Midland owns its 275,000 square foot principal offices located in Amelia, Ohio. Midland’s insurance subsidiaries lease office space in Amelia, Ohio, Montgomery, Alabama and St. Louis, Missouri. Midland’s transportation subsidiaries lease offices in Metairie, Louisiana and St. Louis, Missouri. As described under “Liquidity, Capital Resources and Changes in Financial Condition” on page 32, Midland intends to complete the expansion of its headquarters in 2007. Midland’s premises are suitable and adequate for their intended use.
(c) On January 1, 2002, the Company adopted SFAS 142 and recorded an impairment charge related to goodwill of $1.5 million, net of tax of $0.8 million.
(d) The Company adopted SFAS 123(R ) in 2005 which increased stock option expense $2.5 million and $1.9 million in 2006 and 2005, respectively. Net income (after tax) was reduced by $1.6 million and $1.2 million, or $0.08 and $0.06 per share (diluted and basic), in 2006 and 2005, respectively. Prior year results were not restated.
The Midland Company (“Midland” or the “Company”) is a highly focused provider of specialty insurance products and services through its American Modern Insurance Group, Inc. (“AMIG” or “American Modern”) subsidiary, which contributes approximately 94 percent of the company’s revenues. The Company also maintains an investment in a niche river transportation business, M/G Transport Services Inc. The Company has divided its insurance products into four distinct groups: residential property, recreational casualty, financial institutions, and all other insurance products. The discussions of “Results of Operations” and “Liquidity, Capital Resources and Changes in Financial Condition” address these four reportable insurance segments and our transportation business. A summary description of the operations of each of these segments is included below.
M/G Transport Services, Inc. and MGT Services, Inc. (collectively M/G Transport) operates a fleet of dry cargo barges for the movement of dry bulk commodities such as petroleum coke, ores, barite, sugar and other dry cargoes primarily on the lower Mississippi River and its tributaries and manages river transportation equipment owned by others on a fee based arrangement.
American Modern’s catastrophe reinsurance program is a significant aspect of our exposure management. Our 2006 catastrophe reinsurance structure was similar to the 2005 program with a $3.0 million increase in retention, from $7 million to $10 million, and the purchase of an additional $40 million of protection on top of our previous $110 million cover. Due to the volatile weather patterns of 2005, we absorbed a significant increase in our base reinsurance cost in 2006 that nearly doubled the base cost of 2005. This increase, along with the additional cover, adversely impacted our 2006 pre-tax earnings by approximately $12.0 million, or $0.40 per share (diluted). We have already begun efforts to recoup these costs through appropriate rate increases, commission adjustments and/or product changes. However, this is a process that takes some time, including additional time after state approvals to get the new rates and product changes into place within the renewal book and earned premium. These efforts produced minimal benefit to our 2006 profits, and likely will not be fully realized until 2007.
Our 2007 catastrophe reinsurance program is similar to the 2006 structure, but includes an additional $50 million layer of protection on top of our previous $150 million cover. The cost of our base catastrophe reinsurance program, which includes the purchase of the additional cover, will adversely impact our 2007 earnings by approximately $0.16 per share (diluted) as compared to 2006.
make/model table to improve accuracy of class and identification of ineligible units. The decrease in watercraft direct and assumed written premiums was due primarily to underwriting actions taken to balance our coastal exposures. Although these actions are currently reducing our ability to grow these lines, we believe the recreational casualty products are now better positioned to provide profitable growth in the upcoming years.
The increase in direct and assumed written premiums for our financial institutions insurance products was driven primarily by the mortgage fire product which increased $30.2 million compared to the prior year. The increase in mortgage fire premiums is due to the signing of several new accounts throughout the year. Income increased for our financial institutions insurance products due to the mortgage fire profits generated from the increased written premiums.
American Modern’s excess and surplus lines and credit life products were the primary drivers of the increase in direct and assumed written premiums in 2006 compared to 2005. A large percentage of the Company’s excess and surplus lines gross written premium is ceded to
reinsurers. In addition, a large percentage of credit life direct and assumed written premium is ceded to an insurance affiliate of the producing agent. The growth in our credit life insurance line was assisted by the acquisition of Southern Pioneer Life Insurance Company in July of 2006. This acquisition contributed $7.8 million of direct and assumed written premiums during the second half of 2006. The improvement in profitability in 2006 compared to 2005 is due primarily to the improved underwriting results related to the long haul truck, credit life and excess and surplus lines business combined with the profits generated from Southern Pioneer Life.
The Company’s operating and administrative expenses increased 13.3% to $127.2 million in 2006 compared to $112.3 million in 2005. This increase is due primarily to expenses related to an increase in employee salaries and benefits.
The following chart shows American Modern’s gross written premium, net written premium and net earned premium by business segment for the years ended December 31, 2005 and 2004 (in millions):
The manufactured housing combined ratio, including catastrophe losses, decreased slightly to 94.4% in 2005 compared to 94.9% in 2004. Excluding catastrophe losses for both years, the combined ratio improved to 84.7% in 2005 from 86.0% in 2004. This improvement was due primarily to rate increases combined with improved underwriting. The site-built dwelling combined ratio increased to 98.3% in 2005 compared to 93.2% in 2004. Excluding catastrophe losses for both years, the combined ratio increased by 2 points to 91.9% in 2005 compared to 89.9% in 2004.
Profits increased for our financial institutions insurance products as this segment was impacted by a $3.4 million loss related to the run-off of a cancelled product line in 2004. No such run-off losses were incurred in 2005.
The following chart is an overview of the results of operations of the company’s all other insurance segment (in 000’s).
Although net investment income is allocated to segments and product lines, the investment portfolio is generally managed as a whole and therefore is more meaningfully discussed in total. Net investment income increased to $40.5 million in 2005 from $37.2 million in 2004. This increase was due primarily to an increase in investment yield. The annualized pre-tax equivalent investment yield, on a cost basis, of the Company’s fixed income portfolio was 5.5% in 2005 compared to 5.2% in 2004.
Overall, American Modern’s losses and loss adjustment expenses decreased 17.8% in 2005 to $286.7 million from $348.6 million in 2004. As mentioned in the segment discussions above, the decrease was due primarily to improved underwriting results for the motorcycle, excess and surplus lines, and park and dealer products combined with decreased earned premiums in 2005 compared to 2004. While the overall financial impact of catastrophes in 2005 was worse than 2004, due to reinstatement premiums and other catastrophe related items, loss and loss adjustment expenses due to catastrophes actually decreased in 2005 to $34.9 million compared to $42.7 million in 2004.
increase in employee salaries and benefits. In addition, the Company adopted Statement of Financial Accounting Standards (“SFAS”) 123(R) in 2005 which resulted in the recognition of $1.9 million in stock option expense.
M/G Transport, Midland’s transportation subsidiary, contributed $4.9 million of income, before taxes, in 2005 compared to $1.7 million in 2004. The increased profitability was due partially to significantly improved freight rates during 2005. In addition, M/G Transport focused its resources on shorter, more profitable moves in 2005. This strategy considerably improved M/G Transport’s profitability, but hampered its top line revenues. In fact, M/G Transport’s revenues decreased slightly to $42.2 million in 2005 compared to $45.4 million in 2004.
value. For all of the aforementioned operating leases, the 15-year lease periods were more attractive at the time than the traditional 5-year financing term for conventional long-term debt. As of December 31, 2006 future lease payments required under these operating lease arrangements are (000’s): 2007 - $2,444; 2008 through 2009 - $4,910; 2010 through 2011-$5,069; after 5 years - $20,347. M/G Transport’s operating cash flow is currently sufficient to pay the financial obligations under this agreement. Also included under purchase obligations in the above table is $10.7 million related to a contract to acquire an additional 25 jumbo open barges in 2007.
The Company is in the process of significantly expanding its headquarters. The expansion, which is scheduled for completion in September 2007, will add approximately 205,000 square feet of new office space and will expand an existing training center by approximately 20,000 square feet. The new facility, which is expected to cost approximately $29 million ($17.4 has been capitalized through December 31, 2006 with the remaining $11.6 million included in the purchase obligations line in the above table), will be financed through operating cash flows and short term debt borrowings during the construction phase. The Company is considering various financing options for the building once construction is completed.
Midland has a commercial paper program under which qualified purchasers may invest in the short-term unsecured notes of Midland. As of December 31, 2006, we had $7.9 million of commercial paper debt outstanding, $6.6 million of which represented notes held either directly or indirectly by our executive officers and directors. The effective annual yield paid to all participants in this program was 5.4% as of December 31, 2006, a rate that is considered to be competitive with the market rates offered for similar instruments. As of December 31, 2006, Midland also had $83.0 million of conventional short-term credit lines available at costs not exceeding prime borrowing rates, of which $10.0 million was outstanding. These lines of credit contain minimal covenants and are typically drawn and repaid over periods ranging from two weeks to three months. We also have a mortgage obligation related to the financing of our corporate headquarters building. As of December 31, 2006, the outstanding balance of this mortgage was $13.9 million. This mortgage obligation includes normal and customary debt covenants for instruments of this type. Monthly interest payments are required until maturity in December 2007. The effective interest rate on this obligation is based on LIBOR plus 1% and was 6.31% at December 31, 2006.
The market value of Midland’s consolidated investment portfolio (comprised primarily of the investment holdings of American Modern) increased 8.9% to $1,031.4 million at December 31, 2006 from $947.1 million at December 31, 2005. This increase was due, in part, to the positive cash flow from operations combined with the reinvestment of interest and dividends received throughout 2006. The increase was also due to the $26.0 million increase in unrealized appreciation in the market value of the securities held at December 31, 2006 compared to year end 2005. The increase in the unrealized appreciation was due to a $25.6 million increase in unrealized appreciation related to the equity portfolio combined with a $0.4 million increase in unrealized appreciation pertaining to the fixed income portfolio. Midland’s largest equity holding, 2.5 million shares of U.S. Bancorp, increased to $88.8 million as of December 31, 2006 from $73.5 million as of December 31, 2005.
The average duration of the Company’s debt security investment portfolio as of December 31, 2006 was 5.0 years which management believes provides adequate asset/liability matching.
American Modern generates cash inflows primarily from insurance premium, investment income, proceeds from the sale of marketable securities and maturities of debt security investments. The principal cash outflows for the insurance operations relate to the payment of claims, commissions, premium taxes, operating expenses, capital expenditures, income taxes, interest on debt, dividends and inter-company borrowings and the purchase of marketable
Reinsurance recoverables and prepaid reinsurance premiums consisted of the following amounts (amounts in 000’s):
The decrease in reinsurance recoverables of $21.7 million at December 31, 2006 compared to 2005 is attributable primarily to the settlement of loss recoverables in 2006 related to the 2005 hurricanes. The increase in prepaid reinsurance premiums is due to the related increase in ceded written premiums during 2006.
The increase in property, plant and equipment of $29.0 million at December 31, 2006 compared to 2005 is due to the costs incurred to date related to the expansion of the Company’s headquarters, the continuing investment in modernLINK®, and M/G Transport’s purchase of 15 additional barges.
M/G Transport entered into a fifteen-year lease in 1999 for transportation equipment. Aggregate rental payments under this operating lease over the next eight years will approximate $4.7 million. M/G Transport also entered into three fifteen-year operating leases related to the leasing of an additional 60 barges during the fourth quarter of 2006. Aggregate rental payments under these operating leases over the next fifteen years will approximate $28.1 million. In addition to the 2006 operating leases, M/G Transport purchased fifteen barges in the fourth quarter of 2006 for approximately $6.3 million.
The differences between our net income and comprehensive income are changes in unrealized gains on marketable securities, changes in the fair value of the interest rate swap agreement and additional minimum liability requirements related to our defined benefit pension plans. For the years ended December 31, 2006, 2005 and 2004, such changes increased or (decreased), net of related income tax effects, by the following amounts (amounts in 000’s):
Net unrealized investment gains in equity securities (net of income tax effects) increased $16.6 million in 2006, decreased $2.9 million in 2005 and increased $2.7 million in 2004. For fixed income securities, net unrealized gains increased $0.3 million in 2006, decreased $11.0 million in 2005 and decreased $1.7 million in 2004.
lives of the policies in proportion to the amount of insurance protection provided. American Modern generally does not consider anticipated investment income in determining premium deficiencies (if any) on short-term contracts. Policy acquisition costs, primarily commission expenses and premium taxes, are capitalized and expensed over the terms of the related policies on the same basis as the related premiums are earned. Selling and administrative expenses that are not primarily related to premiums written are expensed as incurred.
Revenues for river transportation activities are recognized when earned. If freight services are in process at the end of a reporting period, an allocation of revenue between reporting periods is made based on relative transit time in each reporting period with expenses recognized as incurred.
Management validates the recorded reserve amount by engaging an accredited consulting actuarial specialist. Following the end of each quarterly reporting period, but prior to the issuance of the financial statements, the consulting actuary develops an “acceptable actuarial range” for loss reserves. The external actuary utilizes various statistical models and analyses, in accordance with generally accepted actuarial standards, to determine this acceptable actuarial range. Management compares the recorded amount of loss reserves to the actuarial range. This range typically involves a fluctuation of approximately 10 percent. The loss reserve recorded balance is affirmed if it is within the acceptable actuarial range. If the recorded balance is outside of the actuarial range, management would make the necessary adjustment to the recorded balance. Historically, the recorded balance has been within the acceptable actuarial range, therefore no such adjustment has been necessary. We have consistently applied this approach to estimating loss reserves.
A summary of our loss reserves at December 31, 2006 and 2005 is included below:
Each year, the credentialed consulting actuary computes an acceptable range for property and casualty reserves, which affirms management’s recorded balance if the recorded amount is within the range. At December 31, 2006, our estimate of property and casualty net loss reserves totaled $139.0 million, which was affirmed by the company’s consulting actuary range of $125.9 million to $143.7 million. However, in light of the significant assumptions and judgments used to estimate loss reserves, there can be no assurance that the actual losses ultimately experienced will fall within the consulting actuary’s range. The range is based on a “reasonable best case” and “reasonable worst case” with varying development patterns across our lines of business. However, the development of the December 31, 2006 loss reserves could be impacted by the following:
With the benefit of hindsight, including one year of actual development patterns observed during 2006, our 2005 loss reserves were subsequently re-estimated to be $138.1 million. This produced a net cumulative redundancy, after one year of development, of $10.0 million. Although the 2005 loss reserves developed favorably in 2006, the redundancy was lower than what was experienced over the last few years. The lower redundancy related to the 2005 loss reserves was due primarily to adverse development in 2006 related to assessments associated with hurricane Katrina, our personal liability lines and our excess and surplus lines of business. The Company continued to see favorable development related to its motorcycle product.
In 2004 and 2005, we experienced more favorable development patterns than we have historically experienced in several of our lines. These lines included the motorcycle and excess and surplus lines as well as personal liability coverages associated with some of our products. The development patterns were more favorable than our historical trends and baseline industry information would have indicated at that time. In addition, during 2004 and 2005, we also experienced a decrease in the non-catastrophe related frequency in our residential property products, such as manufactured housing and site-built dwelling. The actual frequency that we have experienced during these years is below our historical averages, which are included as part of our baseline assumptions. However, we believe that this level of frequency is a short term variation and may not be sustainable over a long period of time.
Although we have experienced better than expected claim activity in 2004 and 2005, we believe that several of our lines of business (including excess and surplus lines, personal liability and park and dealer liability) may still experience additional development in the future because of the liability components that are underwritten. Therefore, the 2004 redundancy reflected after one year of development may ultimately be more or less in future years. The potential for future development is evidenced by the fact that we experienced some adverse development related to losses that occurred in 2004 during 2006 in our personal liability and excess and surplus lines business.
Consequently, despite the recent experience, we have not changed our reserving approach or assumptions and we do not anticipate changing our reserving methodology until we believe that development trends have become sustainable. In determining our estimate of loss reserves, we apply caution to short term variations from historical patterns. We believe that short term variations must be viewed with skepticism and history shows that they do not produce data that is actionable until validated for an appropriate period of time. The evaluation of short term variations is highly subjective and often depends on specific facts and circumstances. Generally, to determine if a short term variation requires action, we analyze the specific facts and circumstances of the trend and evaluate data to determine whether the trend is sustainable. We believe that this approach avoids inappropriate volatility to the income statement. In order to determine whether variations from our historical patterns represent ongoing trends, management meets quarterly with Claims and Product personnel to review business developments, claim frequency and severity statistics and other relevant developmental trends. Additionally, management from various areas of the business (including product, claims and underwriting personnel) meet monthly to discuss trends relating to the products. Management also considers changes in our business, product mix and case base claims reserving philosophies when deciding whether the loss development patterns are sustainable.
As mentioned above, management considers trends or patterns in claim experience in determining its best estimate of loss reserves. Management regularly reviews the level of loss reserves against actual loss development. As part of the retrospective analysis, management compares actual development to our underlying assumptions and we consider these results in assessing whether any adjustments to the loss reserves are necessary. This retrospective review is the primary criteria used in refining the levels of loss reserves recorded in the financial statements. As part of this review, management also considers trends or patterns noted in management’s regular discussions with internal and external consulting actuaries. We meet with our consulting actuary on a quarterly basis and have ongoing discussions as necessary. During the meetings with our consulting actuary, we use available statistical information to re-estimate prior period loss reserves which includes the development of the case base loss reserves. We also consider the summarized statistical results from previous meetings with our external actuary in refining our IBNR reserves. In addition, management meets quarterly with Claims and Product personnel to review ongoing business trends, claim frequency and severity statistics and other relevant developmental trends. We consider changes in our business, product mix, current events and any changes in case base claims reserving philosophies.
Historical loss reporting pattern is applied directly to the latest cumulative reported losses (paid plus case reserves) to estimate ultimate losses
Tends to be responsive to changes in reported losses. May also provide more accurate estimate of ultimate losses for less mature years if historical levels of reserve accuracy are maintained
May inaccurately react to a change in the adequacy of case reserves
Historical loss payment pattern is applied directly to the latest cumulative paid losses to estimate ultimate losses.
The nature of liability payment patterns requires the application of large development factors to relatively small payments in most immature years
Changes in claim closing rates will cause differences in historical averages (i.e. claim population at the same age of development is different.) This method does not reflect claims adjustment information, which is more important in older years.
This method is less sensitive than the incurred loss development method to the volatility that is present in the reported losses in the early stages of development
The timing of information received. As more information becomes available, (i.e., through physical inspections, actual claim settlement, etc.) case base reserves are adjusted appropriately to reflect current information.
In order to determine an acceptable actuarial range of loss reserves, the consulting actuary utilizes various statistical models. The most significant assumptions relate to the development factors which are utilized to predict the ultimate losses expected to be incurred. The consulting actuary utilizes historical development factors, including the use of 3- and 5-year historical development averages to estimate the ultimate liability. Our consulting affirming actuary utilizes development factors that are applicable to certain lines of business based on their risk characteristics (i.e., property, liability, motorcycle, excess and surplus). Additionally, development patterns are developed for each accident year. The development factors that are
Given the way in which we assess the adequacy of our loss reserves, it is not practicable to individually isolate and quantify the impact of specific factors attributable to key assumptions as many of these items are inter-related and are also offset by other significant factors such as frequency and severity.
While management believes the amounts are fairly stated, the ultimate liability, once fully developed, may be more than or less than the recorded amount. If the ultimate pay outs would significantly exceed the expected amounts, the Company has several potential options to utilize in order to satisfy the additional obligations. For example, the Company could liquidate a portion of its investment portfolio or draw on conventional short-term credit lines available, at costs not exceeding prime rates. The Company believes either of these options would be sufficient to meet any increases in required loss payments. Slowness to recognize or respond to new or unexpected loss patterns, such as those caused by the risk factors listed in the Company’s Safe Harbor Statement, could lead to a shortage in reserves, which would lead to a decrease in after-tax earnings.
Company pays a percentage of earned premiums to reinsurers in return for coverage against catastrophic losses. Additional reasons for entering reinsurance agreements include the following:
Our 2006 catastrophe reinsurance structure was similar to the 2005 program with a $3.0 million increase in retention, from $7 million to $10 million, and the purchase of an additional $40 million of protection on top of our previous $110 million cover. Due to the volatile weather patterns of 2005, we absorbed a significant increase in our base reinsurance cost in 2006 that nearly doubled the base cost of 2005. This increase, along with the additional cover, adversely impacted our 2006 pre-tax earnings by approximately $12.0 million, or $0.40 per share (diluted).
Our 2007 catastrophe reinsurance program is similar to the 2006 structure, but includes an additional $50 million layer of protection on top of our previous $150 million cover. The cost of our base catastrophe reinsurance program, which includes the purchase of the additional cover, will adversely impact our 2007 earnings by approximately $0.16 per share (diluted).
For fixed income and equity securities, we consider the following factors, among others, to determine if a security is other-than-temporarily impaired:
the extent and duration to which market value is less than cost
In October 2005, the American Institute of Certified Public Accountants issued Statement of Position (“SOP”) 05-1. SOP 05-1 provides accounting guidance for deferred policy acquisition costs on internal replacements of insurance and investment contracts other than those specifically described in Statement of Financial Accounting Standards (“SFAS”) No. 97, “Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments.” SOP 05-1 defines an internal replacement as a modification in product benefits, features, rights or coverages that occurs by the exchange of a contract for a new contract, or by amendment, endorsement or rider to a contract, or by the election of a feature or coverage within a contract. The provisions of SOP 05-1 are effective for internal replacements occurring in fiscal years beginning after December 15, 2006. The SOP is not expected to have a material impact on the Company’s Consolidated Financial Position or Results of Operations.
In June 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes.” The interpretation clarifies the accounting for uncertainty in income taxes recognized in a company’s financial statements in accordance with Statement of Financial Accounting Standards No. 109, “Accounting for Income Taxes.” Specifically, the pronouncement prescribes a recognition threshold and a measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. The interpretation also provides guidance on the related de-recognition, classification, interest and penalties, accounting for interim periods, disclosure and transition of uncertain tax positions. The interpretation is effective for fiscal years beginning after December 15, 2006. The Company does not expect the adoption of this new pronouncement to have a material effect on its financial position or results of operations.
In September 2006, the FASB issued Statement of Financial Accounting Standards No. 157, “Fair Value Measurements” (“SFAS 157”). This Standard defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosures about fair value measurements. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007 and interim periods within those years. The Company is assessing the impact that SFAS 157 will have on its consolidated financial statements.
Also in September 2006, the FASB issued Statement of Financial Accounting Standards No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans - an amendment of FASB Statement No. 87, 88, 106 and 132(R)” (“SFAS 158”). This Standard requires recognition of the funded status of a benefit plan in the statement of financial position. The Standard also requires recognition in other comprehensive income certain gains and losses that arise during the period but are deferred under pension accounting rules, as well as modifies the timing of reporting and adds certain disclosures. The recognition and disclosure elements of SFAS 158 are effective for fiscal years ending after December 15, 2006. The requirement to measure plan assets and benefit obligations as of the date of the employer’s fiscal year-end statement of financial position is effective for fiscal years ending after December 15, 2008. The adoption of SFAS 158 resulted in a reduction of shareholders’ equity of $3.6 million, net of tax, at December 31, 2006.
We have audited the accompanying consolidated balance sheets of The Midland Company and subsidiaries (the “Company”) as of December 31, 2006 and 2005, and the related consolidated statements of income, changes in shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2006. Our audits also included the financial statement schedules listed in the index at 15(a)(2). 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.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of The Midland Company and subsidiaries as of December 31, 2006 and 2005, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2006, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over financial reporting as of December 31, 2006, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 7, 2007, expressed an unqualified opinion on management’s assessment of the effectiveness of the Company’s internal control over financial reporting and an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.
Treasury stock issued under the Company’s performance stock award plan amounted to $1,978 and $1,155 for 2006 and 2005, respectively.
The accounting policies of the Company and its subsidiaries conform to accounting principles generally accepted in the United States of America. The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make numerous estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. The accompanying consolidated financial statements include estimates for items such as insurance loss reserves, income taxes, various other liability accounts and deferred insurance policy acquisition costs. Actual results could differ from those estimates. Policies that affect the more significant elements of the consolidated financial statements are summarized below.
Principles of Consolidation - The consolidated financial statements include the accounts of the Company and all subsidiary companies. Material intercompany balances and transactions have been eliminated.
During 2006, the Company performed an extensive review of its useful life and salvage value estimates as they relate to M/G Transport’s barges. As a result of this review, the Company determined that the useful lives of the barges should be extended from 20 years to 23 years. In addition, the Company determined that the salvage values of each barge should be increased from $10,000 to $30,000. Both of these changes were implemented prospectively and were effective on October 1, 2006. The effect of this change in accounting estimate on the Company’s net income was $146,000 for the fourth quarter of 2006.
Federal Income Tax - Deferred federal income taxes are recognized to reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for federal income tax purposes. The Company continually reviews deferred tax assets to determine the necessity of a valuation allowance.
American Modern and its independent reinsurance brokers regularly conduct “market security” evaluations of both its current and prospective reinsurers. Such evaluations include a complete review of each reinsurer’s financial condition along with an assessment of credit risk concentrations arising from similar geographic regions, activities or economic characteristics of the reinsurers to minimize its exposure to significant losses from reinsurer insolvencies. The specific evaluation procedures include, but are not limited to, reviewing the periodic financial statements and ratings assigned to each reinsurer from rating agencies such as S&P, Moody’s and A.M. Best. During 2006, approximately 85% of the Company’s catastrophe reinsurers had an A.M. Best or S&P rating of “A” or higher.
designated as a cash flow hedge and were deemed to be 100% effective. Thus, the changes in the fair value of the swap agreements are recorded as a separate component of shareholders’ equity and have no impact on the Consolidated Statements of Income. The interest rate swap agreements ended during 2005 and, therefore, no balances were outstanding related to these derivatives at December 31, 2006 or 2005. At December 31, 2004, $0.3 million in deferred losses, net of tax, related to this hedge were recorded in accumulated other comprehensive income.
The fair values of the 2006, 2005 and 2004 option grants were estimated on the date of the grant using the Black Scholes option-pricing model with the following (weighted average) assumptions:
New Accounting Standards - In October 2005, the American Institute of Certified Public Accountants issued Statement of Position (“SOP”) 05-1. SOP 05-1 provides accounting guidance for deferred policy acquisition costs on internal replacements of insurance and investment contracts other than those specifically described in Statement of Financial Accounting Standards (“SFAS”) No. 97, “Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments.” SOP 05-1 defines an internal replacement as a modification in product benefits, features, rights or coverages that occurs by the exchange of a contract for a new contract, or by amendment, endorsement or rider to a contract, or by the election of a feature or coverage within a contract. The provisions of SOP 05-1 are effective for internal replacements occurring in fiscal years beginning after December 15, 2006. The SOP is not expected to have a material impact on the Company’s Consolidated Financial Position or Results of Operations.
At December 31, 2006 and 2005, the fair value of the Company’s investment in the common stock of US Bancorp, which exceeded 10% of the Company’s shareholders’ equity, was $88.8 million and $73.5 million, respectively. Also, at December 31, 2006 and 2005, the market value of the Company’s investment portfolio includes approximately $24.2 million and $35.1 million, respectively, of convertible securities, some of which contain derivatives features.
The following is investment information summarized by investment category (amounts in 000’s):
Included in Net Realized Investment Gains (Losses) for 2006, 2005 and 2004 is the change in the fair value of derivative features of (amounts in 000’s) $1,041, $392 and $764 respectively.
The cost or amortized cost and approximate fair value of debt securities held at December 31, 2006, summarized by contractual maturities, are shown below. Actual maturities may differ from contractual maturities when there exists a right to call or prepay obligations with or without call or prepayment penalties (amounts in 000’s).
The Company’s fixed income portfolio primarily consists of high quality investment grade securities and has an “AA” Standard & Poor’s average quality rating at December 31, 2006. The Company performs quarterly comprehensive reviews of individual fixed income and equity portfolio holdings that have a market value less than their respective carrying value. The Company, with the assistance of its external professional money managers, applies both quantitative and qualitative criteria in its evaluation of possible other-than-temporary impairment, including facts specific to each individual investment, including, but not limited to, the length of time the fair value has been below carrying value, the extent of the decline, the Company’s intent to hold or sell the security, the expectation for each security’s performance as well as prospects for recovery, the credit worthiness and related liquidity of the issuer and the issuer’s business sector.
The following table shows the Company’s investments’ gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at December 31, 2006 and 2005 (amounts in 000’s):
At December 31, 2006 and 2005, property, plant and equipment stated at original cost consist of the following (amounts in 000’s):
Included in Software Development in the above table is $25.6 million and $17.5 million of construction in progress for 2006 and 2005, respectively, related to the development of modernLINK, the Company’s proprietary information systems and web enablement initiative. The construction in progress amount includes $1.9 million and $0.5 million of capitalized interest for 2006 and 2005, respectively.
Depreciation expense recorded in 2006, 2005 and 2004 was (amounts in 000’s): $8,978, $10,250 and $10,043, respectively.
As of December 31, 2006 and 2005, the unamortized balance of modernLINK’s software development costs was $28.3 million and $20.1 million, respectively.
Acquisition costs capitalized during 2006, 2005 and 2004 amounted to $178.2 million, $164.0 million and $176.3 million, respectively. Amortization of deferred acquisition costs was $167.3 million, $166.1 million and $173.8 million for 2006, 2005 and 2004, respectively.
The Company had conventional lines of credit with commercial banks of $83 million at both December 31, 2006 and 2005 with $10 million and $14 million in use under these agreements at December 31, 2006 and 2005, respectively. Borrowings under these lines of credit constitute senior debt. Total commercial paper debt outstanding at December 31, 2006 and 2005 was $7.9 million and $6.0 million, respectively.
Equipment and real estate obligations are collateralized by transportation equipment and real estate with a net book value of $39.6 million at December 31, 2006.
The federal income tax provision for the years ended December 31, 2006, 2005 and 2004 is different from amounts derived by applying the statutory tax rates to income before federal income tax as follows (amounts in 000’s):
Premium income in the accompanying consolidated statements of income include (amounts in 000’s) $63,580, $53,343 and $54,088 of earned premiums on assumed business and is net of $127,368, $112,777, and $69,444 of earned premiums on ceded business for 2006, 2005, and 2004, respectively. Written premiums consist of the following (amounts in 000’s):
The net earned premium for the property and casualty group for 2006, 2005 and 2004 was $659,379, $621,235 and $661,579, respectively.
With the benefit of hindsight, including one year of actual development patterns observed during 2006, the Company’s 2005 loss reserves were subsequently re-estimated to be $138.1 million. This produced a net cumulative redundancy, after one year of development, of $10.0 million which benefited incurred losses in 2006. Although the 2005 loss reserves developed favorably in 2006, the redundancy was lower than what was experienced over the last few years. The lower redundancy related to the 2005 loss reserves was due primarily to adverse development in 2006 related to assessments associated with hurricane Katrina combined with the Company’s personal liability lines and excess and surplus lines of business. The Company continued to see favorable development related to its motorcycle product.
At December 31, 2006, the actuarial loss and prior service cost recognized in accumulated other comprehensive income and not yet recognized as a component of net periodic benefit cost consist of (in 000’s) $7,776 and $262, respectively.
The estimated actuarial loss and prior service cost that will be amortized from accumulated other comprehensive income into net periodic benefit cost in 2007 are (in 000’s) $479 and $30, respectively.
The Company made a cash contribution of $1.0 million in 2006 which exceeded its required cash contribution of $0.6 million. The Company’s expected pension benefit payments, which reflect expected future service, for the next ten years are as follows (amounts in 000’s): 2007 - $1,264; 2008 - $1,311; 2009 - $1,364; 2010 - $1,463; 2011 - $1,567; 2012 through 2016 - $10,459.
At December 31, 2006 (prior to adoption of SFAS 158) and 2005, the Company’s additional minimum pension liabilities were $4.1 million and $6.0 million, respectively. Related to these actuarily determined minimum pension liabilities, comprehensive income was increased by $1.2 million at December 31, 2006, net of deferred federal income taxes and prior to adoption of SFAS 158, and reduced by $1.6 million, net of deferred federal income taxes, at December 31, 2005.
The Company implemented a restricted stock award program during 1993. Under this program, restricted grants of the Company’s common stock will vest after a five-year incentive period, conditioned upon the recipient’s employment throughout the period. During the vesting period, shares issued are nontransferable, but the shares are entitled to all of the other rights of outstanding shares. In 2004, 202,000 shares were distributed relating to the 1999 grant. At December 31, 2006 and 2005, no restricted stock awards were outstanding.
The following table is a reconciliation of the number of shares used to compute Basic and Diluted earnings per share. No adjustments are necessary to the income used in the Basic or Diluted calculations for the years ended December 31, 2006, 2005 or 2004.
Various litigation and claims against the Company and its subsidiaries are in process and pending. Based upon a review of open matters with legal counsel, Management believes that the outcome of such matters will not have a material effect upon the Company’s consolidated financial position, results of operations or cash flows. The Company also has credit exposure with customers, generally in the form of premiums receivable. Management monitors these exposures on a regular basis. However, as collectibility of such receivables is dependent upon the financial stability of the customers, the Company cannot assure collections in full. Where appropriate, the Company has provided a reserve for such exposures.
On February 5, 2004, the Company sold 1,150,000 shares of its common stock pursuant to an approved universal shelf registration statement previously filed with the Securities and Exchange Commission on October 21, 2003. The net proceeds derived from the sale of $25.1 million were used to increase the capital and paid-in surplus of the Company’s insurance subsidiaries to fund future growth and for other general corporate purposes.
The residential property segment includes primarily manufactured housing and site-built dwelling insurance products. Approximately 41% of American Modern’s property and casualty and credit life gross written premium relates to physical damage insurance and related coverages on manufactured homes, generally written for a term of 12 months with many coverages similar to homeowner’s insurance policies. The recreational casualty segment includes specialty insurance products such as motorcycle, watercraft, recreational vehicle, collector car and snowmobile. The financial institutions segment includes specialty insurance products such as mortgage fire, collateral protection and debt cancellation, which are sold to financial institutions or their customers. The all other insurance segment includes products such as credit life, long-haul truck physical damage, commercial, excess and surplus lines and also includes the results of our fee producing subsidiaries.
Listed below is financial information required to be reported for each industry segment. The accounting policies used for segment reporting are the same as the accounting policies for the consolidated financial statements. Certain amounts are allocated and certain amounts are not allocated (e.g., assets and investment gains) to each segment for management review. Operating segment information based upon how it is reviewed by the chief operating decision maker, the Company’s President and Chief Executive Officer, is as follows for the years ended December 31, 2006, 2005 and 2004 (amounts in 000’s):
No single customer contributed in excess of 10% of consolidated revenues in 2006, 2005 or 2004.