We have prepared the selected historical consolidated financial data, other than the statutory data, in conformity with GAAP. We have derived the statutory data from the annual statements of our insurance subsidiary, Proformance, filed with the New Jersey Department of Banking and Insurance prepared in accordance with statutory accounting practices, which vary in certain respects from GAAP. You should read this selected consolidated financial data together with our consolidated financial statements and the related notes and the section of this Form 10-K entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”
The primary driver for a significant portion of our growth from 2002 through 2003 was an agreement entered into on December 18, 2001 with OCIC, and OCNJ, to become a replacement carrier pursuant to which OCNJ would transfer to Proformance the obligation to offer renewals for all of OCNJ’s New Jersey private passenger automobile business effective March 18, 2002. Primarily as a result of this
transaction our direct written premiums, net written premiums and net earned premiums increased from $49.8 million, $25.5 million and $25.4 million, respectively, for the year ended December 31, 2001, to $163.2 million, $147.0 million and $143.2 million, respectively, for the year ended December 31, 2003. In addition total assets, losses and loss adjustment expense reserves, as well as total shareholders’ equity, increased from $78.3 million, $56.7 million and $(4.0) million, respectively as of December 31, 2001 to $266.7 million, $134.2 million and $49.8 million, respectively as of December 31, 2003.
The loss ratio, when calculated on a statutory basis, is the ratio of losses and loss adjustment expenses to net earned premiums. The expense ratio, when calculated on a statutory accounting basis, is the ratio of underwriting expenses to net written premiums. The expense ratio, when calculated on a GAAP basis, differs from the statutory method specifically as it related to policy acquisition expenses. Policy acquisition expenses are expensed as incurred under the statutory accounting method. However, for GAAP, policy acquisition expenses are deferred and amortized over the period in which the related premiums are earned. The combined ratio is the sum of the loss ratio and the expense ratio. Management considers the statutory methods for calculating the loss, expense and combined ratios to compare our performance to benchmarks used by rating agencies and regulatory bodies that monitor the insurance industry.
In 1997, we entered into two separate loan agreements. In March of 2002, one of the loans was paid in full and in December of 2002 the remaining loan was paid in full.
The following discussion of the financial condition, changes in financial condition and results of operations of NAHC should be read in conjunction with the audited Condensed Consolidated Financial Statements and Notes thereto included elsewhere in this Form 10-K.
This Form 10-K may contain certain forward-looking statements within the meaning of Section 27A of the Securities Act and Section 21E of the Exchange Act. These forward-looking statements represent the Company’s expectations or beliefs, including, but not limited to, statements concerning the Company’s
operations and financial performance and condition. In particular, statements using words such as “may,” “should,” “estimate,” “expect,” “anticipate,” “intend,” “believe,” “predict,” “potential,” or words of similar import generally involve forward-looking statements. For example, we have included certain forward-looking statements in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” with regard to trends in results, prices, volumes, operations, investment results, margins, risk management and exchange rates. This Form 10-K also contains forward-looking statements with respect to our business and industry, such as those relating to our strategy and management objectives and trends in market conditions, market standing, product volumes, investment results and pricing conditions. In light of the risks and uncertainties inherent in all future projections, the inclusion of forward-looking statements in this Form 10-K should not be considered as a representation by us or any other person that our objectives or plans will be achieved. Numerous factors could cause our actual results to differ materially from those in forward-looking statements including, but not limited to, those discussed in this Form 10-K, including in “Risk Factors” above. As a consequence, current plans, anticipated actions and future financial condition and results may differ from those expressed in any forward-looking statements made by or on behalf of the Company. Additionally, forward-looking statements speak only as of the date they are made, and we undertake no obligation to release publicly the results of any future revisions or updates we may make to forward-looking statements to reflect new information or circumstances after the date hereof or to reflect the occurrence of future events.
our business model which is designed to align our Partner Agents’ interests with management by requiring many of them to retain an ownership stake in us;
Direct written premiums for the year ended December 31, 2005 decreased by $9.3 million, or 4.5%, to $198.0 million from $207.3 million in the comparable 2004 period.
For the year ended December 31, 2005 the decrease in direct written premiums is due to the following: We began the process of converting our personal lines business from six-month policies to twelve month policies on January 1, 2005. The conversions were substantially completed as of December 31, 2005. As part of this process we converted substantially all of the personal lines policies that came up on their annual renewal during the period. This conversion generated an additional $60.6 million of direct written premium for the year ended December 31, 2005. In addition, new business generated by our Partner Agents was $22.8 million, offset by attrition of existing business of $16.0 million as well as a reduction of $76.7 million of replacement carrier business as we continued the re-underwriting process and the attrition of closed agents business, in a continuing effort to achieve the desired retention, based on profitable business, of the business associated with those transactions. As of December 31, 2005, the re-underwriting process for the OCIC, Met P&C and Sentry Insurance replacement carrier transactions was substantially completed. In addition, the re-underwriting process for the Hartford and Hanover replacement carrier transactions will commence upon expiration of the original renewal policies that are issued in connection with those transactions.
We manage and report our business as a single segment based upon several factors. Although our insurance subsidiary, Proformance Insurance Company writes private passenger automobile, homeowners and commercial lines insurance, we consider those operating segments as one operating segment due to the fact that the nature of the products are similar, the nature of the production processes are similar, the type of class of customer for the products are similar, the methods used to distribute the products are similar and the nature of the regulatory environment is similar. In addition, these lines of business have historically demonstrated similar economic characteristics and as such are aggregated and reported as a single segment. Also, in addition to Proformance, all other operating segments wholly owned by the Company are aggregated and reported as a single segmentdue to the fact that the nature of the products are similar, the nature of the production processes are similar, the type of class of customer for the products are similar, the methods used to distribute the products are similar and the nature of the regulatory environment is similar.
During the prior four years, much of our premium growth and capitalization growth have resulted from our replacement carrier transactions. For the year ended December 31, 2005, we derived no revenue from replacement carrier transactions, compared to $18.0 million and $14.0 million for the year ended December 31, 2004 and for the year ended December 31, 2003, respectively. This constituted 0% of our total revenue for the year ended December 31, 2005 and 8.6% and 8.5%, respectively, of our total revenue in the prior years. For the years ended December 31, 2005, 2004 and 2003, the Company paid $0.2 million, $0 and $0, respectively, in connection with fees paid in consideration of the acquisition of policy renewal rights. Our strategy includes entering into additional replacement carrier transactions as opportunities arise. However, due to improvements in the New Jersey insurance market during 2005, it is not likely that we will enter into replacement carrier transactions which have as significant an impact on the Company’s operations or are comparable in size to those entered into prior to 2005.
As a result of these transactions, we increased the number of independent insurance agencies who are shareholders in NAHC and who, with their aggregate premium volume, provide what we believe are significant growth opportunities for us. Our strategy is to underwrite an increased share of those agencies’ business now underwritten by competing carriers. Successful execution of our intended plan will require an underwriting operation designed to attract and retain more of our agencies’ clientele, and may be affected by lower-priced competing products or enhanced sales incentive compensation plans by our competitors. These factors may require us to increase our new business acquisition expenses from the levels currently experienced to achieve significant new product sales.
Upon the closing, Proformance was required to pay to Hanover a one-time fee of $450,000. In addition, we will make two annual payments equal to 5% of the written premium on renewed business for the preceding twelve months, calculated at the 12 month and 24 month anniversaries, payable to Hanover within 30 days of such anniversary dates.
Hanover is not liable for any fees and or other amounts to be paid to Proformance and as such Proformance will not recognize any Replacement carrier revenue from this transaction. The revenue that will be recognized as part of this transaction will be from the premium generated by the policies that renew with Proformance.
Upon the closing, Proformance was required to pay to The Hartford a one-time fee of $150,000. In addition, a one-time payment equal to 5% of the written premium of the retained business will be paid to The Hartford within 45 days of the end of the twelve-month non-renewal period.
With respect to our replacement carrier transaction for the 2004 year with OCIC and OCNJ, on February 22, 2005 Proformance notified OCNJ that OCNJ owed Proformance $7,762,000 for the 2004 year in connection with the requirement that a premium-to-surplus ratio of 2.5 to 1 be maintained on the OCNJ renewal business. Pursuant to our agreement, OCNJ had until May 15, 2005 to make payment to us. Subsequent to the notification provided to OCIC and OCNJ, we had several discussions with OCIC relating to certain components to the underlying calculation which supports the amount owed to Proformance for the 2004 year. As part of these discussions, OCIC had requested additional supporting documentation and raised issues with respect to approximately $2,000,000 of loss adjustment expense, approximately $800,000 of commission expense, and approximately $600,000 of NJAIRE assessments, or a total of $3,412,000, allocated to OCNJ. We recorded $4,350,000 (the difference between the $7,762,000 we notified OCNJ they owed us, and the $3,412,000 as outlined above) as replacement carrier revenue from related party in our consolidated statement of income for the year ended December 31, 2004 with respect to the OCIC replacement carrier transaction. We recorded $4,350,000 because it was management’s best estimate of the amount for which we believed collectability was reasonably assured based on several factors. First, the calculation to determine the amount owed by OCIC to us is complex and certain elements of the calculation are significantly dependent on management’s estimates and judgment and thus more susceptible to challenge by OCIC. We also note our experience in the past in negotiating these issues with OCIC. For example, in 2003 we notified OCNJ that OCNJ owed Proformance approximately $10,100,000 for 2003. After negotiations we ultimately received $6,820,000. Accordingly, because of the nature of the calculation, the inherent subjectivity in establishing certain estimates upon which the calculation is based, and our experience from 2003, management’s best estimate of the amount for 2004 for which we believed collectability from OCIC was reasonably assured was $4,350,000. On June 27, 2005, we received $3,654,000 from OCIC in settlement of the amounts due to
Underwriting, acquisition and insurance related expenses include policy acquisition expenses which consist of commissions and other underwriting expenses, which are costs that vary with and are directly related to the underwriting of new and renewal policies and are deferred and amortized over the period in which the related premiums are earned. Also included in underwriting, acquisition and related insurance expenses, NJAIRE assessments, professional fees and other expenses relating to insurance operations.
The preparation of financial statements in conformity with GAAP requires us to make estimates and assumptions that affect amounts reported in our financial statements. As additional information becomes available, these estimates and assumptions are subject to change and thus impact amounts reported in the future. We have identified below two accounting policies that we consider to be critical due to the amount of judgment and uncertainty inherent in the application of these policies. In addition, please see “Overview” above for a discussion of the amount we estimated and recorded as replacement carrier revenue from related party in our condensed consolidated statement of income for the year ended December 31, 2005 with respect to the OCIC replacement carrier transaction.
Significant periods of time can elapse between the occurrence of an insured loss, the reporting to us of that loss and our final payment of that loss. To recognize liabilities for unpaid losses, we establish reserves as balance sheet liabilities. Our reserves represent actuarially determined best estimates of amounts needed to pay reported and unreported losses and the expenses of investigating and paying those losses, or loss adjustment expenses. Every quarter, we review our previously established reserves and adjust them, if necessary.
We have made no changes in key assumptions to the estimates of reserves (i.e., liabilities for loss and loss adjustment expenses) since December 31, 2005. Changes in reserve estimates evolve over a period of time and we make reserve adjustments in the period that we consider relevant factors to be present which represent what we consider to be reliable trends on which to base such adjustments.
In establishing our net reserves as of December 31, 2005, our actuaries determined that the range of reserve estimates at that date was between $175.6 million and $204.7 million. The amount of net reserves at December 31, 2005, which represents the best estimate of management and our actuaries within that range, was $191.3 million. There are two major factors that could result in ultimate losses below management’s best estimate:
In November 2005, the FASB issued FASB Staff Position (“FSP”) FAS 115-1 and FAS 124-1, “The Meaning of Other-Than-Temporary Impairment and Its Applications of Certain Investments” (“FSP 115-1”), which provides guidance on determining when investments in certain debt and equity securities are considered impaired, whether that impairment is other-than-temporary, and how to measure such impairment
loss. FSP 115-1 also includes accounting considerations subsequent to the recognition of an other-than-temporary impairment and requires certain disclosures about unrealized losses that have not been recognized as other-than-temporary impairments. FSP 115-1 supersedes Emerging Issues Task Force (“EITF”) Issue No. 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Applications of Certain Investments” (“EITF 03-1”) and EITF Topic D-44, Recognition of Other-Than-Temporary Impairment on the Planned Sale of a Security Whose Cost Exceeds Fair Value (“Topic D-44”) and nullifies the accounting guidance on the determination of whether an investment is other-than-temporarily impaired as set forth in EITF 03-1. FSP 115-1 is required to be applied to reporting periods beginning after December 15, 2005 and management has determined that the effect of adopting FSP 115-1 will not have a material impact on the Company’s consolidated financial statements. The Company has complied with the disclosure requirements of EITF-03-1, which were effective December 31, 2003 and remain in effect.
Our principal investments are in fixed maturities, all of which are exposed to at least one of three primary sources of investment risk: credit, interest rate and market valuation. The financial statement risks are those associated with the recognition of impairments and income, as well as the determination of fair values. Recognition of income ceases when a bond goes into default. We evaluate whether impairments have occurred on a case-by-case basis. Management considers a wide range of factors about the security issuer and uses its best judgment in evaluating the cause and amount of decline in the estimated fair value of the security and in assessing the prospects for near-term recovery. Inherent in management’s evaluation of the security are assumptions and estimates about the operations of the issuer and its future earnings potential. Considerations we use in the impairment evaluation process include, but are not limited to: (i) the length of time and the extent to which the market value has been below amortized cost; (ii) the potential for impairments of securities when the issuer is experiencing significant financial difficulties; (iii) the potential for impairments in an entire industry sector or subsection; (iv) the potential for impairments in certain economically depressed geographic locations; (v) the potential for impairment of securities where the issuer, series of issuers or industry has a catastrophic type of loss or has exhausted natural resources; (vi) other subjective factors, including concentrations and information obtained from regulators and rating agencies and (vii) management’s intent and ability to hold securities to recovery. In addition, the earnings on certain investments are dependent upon market conditions, which could result in prepayments and changes in amounts to be earned due to changing interest rates or equity markets.
In addition, on October 21, 2003 and December 8, 2003, respectively, we entered into two additional replacement carrier agreements with Sentry Insurance and Met P&C whereby we agreed to become the replacement carrier for the personal lines business of each entity in New Jersey. We received $0.9 million and received an additional $2.6 million in 2004 from Sentry, $2.8 million of which we recorded as deferred revenue as of December 31, 2003 and $0.7 million recorded as replacement carrier revenue for the year ended December 31, 2003. We received $20.1 million ($9.5 million recorded as deferred revenue as of December 31, 2003, $0.6 million recorded as replacement carrier revenue from a related party for the year ended December 31, 2003, and $10.0 million in the form of a capital contribution) from Met P&C. For the year ended December 31, 2004, we recorded $13.6 million of replacement carrier revenue in connection with these transactions ($9.5 million from Met P&C and $4.1 million from Sentry Insurance) as we completed our obligations under the terms of each agreement to offer renewals to each Sentry Insurance and Met P&C policyholder transferred to Proformance. We do not expect to record replacement carrier revenue in the future unless we enter into additional replacement carrier transactions that generate replacement carrier revenue. These transactions contributed to our increase in shareholders’ equity from $18.1 million as of December 31, 2002 to $67.8 million as of December 31, 2004.
Direct Written Premiums. Direct written premiums for the twelve months ended December 31, 2005 decreased by $9.3 million, or 4.5%, to $198.0 million from $207.3 million in the comparable 2004 period. For the year ended December 31, 2005 the decrease in direct written premiums is due to the following: We began the process of converting our personal lines business from six-month policies to twelve month policies on January 1, 2005. As part of this process we converted substantially all of the personal lines policies that came up on their annual renewal during the period. This conversion generated an additional $60.6 million of direct written premium for the year ended December 31, 2005. In addition, new business generated by our Partner Agents was $22.8 million, offset by attrition of existing business of $16.0 million as well as a reduction of $76.7 million of replacement carrier business as we continued the re-underwriting process and the attrition of closed agents business, in a continuing effort to achieve the desired retention, based on profitable business, of the business associated with those transactions.
Income Tax Expense. Income tax expense for the twelve months ended December 31, 2005 and 2004 was $1.9 million and $8.9 million, respectively. The decrease of $7.0 million in income tax expense for the year
ended December 31, 2005 from the same period in the prior year was due to the decrease in income before tax for the same period.
Net Earned Premiums. Net earned premiums for the year ended December 31, 2004 increased by $36.8 million, or 25.7%, to $180.0 million from $143.2 million in the comparable 2003 period. This increase was due to the increase in net written premiums for the same period.
Replacement Carrier Revenue. Replacement carrier revenue for the year ended December 31, 2004 was $18.0 million compared to $14.0 million in 2003. Replacement carrier revenue for the year ended December 31, 2004 was associated with the additional consideration in connection with the OCIC replacement carrier transaction of $4.4 million and replacement carrier revenue associated with the Met P&C and Sentry Insurance replacement carrier transactions of $9.5 million and $4.1 million, respectively.
Net Realized Investment Gain (Loss). Net realized investment gain (loss) for the years ended December 31, 2004 and 2003 were $1.9 million and $1.4 million, respectively.
Net Income. Net income after tax for the years ended December 31, 2004 and 2003 was $17.4 million and $19.1 million, respectively, as a result of the factors discussed above.
For the years ended December 31, 2005, 2004 and 2003, our consolidated cash flow from financing activities was $62.7 million, $0.0 million and $12.5 million, respectively. The increase in our consolidated cash flows from financing activities for the year ended December 31, 2005 is directly related to the capital received in connection with the Company’s initial public offering which was completed on April 21, 2005. The primary source of cash from financing activities for the periods ended December 31, 2004 and 2003 is related to the proceeds from the issuance of NAHC’s common stock. The amount for the year ended December 31, 2003 related to the purchase of our stock by Met P&C as well as a group of former OCIC agents that elected to become Partner Agents.
There are no restrictions on the payment of dividends by our non-insurance subsidiaries other than customary state corporation laws regarding solvency. Dividends from Proformance are subject to restrictions relating to statutory surplus and earnings. Proformance may not make an “extraordinary dividend” until 30 days after the Commissioner of the New Jersey Department of Banking and Insurance (which we refer to as the Commissioner) has received notice of the intended dividend and has not objected or has approved it in such time. An extraordinary dividend is defined as any dividend or distribution whose fair market value together with that of other distributions made within the preceding twelve months exceeds the greater of 10% of the insurer’s surplus as of the preceding December 31, or the insurer’s net income (excluding realized capital gains) for the twelve-month period ending on the preceding December 31, in each case determined in accordance with statutory accounting practices. Under New Jersey law, an insurer may pay dividends that are not considered extraordinary only from its unassigned funds, also known as its earned surplus. The insurer’s remaining surplus must be both reasonable in relation to its outstanding liabilities and adequate to its financial needs following payment of any dividend or distribution to stockholders. As of December 31, 2005, Proformance is not permitted to pay any dividends without the approval of the Commissioner as it has negative unassigned surplus as a result of historical underwriting losses. Proformance has not paid any dividends in the past and we do not anticipate that Proformance will pay dividends in the foreseeable future because we wish to reduce our reinsurance purchases in order to retain more of the gross premiums written we generate. We also seek stronger financial strength ratings for Proformance, and both of these objectives require that the capital of Proformance be increased. In addition, the payment of dividends and other distributions by Mayfair is regulated by Bermuda insurance law and regulations.
Because our non-insurance subsidiaries generate revenues, profits and net cash flows that are generally unrestricted as to their availability for the payment of dividends, we expect to use those revenues to service all of our corporate financial obligations, such as shareholder dividends, if declared. The percentage of our total revenues generated by our non-insurance subsidiaries for the years ended December 31, 2005 and 2004 were 4.1% and 4.5%, respectively.
As of December 31, 2005, we did not have any material commitments for capital expenditures.
As of December 31, 2005, equity and preferred securities having an unrealized loss of $255,490 a fair value of $2,902,740 and an amortized cost of $3,158,230 were in a continuous unrealized loss position for less than twelve months. As of December 31, 2004, equity and preferred securities having an unrealized loss of $81,418, a fair value of $732,780 and an amortized cost of $814,198 were in a continuous unrealized loss position for less than twelve months.
industrial and miscellaneous, $14,430 related to mortgage backed securities and $325,820 related to equity securities.
Our gross unrealized losses represented 1.12% of cost or amortized cost of the investment portfolio as of December 31, 2005. Fixed maturities represented 95.7% of the investment portfolio and 90.4% of the unrealized losses as of December 31, 2005.
Our fixed income securities in an unrealized loss position have an average “AA1” credit rating by Moody’s, with extended maturity dates, which have been adversely impacted by the increase in interest rates after the purchase date. As part of our ongoing security monitoring process by our investment manager and investment committee, it was concluded that no securities in the portfolio were considered to be other than temporarily impaired as of December 31, 2005. We believe, with the investment committee’s confirmation, that securities that are temporarily impaired that continue to pay principal and interest in accordance with their contractual terms, will continue to do so.
Management considers a number of factors when selling securities. For fixed income securities, management considers realizing a loss if the interest payments are not made on schedule or the credit quality has deteriorated. Management also considers selling a fixed income security in order to increase liquidity. Management considers selling an equity security at a loss if it believes that the fundamentals, i.e., earnings growth, earnings guidance, prospects of dividends, and management quality have deteriorated. Management considers selling equity securities at a gain for liquidity purposes. Our investment manager is restricted with respect to the sales of all securities in an unrealized loss position. These transactions require the review and approval by senior management prior to execution.
We review our unrealized gains and losses on at least a quarterly basis to determine if the investments are in compliance with our interest rate forecast and the equity modeling process. Specifically, in the current economic environment, we would consider selling securities if we can reallocate the sales proceeds to more suitable investments as it relates to either our interest rate forecast or equity model.
down to the current market value. The amount of the write-down will be calculated as the difference between cost and fair market value and accounted for as a realized loss for accounting purposes which negatively impacts future earnings.
There were no securities that were considered other-than-temporarily impaired as of December 31, 2005. The Company had one security with a fair value of $1,230,740 and actual cost of $1,491,255 which was considered other-than-temporarily impaired as of December 31,2004. The Company recorded a realized loss related to the security in the amount of $260,515 as of December 31, 2004. The following summarizes our unrealized losses by designated category as of December 31, 2005.
Securities with a Decline in Market Value Below Carrying Values Less than 20%
Securities with a Decline in Market Value below Carrying Values of 20%-50%
Securities with a Decline in Market Value Below Carrying Values Greater than 50%
the legal environment whereby court decisions and changes in backlogs in the court system could influence claim payout patterns.
our mix of business because property and first-party claims settle more quickly than bodily injury claims.
reinsurance programs - changes in Proformance’s retention will influence the payout of the liabilities. As Proformance’s net retention increases, the liabilities will take longer to settle than in past years.
Represents our minimum rental commitments as of December 31, 2005 pursuant to our seven-year lease agreement for the use of our office space and equipment at 4 Paragon Way, Freehold, NJ 07728 and our four-year lease agreement for the use of our office space and equipment at 3 Paragon Way, Freehold, NJ 07728.
(“FSP 115-1”), which provides guidance on determining when investments in certain debt and equity securities are considered impaired, whether that impairment is other-than-temporary, and how to measure such impairment loss. FSP 115-1 also includes accounting considerations subsequent to the recognition of an other-than-temporary impairment and requires certain disclosures about unrealized losses that have not been recognized as other-than-temporary impairments. FSP 115-1 supersedes Emerging Issues Task Force (“EITF”) Issue No. 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Applications of Certain Investments” (“EITF 03-1”) and EITF Topic D-44, Recognition of Other-Than-Temporary Impairment on the Planned Sale of a Security Whose Cost Exceeds Fair Value (“Topic D-44”) and nullifies the accounting guidance on the determination of whether an investment is other-than-temporarily impaired as set forth in EITF 03-1. FSP 115-1 is required to be applied to reporting periods beginning after December 15, 2005 and management has determined that the effect of adopting FSP 115-1 will not have a material impact on the Company’s consolidated financial statements. The Company has complied with the disclosure requirements of EITF-03-1, which were effective December 31, 2003 and remain in effect.