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 Global Market. On March 14, 2005, the Company changed its trading symbol on the NASDAQ Global Market from “UNGL” to “INDM.”
The Company adopted Statement of Financial Accounting Standards (“SFAS”) No. 155, “Accounting for Certain Hybrid Financial Instruments an amendment of FASB Statements No. 133 and 140” (“SFAS 155”) on January 1, 2007. As a result, the changes in the Company’s convertible bond and convertible preferred stock portfolios are included as components of net realized gains and losses. Prior to 2007, SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”), as amended, required that convertible instruments be bifurcated if they were classified as available for sale under SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities.” The change in the market value of the underlying security was included as a component of accumulated other comprehensive income and change in the value of the derivative component.
For equity securities, management carefully reviews securities with unrealized losses that have 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 along with other factors to determine if it should be impaired. For securities with significant declines in value for periods shorter than six months, the security is evaluated to determine if impairment is required.
The Company accounts for derivative instruments under SFAS 133 which established accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities. All derivatives, whether designated in hedging relationships or not, are required to be recorded on the balance sheet at fair value.
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 had previously entered into the interest rate swap with a high credit quality counterparty, which is rated “A1” by Moody’s Investors Service Inc. (“Moody’s”). As of December 31, 2007, the swap was no longer in place due to the retirement of Penn-America Statutory Trust I (“Penn Trust I”) on December 4, 2007. See Note 8 for further details regarding the retirement of Penn Trust I.
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 and concluded that there was no impairment as of December 31, 2007.
The Company expects that amortization expense for the next five succeeding years will be as follows:
These amounts are subject to change based upon the reviews of recoverability and useful lives that are performed at least annually.
During 2007, the Company decreased its uncollectible reinsurance reserve by $4.4 million due to a reduction in ceded loss reserves, including losses incurred but not reported, as a result of better than expected loss emergence. During 2006, the Company decreased its uncollectible reinsurance reserve by $8.6 million due to (i) an A.M. Best rating upgrade of one of the reinsurers included in the Company’s reserve, (ii) continued collections and reductions of receivables from other reinsurers included in the reserve, and (iii) better than expected loss emergence.
In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS 157”), which defines fair value, establishes a framework for measuring fair value, outlines a fair value hierarchy based on inputs used to measure fair value, and enhances disclosure requirements for fair value measurements. SFAS 157 does not change existing guidance as to whether or not an instrument is carried at fair value.
The Company’s investments are carried at their fair value. In accordance with SFAS 157, assets recorded at fair value are categorized based upon a fair value hierarchy (level 1, 2, and 3). Level 1 inputs utilize quoted prices (unadjusted) in active markets for identical assets that the Company has the ability to access. Level 2 inputs utilize inputs other than quoted prices included in Level 1 that are observable for the asset, either directly or indirectly.
Level 3 inputs are unobservable inputs for the asset, and include situations where there is little, if any, market activity for the asset. The Company is currently evaluating its disclosures relating to the fair value hierarchy.
On February 15, 2007, the FASB issued SFAS 159, which gives entities the option to measure eligible assets, financial liabilities and firm commitments at fair value (i.e., the fair value option), on an instrument-by-instrument basis. The election to use the fair value option is available at specified elections dates, such as when an entity first recognizes a financial asset or financial liability or upon entering into a firm commitment. Subsequent changes in fair value must be recorded in earnings. Additionally, SFAS 159 allows for a one-time election for existing positions upon adoption, with the transition adjustment recorded in beginning retained earnings.
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, 2007 or 2006.
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, 2006:
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, 2007, concluded the unrealized losses discussed above are not other than temporary impairments. The impairment evaluation process is discussed in the “Investment” section of Note 2 (“Summary of Significant Accounting Policies”).
Many of the common stocks that comprise the $2.0 million unrealized loss as of December 31, 2007 are in the financial services sector. Several of these stocks incurred losses during 2007 due to write-downs of subprime investments by the stocks’ issuers. Management does not believe these stocks should be impaired at this time and is continuing to closely monitor these investments.
The Company recorded the following other than temporary losses on its investment portfolio for the years ended December 31, 2007, 2006, and 2005:
The amortized cost and estimated fair value of bonds classified as available for sale at December 31, 2007, 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, 2007, 2006, and 2005 were as follows:
Proceeds from the sales of bonds classified as available-for-sale resulting in net realized investment gains (losses) for the years ended December 31, 2007, 2006, and 2005 were $217.4 million, $340.1 million, and $371.7 million, respectively.
Proceeds from the sales of equity securities classified as available-for-sale resulting in net realized investment gains (losses) for the years ended December 31, 2007, 2006 and 2005 were $34.9 million, $36.9 million, and $76.1 million, respectively.
The sources of net investment income for the years ended December 31, 2007, 2006, and 2005 were as follows:
At December 31, 2007 and 2006, the Company held collateral securing its reinsurance receivables of $520.8 million and $642.9 million, respectively. Prepaid reinsurance premiums were $29.2 million and $38.3 million at December 31, 2007 and 2006, respectively. Reinsurance receivables, net of collateral held, were $198.9 million and $339.6 million at December 31, 2007 and 2006, respectively.
The Company reduced gross and ceded unpaid loss and loss adjustment expenses related to prior periods by $177.1 million and $152.6 million, respectively, in 2007 due to better than expected loss emergence.
The Company reduced gross and ceded unpaid loss and loss adjustment expenses related to prior periods by $114.1 million and $107.1 million, respectively, in 2006 due to better than expected loss emergence.
$10.0 million in excess of $5.0 million layer. As a result, the Company’s property treaty now covers losses of $14.0 million in excess of $1.0 million per risk.
Effective April 29, 2007, the Company increased the retention on its general casualty excess of loss treaty by changing the terms regarding loss adjustment expenses from inclusive to pro rata. The Company’s ultimate net loss on this treaty, not including loss adjustment expenses which are allocated in proportion to losses retained and ceded, remains at $0.75 million per risk.
The Company’s income from continuing operations before income taxes from the Non-U.S. Subsidiaries and U.S. Subsidiaries, including the results of the quota share agreement between Wind River Reinsurance and the Insurance Operations, for the years ended December 31, 2007, 2006, and 2005 were as follows:
income before income taxes in 2005 of $66.6 million represents $44.1 million from its foreign operations and $22.5 million from its United States operations.
In 2005, the Company recognized an extraordinary gain of $1.4 million for tax benefits derived from acquisition costs included as a reduction in equity as a result of the Wind River Acquisition, that have been or will be deducted in the future from income for federal tax purposes.
The tax effects of temporary differences that give rise to significant portions of the net deferred tax assets at December 31, 2007 and 2006 are presented below:
Management believes it is more likely than not that the deferred tax assets will be completely utilized in future years. As a result, there is no valuation allowance at December 31, 2007 and 2006.
The Company or one of its subsidiaries has filed income tax returns in the U.S. federal jurisdiction, and various states and foreign jurisdictions. The Company is no longer subject to U.S. federal tax examinations by tax authorities for tax years before 2003. The Internal Revenue Service (“IRS”) commenced examinations of the Company’s U.S. income tax returns for the period from September 6, 2003 through December 31, 2003 and the year ended December 31, 2004 in the third quarter of 2006. The IRS completed its examination during the fourth quarter of 2007. No audit adjustments were made.
The Company adopted the provisions of FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109” (“FIN 48”), on January 1, 2007. As a result, the Company
If recognized, the gross unrecognized tax benefits could lower the effective income tax rate in any future period. There has been no change to the provision for gross unrecognized tax benefits during 2007. The Company is not aware of anything at this time that would require it to make any changes to its tax reserve.
The Company classifies all interest and penalties related to uncertain tax positions as income tax expense. As of December 31, 2007, the Company has recorded $0.5 million in liabilities for tax-related interest and penalties on its consolidated balance sheet.
Unpaid loss and loss adjustment expenses and gross reinsurance receivable on unpaid losses acquired on January 24, 2005, as a result of the merger with Penn-America Group, Inc.
During 2006, the Penn-America Insurance Companies increased incurred losses related to insured events of years 2004 and prior by $4.3 million. This increase in incurred losses related primarily to the Company’s casualty lines of business relating to accident years 1997 through 2003.
The Company has exposure to A&E claims. The asbestos exposure primarily arises from the sale of product liability insurance, and the environmental exposure arises from the sale of general liability and commercial multi-peril insurance. In establishing the liability for unpaid losses and loss adjustment expenses related to A&E exposures, management considers facts currently known and the current state of the law and coverage litigation. Liabilities are recognized for known claims (including the cost of related litigation) when sufficient information has been developed to indicate the involvement of a specific insurance policy, and management can reasonably estimate its liability. In addition, liabilities have been established to cover additional exposures on both known and unasserted claims. Estimates of the liabilities are reviewed and updated continually. Developed case law and claim history do not exist for such claims, especially because significant uncertainty exists about the outcome of coverage litigation and whether past claim experience will be representative of future claim experience. Included in net unpaid losses and loss adjustment expenses as of December 31, 2007, 2006, and 2005 were IBNR reserves of $18.8 million, $6.7 million, and $7.5 million, respectively, and case reserves of approximately $7.9 million, $4.5 million, and $4.0 million, respectively, for known A&E-related claims.
The following table shows the Company’s net reserves for A&E losses:
On December 4, 2007, the Company redeemed all of the $15.0 million issued and outstanding notes of Penn-America Statutory Trust I (“Penn Trust I”), and the fixed rate interest rate swap on these notes that locked the interest at an annual rate of 7.4% expired. In conjunction with this redemption, the $15.5 million of junior
In 2003, trusts formed and owned by the Company issued a total of $30.0 million of trust preferred securities. In 2002 and 2003, trusts formed and owned by PAGI issued a total of $30.0 million of trust preferred securities. The funds were used to purchase junior subordinated interest notes and to support the business growth in the insurance subsidiaries and general business needs. A summary of the terms related to the trust preferred securities that are still currently outstanding is as follows:
Payable quarterly at the three month London Interbank Offered Rate (“LIBOR) plus 4.05%
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. During 2007, the Company borrowed and repaid $22.9 million under this credit facility. As of December 31, 2007, there was no balance due in connection with this credit facility.
Loans payable of $1.2 million and $2.8 million as of December 31, 2007 and 2006 were comprised of one and three loans payable, respectively, to former minority shareholders. There were no minority shareholders at December 31, 2007 and 2006. The current portion of these loans that will be payable in 2008 is $0.3 million. Interest expense related to loans payable was $0.05 million, $0.1 million, and $0.1 million for 2007, 2006, and 2005, respectively.
As of December 31, 2007, Fox Paine & Company beneficially owns shares having approximately 86.1% of the Company’s total outstanding voting power. Fox Paine & Company can nominate five of the directors of the Company’s Board of Directors. The Company’s Chairman is a member of Fox Paine & Company. In addition, another director is an employee of Fox Paine & Company. The Company directly reimbursed Fox Paine & Company $0.3 million, $0.1 million, and $0.2 million during 2007, 2006, and 2005, respectively, for expenses incurred in providing management services.
On May 25, 2006, the Company, Fox Paine & Company, and Wind River Holdings, L.P, formerly The AMC Group, L.P. (“Wind River Holdings”), entered into Amendment No. 1 (the “Amendment”) to the Management Agreement (as amended, the “Management Agreement”). The Amendment terminated Wind River Holdings’ services as of May 25, 2006, and provided that Wind River Holdings refund $0.04 million to the Company as a net repayment of the Annual Service Fee paid by the Company to Wind River Holdings on November 2, 2005. Furthermore, the Amendment modified the Agreement to reflect the Company’s new 6.22% guaranteed senior notes, which were issued in 2005, as opposed to the 5% senior notes, which were repaid by the Company in 2005 upon the issuance of the guaranteed senior notes. Per terms of the Amendment, the next management fee payment of $1.5 million was payable to Fox Paine & Company and was paid on November 8, 2006.
In October 2006, the Company paid Fox Paine & Company a fee of $0.5 million for investment banking services provided in connection with the sale of substantially all of the assets of the Company’s Agency Operations.
The Company paid $0.9 million and $0.5 million in 2007 and 2006, respectively, in premium to Validus Reinsurance, Ltd. (“Validus”), a current participant on the Company’s $100.0 million in excess of $10.0 million catastrophe reinsurance treaty and the Company’s $30.0 million in excess of $30.0 million and $25.0 million in excess of $5.0 million catastrophe reinsurance treaties, which expired on May 31, 2007. No losses have been ceded by the Company under these treaties. Validus is also a participant in a quota share retrocession agreement with Wind River Reinsurance. The Company estimated that the following written premium and losses have been assumed by Validus from Wind River Reinsurance in 2007:
As mentioned in Note 9 above, the Company has a remaining commitment of $4.1 million to the Fox Paine Capital Fund, II. 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 is party to a Management Agreement, as amended, with Fox Paine & Company, whereby in connection with certain management services provided to it by Fox Paine & Company, the Company agreed to pay an annual management fee of $1.5 million to Fox Paine & Company. The most recent annual management fee of $1.5 million was paid to Fox Paine & Company on November 1, 2007. The next annual management fee payment of $1.5 million is payable on November 1, 2008.
Approximate dollar value of shares is as of the last date of the applicable month.
Includes 2,203 shares surrendered by employees as payment of taxes withheld on the vesting of restricted stock.
On December 31, 2007, in connection with the share repurchase program, the Company contracted to purchase 5,000 shares for $0.1 million which did not settle until January 4, 2008. As a result, these shares are not included in the above table.
During January 2008, an additional 88,362 shares were repurchased, including the 5,000 shares mentioned above, as part of the share repurchase program. Including the January 2008 repurchase, a total of 2,535,063 shares were repurchased at an average purchase price of $19.72 per share as part of the share repurchase program.
On January 1, 2006, the Company adopted the provisions of SFAS 123R, which revised SFAS 123, using the modified prospective application method. SFAS 123R sets accounting requirements for share-based compensation to employees and non-employee directors, and requires companies to recognize in the statement of operations the grant-date fair value of stock options and other equity based compensation. For the purpose of determining the fair value of stock option awards, the Company uses the Black-Scholes option-pricing model. SFAS 123R requires the estimation of forfeitures when recognizing compensation expense and that this estimate be adjusted over the requisite service period should actual forfeitures differ from such estimates. Changes in estimated forfeitures are recognized through a cumulative adjustment to compensation in the period of change.
During the period from September 5, 2003 to December 31, 2003, the Company granted 566,661 Time-Based Options and 895,989 Performance-Based Options under the Plan. The Time-Based Options were originally scheduled to vest in 20% increments over a five-year period, with any unvested options forfeitable upon termination of employment for any reason, and expire 10 years after the grant date. The first vesting period ended on December 31, 2004. The Performance-Based Options were originally scheduled to vest in 25% increments and
During 2005, the Company granted 261,484 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.
During 2007, the Company granted 217,473 Time-Based Options and 197,473 Performance-Based Options under the Plan. The Timed-Based Options vest in 25% increments over a four-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.
Option intrinsic values, which are the differences between the fair market value of $19.92 at December 31, 2007 and the strike price of the option, are as follows:
Option activity for the years ended December 31, 2005, 2006 and 2007 is as follows:
During 2006, the Company granted an aggregate of 216,200 Restricted Shares to key employees of the Company and an aggregate of 20,720 fully vested Director Restricted Shares, at a weighted average fair value of $20.81 per share, to non-employee directors of the Company under the Plan. Included in the 216,200 shares, as a result of the Compensation Committee approval of an award of an Annual Integration Bonus as described below under the heading “Annual Incentive Plans,” the Company granted 173,700 Restricted Shares to Plan Participants employed as of February 15, 2006. Of the 173,700 Restricted Shares, 61,436 shares vested immediately, 67,545 shares (including 20,000 shares, subject to certain restrictions, which were awarded to several key employees) vest over five years, and 44,719 shares vest over a three-year period. Also included in the 216,200 Restricted Shares, the Company granted Restricted Shares to key executives of the Company in exchange for signed employment and/or non-compete agreements. The related 42,500 Restricted Shares vest 331/3% on each subsequent anniversary date of the award for a period of three years.
During the third quarter of 2006, the Board of Directors authorized a grant of Restricted Shares to officers of the Company if the Company achieves a minimum 10% return on equity based on 2006’s operating results. 54,484 Restricted Shares were awarded during the first quarter of 2007, based on the December 31, 2006 market value of the Company’s common shares, and will vest 34% on January 1, 2008 and 33% on each January 1 of years 2009 and 2010. The Board of Directors also authorized a grant of Restricted Shares to these individuals if the Company earns no less than 85% of planned 2006 net income excluding after-tax net realized investment gains (losses), after-tax gain and one-time charges from discontinued operations, and after-tax extraordinary items that do not reflect overall operating trends. The results of calendar year 2006 will be examined three years hence by an independent actuary. If net income excluding after-tax net realized investment gains (losses), after-tax gain and one-time charges from discontinued operations, and after-tax extraordinary items that do not reflect overall operating trends, adjusted to reflect the results of the actuarial study, is greater than or equal to net income excluding after-tax net realized investment gains (losses), after-tax gain and one-time charges from discontinued operations, and after-tax extraordinary items that do not reflect overall operating trends as originally reported, Restricted Shares may be awarded based on the December 31, 2006 market value of the Company’s common shares. The awards are being expensed over the intrinsic service period, which includes the performance period and the employee service period. The employee must be continually employed through the vesting date to be eligible to receive the award. The Company recognized $0.5 million and $0.3 million of expense in 2007 and 2006, respectively, related to these awards.
On February 15, 2006, the Compensation Committee of the Company modified certain aspects of the Integration Plan.
Effective May 9, 2007, Larry A. Frakes was hired as the Company’s President and Chief Operating Officer, as well as Chief Executive Officer of all of the Company Affiliates. Mr. Frakes’ four-year employment agreement includes several equity components including (a) the granting of $10.0 million of stock options, or 394,946 shares split evenly between time-based and performance-based options at the grant date market value of $25.32 per share; (b) an annual bonus program under which the first $0.5 million is paid in restricted stock based on the market value at December 31 of the subject Bonus Year; (c) the purchase of $1.0 million of the Company’s Class A common shares by Mr. Frakes; and (d) the requirement that, effective January 1, 2009, Mr. Frakes hold Class A common shares of the Company with a value of the lesser of two times his Annual Compensation or the sum of owned, granted, and vested Class A common shares. The time-based options vest at 25% on each December 31 of years
2008 through 2011. The performance-based options generally vest at the same rate based on the achievement of various Company financial performance goals. The restricted stock portion of the 2008, 2009, and 2010 bonuses vest at 25% per year each year after the bonus year, and awards for the 2010 bonus year and thereafter will vest at 33.3% per year each year after the bonus year.
In February 2008, Mr. Frakes’ employment agreement was amended and restated. See Note 17 for details concerning this amendment and restatement.
The Company maintains a 401(k) defined contribution plan that covers all eligible U.S employees. Under this plan, the Company matches 100% of the first 6% contributed by an employee. Vesting on contributions made by the Company for new employees occurs pro-rata over a three year period. Total expenses for the plan for the year ended December 31, 2007 were $1.3 million.
As mentioned in Note 11, the Company has repurchased approximately 2.4 million shares of its Class A common shares in 2007 under the share repurchase program that was authorized in October 2007. As a result, there were approximately 22.3 million outstanding Class A common shares at December 31, 2007 compared to approximately 24.5 million shares outstanding at December 31, 2006. Including Class B common shares, there
The Company’s Reinsurance Operations segment resulted from the amalgamation of the Non-U.S. Insurance Operations into a single Bermuda based entity, Wind River Reinsurance, in September 2006. The Reinsurance Operations segment began offering third party reinsurance in the third quarter of 2006 and entered into its initial third party reinsurance treaty effective January 1, 2007. As such, there are no results for the Reinsurance Operations segment for the prior years.
Includes $2,223 from the predecessor of Wind River Reinsurance and excise tax of $2,932 relating to offshore cession.
Includes $3,741 from the predecessor of Wind River Reinsurance and excise tax of $2,741 relating to offshore cession.
On January 28, 2008, the Company’s shareholders approved an amendment to the Share Incentive Plan that allows for the repricing, without shareholder approval, of stock options and other stock-based awards granted under the Share Incentive Plan.
On February 5, 2008, the Company entered into an amended and restated employment agreement with Larry A. Frakes, the Company’s President and Chief Executive Officer, which amended and restated Mr. Frakes’ original employment agreement that was entered into on May 10, 2007. The amended and restated employment agreement changes and clarifies the terms of options granted under the original employment agreement. The original agreement granted Mr. Frakes $10.0 million of options, or 394,946 shares, as described in Note 12. The amended and restated agreement grants Mr. Frakes $10.0 million of options with a strike price equal to the average price per share that was paid by Mr. Frakes upon his purchase of $1.0 million of the Company’s Class A common shares.