The Company leases certain office space at One Bala Plaza, Bala Cynwyd, PA which serves as its headquarters location, and also leases 36 offices for its field marketing organization.
Minority Interest amount represents mandatorily redeemable preferred securities of a consolidated subsidiary trust. The trust solely held debentures issued by the Company.
The Company designs, markets, and underwrites specialty commercial and personal property and casualty insurance products for select markets or niches. The Company’s operations are classified into three reportable business segments which are organized around its three underwriting divisions: The Commercial Lines Underwriting Group, which has underwriting responsibility for the commercial multi-peril package, commercial automobile and specialty property and inland marine insurance products; The Specialty Lines Underwriting Group, which has underwriting responsibility for the professional and management liability insurance products; and The Personal Lines Group, which has responsibility for personal property and casualty insurance products for the manufactured housing and homeowners markets. The Company operates solely within the United States through its 12 regional and 24 field offices.
The Company also generates revenue from its investment portfolio, which approximated $1.5 billion at December 31, 2004 and generated $51.2 million in gross pre-tax investment income during 2004. The Company utilizes external independent professional investment managers with the objective of realizing relatively high levels of investment income while generating competitive after-tax total rates of return within duration and credit quality targets.
Management measures the results of operations through monitoring certain measures of growth and profitability, including, but not limited to: number of policies written, pricing, risk selection, loss ratio (sum of net loss and loss adjustment expenses divided by net earned premiums) and expense levels.
Due to the multiple hurricane events the Company purchased additional reinsurance coverages to supplement the original catastrophe reinsurance coverage in 2004 which was utilized. These multiple hurricane events resulted in accelerating the recognition of $26.0 million in catastrophe reinsurance premium expense as a result of utilizing certain of the catastrophe reinsurance coverages. Of this $26.0 million in accelerated reinsurance premium expense, $10.3 million of the accelerated premium expense was attributable to the additional reinsurance coverages which were purchased.
As a result of the active 2004 hurricane season there have been a small number of insurers that have announced their intention to either withdraw from the Florida Marketplace or reduce homeowners and related product writings. The Company doesn’t believe these events will have a material impact on its marketing plan. However, the Company plans to shift its product mix by reducing manufactured housing product policies and increasing homeowners’ product policies. The Company plans to reduce its manufactured housing exposures by restricting new business and further limiting exposure concentrations. Although one Florida Company has declared insolvency as a result of losses incurred during the 2004 hurricane season, the Company is not aware of any pending assessment from the Florida Insurance Guarantee Association (“FIGA”) to pay for losses resulting from the insolvency. Any assessment from FIGA is recoverable through policy surcharges. Additionally, Citizens Property Insurance Company (“CPIC”) is the Florida market mechanism for homeowners’ coverage. CPIC experienced significant losses from the 2004 hurricanes and has indicated the
The Company believes its core strategy of adhering to an underwriting philosophy of sound risk selection and pricing discipline, a mixed marketing platform for its product distribution and the creation of value added features not typically found in property and casualty products have also contributed to generating premium growth above industry averages, as well as enabling the Company to produce combined ratios (the sum of net loss and loss adjustment expenses and acquisition costs and other underwriting expenses, divided by net earned premiums) well below industry averages.
In October, 2004, the New York Attorney General’s office filed a complaint in New York state court against Marsh & McClennan Companies, Inc. (“Marsh”), the nation’s largest insurance broker. The complaint accuses Marsh of participating in bid-rigging schemes and improper disclosure to its customers of the fact that Marsh was receiving contingent commissions from insurers which issued insurance policies to such customers. These commissions are based on the volume and/or profitability of business placed by Marsh. The complaint also asserted that a number of insurers engaged in bid rigging. Shortly after this complaint was filed, Marsh and a number of the insurers named in the complaint publicly announced that they would be terminating their contingent commission arrangements. Marsh has agreed to pay a significant amount in settlement of the matters referred to in the complaint.
The Pennsylvania Insurance Department and insurance regulatory agencies in other states are currently reviewing this practice. One or more of such agencies may in the future issue regulations concerning the payment of contingent commissions and/or the disclosure thereof to customers. In 2004, the Company, as well as many other Pennsylvania domiciled insurance companies, received an inquiry from the Pennsylvania Insurance Department requesting information concerning compensation and other arrangements with our brokers and agents, and the Company has responded to that inquiry.
Insurance regulatory agencies are likely to impose requirements on the insurance industry with respect to the payment of contingent commissions and/or the disclosure of contingent commissions to customers and proposed customers. If these requirements are imposed, they may impact the manner in which the Company compensates its brokers and may have an impact on the Company’s business. In November 2004, the National Association of Insurance Commissioners Executive Task Force on Broker Activities proposed model legislation that would impose disclosure requirements on brokers, and would require brokers to obtain the insured’s written consent before receiving compensation from an insurance company for the same transaction.
The Company has arrangements with approximately 56 agents and 77 brokers (collectively “Preferred Agents”) under which the Company pays profit share based on the profitability to the Company of business placed by these Preferred Agents with the Company. Approximately 25% of the Company’s gross written premiums are produced through Preferred Agents with which the Company has profit share arrangements. It is possible that the filing of the complaint against Marsh and the settlement thereof and/or future legislation, regulations and/or case law could affect these arrangements. The Company is not able at this time to predict the impact of such matters, if any, on the Company.
As of September 30, 2004, the Company’s four insurance subsidiaries participated in an intercompany reinsurance pooling agreement and were rated “A+” (Superior) by A.M. Best Company. According to A.M. Best Company, companies rated “A+” (Superior) have, on balance, superior financial strength, operating performance and market profile, when compared to the standards established by A.M. Best Company, and have a very strong ability to meet their ongoing obligations to policyholders. Effective October 1, 2004 the Company’s four insurance subsidiaries entered into a new intercompany reinsurance pooling arrangement. The Company’s insurance subsidiaries, Philadelphia Indemnity Insurance Company and Philadelphia Insurance Company, entered into an intercompany reinsurance pooling arrangement which includes substantially all the Company’s commercial and specialty lines business. The Company’s two other insurance subsidiaries, Mobile USA Insurance Company and Liberty American Insurance Company, also entered into an intercompany reinsurance pooling arrangement which substantially includes all the Company’s personal lines segment business. As a result of this arrangement, A.M. Best Company assigned an “A-” (Excellent) rating to these two companies. The rating of Philadelphia Indemnity Insurance Company and Philadelphia Insurance Company remained at “A+”.
the total invested assets (total investments plus cash equivalents) on a cost basis consisted of investments in fixed maturity and equity securities, respectively, versus 87.8% and 6.6%, respectively, at December 31, 2003.
Of the total investments in fixed maturity securities, asset backed, mortgage pass-through, and collateralized mortgage obligation securities, on a cost basis, amounted to $96.0 million, $229.6 million and $62.6 million, respectively, as of December 31, 2004 and $183.0 million, $159.2 million and $53.8 million, respectively, as of December 31, 2003. The asset backed, mortgage pass-through, and collateralized mortgage obligation investments are amortizing securities possessing favorable prepayment risk and/or extension profiles.
The Company regularly performs various analytical procedures with respect to its investments, including identifying any security whose fair value is below its cost. Upon identification of such securities, a detailed review is performed for all securities, except interests in securitized assets, meeting predetermined thresholds to determine whether such decline is other than temporary. If the Company determines a decline in value to be other than temporary, based upon its detailed review, or if a decline in value for an equity investment has persisted continuously for nine months, the cost basis of the security is written down to its fair value. The factors considered in reaching the conclusion that a decline below cost is other than temporary include, but are not limited to: whether the issuer is in financial distress; the performance of the collateral underlying a secured investment; whether a significant credit rating action has occurred; whether scheduled interest payments have been delayed or missed; whether changes in laws and/or regulations have impacted an issuer or industry; an assessment of the timing of a security’s recovery to fair value; and an ability and intent to hold the security to recovery of fair value. The amount of any write down is included in earnings as a realized loss in the period the impairment arose. This evaluation resulted in non-cash realized investment losses of $2.5 million and $1.0 million for the years ended December 31, 2004 and 2003, respectively. The Company attributes these other than temporary declines in fair value primarily to issuer specific conditions, except for as noted in the following paragraph.
The following table identifies the period of time securities with an unrealized loss at December 31, 2004 have continuously been in an unrealized loss position. Included in the amounts displayed in the table are $0.1 million of unrealized losses due to non-investment grade fixed maturity securities having a fair value of $1.2 million. No issuer of securities or industry represents more than 3.6% and 16.0%, respectively, of the total estimated fair value, or 4.6% and 11.9%, respectively, of the total gross unrealized loss included in the table below. As mentioned above, there are certain risks and uncertainties inherent in the Company’s impairment methodology, including, but not limited to, the financial condition of specific industry sectors and the resultant effect on any such underlying security collateral values and changes in accounting, tax, and/or regulatory requirements which may have an effect on either, or both, the investor and/or the issuer. Should the Company subsequently determine a decline in the fair value below the cost basis to be other than temporary, the security would be written down to its fair value and the difference would be included in earnings as a realized loss for the period such determination was made.
During 2004 the Company’s gross loss on the sale of fixed maturity and equity securities amounted to $1.3 million and $1.9 million, respectively. The fair value of the fixed maturity and equity securities at the time of sale was $30.7 million and $7.5 million, respectively. During 2003 the Company’s gross loss on the sale of fixed maturity and equity securities amounted to $0.7 million and $0.8 million, respectively. The fair value of the fixed maturity and equity securities at the time of sale was $20.1 million and $4.4 million, respectively.
The decision to sell these securities was based upon an assessment of economic conditions and ongoing portfolio management objectives of maximizing the Company’s after-tax net investment income.
The Company’s financial instruments are subject to the market risk of potential losses from adverse changes in market rates and prices. The primary market risks to the Company are equity price risk associated with investments in equity securities and interest rate risk associated with investments in fixed maturities. The Company has established, among other criteria, duration, asset quality and asset allocation guidelines for managing its investment
The carrying amount for the Company’s investments approximates their estimated fair value. The Company measures the fair value of investments based upon quoted market prices or by obtaining quotes from third party broker-dealers. Material assumptions and factors utilized by such broker-dealers in pricing these securities include: future cash flows, constant default rates, recovery rates and any market clearing activity that may have occurred since the prior month-end pricing period. The Company’s total investments include $4.7 million in securities for which there is no readily available independent market price.
- - Other than temporary impairment, excluding interests in securitized assets
The Company regularly performs various analytical procedures with respect to its investments, including identifying any security whose fair value is below its cost. Upon identification of such securities, a detailed review is performed for all securities, meeting predetermined thresholds, to determine whether such decline is other than temporary. If the Company determines a decline in value to be other than temporary, based upon its detailed review, or if a decline in value for an equity investment has persisted continuously for nine months, the cost basis of the security is written down to its fair value. The factors considered in reaching the conclusion that a decline below cost is other-than-temporary include, but are not limited to, whether: the issuer is in financial distress; the performance of the collateral underlying a secured investment; a significant credit rating action has occurred; scheduled interest payments have been delayed or missed; changes in laws and/or regulations have impacted an issuer or industry; and assessment of the timing of a security’s recovery to fair value; and an ability and intent to hold. The amount of any write-down is included in earnings as a realized loss in the period the impairment arose (see Investments). Gross unrealized losses for investments excluding interests in securitized assets at December 31, 2004 were $4.0 million.
The Company conducts its impairment evaluation and recognition for interests in securitized assets in accordance with the guidance provided by the Emerging Issues Task Force of the Financial Accounting Standards Board. Under this guidance, impairment losses on securities must be recognized if both the fair value of the security is less than its book value and the net present value of expected future cash flows is less than the net present value of expected future cash flows at the most recent (prior) estimation date. If these criteria are met, an impairment charge, calculated as the difference between the current book value of the security and its fair value, is included in earnings as a realized loss in the period the impairment arose (see Investments). Gross unrealized losses for investments in securitized assets at December 31, 2004 were $1.3 million.
developments. These estimates are reviewed regularly and any adjustments resulting therefrom are made in the accounting period in which the adjustment arose.
Policy acquisition costs ($91.6 million and $56.3 million as of December 31, 2004 and 2003, respectively) which include commissions (net of ceding commissions), premium taxes, fees, and certain other costs of underwriting policies, are deferred and amortized over the same period in which the related premiums are earned. Deferred acquisition costs are limited to the estimated amounts recoverable after providing for losses and expenses that are expected to be incurred, based upon historical and current experience. Anticipated investment income is considered in determining whether a premium deficiency exists. The methods of making such estimates and establishing the deferred costs are continually reviewed by the Company, and any adjustments therefrom are made in the accounting period in which the adjustment arose.
Premiums: Premium information relating to the Company’s business segments is as follows (in millions):
• Continued expansion of marketing efforts relating to commercial lines and specialty lines products through the Company’s field organization and preferred agents.
• The insurance subsidiaries of Liberty American Insurance Group, Inc. (a subsidiary of the Company) have recently commenced writing a previously brokered homeowners product on a direct basis due to a recent termination of a brokerage agreement. Gross written premiums from this homeowners product approximated $17.1 million for the year ended December 31, 2004.
• In-force policy counts have increased 14.7%, 30.0%, and 16.0% for the commercial lines, specialty lines and personal lines segments, respectively, primarily as a result of the factors discussed above.
• Realized average rate increases on renewal business approximating 2.2%, 2.7%, and 7.1% for the commercial, specialty and personal lines segments, respectively.
The respective net written premium changes for commercial lines, specialty lines and personal lines segments for the year ended December 31, 2004 vs. December 31, 2003 were (in millions):
• A change in the Company’s reinsurance program whereby, effective April 1, 2003, the Company entered into a Quota Share reinsurance agreement covering substantially all of the Company’s lines of business. Under this agreement:
• Of the $199.4 million of net written premiums ceded during the year ended December 31, 2003, $63.5 million represents 22% of the Company’s April 1, 2003 unearned premium reserve which was ceded upon entering into the quota share agreement. This cession of the unearned premium reserve reduced net written premiums which approximated the following by segment: commercial lines ($44.0 million), specialty lines ($13.3 million), and personal lines ($6.2 million).
• The Company experienced catastrophe losses attributable to Hurricanes Charley, Frances, Ivan and Jeanne. Due to these multiple hurricane events, the Company purchased additional catastrophe reinsurance coverages (which provide coverage from the inception date of the coverage through May 31, 2005) to supplement its original catastrophe reinsurance program. The estimated aggregate pre-tax cost of these additional catastrophe reinsurance coverages is $22.9 million. Additionally, these multiple hurricane events resulted in accelerating the recognition of $26.0 million (Commercial Lines Segment ($2.2 million), and Personal Lines Segment ($23.8 million)) catastrophe reinsurance premium expense during 2004 due to the utilization of certain of the catastrophe reinsurance coverages. Of this $26.0 million, $10.3 million was attributable to the additional reinsurance coverages referred to above. This acceleration of reinsurance premium expense increased reinsurance ceded written and earned premiums and reduced net written and earned premiums.
The total return, which includes the effects of both income and price returns on securities, of the Company’s fixed income portfolio was 4.05% and 4.36% for the years ended December 31, 2004 and 2003, respectively, as compared to the Lehman Brothers Intermediate Aggregate Bond Index (“the Index”) total return of 3.76% and 3.81% for the same periods, respectively. The Company expects some variation in its portfolio’s total return compared to the Index because of the differing sector, security and duration composition of its portfolio compared to the Index.
Net Realized Investment Gain (Loss): Net realized investment gains were $0.8 million for the years ended December 31, 2004 and 2003. The Company realized net investment gains of $4.2 million and $6.4 million from the sale of fixed maturity and equity securities, respectively, for the year ended December 31, 2004, and $6.1 million and $3.7 million in non-cash realized investment losses for fixed maturity and common stock investments, respectively, as a result of the Company’s impairment evaluation. $1.4 million of the $3.7 million non-cash realized investment losses is due to a December 2004 decision to change certain of the Company’s common stock investment managers. As a result of this decision the Company wrote down certain common stock securities since there was no longer an intent to hold the securities to recovery.
Net Loss and Loss Adjustment Expenses: Net loss and loss adjustment expenses increased $116.9 million (32.5%) to $476.1 million for the year ended December 31, 2004 from $359.2 million for the same period of 2003 and the loss ratio decreased to 61.8% in 2004 from 62.5% in 2003. This increase in net loss and loss adjustment expenses and/or loss ratio was primarily due to:
• Acceleration of the recognition of $26.0 million of catastrophe reinsurance premium expense, which reduced net earned premiums, due to the utilization of certain of the catastrophe reinsurance coverages. The hurricane losses and associated accelerated catastrophe reinsurance premium expense contributed 8.8 percentage points to the combined ratio.
Acquisition Costs and Other Underwriting Expenses: Acquisition costs and other underwriting expenses increased $51.5 million (31.6%) to $214.4 million for the year ended December 31, 2004 from $162.9 million for the same period of 2003, and the expense ratio decreased to 27.8% in 2004 from 28.4% in 2003. This increase in acquisition costs and other underwriting expenses was due primarily to the 34.1% growth in net earned premiums. The decrease in the expense ratio is due primarily to an increase in ceding commissions earned and an increase in the ceding commission percentage earned under a quota share reinsurance agreement (see Premiums). This decrease was offset in part by the accelerated recognition of $26.0 million in catastrophe reinsurance expense which reduced net earned premiums. For the years ended December 31, 2004 and 2003, the Company ceded $132.5 million and $116.8 million, respectively, of net earned premiums and earned $61.5 million and $46.7 million, respectively, in ceding commission under a quota share reinsurance agreement. The quota share reinsurance agreement lowered the reported expense ratio by 3.1 and 2.0 percentage points during 2004 and 2003, respectively.
• The displacement of certain competitor property and casualty insurance companies and their independent agency relationships continues to result in new agency relationship opportunities for the Company. These relationship opportunities have resulted in additional policyholders and premium writings for the Company’s commercial and specialty lines segments.
The respective net written premium changes for commercial lines, specialty lines and personal lines segments for the year ended December 31, 2003 vs. December 31, 2002 were (in millions):
• The Company entering into a Quota Share reinsurance agreement (effective April 1, 2003) covering all of the Company’s lines of business. Under this agreement, the Company cedes 22% of its net written premium (including 22% of the net unearned premium reserves at April 1, 2003) and loss and loss adjustment expenses. The Company also receives a provisional commission of 33.0% adjusted pro-rata based upon the ratio of losses incurred to premiums earned. Pursuant to this reinsurance agreement the Company withholds the reinsurance premium reduced by the reinsurers’ expense allowance and the Company’s ceding commission allowance in a Funds Held Payable to Reinsurer account. This Funds Held Payable to Reinsurer account is also reduced by ceded paid losses and loss adjustment expenses under this agreement, and increased by an interest credit. During the year ended December 31, 2003, the Company ceded $194.0 million of written premium, which included unearned premium reserves of $63.6 million at April 1, 2003.
The total return, which includes the effects of both income and price returns on securities, of the Company’s fixed income portfolio was 4.36% and 9.09% for the years ended December 31, 2003 and 2002, respectively, and was similar to the Lehman Brothers Intermediate Aggregate Bond Index (“the Index”) total return of 3.81% and 9.51% for the same periods, respectively. The Company expects some variation in its portfolio’s total return compared to the index because of the differing sector, security and duration composition of its portfolio compared to the index.
The Company realized $3.4 million in net investment gains from the sale of fixed maturity securities and $3.1 million in net investment losses from the sale of common stock equity securities for the year ended December 31, 2002. Additionally, $2.1 million and $1.6 million in non-cash realized investment losses were recorded for common stock and fixed maturity investments, respectively as a result of the Company’s impairment evaluations.
Other Income: Other income approximated $5.5 million for the year ended December 31, 2003 and $0.9 million for the same period of 2002. Other income primarily consists of commissions earned on brokered personal lines business, and to a lesser extent brokered commercial lines business. The Company is seeking to increase brokering activities in its personal lines segment as it is restricting new business and not renewing certain policies in designated areas of Florida as a result of its property exposures in these areas and related catastrophe loss considerations.
Net Loss and Loss Adjustment Expenses: Net loss and loss adjustment expenses increased $91.8 million (34.3%) to $359.2 million for the year ended December 31, 2003 from $267.4 million for the same period of 2002 and the loss ratio decreased to 62.5% in 2003 from 64.0% in 2002. This increase in net loss and loss adjustment expenses was due to the 37.5% growth in net earned premiums, a $38.8 million increase in the estimated gross and
net loss for unreported claims incurred and related claim adjustment expenses on residual value polices issued during the years 1998 through 2002, and a $5.8 million net increase in the estimated gross and net loss reserves for loss and loss adjustment expenses primarily for claims made professional liability and commercial automobile lines of business in prior accident years. Additionally, during the year the Company ceded $111.5 million of net earned premium and $62.7 million in net loss and loss adjustment expenses pursuant to the quota share reinsurance agreement (see Premiums).
Other Operating Expenses: Other operating expenses increased $1.4 million to $7.8 million for the year ended December 31, 2003 from $6.4 million for the same period of 2002 as the Company continues to control its expenses during this period of premium growth.
Philadelphia Consolidated Holding Corp. (PCHC) is a holding company whose principal assets currently consist of 100% of the capital stock of its subsidiaries. PCHC’s primary sources of funds are dividends from its subsidiaries, and payments received pursuant to tax allocation agreements with the insurance subsidiaries and proceeds from the issuance of shares pursuant to the Company’s Stock Purchase and Option Plans. For the year ended December 31, 2004, payments to PCHC pursuant to such tax allocation agreements totaled $41.4 million. The payment of dividends to PCHC from the insurance subsidiaries is subject to certain limitations imposed by the insurance laws of the Commonwealth of Pennsylvania and State of Florida. Accumulated statutory profits or policyholders’ surplus of the insurance subsidiaries from which dividends may be paid totaled $257.5 million at December 31, 2004. Of this amount, the insurance subsidiaries are entitled to pay a total of approximately $58.6 million of dividends in 2005 without obtaining prior approval from the Insurance Commissioner of the Commonwealth of Pennsylvania or State of Florida. During 2004 Mobile Homeowners Insurance Agencies, Inc. paid dividends of $3.5 million to Liberty American Insurance Group, Inc. (“LAIG”), a subsidiary of PCHC, and LAIG paid dividends of $1.0 million to PCHC. During 2004 there were no stock repurchases under the stock repurchase authorization. At December 31, 2004 the remaining stock repurchase authorization is $45.0 million.
The Company’s catastrophe reinsurance program consists of its open market (“OM”) program which has been placed principally with large reinsurers that are rated at least “A” (“Excellent”) by A.M. Best, a 15% quota share reinsurance arrangement, and the Florida Hurricane Catastrophe Fund (“FHCF”). Certain of the Company’s reinsurers have agreed to be billed and make payments to the Company based upon expected catastrophe claims payments to be made by the Company in the near future. Although the Company believes that it will collect all of its reinsurance recoverables, there can be no assurance as to this. The Company believes it will have adequate funds to pay the estimated hurricane catastrophe losses noted above. The Company’s estimated total reinsurance recoverables, reinsurance recoverables on paid, catastrophe reinsurance billings and reinsurance collections with respect to its catastrophe reinsurance programs as of December 31, 2004 for the above mentioned hurricane events are summarized in the table below.
The Company produced net cash from operations of $390.5 million in 2004, $298.5 million in 2003 and $205.0 million in 2002. Sources of operating funds consist primarily of net premiums written and investment income. Funds are used primarily to pay claims and operating expenses and for the purchase of investments. Cash from operations in 2004 was primarily generated from strong premium growth during such year due to increases in the number of policies written and price increases realized on renewal business. Net loss and loss expense payments were $285.9 million in 2004, $237.4 million in 2003, and $157.9 million in 2002. Net cash from operations also included cash provided from tax savings as a result of the exercise of employee stock options amounting to $1.0 million, $0.9 million and $1.3 million for 2004, 2003 and 2002, respectively. Management believes that the Company has adequate liquidity to pay all claims and meet all other cash needs.
Two of the Company’s insurance subsidiaries are members of the Federal Home Loan Bank of Pittsburgh (“FHLB”). A primary advantage of FHLB membership is the ability of members to access credit products from a reliable capital markets provider. The availability of any one member’s access to credit is based upon its FHLB eligible collateral. The insurance subsidiaries have utilized a portion of their borrowing capacity to purchase a diversified portfolio in investment grade floating rate securities. These purchases were funded by floating rate FHLB borrowings to achieve a positive spread between
In the normal course of business, the Company has entered into various reinsurance contracts with unrelated reinsurers. The Company participates in such agreements for the purpose of limiting loss exposure and diversifying business. Reinsurance contracts do not relieve the Company from its obligations to policyholders. To reduce the potential for a write-off of amounts due from reinsurers, the Company evaluates the financial condition of its reinsurers, principally contracts with large reinsurers that are rated at least “A” (Excellent) by A.M. Best Company, regularly monitors its reinsurance receivables and attempts to collect the obligations of its reinsurers on a timely basis.
Under certain reinsurance agreements, the Company is required to maintain investments in trust accounts to secure its reinsurance obligations (primarily the payment of losses and loss adjustment expenses on business it does not write directly). At December 31, 2004, the investment and cash balances in such trust accounts totaled approximately $1.7 million. In addition, various insurance departments of states in which the Company operates require the deposit of funds to protect policyholders within those states. At December 31, 2004, the balance on deposit for the benefit of such policyholders totaled approximately $15.3 million.
The Insurance Subsidiaries, which operate under an intercompany reinsurance pooling agreement, must have certain levels of surplus to support premium writings. Guidelines of the National Association of Insurance Commissioners (the “NAIC”) suggest that a property and casualty insurer’s ratio of annual statutory net premium written to policyholders’ surplus should not exceed 3-to-1. The ratio of combined annual statutory net premium written by the insurance subsidiaries to their combined policyholders’ surplus was 1.8-to-1.0 and 1.5-to-1.0 for 2004 and 2003, respectively.
The NAIC’s risk-based capital method is designed to measure the acceptable amount of capital and surplus an insurer should have based on the inherent specific risks of each insurer. The adequacy of a company’s actual capital and surplus is evaluated by a comparison to the risk-based capital results. Insurers failing to meet minimum risk-based capital requirements may be subject to scrutiny by the insurer’s domiciliary insurance department and ultimately rehabilitation or liquidation. As of December 31, 2004, PIIC, PIC, MUSA and LAIC exceeded their minimum risk-based capital requirements of $194.3 million, $13.0 million, $17.3 million and $13.5 million, respectively, by 115%, 185%, 30% and 96%, respectively.
The Company has certain contractual obligations and commitments as of December 31, 2004 which are summarized below:
(3) Represents 12 month collateralized borrowings from the Federal Home Loan Bank of Pittsburgh.
(4) Represents open commitments under certain limited partnership agreements, information technology development agreements and audit services.
In December 2004, the Financial Accounting Standards Board (“FASB”) issued FASB Statement No. 123® (“SFAS 123R”) “Share-Based Payment”. SFAS 123R replaces SFAS 123, “Accounting for Stock-Based Compensation,” and supersedes APB Opinion 25, “Accounting for Stock Issued to Employees.” SFAS 123R requires that the cost of share-based
Certain information included in this report and other statements or materials published or to be published by the Company are not historical facts but are forward-looking statements relating to such matters as anticipated financial performance, business prospects, technological developments, new and existing products, expectations for market segment and growth, and similar matters. In connection with the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995, the Company provides the following cautionary remarks regarding important factors which, among others, could cause the Company’s actual results and experience to differ materially from the anticipated results or other expectations expressed in the Company’s forward-looking statements. The risks and uncertainties that may affect the operations, performance, development, results of the Company’s business, and the other matters referred to above include, but are not limited to: (i) changes in the business environment in which the Company operates, including inflation and interest rates; (ii) changes in taxes, governmental laws, and regulations; (iii) competitive product and pricing activity; (iv) difficulties of managing growth profitably; (v) claims development and the adequacy of our liability for unpaid loss and loss adjustment expenses; (vi) severity of natural disasters and other catastrophe losses; (vii) adequacy of reinsurance coverage which may be obtained by the Company; (viii) ability and willingness of our reinsurers to pay; and (ix) future terrorist attacks. The Company does not intend to publicly update any forward looking statement, except as may be required by law.
Summary of Investments - Other Than Investments in Related Parties As of December 31, 2004
Supplementary Insurance Information As of and For the Years Ended December 31, 2004, 2003 and 2002
Reinsurance For the Years ended December 31, 2004, 2003 and 2002
In our opinion, the accompanying consolidated balance sheets and related consolidated statements of operations and comprehensive income, of changes in shareholders’ equity and of cash flows present fairly, in all material respects, the financial position of the Company at December 31, 2004 and 2003, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2004 in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit of financial statements includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
The carrying amount for the Company’s investments approximates their estimated fair value. The Company measures the fair value of investments based upon quoted market prices or by obtaining quotes from third party broker-dealers. Material assumptions and factors utilized by such broker-dealers in pricing these securities include: future cash flows, constant default rates, recovery rates and any market clearing activity that may have occurred since the prior month-end pricing period. For mortgage and asset-backed securities (“structured securities”) of high credit quality, changes in expected cash flows are recognized using the retrospective method. For structured securities where the possibility of credit loss is other than remote, changes in expected cash flows are recognized on the prospective method over the remaining life of the securities. Cash flow assumptions for structured securities are obtained from broker dealer survey values or internal estimates consistent with the current interest rate and economic environments. These assumptions represent the Company’s best estimate of the amount and timing of estimated principal and interest cash flows based on current information and events that a market participant would use in determining the current fair value of the security. The Company’s total investments include $4.7 million in securities for which there is no readily available independent market price.
The Company regularly performs various analytical procedures with respect to its investments, including identifying any security whose fair value is below its cost. Upon identification of such securities, a detailed review is performed for such securities, excluding interests in securitized assets, meeting predetermined thresholds to determine whether a decline in fair value below a security’s cost basis is other than temporary. If the Company determines a decline in value to be other than temporary, the cost basis of the security is written down to its fair value with the amount of the write down included in earnings as a realized loss in the period the impairment arose. This evaluation resulted in non-cash realized investment losses of $2.5 million, $1.0 million and $2.1 million for the years ended December 31, 2004, 2003 and 2002, respectively.
The Company held no derivative financial instruments, nor embedded financial derivatives, as of December 31, 2004 and 2003.
Policy acquisition costs, which include commissions (net of ceding commissions), premium taxes, fees, and certain other costs of underwriting policies, are deferred and amortized over the same period in which the related premiums are earned. Deferred acquisition costs are limited to the estimated amounts recoverable from future income, including anticipated investment income, after providing for losses and expenses included in future income that are expected to be incurred, based upon historical and current experience. If such costs are estimated to be unrecoverable, they are expensed.
Goodwill impairment testing requires the evaluation of the fair value of each reporting unit to its carrying value, including the goodwill, and an impairment charge is recorded if the carrying amount of the reporting unit exceeds its estimated fair value. As a result of the impairment analysis, no change in the carrying amount of goodwill, which arose from the purchase of Liberty, was recorded by the Company for the years ended December 31, 2004, 2003 and 2002, respectively.
The Company files a consolidated federal income tax return. Deferred income taxes are recognized for the tax consequences of temporary differences by applying enacted statutory tax rates applicable to the differences between the financial statement carrying amounts and the tax bases of existing assets and liabilities. The effect on deferred taxes for a change in tax rates is recognized in income in the period that includes the enactment date.
Components of comprehensive income, as detailed in the Consolidated Statements of Operations and Comprehensive Income, are net of tax. The related tax effect of Holding Gains (Losses) arising during the year was $1.9 million, $0.6 million and $3.0 million in 2004, 2003 and 2002, respectively. The related tax effect of Reclassification Adjustments was $0.3 million, $0.3 million, and ($1.2) million in 2004, 2003 and 2002, respectively.
draft provides guidance on accounting by insurance enterprises for deferred acquisition costs on certain internal replacements other than those specifically described in FASB Statement No. 97. The Company is evaluating the exposure draft and does not presently anticipate a material effect on its operations or financial position as a result of adoption.
• Under SAP, policy acquisition costs, such as commissions, premium taxes, fees, and other costs of underwriting policies are charged to current operations as incurred, while under GAAP, such costs are deferred and amortized on a pro rata basis over the period covered by the policy.
• Under SAP, premiums receivable are considered nonadmitted if determined to be uncollected based upon aging criteria as defined in SAP.
Dividend Restrictions: The Insurance Subsidiaries are subject to various regulatory restrictions which limit the maximum amount of annual shareholder dividends allowed to be paid. The maximum dividend which the Insurance Subsidiaries may pay to Philadelphia Insurance during 2005 without prior approval is $58.6 million. Dividends paid for the years ended December 31, 2004 and 2003 were $0 million and $4.0 million, respectively.
Risk-Based Capital: Risk-based capital is a method developed by the National Association of Insurance Commissioners (“NAIC”) designed to measure the acceptable amount of capital and surplus an insurer should have based on the inherent specific risks of each insurer. The adequacy of a company’s actual capital and surplus is evaluated by a comparison to the risk-based capital results. Insurers failing to meet minimum risk-based capital requirements may be subject to scrutiny by the insurer’s domiciliary insurance department and ultimately rehabilitation or liquidation. As of December 31, 2004, PIIC, PIC, MUSA and LAIC exceeded their minimum risk-based capital requirement of $194.3 million, $13.0 million, $17.3 million and $13.5 million, respectively, by 115%, 185%, 30% and 96%, respectively.
securities, except interests in securitized assets, meeting predetermined thresholds to determine whether such decline is other than temporary. If the Company determines a decline in value to be other than temporary, based upon its detailed review, or if a decline in value for an equity investment has persisted continuously for nine months, the cost basis of the security is written down to its fair value. The factors considered in reaching the conclusion that a decline below cost is other than temporary include, but are not limited to: whether the issuer is in financial distress; the performance of the collateral underlying a secured investment; whether a significant credit rating action has occurred; whether scheduled interest payments have been delayed or missed; whether changes in laws and/or regulations have impacted an issuer or industry; an assessment of the timing of a security’s recovery to cost; and an ability and intent to hold the security to recovery of cost. The amount of any write down is included in earnings as a realized loss in the period the impairment arose. This evaluation resulted in non-cash realized investment losses of $2.5 million and $1.0 million for the years ended December 31, 2004 and 2003, respectively. The Company attributes these other than temporary declines in fair value primarily to issuer specific conditions, except for as noted in the following paragraph.
The following table (in thousands) identifies the period of time securities with an unrealized loss at December 31, 2004 have continuously been in an unrealized loss position. Included in the amounts displayed in the table are $0.1 million of unrealized losses due to non-investment grade fixed maturity securities having a fair value of $1.2 million. No issuer of securities or industry represents more than 3.6% and 16.0%, respectively, of the total estimated fair value, or 4.6% and 11.9%, respectively, of the total gross unrealized loss included in the table below. As previously discussed, there are certain risks and uncertainties inherent in the Company’s impairment methodology, such as the financial condition of specific industry sectors and the resultant effect on underlying security collateral values. Should the Company subsequently determine a decline in the fair value below the cost basis to be other than temporary, the security would be written down to its fair value and the difference would be included in earnings as a realized loss for the period such determination was made.
The Company had no debt or equity investments in a single issuer totaling in excess of 10% of shareholders’ equity at December 31, 2004.
The cost and estimated market value of fixed maturity securities at December 31, 2004, by remaining contractual maturity, are shown below (in thousands). Expected maturities may differ from contractual maturities because certain borrowers have the right to call or prepay obligations with or without call or prepayment penalties.
During the fourth quarter of 2004 the Company sold one fixed maturity security which was non-income producing. There were no remaining non-income producing fixed maturity securities as of December 31, 2004. Investment expense includes $0.0 million, $0.0 million, and $0.1 million, in investment management fees paid to a director of the Company in 2004, 2003, and 2002, respectively. These transactions are in the ordinary course of business at negotiated prices comparable to those of transactions with other investment advisors.
Additionally, the Insurance Subsidiaries have investments, principally pass-through mortgage backed and collateralized mortgage obligation securities, which collateralize the borrowings from the Federal Home Loan Bank of Pittsburgh, see Note 9. The carrying value of these investments was $46.8 million and $59.1 million as of December 31, 2004 and 2003, respectively.
PIIC and PIC are required to hold a certain minimum amount of Federal Home Loan Bank of Pittsburgh common stock as a requirement of membership in the Federal Home Loan Bank of Pittsburgh. The required minimum amount of common stock is based on the amount of PIIC’s and PIC’s outstanding borrowings plus the unused maximum borrowing capacity, as defined by the Federal Home Loan Bank of Pittsburgh. As of December 31, 2004, the carrying value of Federal Home Loan Bank of Pittsburgh common stock was $1.8 million.
The Company maintains investments in trust accounts under reinsurance agreements with unrelated insurance companies. These investments collateralize the Company’s obligations under the reinsurance agreements. The Company possesses sole responsibility for investment and reinvestment of the trust account assets. All dividends, interest and other income, resulting from investment of these assets are distributed to the Company on a monthly basis. At December 31, 2004 and 2003 the carrying values of these trust fund investments were $1.7 million.
The following table summarizes property and equipment at December 31, 2004 and 2003 (dollars in thousands):
During 2004 the company increased its estimated gross and net ultimate losses and loss adjustment expenses primarily for accident years 1997 through 2002 and decreased its estimated gross and net ultimate losses and loss adjustment expenses for accident year 2003 by the following amounts:
The increase in accident years 1997 through 2002 is principally attributable to case reserve development above expectations primarily across various professional liability products in the specialty lines segment and general liability and commercial automobile coverages in the commercial lines segment. The decrease in accident year 2003 is principally attributable to better than expected claim frequency primarily for general liability and commercial automobile coverages in the commercial lines segment.
• Adverse trends further deteriorating in both claims frequency and severity for leases expiring in 2003. During the second quarter of 2003, the Company engaged a consulting firm to aid in evaluating the ultimate potential loss exposure under these policies. Based upon the study and subsequent evaluation by the Company the Company changed its assumptions relating to future frequency and severity of losses, and increased the estimate for unpaid loss and loss adjustment expenses by $33.0 million. The Company primarily attributes this deterioration to the following factors that led to a softening of prices in the used car market subsequent to the September 11, 2001 terrorist attacks: prolonged 0% new car financing rates and other incentives which increased new car sales and the volume of trade-ins, daily rental units being sold into the market earlier and in greater numbers than expected, further adding to the over supply of used cars and the overall uncertain economic conditions.
• The Company entering into an agreement with U.S. Bank, N.A. d/b/a Firstar Bank (“Firstar”) for residual value insurance policies purchased by Firstar. Under the terms of the agreement, the Company paid Firstar $27.5 million in satisfaction of any and all claims made or which could have been made by Firstar under the residual value policies. The Company increased the gross and net reserves for loss and loss adjustment expenses from $21.7 million to $27.5 million.
- The Company increased its estimate for unpaid loss and loss adjustment expenses for non residual value policies by $43.5 million ($30.8 million net of reinsurance recoverables) primarily for accident years 1999 to 2001 and decreased its estimate of the unpaid loss and loss adjustment expenses by $30.6 million ($25.0 million net of reinsurance recoverables) for the 2002 accident year. The increase in accident years 1999 to 2001 is principally attributable to:
• $19.6 million ($13.7 million net of reinsurance recoverables) of development in professional liability products as a result of case reserves developing greater than anticipated from the year-end 2002 ultimate loss estimate; $18.1 million ($11.1 million net of reinsurance recoverables) of development in the automobile and general liability coverages for commercial package products due to losses developing beyond the underlying pricing assumptions; and $5.8 million ($6.0 million net of reinsurance recoverables) of development in the commercial automobile excess liability insurance and GAP commercial automobile products due to losses developing beyond the underlying pricing assumptions.
• $4.2 million ($4.7 million net of reinsurance recoverables) and $26.4 million ($20.3 million net of reinsurance recoverables) of favorable development in professional liability products and commercial package products, respectively, due to conservative initial loss estimates combined with favorable product pricing.
The Company also increased the liability for unpaid loss and loss adjustment expenses on the Commercial Automobile Excess Liability Insurance (“Excess Liability”) product sold to rental car companies (Commercial Lines Underwriting Segment) primarily for the 2000 and 2001 accident years by $6.9 million ($4.9 million net of reinsurance). As of December 31, 2001 the Company had estimated a total liability for unpaid loss and loss adjustment expenses for the Excess Liability policies issued in these years of $23.0 million ($21.6 million net of reinsurance). Excess Liability provides automobile liability coverage in excess of the state mandated limits which are provided by the rental car company. During the third quarter of 2002, pursuant to a routine underwriting review focusing on price adequacy and loss experience, the Company non-renewed a significant Excess Liability customer as a result of an unacceptable underwriting risk profile. This adverse loss development was primarily due to pricing inadequacy and the adverse loss experience of this customer. Additionally, the Company has experienced a delay in both the reporting of claims and the claim litigation discovery process as a result of this policyholder and another Excess Liability policyholder filing for Chapter 11 during the third quarter 2002 and fourth quarter 2001, respectively.
Effective April 1, 2003, the Company entered into a quota share reinsurance agreement. Under this agreement, the Company ceded 22% of its net written premiums and loss and loss adjustment expenses for substantially all of the Company’s lines of
business on policies effective April 1, 2003 through December 31, 2003, and 10% of its commercial and specialty lines net written premiums and loss and loss adjustment expenses for policies effective January 1, 2004 and thereafter. The Company receives a provisional commission of 33.0% adjusted pro-rata based upon the ratio of losses incurred to premiums earned. Pursuant to this reinsurance agreement the Company withholds the reinsurance premium due the reinsurers reduced by the reinsurers’ expense allowance, and the Company’s ceding commission allowance in a Funds Held Payable to Reinsurer account. This Funds Held Payable to Reinsurer account is also reduced by ceded paid losses and loss adjustment expenses under this agreement, and increased by an interest credit. In addition, the agreement allows for a profit commission to be paid to the Company upon commutation. Activity for the Funds Held Payable to Reinsurer is summarized as follows (in thousands):
The Company had aggregate borrowings of $33.4 million and $48.5 million as of December 31, 2004 and 2003, respectively, from the Federal Home Loan Bank of Pittsburgh. These borrowings bear interest at adjusted LIBOR and mature twelve months or less from inception. The proceeds from these borrowings are invested in asset backed and collateralized mortgage obligation securities to achieve a positive spread between the rate of interest on these securities and the borrowing rates. The weighted-average interest rate on borrowings outstanding as of December 31, 2004 was 2.52%.
Philadelphia Insurance has entered into tax sharing agreements with each of its subsidiaries. Under the terms of these agreements, the income tax provision is computed as if each subsidiary were filing a separate federal income tax return, including adjustments for the income tax effects of net operating losses and other special tax attributes, regardless of whether those attributes are utilized in the Company’s consolidated federal income tax return.
The number of weighted share equivalents not included in the weighted-average share equivalents outstanding calculation amounted to 24, 2,730 and 9,620 for the years ended December 31, 2004, 2003 and 2002, respectively.
Under the Company’s stock option plan, stock options may be granted for the purchase of common stock at a price not less than the fair market value on the date of grant. Options are primarily exercisable after the expiration of five years following the grant date. Under this plan, as amended, the Company has reserved 5,500,000 shares of common stock for issuance pursuant to options granted under the plan. As of December 31, 2004, 1,645,975 shares of common stock remain reserved for future issuance pursuant to options granted under this plan.
Directors Stock Purchase Plan (“Directors Plan”): The Directors Plan has been established for the benefit of non-employee Directors. The aggregate maximum number of shares that may be issued pursuant to the Directors Plan is 50,000. Non-employee Directors, during monthly offering periods, may designate a portion of his or her fees to be used for the purchase of shares under the terms of the Directors Plan at a purchase price of the lesser of 85% of the fair market value of the shares on the first business day of the offering period or the date the shares are purchased. Under the Directors Plan, the Company issued 5,209 and 3,325 shares in 2004 and 2003, respectively. The weighted-average fair value of those purchase rights granted in 2004 and 2003 was $8.43 and $5.96, respectively.
Approximately $14.5 million of the Company’s reinsurance receivable balances at December 31, 2004 are with Converium Reinsurance North American Inc. (“CRNA”). During the third quarter of 2004, Converium AG (Switzerland), CRNA’s parent company, placed CRNA into an orderly runoff, of the $14.5 million reinsurance receivable balances with CRNA, $2.5 million are receivables on paid losses and $12.0 million are receivables on unpaid loss and loss adjustment expense. The Company is monitoring CRNA’s ability to pay claims, and at this time, believes, that the amounts with CRNA will be collectible.
The future minimum rental payments required under operating leases that have initial or remaining non-cancelable lease terms in excess of one year as of December 31, 2004 were as follows (in thousands):
(4) Net Realized Investment Gain (Loss) for the three months ended March 31, 2003, June 30, 2003, September 30, 2003 and December 31, 2003 includes non-cash realized losses of $1.5 million, $1.7 million, $0.4 million and $6.7 million, respectively, as a result of impairment evaluations.
The segments follow the same accounting policies used for the Company’s consolidated financial statements as described in the summary of significant accounting policies. Management evaluates a segment’s performance based upon premium production and the associated loss experience which includes paid losses, an amount determined on the basis of claim adjusters’ evaluation with respect to insured events that have occurred and an amount for losses incurred that have not been reported. Investments and investment performance including investment income and net realized investment gain (loss); acquisition costs and other underwriting expenses including commissions, premium taxes and other acquisition costs; and other operating expenses are managed at a corporate level by the corporate accounting function in conjunction with other corporate departments and are included in “Corporate”.
During February 2005, the Company entered into a Reinsurance Commutation and Release Agreement effective as of January 1, 2005 with respect to the 2003 Whole Account Net Quota Share Reinsurance contract. As a result of this commutation, the Company reduced its Funds Held Payable to Reinsurer liability by approximately $76.7 million, offset by an increase to its net Unpaid Loss and Loss Adjustment Expenses by $64.3 million, an increase to its net Unearned Premiums by $0.2 million and a reduction to its previously recorded profit commission receivable by approximately $12.2 million, in each case effective as of January 1, 2005. No gain or loss was realized as a result of this commutation.