in other underwriting expenses.
The $4.4 million decrease in other underwriting expenses was primarily due to a decrease in taxes, licenses, and fees and other miscellaneous expenses.
Corporate and other operating expenses consist of outside legal fees, other professional fees, directors’ fees, management fees, and taxes incurred which are not related to operations. Corporate and other operating expenses were $6.6 million for 2004, compared with $1.3 million for 2003, an increase of $5.3 million. This increase was primarily attributable to increased costs as a result of becoming a publicly traded company.
Income tax benefit was $2.0 million for 2004, compared with $5.4 million of tax expense for 2003. The increase in tax benefit was primarily attributable to (1) the implementation of our quota share reinsurance arrangement with our Non-U.S Insurance Operations that resulted in lower taxable underwriting and investment income and (2) an increase in the federal tax deduction for interest on a note payable to our Non-U.S. Subsidiaries to $11.5 million in 2004 from $3.8 million in 2003. Our effective tax benefit for 2004 was 6.2%, compared with an effective tax rate of 16.1% for 2003. The effective tax benefit realized in 2004 is not indicative of the effective rate expected in future years. The effective rates differed from the 6.8% weighted average rate due in part to investment in tax-exempt securities. We have an alternative minimum tax credit carryover of $12.3 million, which, subject to statutory limitations, can be carried forward indefinitely. We are limited by Internal Revenue Code section 383 on the amount of our income that can be offset by an alternative minimum tax carryover following the Acquisition. The section 383 limitation is an amount equal to the value of the purchase price of the Acquisition less stock redemptions multiplied by the long-term tax-exempt rate. The limitation applies until the carryforward is fully utilized. The income limitation as a result of the Acquisition is $8.3 million per year.
Equity in net earnings of partnerships was $1.5 million for 2004, compared with $2.6 million for 2003, a decrease of $1.1 million. The decrease is primarily attributable to the performance of a limited partnership investment which invests mainly in convertible bonds and equities.
The extraordinary gain of $1.2 million for 2004 represents the recognition of tax benefits derived from acquisition costs incurred in connection with the Acquisition, which are currently considered to be deductible for federal tax purposes. The extraordinary gain of $46.4 million for 2003 represents the excess of the estimated fair value of net assets over purchase price from the Acquisition.
United America Indemnity is a holding company. Its principal asset is its ownership of the shares of its direct and indirect subsidiaries, including United National Insurance Company, Diamond State Insurance Company, United National Specialty Insurance Company, United National Casualty Insurance Company, Wind River Barbados, Wind River Bermuda, Penn-America Insurance Company, Penn-Star Insurance Company, Penn-Patriot Insurance Company, and Penn Independent Corporation.
is approximately $36.0 million. For 2006, the maximum amount of distributions that could be paid by the Penn-America Insurance Companies as dividends under applicable laws and regulations without regulatory approval is approximately $22.0 million, including $7.2 million that would be distributed to United National Insurance Company or its subsidiary, Penn Independent Corporation, based on the December 31, 2005 ownership percentages.
the fact that we collect premiums in advance of losses paid;
Net cash was provided by financing activities in 2005, 2004, and 2003 of $15.6 million, $7.3 million and $53.9 million, respectively. In 2005, the main sources of the cash flow were proceeds of $90.0 million from the issuance of senior notes offset by the repayment of $72.8 million of senior notes and related interest to a related party and the net repayments of a credit facility of $0.8 million. In 2004, the principal source of the cash flow was the issuance of 462,500 Class A common shares at a price of $17.00 per share in January 2004, in connection with exercise by the underwriters of the remaining overallotment option related to our initial public offering. Proceeds to United America Indemnity, net of underwriting discounts of $0.5 million, were $7.3 million. In 2003, the main sources of the cash flow included $165.6 million from our December 15, 2003 IPO and $30.0 million due to the issuance of trust preferred securities, offset by the $150.0 million used in the redemption of our Series A preferred shares. Additionally, we also realized $240.0 million upon the issuance of common and preferred shares to Fox Paine & Company during the Acquisition, of which $100.0 million was used for the Acquisition, and $17.6 million was used for fees and expenses of the Acquisition.
The quota share arrangement was modified as of May 1, 2004. The new arrangement stipulates that 60% of the United National Insurance Companies’ net retained insurance liability on new and renewal business bound May 1, 2004 and later be ceded to Wind River Bermuda. The modified arrangement also stipulates that 60% of the United National Insurance Companies’ April 30, 2004 unearned premium be ceded to Wind River Bermuda. Also, as a result of the modification, none of the net retained liability on new and renewal business bound May 1, 2004 and later by the United National Insurance Companies has been directly assumed by Wind River Barbados.
Reinsurance premiums ceded by the United National Insurance Companies through January 2005 were paid to Wind River Bermuda and Wind River Barbados. Since Wind River Barbados and Wind River Bermuda are not authorized reinsurers in the United States, the insurance laws and regulations of Pennsylvania, Indiana and Wisconsin require the establishment of reinsurance trusts for the benefit of the United National Insurance Companies. The funding requirement includes the amount due on ceded paid loss and loss adjustment expenses, ceded unearned premium reserves, and ceded loss and loss adjustment reserves.
All trusts that we are required to maintain as a result of the above mentioned pooling agreements and quota share arrangements are adequately funded.
Effective January 1, 2005, Wind River Barbados entered into a quota share reinsurance agreement with Wind River Bermuda. Under the terms of this reinsurance agreement, Wind River Barbados assumed 35% of Wind River Bermuda’s net retained insurance liability on losses occurring on or after January 1, 2005 on all new and renewal insurance and reinsurance business effective on or after January 1, 2005.
Prospectively, as fixed income investments mature and new cash is obtained, the cash available to invest will be invested in accordance with our investment policy. Our investment policy allows us to invest in taxable and tax-exempt fixed income investments as well as publicly traded and private equity investments. With respect to bonds, our credit exposure limit for each issuer varies with the issuer’s credit quality. The allocation between taxable and tax-exempt bonds is determined based on market conditions and tax considerations, including the applicability of the alternative minimum tax. The maximum allowable investment in equity securities under our investment policy is 30% of our capital and surplus, or $192.0 million at December 31, 2005.
demand line of credit, and access to the debt and equity capital markets. We believe we have sufficient liquidity to meet our capital needs.
In July 2005, United America Indemnity Group sold $90.0 million of guaranteed senior notes, due July 20, 2015. These senior notes have an interest rate of 6.22%, payable semi-annually. On July 20, 2011 and on each anniversary thereafter to and including July 20, 2014, United America Indemnity Group is required to repay $18.0 million of the principal amount. On July 20, 2015, United America Indemnity Group is required to pay any remaining outstanding principal amount on the notes. The notes are guaranteed by United America Indemnity, Ltd.
In conjunction with the issuance of these new senior notes, Wind River Investment Corporation (“Wind River”) reached agreement with the trustee of the Ball family trusts for the prepayment of the $72.8 million principal and related interest due as of July 20, 2005 on senior notes issued by Wind River. The terms of the prepayment agreement required the Ball family trusts to pay Wind River for $0.3 million of the issuance costs of the new senior notes plus $1.0 million of the incremental interest costs that United America Indemnity Group is estimated to incur under the new senior notes. The total amount of these payments of $1.3 million was recorded as a gain on the early extinguishment of debt.
For 2006, we believe that Wind River Barbados and Wind River Bermuda should have sufficient liquidity and solvency to pay dividends. In the future, we anticipate paying dividends from our Bermuda operations to fund obligations of United America Indemnity, Ltd. Wind River Bermuda is prohibited, without the approval of the BMA, from reducing by 15% or more its total statutory capital as set out in its previous year’s financial statements, and any application for such approval must include such information as the BMA may require. Wind River Bermuda can currently pay a dividend of up to $17.2 million without requesting BMA approval. We expect its dividend paying capacity will increase once Wind River Bermuda and Wind River Barbados are combined into a single entity.
On December 4, 2002, Penn-America Statutory Trust I (“Penn Trust I”), a business trust subsidiary formed by Penn-America Group, Inc. issued $15.0 million of Trust Preferred Securities. These securities have a thirty-year maturity, with a provision that allows the Company to call these securities at par after five years
On May 15, 2003, Penn-America Statutory Trust II (“Penn Trust II”), a business trust subsidiary formed by Penn-America Group, Inc., issued $15.0 million of floating rate capital securities. These securities have a thirty-year maturity, with a provision that allows the Company to call these securities at par after five years from the date of issuance. Cash distributions are paid quarterly in arrears at a rate of 410 basis points over three-month LIBOR. Distributions on these securities can be deferred for up to five years, but in the event of such deferral, Penn-America Group, Inc. may not declare or pay cash dividends on its common stock. Penn-America Group, Inc. guarantees all obligations of Penn Trust II with respect to distributions and payments of these securities.
On October 29, 2003, United National Group Capital Statutory Trust II (“UNG Trust II”), a business trust subsidiary formed by AIS, issued $20.0 million of Trust Preferred Securities. These securities have a thirty-year maturity, with a provision that allows the Company to call these securities at par after five years from the date of issuance. Cash distributions are paid quarterly in arrears at a rate of 385 basis points over three-month LIBOR. Distributions on these securities can be deferred for up to five years, but in the event of such deferral, AIS may not declare or pay cash dividends on its common stock. AIS guarantees all obligations of UNG Trust II with respect to distributions and payments of these securities.
Proceeds from the sale of the Trust Preferred Securities of $20.0 million and $0.6 million of floating rate common securities issued to AIS by UNG Trust II were used to acquire $20.6 million of floating rate junior subordinated deferrable interest rate debentures issued by AIS. These junior subordinated debentures have the same terms with respect to maturity, payments, and distributions as the Trust Preferred Securities issued by UNG Trust II. The proceeds from these junior subordinated debentures are being used to support growth in the Company’s insurance subsidiaries and for general corporate purposes.
United National Insurance Company has a $25.0 million discretionary demand line of credit. There were no outstanding borrowings against the this line of credit as of December 31, 2005.
There were no outstanding borrowings against the discretionary demand line of credit as of December 31, 2005. The amounts shown above represent fees due on the amount available for borrowing.
Substantial future increases in inflation could result in future increases in interest rates, which in turn are likely to result in a decline in the market value of the investment portfolio and resulting unrealized losses or reductions in shareholders’ equity.
Some of the statements under “Business,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and elsewhere in this report may include forward-looking statements that reflect our current views with respect to future events and financial performance that are intended to be covered by the safe harbor for forward-looking statements provided by the Private Securities Litigation Reform Act of 1995. Forward-looking statements are statements that are not historical facts. These statements can be identified by the use of forward-looking terminology such as “believe,” “expect,” “may,” “will,” “should,” “project,” “plan,” “seek,” “intend,” or “anticipate” or the negative thereof or comparable terminology, and include discussions of strategy, financial projections and estimates and their underlying assumptions, statements regarding plans, objectives, expectations or consequences of identified transactions, and statements about the future performance, operations, products and services of the companies.
Our business and operations are and will be subject to a variety of risks, uncertainties and other factors. Consequently, actual results and experience may materially differ from those contained in any forward-looking statements. Such risks, uncertainties and other factors that could cause actual results and experience to differ from those projected include, but are not limited to, the following: (1) the ineffectiveness of our business strategy due to changes in current or future market conditions; (2) the effects of competitors’ pricing policies, and of changes in laws and regulations on competition, including industry consolidation and development of competing financial products; (3) greater frequency or severity of claims and loss activity than our underwriting, reserving or investment practices have anticipated; (4) decreased level of demand for our insurance products or increased competition due to an increase in capacity of property and casualty insurers; (5) risks inherent in establishing loss and loss adjustment expense reserves; (6) uncertainties relating to the financial ratings of our insurance subsidiaries; (7) uncertainties arising from the cyclical nature of our business; (8) changes in our relationships with, and the capacity of, our general agents; (9) the risk that our reinsurers may not be able to fulfill obligations; (10) investment performance and credit risk; and (11) uncertainties relating to governmental and regulatory policies.
The foregoing review of important factors should not be construed as exhaustive and should be read in conjunction with the other cautionary statements that are set forth in “Risk Factors” in Item 1A and
elsewhere in this Annual Report on Form 10-K. We undertake no obligation to publicly update or review any forward-looking statement, whether as a result of new information, future developments or otherwise.
We have completed integrated audits of United America Indemnity, Ltd.’s 2005 and 2004 consolidated financial statements and of its internal control over financial reporting as of December 31, 2005, and an audit of the financial position of the Company as of December 31, 2003 and results of its operations and its cash flows for the period September 6, 2003 through December 31, 2003 in accordance with the standards of the Public Company Accounting Oversight Board (United States). Our opinions, based on our audits, are presented below.
In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of United America Indemnity, Ltd. and its subsidiaries (“Successor Company”) at December 31, 2005 and 2004, and the results of their operations and their cash flows for the years then ended December 31, 2005 and 2004 and for the period September 6, 2003 through December 31, 2003 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedules listed in the accompanying index present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit of financial statements includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial
In our opinion, the consolidated statements of operations, comprehensive income (loss), changes in shareholders’ equity and cash flows listed in the accompanying index present fairly, in all material respects, the results of operations and cash flows of Wind River Investment Corporation and its subsidiaries (“Predecessor Company”) for the period January 1, 2003 through September 5, 2003 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedules listed in the accompanying index present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audit. We conducted our audit of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
United America Indemnity, Ltd. (“United America Indemnity” or the “Company”), was incorporated on August 26, 2003, and is domiciled in the Cayman Islands. On January 24, 2005, the Company changed its name from United National Group, Ltd. to United America Indemnity, Ltd. The Company’s Class A common stock is publicly traded on the NASDAQ National Market. On March 14, 2005, the Company changed its trading symbol on the NASDAQ National Market from “UNGL” to “INDM.”
The Company offers two general classes of insurance products: property and general liability insurance products and professional liability insurance products. Collectively, the Company’s U.S. insurance subsidiaries are licensed in all 50 states and the District of Columbia. The Company is also a wholesale insurance broker and underwriting manager for all types of commercial and industrial accounts.
The consolidated financial statements include the accounts of United America Indemnity and its wholly owned subsidiaries:
United America Indemnity Group, Inc. (“United America Indemnity Group”), fka U.N. Holdings II, Inc.,
In connection with the acquisition of Wind River, the assets and liabilities acquired by the Company were adjusted to fair value. Accordingly, the fair values of the reserve for unpaid losses and loss adjustment expenses and reinsurance receivables were estimated by (1) discounting the gross reserve for unpaid losses and loss adjustment expenses and reinsurance receivables, (2) applying a risk margin to the gross reserves and reinsurance receivables and (3) reducing gross reinsurance receivables by an amount equal to an estimate of
The risk margin applied to the discounted reserve for unpaid losses and loss adjustment expenses and reinsurance receivables was approximately 10% and intended to reflect management’s estimate of the cost Wind River would incur to reinsure the full amount of its unpaid losses and loss adjustment expenses with a third-party reinsurer. This risk margin was based upon management’s assessment of the uncertainty inherent in the reserve for unpaid losses and loss adjustment expenses and their knowledge of the reinsurance marketplace.
On January 24, 2005, the Company acquired 100% of the voting equity interest of Penn Independent Corporation (together with its subsidiaries, “Penn Independent Group”), a wholesale insurance broker and underwriting manager for all types of commercial and industrial accounts, from Penn Independent Group’s shareholders for $98.5 million in cash. Penn Independent Group also owns, through its wholly owned subsidiary PIC Holdings, Inc., 30.5% of the voting equity interest of Penn-America Group, Inc. Upon the acquisition of Penn Independent Group, the Company also indirectly acquired Penn Independent Group’s shares of Penn-America Group, Inc. common stock. Penn Independent Group’s results of operations are
included in the Company’s results of operations subsequent to the date of the acquisition. In accordance with the terms of the acquisition, $6.0 million of the purchase price was placed in escrow on January 24, 2005 to secure potential indemnification for pre-closing taxes and damages resulting from breach of warranties, representations or covenants due to the Company under the terms of the stock purchase agreement between the Company, Penn Independent Corporation, its former principal shareholders and Irvin Saltzman. The Company released $2.0 million of the escrowed funds to Irvin Saltzman on July 24, 2005 and on January 24, 2006. The remaining $2.0 million held in escrow is scheduled to be released to Irvin Saltzman on July 24, 2006 if no claims have been filed by the Company before then. The Company has filed no claims under the escrow agreement to date.
not affect net reinsurance receivables materially because Penn-America Group, Inc. had recorded an allowance for uncollectible reinsurance, which was considered a reasonable estimate of the credit risk inherent in the reinsurance receivables as of the acquisition date.
As a result of these adjustments, the fair value of the gross unearned premium reserves was reduced by $26.3 million as of January 24, 2005, with a $5.2 million decrease in prepaid reinsurance premiums, thereby resulting in an $21.1 million decrease in the net unearned premium reserves. The adjustments to the gross and net unearned premium reserves had a directly proportional impact to gross and net premiums earned.
Penn-America Group, Inc. leased its home office facility in Hatboro, Pennsylvania from Irvin Saltzman through October 18, 2005, and the lease was accounted for as a capital lease. On October 19, 2005, AIS, an indirect wholly owned subsidiary of the Company, purchased the Hatboro facility from Irvin Saltzman for $5.5 million in cash, and incurred $0.1 million in expenses related to the acquisition.
The Predecessor’s investments in convertible bonds, preferred stocks, and common stocks were classified as trading. The change in the difference between amortized cost and market value was included in income.
The Company regularly performs various analytical valuation procedures with respect to its investments, including identifying any security where the fair value is below its cost. Upon identification of such securities, a detailed review is performed to determine whether the decline is considered other than temporary. This review includes an analysis of several factors, including but not limited to, the credit ratings and cash flows of the securities, and the magnitude and length of time that the fair value of such securities is below cost. The factors considered in reaching the conclusion that a decline below cost is other than temporary include, among others, whether (1) the issuer is in financial distress, (2) the investment is secured, (3) a significant credit rating action occurred, (4) scheduled interest payments were delayed or missed and (5) changes in laws or regulations have affected an issuer or industry.
During the year ended December 31, 2005, the Company recorded other than temporary impairment losses of $0.8 million attributable to its common stock portfolio. During the year ended December 31, 2004, the Company recorded other than temporary impairment losses of $0.2 million attributable to its common stock portfolio. No such losses were incurred during the period from September 6, 2003 to December 31, 2003. During the period from January 1, 2003 to September 5, 2003, the Predecessor recorded other than temporary impairment losses of $1.9 million on its fixed income portfolio and $0.7 million on its investments in limited partnerships.
By using derivative instruments, the Company is exposed to credit risk based on current market conditions and potential payment obligations between the Company and its counterparty. The Company has entered into the interest rate swap with a high credit quality counterparty, which is rated “A1” by Moody’s Investors Service Inc. (“Moody’s”). The Company’s interest rate swap contract is governed by an International Swaps and Derivatives Association Master Agreement, and includes provisions that require collateral to be pledged by the Company or its counterparty if the current value of the interest rate swap exceeds certain thresholds. As of December 31, 2005, no collateral was held by the Company’s counterparty.
For the purpose of the statements of cash flows, the Company considers all liquid instruments with maturities, at date of acquisition, of three months or less to be cash equivalents. The Company has a cash management program that provides for the investment of excess cash balances primarily in short-term money market instruments. Generally, bank balances exceed federally insured limits. The carrying amount of cash and cash equivalents approximates fair value.
The Company evaluates the collectibility of agents’ balances and accounts receivable based on a combination of factors. In circumstances in which the Company is aware of a specific agent’s inability to meet its financial obligations to the Company, a specific allowance for bad debts against amounts due is recorded to reduce the net receivable to the amount reasonably believed by the Company’s management to be collectible. No such instances occurred in 2005. For all remaining balances, allowances are recognized for bad debts based on historical statistics of the length of time the receivables are past due. The allowance for bad debts was $0.6 million and $0.1 million as of December 31, 2005 and 2004, respectively. For 2005, there were net bad debts written off of $0.07 million.
Effective July 1, 2001, the Company’s predecessor adopted the provisions of SFAS No. 141, “Business Combinations” and SFAS No. 142, “Goodwill and Other Intangible Assets” (“SFAS 142”). On January 24, 2005, the Company recorded $102.0 million and $32.5 million of goodwill and intangible assets, respectively, as a result of the acquisition of Penn Independent Corporation and the merger with Penn-America Group, Inc.
In accordance with SFAS 142, the Company tests for impairment of goodwill and other indefinite lived assets at least annually and more frequently as circumstances warrant. The Company performed its annual impairment review of goodwill and other indefinite lived assets during the fourth quarter of 2005. Nothing has been noted to date that would indicate that goodwill and other indefinite lived assets are impaired as of December 31, 2005.
On February 28, 2003, AIS converted from a C Corporation to an S Corporation. AIS and its subsidiaries filed a consolidated federal tax return as of February 28, 2003. For the tax period from March 1, 2003 to September 5, 2003, United National Insurance Company and its subsidiaries filed a consolidated federal income tax return and AIS and its other subsidiaries, AIAA and IU, each filed a separate, stand-alone federal income tax return.
On September 5, 2003, Wind River and AIS converted from an S Corporation to a C Corporation. A consolidated income tax return was filed for all U.S. entities for the stub period from September 6, 2003 to December 31, 2003 and the year ended December 31, 2004. A consolidated income tax return for all U.S. companies will be filed for the year ended December 31, 2005.
Premiums written are recognized as earned ratably over the terms of the respective policies.
Agency expenses include commissions retained by retail agents and brokers on policies bound by the Agency Operations. Operating expenses include personnel expenses and general operating expenses of the Agency Operations.
The extraordinary gain of $1.4 million and $1.2 million for 2005 and 2004, respectively, represents the recognition of tax benefits derived from acquisition costs incurred in connection with the Company’s acquisition of Wind River Investment Corporation, which are currently considered to be deductible for federal tax purposes. The extraordinary gain of $46.4 million for 2003 represents the excess of the estimated fair value of net assets over purchase price from the Acquisition.
Basic earnings per share has been calculated by dividing net income available to common shareholders by the weighted-average common shares outstanding. Diluted earnings per share has been calculated by dividing net income available to common shareholders by the weighted-average common shares outstanding and the weighted-average share equivalents outstanding, which include options and warrants.
In March 2004, the FASB issued Emerging Issues Task Force Issue No. 03-01, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” (“EITF 03-01”) which provides new guidance for assessing impairment losses on debt and equity investments. Additionally, EITF 03-01 includes new disclosure requirements for investments that are deemed to be temporarily impaired. In September 2004, the FASB delayed the guidance regarding the impairment related to debt instruments. The disclosure requirements, however, are still in effect.
The amortized cost and estimated fair value of investments classified as available for sale were as follows as of December 31, 2005 and 2004:
The Company did not hold any debt or equity investments in a single issuer that was in excess of 10% of shareholders’ equity at December 31, 2005 or 2004.
The following table contains an analysis of the Company’s securities with gross unrealized losses, categorized by the period that the securities were in a continuous loss position as of December 31, 2004:
Subject to the risks and uncertainties in evaluating the potential impairment of a security’s value, the impairment evaluation conducted by the Company as of December 31, 2005, concluded the unrealized losses discussed above are not other than temporary impairments. The impairment evaluation process is discussed in the “Investment” section of Note 4 (“Summary of Significant Accounting Policies”).
The amortized cost and estimated fair value of bonds classified as available for sale at December 31, 2005, by contractual maturity, are shown below. Actual maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
The components of net realized investment gains (losses) on the sale of investments for the years ended December 31, 2005 and 2004, the period from September 6, 2003 to December 31, 2003, and the period from January 1, 2003 to September 5, 2003, were as follows:
December 31, 2003, and the period from January 1, 2003 to September 5, 2003, were $371.7 million, $298.4 million, $186.8 million, and $70.6 million, respectively.
The sources of net investment income for the years ended December 31, 2005 and 2004, the period from September 6, 2003 to December 31, 2003 and the period from January 1, 2003 to September 5, 2003 were as follows:
There was one non income-producing bond in the amount of $0.8 million for the years ended December 31, 2005 and 2004, the period from September 6, 2003 to December 31, 2003, and the period from January 1, 2003 to September 5, 2003. The Company has evaluated the investment and believes the value will be recouped.
The Company cedes insurance to unrelated insurers on a pro rata (“quota share”) and excess of loss basis in the ordinary course of business to limit its net loss exposure. Reinsurance ceded arrangements do not discharge the Company of primary liability as the originating insurer. Moreover, reinsurers may fail to pay us due to a lack of reinsurer liquidity, perceived improper underwriting, losses for risks that are excluded from reinsurance coverage, and other similar factors, all of which could adversely affect the Company’s financial results.
At December 31, 2005 and 2004, the Company carried reinsurance receivables of $1,278.1 million and $1,531.9 million, respectively. These amounts are net of two purchase accounting adjustments. The first purchase accounting adjustment, which was due to discounting the loss reserves to their present value and applying a risk margin to the discounted reserves, lowered the reinsurance receivables balance by $21.2 million in 2005 and $49.4 million in 2004. The second purchase accounting adjustment netted uncollectible reinsurance reserves of $49.1 million against the reinsurance receivables to properly reflect the reinsurance receivables at their fair value at the Wind River Acquisition date. Due to commutations and charge-offs of uncollectible reinsurance recoverables, this purchase accounting adjustment has been reduced to $28.7 million at December 31, 2005 and 2004. The Company also established an uncollectible reinsurance reserve of $0.2 million during 2005.
The Company’s current property writings create exposure to catastrophic events, and its casualty writings create exposure to casualty clash events. Casualty clash exposure arises when two or more insureds are involved in the same loss occurrence. To protect from these exposures, the Company has purchased $55.0 million in excess of $5.0 million of property catastrophe for events occurring in 2006 and $10.0 million in excess of $3.0 million of casualty clash coverages, both of which are on a per occurrence basis. The Company ceded $1.9 million in losses as a result of Hurricane Wilma and has not purchased reinstatement coverage. As a result, if a catastrophe occurs between now and June 30, 2006, the Company would retain the first $6.9 million of losses. To the extent that there may be increased catastrophe or casualty clash exposure in the future, the Company may increase its reinsurance protection for these exposures commensurately.
As of December 31, 2005, the Company had aggregate unsecured reinsurance receivables that exceeded 3% of shareholders’ equity from the following groups of reinsurers. Unsecured reinsurance receivables include amounts receivable for paid and unpaid losses and loss adjustment expenses and prepaid reinsurance premiums, less amounts secured by collateral.
U.A.I. (Gibraltar) Limited and U.A.I. (Gibraltar) II Limited are tax-exempt companies in Gibraltar subject to a tax exempt certificate issued by the Gibraltar authorities. They are therefore exempt from all Gibraltar taxes and gains made by the Company.
In 2005 and 2004, the Company recognized extraordinary gains of $1.4 million and $1.2 million, respectively, for tax benefits derived from acquisition costs included as a reduction in equity as a result of the Acquisition, that have been or will be deducted in the future from income for federal tax purposes.
The Company has an alternative minimum tax credit carryover of $13.0 million, which, subject to statutory limitations, can be carried forward indefinitely.
In 2005, the Company decreased its net loss reserve relative to accident years 2004 and prior by $1.3 million due to lower than anticipated frequency in our animal mortality program. In 2004, the Company decreased its net loss reserve relative to accident years 2003 and prior by $0.8 million. In 2003, the Company increased its net loss reserve relative to accident years 2002 and prior by $0.6 million.
During 2005, the Penn-America Insurance Companies increased incurred losses related to insured events of prior years by $5.8 million subsequent to January 24, 2005. This increase consisted of an increase in incurred losses related to their casualty lines of business of $11.6 million relating mainly to accident years 1994 through 2000 offset partially by a decrease in incurred losses related to their property lines of business of $5.8 million relating primarily to accident year 2004.
As of December 31, 2005, 2004, and 2003, the survival ratio on a net basis for our open A&E claims was 9.6 years, 17.3 years, and 15.1 years, respectively. As of December 31, 2005, 2004, and 2003, the survival ratio on a gross basis for our open A&E claims was 7.1 years, 9.4 years, and 11.1 years, respectively. The survival ratio, which is the ratio of net reserves to the 3-year average of annual paid claims, is a non-GAAP financial measure that indicates how long the current amount of net reserves are expected to last based on the current rate of paid claims.
On December 4, 2002, Penn Trust I, a business trust subsidiary formed by Penn-America Group, Inc. issued $15.0 million of Trust Preferred Securities. These securities have a thirty-year maturity, with a provision that allows the Company to call these securities at par after five years from the date of issuance. Cash distributions are paid quarterly in arrears at a rate equal to three-month London Interbank Offered Rates (“LIBOR”) plus 4.00%. Distributions on these securities can be deferred for up to five years, but in the event of such deferral, Penn-America Group, Inc. may not declare or pay cash dividends on its common stock. Penn-America Group, Inc. guarantees all obligations of Penn Trust I with respect to distributions and payments of these securities.
Proceeds from the sale of Trust Preferred Securities of $15.0 million and $0.5 million of floating rate common securities issued to Penn-America Group, Inc. by Penn Trust I were used to acquire $15.5 million of floating rate junior subordinated deferrable interest rate debentures issued by the Company. These junior subordinated debentures have the same terms with respect to maturity, payments, and distributions as the Trust Preferred Securities issued by Penn Trust I. In 2002, Penn-America Group, Inc. contributed net proceeds of $14.5 million for these junior subordinated debentures to Penn-America Insurance Company to support the business growth in its insurance subsidiaries.
Proceeds from the sale of the Trust Preferred Securities of $15.0 million and $0.5 million of floating rate common securities issued to Penn-America Group, Inc. by Penn Trust II were used to acquire $15.5 million of floating rate junior subordinated deferrable interest rate debentures issued by Penn-America Group, Inc. These junior subordinated debentures have the same terms with respect to maturity, payments, and distributions as the Trust Preferred Securities issued by Penn Trust II. The proceeds from these junior subordinated debentures are being used to support growth in the Company’s insurance subsidiaries and for general corporate purposes.
The entire proceeds from the sale of the trust preferred securities, including the proceeds from the sale of common securities of UNG Trust II to AIS, were used to fund the purchase of $20.6 million (in principal amount) of floating rate junior subordinated deferrable interest debentures issued by AIS under an indenture, dated as of October 29, 2003, between AIS and U.S. Bank National Association, as trustee.
In conjunction with the issuance of these new senior notes, Wind River Investment Corporation (“Wind River”) reached agreement with the trustee of the Ball family trusts for the prepayment of the $72.8 million principal and related interest due as of July 20, 2005 on senior notes issued by Wind River. The terms of the prepayment agreement required the Ball family trusts to pay Wind River for $0.3 million of the issuance costs of the new senior notes plus $1.0 million of the incremental interest costs that United America Indemnity Group is estimated to incur under the new senior notes. The total amount of these payments of $1.3 million by the Ball family trusts was recorded as a gain on the early extinguishment of debt.
During 2002, the Company established a $25.0 million Revolving Credit Facility with Citizens Bank of Pennsylvania. Interest is payable monthly at LIBOR plus 65 basis points or the Prime Rate. The Revolving Credit Facility was converted to a Demand Discretionary Facility in February 2003. As of December 31, 2005, there was no balance due in connection with this credit facility.
At December 31, 2005 and 2004, Wind River Barbados was a limited partner in investment funds managed by Fox Paine & Company. The Company’s investment in these limited partnerships was valued at $6.1 million and $6.2 million at December 31, 2005 and 2004, respectively. At December 31, 2005, the Company had an additional capital commitment of $3.9 million to these limited partnerships.
On October 15, 2004, DVUA Massachusetts, Inc. entered into a shareholders’ agreement with a minority shareholder issuing twenty shares. As of December 31, 2005, the minority shareholder owned 20.0% of the outstanding shares of DVUA Massachusetts, Inc. As of December 31, 2005, PIC Holdings owned 80.0% of the outstanding common stock of DVUA Massachusetts Agency, Inc. Minority interest as of December 31, 2005 was $0.06 million.
Total rental expense under operating leases for the years ended December 31, 2005 and 2004, the period from September 6, 2003 to December 31, 2003, and the period from January 1, 2003 to September 5, 2003 were $4.0 million, $2.6 million, $0.7 million, and $1.4 million, respectively. At December 31, 2005, future minimum payments under non-cancelable operating leases were as follows:
On November 23, 2004, UNIC settled, in consideration of a payment in the amount of $1.8 million by Gulf Underwriters Insurance Company (“Gulf”) to UNIC, a lawsuit instituted by Gulf pending in the Superior Court of Fulton County, Georgia. The lawsuit had sought to rescind a facultative reinsurance certificate issued by Gulf to UNIC with regard to an individual insurance policy. The reinsurance certificate provided 100% reinsurance to UNIC for loss and loss adjustment expenses paid under the insurance policy. The lawsuit had followed UNIC’s billing to Gulf for reimbursement of a loss in the amount of $3.1 million that UNIC had paid under that insurance policy and for which UNIC filed a counterclaim against Gulf. No gain or loss was recognized from the settlement of this lawsuit.
The Company has committed to investing into several limited liability partnership funds. As of December 31, 2005, $41.2 million has been invested. The Company has a remaining commitment of $3.9 million. The timing and funding of this remaining commitment has not been determined. As investment opportunities are identified by the partnerships, capital calls will be made.
The Company maintains the United America Indemnity, Ltd. Share Incentive Plan (as so amended, the “Plan”). The purpose of the Plan is to give the Company a competitive advantage in attracting and retaining officers, employees, consultants and non-employee directors by offering stock options, restricted stock and other stock-based awards. As amended in May 2005, the Company may issue up to 5.0 million Class A common shares for issuance pursuant to awards granted under the Plan.
On September 5, 2003, the Company granted options to purchase Class A common shares to two officers of the Company (“Option-A Tranche”). The Option-A Tranche options have an exercise price of $6.50 per share and expire on September 5, 2013, and were fully vested at the time of the grant. The Company recorded $0.9 million of compensation expense during the period from September 5, 2003 to December 31, 2003, which represents the fair value of the Option-A Tranche on the date of the grant since they were fully vested. During 2005, 93,825 of the Option-A Tranche options were forfeited.
During 2005, the Company granted 436,492 Time-Based Options and 133,415 Performance-Based Options under the Plan. The Time-Based Options vest in 20% increments over a five-year period, with any unvested options forfeited upon termination of employment for any reason, and expire 10 years after grant date. The Performance-Based Options vest in 25% increments and are conditional upon the Company achieving various operating targets and expire 10 years after the grant date.
On December 31, 2005, the Company modified the 2003 grant of 579,201 Time-Based Options and the 2003 grant of 883,489 Performance-Based Options. The Time Based Options were amended so as to modify the vesting schedule for the remaining unvested options, which will now vest at the rate of 12% on December 31, 2006, 12% on December 31, 2007, and 36% on December 31, 2008. Also, the performance hurdle with respect to accelerated option vesting upon a change of control was eliminated. Of the 2003 stock option grants, a total of 369,540 and 15,552 were forfeited and exercised, respectively, before the change. The Performance-Based Options were amended to eliminate the performance vesting criteria relating to the annual option vesting and catch-up vesting. Also, the performance hurdle with respect to accelerated option vesting upon a change of control was eliminated. The remaining unvested options become exercisable at the rate of 10% on December 31, 2006, 10% on December 31, 2007, and 30% on December 31, 2008. As a result of these changes, the Company incurred an additional $2.5 million in stock option expense in 2005.
In 2005, the Company recorded $3.3 million of compensation expense for the 1,460,806 options granted under the Plan. In 2004, the Company recorded $0.5 million of compensation expense for the 1,464,090 options granted under the Plan. In 2003, recorded $0.2 million of compensation expense for the 1,462,690 options granted under the Plan.
In connection with the business combinations of the Company with Penn-America Group and Penn Independent Group, along with their respective subsidiaries, certain executives of Penn-America Group and Penn Independent Group entered into employment agreements which provided for the establishment of an integration bonus payable in Class A common shares of the Company in 2006 and 2007, if specified integrated company performance goals for 2005 and 2006, respectively, are achieved (the “Integration Plan”).
For employees of Penn Independent Corporation, Penn-America Group, Inc. and their subsidiaries, the Company matches 50% of the first 6% contributed by the employee. Vesting in the Company’s contribution is immediate for eligible employees. Total expenses related to this plan for the year ended December 31, 2005 were $0.5 million.
On September 5, 2003, the Company issued a total of 55,000 warrants at an exercise price of $10.00 per share. Expenses associated with the issuance of these warrants were $37,400. There were no such expenses in 2005 or 2004.
In connection with the Company’s merger with Penn-America Group, Inc. and acquisition of Penn Independent Corporation, the Company reevaluated its segment classifications and determined that the Company operates and manages its business through two business segments during 2005 and thereafter. The Insurance Operations segment includes the operations of the United National Insurance Companies, the Penn-America Insurance Companies and Non-U.S. Insurance Operations. The Agency Operations segment consists solely of the operations of Penn Independent Group.
The segments follow the same accounting policies used for the Company’s consolidated financial statements as described in the summary of significant accounting policies.
The Company purchased 100% of the common shares of Penn Independent Corporation and 100% of the common shares of Penn-America Group, Inc. In conjunction with the acquisition, liabilities were assumed as follows:
President and Chief Executive Officer. It is expected that this consolidation will be completed by year-end 2006.
Robert A. Lear resigned from Penn Independent Corporation on January 31, 2006. Robert Cohen has been appointed President and Chief Executive Officer of Penn Independent Corporation.
Messrs. Morris, Schmidt, and Cohen will continue to report directly to the Board of Directors through its Chairman.