James River Group, Inc. is a holding company that owns and manages property/casualty insurance companies focused on specialty insurance niches. We seek to earn a profit from underwriting. This means that we intend for the premiums we earn in any period to be sufficient to pay all of the losses and loss adjustment expenses (LAE) we incur during the period as well as all of the expenses associated with our operations. We have two insurance subsidiaries: James River Insurance Company (James River Insurance) is an excess and surplus lines insurance company authorized to write business in 48 states and the District of Columbia, and Stonewood Insurance Company (Stonewood Insurance) is a workers’ compensation insurance company that primarily markets its products to the residential construction industry in North Carolina. Our insurance companies individually underwrite each risk that we issue a policy for, and our companies do not grant any underwriting authority to our insurance agents and brokers. Our consolidated results include the results for our holding company, our two insurance subsidiaries and three other wholly-owned subsidiaries.
Net income for 2005 was $12.1 million, or $0.94 per diluted share, compared to net income of $8.8 million, or $0.93 per diluted share for 2004. Net income for 2005 included $12.4 million of after-tax costs from Hurricane Katrina, net of reinsurance and including reinsurance reinstatement premiums. Net income for 2005 also benefited from favorable development on prior accident year reserves for direct business of $3.6 million after-tax. Direct written premiums for 2005 increased 66.0% to $236.6 million from $142.5 million for 2004. The combined ratio for 2005 was 91.6% compared to 90.1% for 2004.
The following table summarizes our results for the years ended December 31, 2005, 2004 and 2003:
Gross written premiums (direct written premiums plus assumed written premiums) increased 69.1% from $142.5 million for 2004 to $241.0 million for 2005. Growth in the broker network at James River Insurance and the agency network at Stonewood Insurance were key drivers for the increase in gross written premiums. James River Insurance produced $207.4 million of gross written premiums in 2005 compared to $133.4 million in 2004. Stonewood Insurance produced $33.6 million of gross written premiums in 2005 compared to $9.2 million in 2004. Gross written premiums for Stonewood Insurance for 2005 included $4.4 million of assumed premiums from our participation in the involuntary workers’ compensation pool for North Carolina. Because Stonewood Insurance wrote its first insurance policy effective January 1, 2004, its results for 2004 did not include any renewal premiums, while direct written premiums for 2005 included $7.6 million of renewal premiums.
Net written premiums were $140.6 million for 2005, a 17.0% increase compared to $120.2 million for 2004. The written premium ceding ratio (ratio of ceded written premiums to direct written premiums) increased to 42.4% for 2005 from 15.7% for 2004. The change in the written premium ceding ratio was principally due to our quota share reinsurance contract effective January 1, 2005 that transfers a portion of the risk related to certain property/casualty business written by James River Insurance in 2005 to reinsurers in exchange for a portion of our direct written premiums on that business. Ceded written premiums related to this quota share treaty for 2005 totaled $40.0 million. We also ceded $6.1 million of reinstatement premiums to our reinsurers to reinstate reinsurance coverage for which we had used our reinsurance limits in 2005 due to losses from Hurricane Katrina.
Net earned premiums grew 55.1% to $117.5 million for 2005 compared to $75.8 million for 2004. Premiums are earned ratably over the terms of our insurance policies, generally 12 months. Ceded earned premiums related to the quota share treaty were $40.0 million for 2005. Net earned premium growth for 2005 was also reduced by the $6.1 million of ceded reinstatement reinsurance premiums due to losses from Hurricane Katrina.
Net investment income for 2005 was $10.2 million, up 182% from $3.6 million for 2004. The increase in net investment income reflects the significant growth in our cash and invested assets from $195.2 million at December 31, 2004 to $380.5 million at December 31, 2005. The growth in our cash and invested assets came from net written premiums and $84.6 million of net proceeds from our initial public offering including the underwriters’ exercise of their over-allotment option. The gross investment yield (before investment expenses) on average cash and invested assets for 2005 was 3.8%. The gross investment yield on our average fixed maturity security balance for 2005 was 4.0%. We have significantly increased our holdings of tax-advantaged state and municipal fixed maturity securities over the past twelve months. We believe that after considering their tax-advantaged characteristics, these state and municipal securities represent a good value relative to other market segments. Our tax equivalent yield on our average fixed maturity security balance was 4.4% for 2005. For 2004, the gross investment yield on average cash and invested assets was 3.1%, the gross investment yield on our average fixed maturity security balance was 3.5% and the tax equivalent yield on our average fixed maturity security balance was 3.6%.
The foregoing rollforward shows that a $4.9 million redundancy developed in 2005 on the reserve for losses and LAE held at December 31, 2004. Of this development, $2.5 million and $593,000, respectively, of favorable development occurred in the Excess and Surplus Insurance segment’s casualty lines related to the 2004 and 2003 accident years. Favorable development in 2005 on the Excess and Surplus Insurance segment’s property lines related to the 2004 accident year was $2.4 million. This favorable development was partially offset by $525,000 of adverse development in 2005 for the Workers’ Compensation Insurance segment related to 2004 accident year results, consisting of $696,000 of adverse development on our share of the North Carolina involuntary workers’ compensation pool’s 2004 accident year results offset by $171,000 of favorable reserve development related to the 2004 accident year for direct business written by the Workers’ Compensation Insurance segment. The foregoing reconciliation also shows that a $156,000 redundancy developed in 2004 on the reserve for losses and LAE held at December 31, 2003.
Other operating expenses for 2005 totaled $28.4 million, up 37.5% from other operating expenses incurred during 2004 of $20.7 million. Other operating expenses for 2005 consisted of commissions (net of reinsurance ceding commissions earned) and other underwriting expenses (net of deferred policy acquisition costs) of $10.0 million, amortization of deferred policy acquisition costs of $17.2 million and other costs of $1.2 million. Other operating expenses for 2004 consisted of commissions and other underwriting expenses (net of deferred policy acquisition costs) of $7.0 million, amortization of deferred policy acquisition costs of $12.9 million and other costs of $879,000. Reinsurance ceding commissions earned were $20.8 million for 2005 compared to $5.9 million for 2004, with $9.7 million of the 2005 ceding commissions coming from our quota share reinsurance contract. A portion of the costs of acquiring insurance business, principally commissions and certain policy underwriting and issuance costs, which vary with and are primarily related to the production of insurance business, is deferred. For 2005, $19.8 million of costs were deferred, $10.8 million of which related to commissions and $9.0 million of which related to other acquisition expenses. For 2004, $20.1 million of costs were deferred, $13.4 million of which related to commissions and $6.7 million of which related to other acquisition expenses. Deferred policy acquisition costs are charged to other operating expenses in proportion to premiums earned over the estimated policy term, generally 12 months.
The effective tax rate was 30.1% for 2005 and 15.7% for 2004. Income tax expense for 2005 differs from the amount computed by applying the Federal statutory income tax rate to income before taxes primarily due to interest on tax-advantaged state and municipal securities. Income tax expense for 2004 differs from the amounts computed by applying the Federal statutory income tax rate to income before taxes for 2004 due to our use of net operating loss carryforwards to offset taxable income in that period. Through June
30, 2004, we established a tax valuation allowance equal to total deferred tax assets net of existing deferred tax liabilities and current income tax expense. During the quarter ended September 30, 2004, we concluded that it was more likely than not that we would realize our entire deferred tax asset. We based this conclusion primarily on the fact that we had generated taxable income on an inception-to-date basis sufficient to exhaust all of our net operating loss carryforwards created in our start-up phase. Accordingly, we did not establish a valuation allowance against our deferred tax asset at September 30, 2004 or at any period subsequent to that date.
Net written premiums were $120.2 million in 2004, a 338% increase compared to $27.4 million in 2003. Net written premiums grew from 2003 by a larger percentage than direct written premiums grew because we purchased less reinsurance in 2004 than in 2003. The written premium ceding ratio declined to 15.7% for 2004 from 25.4% for 2003. This was primarily the result of our decision to increase the amount of risk we retain before reinsurance on our primary casualty policies sold by James River Insurance from $405,000 to $1.0 million effective July 1, 2004. Also contributing to the decline in the written premium ceding ratio were lower overall reinsurance costs in 2004 compared to 2003 and the addition of Stonewood Insurance operations in 2004, since the written premium ceding ratio at Stonewood Insurance of 15.6% for 2004 is below the 25.4% ratio we experienced for our company as a whole in 2003. We also had an adjustment to reduce the estimated ceding rate on one of our retrospective experience rated reinsurance treaties in 2004.
Realized investment losses were $71,000 in 2004. There were no realized gains or losses in 2003. There were no write-downs of securities for other-than-temporary impairments in 2004 or 2003.
Other operating expenses for 2004 totaled $20.7 million, up 202% from other operating expenses incurred during 2003 of $6.8 million. Other operating expenses for 2004 consisted of commissions and other underwriting expenses (net of deferred policy acquisition costs) of $7.0 million, amortization of deferred policy acquisition costs of $12.9 million and other costs of $879,000. For 2004, $20.1 million of costs were deferred, $13.4 million of which related to commissions and $6.7 million of which related to other acquisition expenses. The expense ratio was 27.3% for 2004 compared to 134.5% for 2003. Our expense ratio for 2004 was negatively impacted by the 76.5% expense ratio for our Workers' Compensation Insurance segment in Stonewood Insurance's first year of insurance operations. Other operating expenses in 2003 included $3.7 million of expenses incurred by our insurance subsidiaries to build the infrastructure needed prior to commencing insurance operations.
During the quarter ended September 30, 2004, we concluded that it was more likely than not that we would realize our entire deferred tax asset. We based this conclusion primarily on our generation of taxable income on an inception-to-date basis sufficient to exhaust all of our net operating loss carryforwards created in our start-up phase. Accordingly, no valuation allowance was established against our deferred tax assets at December 31, 2004. Income tax expense of $1.6 million was recognized in 2004, representing the excess of the tax expense on our taxable income earned during the year over the reduction in our tax valuation allowance during the year. No income tax expense or benefit was recognized on our income statement in 2003 because our deferred tax assets were offset by a deferred tax valuation allowance.
• The Excess and Surplus Insurance segment offers commercial excess and surplus lines liability and property products through James River Insurance;
• The Corporate and Other segment consists of certain management and treasury activities of our holding company and interest expense associated with our debt.
The loss ratio for the Excess and Surplus Insurance segment was 68.8%, 62.0% and 66.3% for 2005, 2004 and 2003, respectively. We incurred $7.9 million of losses and LAE, net of reinsurance, from Hurricane Katrina in 2005. Hurricane Katrina also impacted our loss ratios as a result of the $6.1 million of ceded
The loss ratio for the Workers' Compensation Insurance segment was 62.7% and 73.5%, for 2005 and 2004, respectively. The loss ratio for the Workers’ Compensation Insurance segment for 2005 was negatively impacted by the 95.2% loss ratio for the year on Stonewood Insurance’s share of the North Carolina involuntary workers’ compensation pool’s results. The loss ratio for the Workers' Compensation Insurance segment for 2005 benefited from $171,000 of favorable reserve development related to direct workers’ compensation business written by Stonewood Insurance related to the 2004 accident year. The loss ratio for 2004 was negatively impacted by claims administration expenses that were high relative to the low volume of claims activity during our first year of workers' compensation insurance operations. For 2004, adjusting and other expenses were 8.6% of net earned premiums for the Workers' Compensation Insurance segment.
The expense ratio for the Workers’ Compensation Insurance segment improved to 34.2% for 2005 from 76.5% for 2004. Underwriting expenses for 2005 included $720,000 of guaranty fund assessment expenses. The expense ratio for the Workers' Compensation Insurance segment in 2004 was negatively impacted by the costs required to establish the infrastructure to handle a high volume of insurance activity.
or until they are needed for other corporate purposes, including potential acquisitions. Net investment income for 2003 of $56,000 reflects the low interest rate environment in that period and the fact that all of the holding company’s funds in 2003 were invested in low yielding cash equivalents.
Interest expense totaled $2.7 million and $793,000 for 2005 and 2004, respectively. Interest expense related to $15.0 million of senior notes and $22.7 million of junior subordinated notes that we issued in May and December 2004.
Net cash provided by operating activities was $106.8 million for 2005 compared to $80.5 million for 2004. Net cash provided by operating activities in both years is primarily attributable to cash received on written premiums exceeding cash disbursed for operating expenses and losses and LAE. The increase in net cash provided by operating activities reflects the growth in our premium cash receipts in 2005 compared to 2004 which exceeded the growth in cash disbursed for operating expenses and losses and LAE. Net cash provided by operating activities in 2003 totaled $11.0 million, reflecting the start-up nature of our operations in that period and the absence of insurance operations in the first six months of 2003.
During 2003, we issued 85,000 shares of Series A Convertible Preferred Stock with proceeds, net of issuance costs, totaling $8.4 million. Of the net proceeds from the sale of the Series A Convertible Preferred Stock shares, $6.9 million was received in 2002. We also issued 700,000 Series B Convertible Preferred Stock shares during 2003, with proceeds, net of issuance costs and notes receivable from employees and directors, of $67.2 million. As a result of these transactions, net cash provided by financing activities for 2003 totaled $68.8 million.
On May 3, 2005, we filed a registration statement on Form S-1 with the Securities Exchange Commission for an initial public offering of our Common Stock. Our registration statement was declared effective on August 8, 2005. On August 9, 2005, we effected a 10 for 1 split of our Common Stock to stockholders of record on that date. Immediately prior to the closing of the initial public offering on August 12, 2005, all of our outstanding Series A convertible preferred stock and Series B Convertible Preferred Stock, including shares representing accrued but unpaid dividends, were converted into 9,956,413 shares of Common Stock. In addition, we amended and restated our certificate of incorporation to increase the number of authorized shares of Common Stock to 100,000,000 and decrease the number of authorized shares of preferred stock to 5,000,000. Gross proceeds from the sale of 4,444,000 shares of Common Stock, at an initial public offering price per share of $18.00, totaled $80.0 million. Costs associated with the initial public offering included $5.6 million of underwriting costs and $995,000 of other issuance costs.
We used a portion of the net proceeds from the initial public offering and the over-allotment exercise to contribute $52.0 million to James River Insurance and $8.5 million to Stonewood Insurance in the third quarter of 2005. The remaining net proceeds were retained at the holding company to provide working capital for us.
We have provided a full, irrevocable and unconditional guarantee of payment of the obligations of each of the trusts under the trust preferred securities. The indentures for the junior subordinated notes contain certain organizational covenants with which we are in compliance as of December 31, 2005.
At December 31, 2005 and 2004, the ratio of total debt outstanding to total capitalization (defined as total debt outstanding plus total stockholders' equity) was 17.6% and 31.8%, respectively. We use capital to support our premium growth and having debt as part of our capital structure allows us to generate higher earnings per share and book value per share results than we could by using entirely equity capital to support our premium growth. Our target debt to total capitalization ratio is 35.0% or less.
receivable are due in 2013 and are classified as a reduction in stockholders' equity on our consolidated balance sheet. In April 2005, the notes receivable from our executive officers and directors totaling $2.0 million were repaid by the borrowers. An additional $10,000 was repaid in August 2005 leaving $535,000 of notes receivable from our employees who are not executive officers outstanding at December 31, 2005.
One of the key financial measures that we use to evaluate our operating performance is return on equity. We calculate return on equity by dividing net income by average stockholders' equity for the period. Our overall financial goal is to produce a return on equity of at least 15.0% over the long-term. Our return on equity was 9.4% for 2005 and 11.6% for 2004.
The amortized cost and fair value of our investments in fixed maturity securities summarized by contractual maturity were as follows:
The following table shows the gross unrealized losses and fair values of investments aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position:
The majority of the unrealized losses on fixed maturity securities are interest rate related. All but two of the fixed maturity securities with unrealized losses at December 31, 2005 had fair values that were greater than 93% of amortized cost and were rated investment grade by Standard & Poor’s or received an equivalent rating from another nationally recognized rating agency. None of the fixed maturity securities
A portion of the costs of acquiring insurance business, principally commissions and certain policy underwriting and issuance costs which vary with and are primarily related to the production of insurance business, are deferred. Deferred policy acquisition costs totaled $13.9 million, or 15.5% of unearned premiums (net of reinsurance), at December 31, 2005. Deferred policy acquisition costs totaled $11.3 million, or 17.1% of unearned premiums (net of reinsurance), at December 31, 2004.
We monitor our aggregate property exposures by geographic area and use computer models to analyze the risk of severe losses from hurricanes and earthquakes. We measure exposure to these catastrophe losses in terms of probable maximum loss (PML), which is an estimate of the highest amount we would expect to pay in any one catastrophe event over a specified period of time. We manage this potential loss by purchasing catastrophe reinsurance coverage. Effective June 1, 2004, we purchased catastrophe reinsurance coverage of $5.0 million per event in excess of our $2.0 million per event retention. Effective June 1, 2005, we increased our catastrophe reinsurance coverage to $36.0 million per event in excess of our $2.0 million per event retention. Our catastrophe reinsurance coverage in place effective June 1, 2005 had one reinstatement in the event we exhausted the $36.0 million of coverage. We ceded $2.7 million of reinstatement premium to our catastrophe reinsurers in 2005. Additionally, we are ceding some losses from Hurricane Wilma to our catastrophe reinsurance coverage. Effective November 1, 2005, we purchased additional catastrophe reinsurance coverage which provides an additional $6.5 million of coverage through May 31, 2006.
At the time of our acquisition of Fidelity Excess and Surplus Insurance Company (Fidelity) in June 2003, Fidelity had a reinsurance agreement with its parent, American Empire Surplus Lines Insurance Company (American Empire). Under this reinsurance agreement, Fidelity ceded all of its liabilities on all insurance business it wrote or assumed through June 30, 2003 to American Empire. American Empire and Fidelity also entered into a trust agreement under which American Empire established a trust account with Fidelity as the beneficiary. Under the trust agreement, American Empire must maintain assets with a current fair value greater than or equal to the ultimate net aggregate losses recoverable under the reinsurance agreement. Cessions under the reinsurance agreement are net of third party reinsurance. At December 31, 2005, reinsurance recoverables from American Empire were $2.8 million. These recoverables are secured by trust assets of $4.1 million. Reinsurance recoverables from third party reinsurers associated with the business that Fidelity wrote before we acquired it were $4.1 million at December 31, 2005. In the event that the third party reinsurers default on their obligations, the recoverables would become subject to our reinsurance agreement with American Empire and, accordingly, American Empire will indemnify us for any such uncollectible third party reinsurance recoverables. The trust assets are limited to cash and investments permitted by Ohio insurance laws. None of the trust assets can be in capital stock or in fixed income securities that are below investment grade. As additional security, Great American Insurance Company (Great American), an affiliate of American Empire, has irrevocably and unconditionally guaranteed the performance by American Empire of all of its obligations under the reinsurance agreement and trust agreement. Great American and American Empire have financial strength ratings of ‘‘A’’ (Excellent) from A.M. Best. We remain liable for the liabilities ceded under the reinsurance agreement in the event that the trust assets are insufficient to cover the ultimate net aggregate losses recoverable under the reinsurance agreement and American Empire and Great American default on their respective obligations.
James River Insurance and Stonewood Insurance each have a financial strength rating of ‘‘A−’’ (Excellent) from A.M. Best. A.M. Best assigns 16 ratings to insurance companies, which currently range from ‘‘A++’’ (Superior) to ‘‘F’’ (In Liquidation). ‘‘A−’’ (Excellent) is the fourth highest rating issued by A.M. Best. The ‘‘A−’’ (Excellent) rating is assigned to insurers that have, in A.M. Best's opinion, an excellent ability to meet their ongoing obligations to policyholders. This rating is intended to provide an independent opinion of an insurer's ability to meet its obligation to policyholders and is not an evaluation directed at investors.
The financial strength ratings assigned by A.M. Best have an impact on the ability of the insurance companies to attract and retain agents and brokers and on the risk profiles of the submissions for insurance that the insurance companies receive. The ‘‘A−’’ (Excellent) ratings obtained by James River Insurance and Stonewood Insurance are consistent with the companies' business plans and allow the companies to actively pursue relationships with the agents and brokers identified in their marketing plans.
The following table reconciles the underwriting profit (loss) of insurance segments by individual segment to consolidated income (loss) before taxes:
used in the incurred Bornhuetter-Ferguson method is typically not adjusted after it is initially set, because the mechanics of that method already incorporate departures from expected reported losses into the reserve calculations. We did not change our actuarial methods during 2005, although we did exercise judgment in estimating reserves for Hurricanes Katrina and Wilma. We have generally selected the actuarial method that yields the highest reserve for each line of business as our best estimate. At December 31, 2005, our aggregate reserve is the sum of the results from the selected estimates for each line of business plus the reserve for losses and LAE associated with Hurricanes Katrina and Wilma that is estimated as described below. This aggregate reserve reflects our best estimate. Since we have selected the higher of the two actuarial methods at each financial statement date, the aggregate reserve includes components calculated using the incurred Bornhuetter-Ferguson method and components calculated using the loss ratio method. This combination of methods varies by line of business and period. The primary factor contributing to the difference between the methods is that the incurred Bornhuetter-Ferguson method incorporates assumptions regarding industry reporting patterns for losses and our reported losses and LAE which are not reflected in the loss ratio method. This means that the incurred Bornhuetter-Ferguson method is more sensitive to our level of reported losses than the loss ratio method.
Events of the magnitude of Hurricanes Katrina and Wilma, each of which occurred in 2005, involve complex coverage issues, and we are aware that resources may be somewhat scarce in the affected areas. Accordingly, we have established reserves in each case that we believe reflect the complexity of the claims and the potential price increases associated with demand for labor and materials in the storm affected areas. In estimating the reserves for losses and LAE relating to Hurricanes Katrina and Wilma, we used case reserve estimates based on information obtained from site inspections by our adjusters and the terms of the coverage provided in the policies. We estimated reserves for incurred but not reported claims using judgment based on an assessment of our property insurance exposures in the path of the storms. Actual results may differ materially from the estimates and assumptions used in preparing the consolidated financial statements.
of recording the net reserve for losses at the highest value from the sensitivity analysis would be to reduce net income by $6.9 million and to reduce stockholders' equity at December 31, 2005 by 3.9%. The impact of recording the net reserve for losses at the lowest value from the sensitivity analysis above would be to increase net income by $6.8 million and increase stockholders' equity at December 31, 2005 by 3.9%. Such changes in the net reserve for losses and LAE would not have an immediate impact on our liquidity, but would affect cash flow in future periods as the incremental or reduced amount of losses are paid.
Our reserves are driven by a number of important assumptions including litigation and regulatory trends, legislative activity, social and economic patterns and claims inflation assumptions. Our reserve estimates reflect current inflation in legal claims settlements and assume we will not be subject to losses from significant new legal liability theories. Our reserve estimates also assume that we will not experience significant losses from mass torts and that we will not incur losses from future mass torts not known to us today. While it is not possible to predict the impact of changes in this environment, if new mass torts or expanded legal theories of liability emerge, our incurred but not reported, commonly referred to as IBNR, claims may differ substantially from our IBNR reserves. Our reserve estimates assume that there will not be significant changes in the regulatory and legislative environment. The impact of potential changes in the regulatory or legislative environment is difficult to quantify in the absence of specific, significant new regulation or legislation. In the event of significant new regulation or legislation, we will attempt to quantify its impact on our business and modify our reserves accordingly.
We evaluate our investments regularly to determine whether there are declines in value that are other-than-temporary. When we determine that a security has experienced an other-than-temporary impairment, the impairment is recognized as a realized investment loss. We consider a number of factors in assessing whether an impairment is other-than-temporary, including the amount and percentage that fair value is below amortized cost, the length of time that fair value has been below amortized cost and the credit quality ratings for the securities, with a special emphasis on securities downgraded below investment grade. We also consider our intent and ability to hold the security for a sufficient period of time to allow for a recovery in value. We recognized an impairment loss of $92,000 in 2005 on a fixed maturity security in our portfolio (see - "Cash and Invested Assets"). We did not recognize any impairment losses in 2004 or 2003.
We carry securities classified as ‘‘available-for-sale’’ at fair value, and unrealized gains and losses on such securities, net of deferred taxes, are reported as a separate component of accumulated other comprehensive income. We do not have any securities classified as ‘‘held-to-maturity’’ or ‘‘trading’’.
Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to our taxable income in the years in which temporary differences between the financial statement carrying amounts of assets and liabilities and their respective tax bases are expected to be recovered or settled.
Some of the reinsurance treaties of James River Insurance contain retrospective experience rated provisions in which the cost of reinsurance purchased by James River Insurance or the amount of ceding commission James River Insurance receives from its reinsurers varies based on the level of incurred losses ceded to the reinsurers, subject to a maximum and a minimum specified in the reinsurance contract. We estimate the ultimate loss experience in determining the amounts to record in the consolidated financial statements for premiums ceded to reinsurers and ceding commissions earned by James River Insurance. As loss experience develops, we adjust the ceded premium rates and ceding commission rates to reflect the loss experience. Although we believe that our estimates are reasonable, it is possible that our actual loss experience may not conform to our assumptions. We regularly review our estimates and adjust them as necessary as experience develops or new information becomes known; such adjustments are included in current operations. The impact of these adjustments in 2004 was to increase net earned premiums for 2004 by $484,000 for the true-up of premiums earned in 2003 and to increase losses and LAE by approximately $290,000. Each of these adjustments in 2004 related to one reinsurance treaty that was effective from July 1, 2003 through June 30, 2004. There were no adjustments to our assumptions related to retrospective experience rated reinsurance provisions in 2005.
We possess intangible insurance assets with an indefinite life. Financial Accounting Standards Board (FASB) Statement No. 142, Goodwill and Other Intangible Assets, prescribes that an intangible asset with an indefinite useful life should not be amortized but instead should be tested for impairment on at least an annual basis, based on a comparison of its fair value and its carrying value. In performing the impairment evaluation for these intangible assets, we first determine that the intangible assets purchased continue to have an indefinite life. Next, we determine the fair value of the intangible assets and compare this fair value to the carrying value. If the carrying value exceeds the fair value, we recognize an impairment writedown to fair value on the intangible asset, and the impairment is reported through earnings. We have had no such impairment writedowns for the years ended December 31, 2005, 2004 or 2003.
On June 30, 2003, we acquired Fidelity, which we renamed James River Insurance Company, from American Empire Surplus Lines Insurance Company (American Empire), a member of the American Financial Group. The purchase price totaled $28.9 million, including $84,000 of acquisition expenses.
With the purchase of Fidelity, we acquired surplus lines approval in 40 states and the District of Columbia and insurance licenses in four states. We recorded intangible insurance assets of $4.2 million in connection with the purchase. The intangible insurance assets arise from regulatory approvals granted by the various state insurance departments to write insurance business on an excess and surplus lines basis in their states. Once these regulatory approvals are granted, we can routinely renew them at little cost provided that we have complied with rules and regulations. We expect cash flows related to the regulatory approvals to transact insurance business to continue indefinitely, so we have concluded that these intangible assets have indefinite lives.
Fidelity ceded all of its liabilities on all insurance business it wrote or assumed through June 30, 2003 to American Empire. American Empire and Fidelity also entered into a trust agreement under which American Empire established a trust account with Fidelity as the beneficiary. Under the trust agreement, American Empire must maintain assets with a current fair value greater than or equal to the ultimate net aggregate losses recoverable under the reinsurance agreement. As additional security, Great American has irrevocably and unconditionally guaranteed the performance by American Empire of all of its obligations under the reinsurance agreement and the trust agreement (see - ‘‘Reinsurance’’).
On December 16, 2004, the FASB issued Statement No. 123 (revised 2004), Share-Based Payment (Statement 123(R)), which is a revision of Statement No. 123, Accounting for Stock-Based Compensation. Statement 123(R) supersedes Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (APB Opinion No. 25) and amends FASB Statement No. 95, Statement of Cash Flows.
For awards issued on or after May 3, 2005, and for awards modified, repurchased or cancelled on or after that date, we use the fair value method to calculate the pro forma disclosures required by Statement 123. When we adopted Statement 123(R) on January 1, 2006, we began recognizing the expense associated with these awards in the consolidated statement of operations over each award’s remaining vesting period using the modified prospective method. Compensation expense in 2006 associated with options granted subsequent to May 3, 2005 is expected to be approximately $900,000. Because the amount, terms and fair values of awards to be issued in the future are uncertain, the total impact of the adoption of Statement 123(R) on our financial statements is not known at this time.
losses that have not been recognized as other-than-temporary impairments. FSP 115-1 amends FASB Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities and nullifies certain requirements of EITF 03-1, The Meaning of Other-Than-Temporary Impairments and Its Application to Certain Investments. FSP 115-1 is effective for reporting periods beginning after December 15, 2005. We believe our existing policies for recognizing other-than-temporary impairments are consistent with the guidance in FSP 115-1; therefore, the adoption of FSP 115-1 is not expected to have a material impact on our consolidated financial condition or results of operations.