YOU SHOULD READ THE FOLLOWING SELECTED CONSOLIDATED FINANCIAL DATA TOGETHER WITH "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS" AND OUR CONSOLIDATED FINANCIAL STATEMENTS AND THE RELATED NOTES INCLUDED ELSEWHERE IN THIS REPORT.
Year Ended December 31, ----------------------------------------------------------------------- 2006 2005 2004 2003 2002 ---------- --------- --------- ---------- ---------- (Dollars and shares in thousands, except per-share data) SELECTED INSURANCE RATIOS: Net loss ratio(6) 61.4% 56.0% 65.7% 66.7% 64.3% Net policy acquisition expense ratio(7) 18.6 20.1 10.8 13.2 20.8 Underwriting and other expense ratio(8) 12.1 13.4 17.8 18.4 13.0 --------- --------- --------- --------- --------- Net combined ratio, excluding policyholder dividends(9) 92.1% 89.5% 94.3% 98.3% 98.1% --------- --------- --------- --------- --------- Dividend ratio(10) 3.7 3.4 3.9 3.5 3.0 --------- --------- --------- --------- --------- Net combined ratio, including policyholder dividends(11) 95.8% 92.9% 98.2% 101.8% 101.1% ========= ========= ========= ========= =========
(2) Includes favorable loss reserve development for the years ended December 31, 2006, 2005, 2004, 2003 and 2002 of $14.2 million, $24.7 million, $8.3 million, $1.0 million and $0.4 million, respectively.
(3) During 2006, the second injury fund assessment rate in South Carolina decreased to 24.5% on losses. The impact of this rate change was to increase 2006 pre-tax income by $2.8 million.
(7) Policy acquisition expenses, including commissions, assessments, premium tax and general and administrative expenses directly associated with policy acquisition, divided by net premiums earned, after the effects of reinsurance.
IN ADDITION TO HISTORICAL INFORMATION, THE FOLLOWING DISCUSSION CONTAINS FORWARD-LOOKING STATEMENTS THAT ARE SUBJECT TO RISKS AND UNCERTAINTIES. OUR ACTUAL RESULTS IN FUTURE PERIODS MAY DIFFER FROM THOSE REFERRED TO HEREIN DUE TO A NUMBER OF FACTORS, INCLUDING THE RISKS DESCRIBED IN THE SECTIONS ENTITLED "RISK FACTORS" AND "FORWARD-LOOKING STATEMENTS AND ASSOCIATED RISKS" AND ELSEWHERE IN THIS REPORT.
o commissions and other underwriting expenses, which consist of commissions we pay to agents, premium taxes and company expenses related to the production and underwriting of insurance policies, less ceding commissions reinsurers pay to us under our reinsurance contracts;
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect amounts reported in the financial statements. As more information becomes known, these estimates and assumptions could change, which would have an impact on the amounts reported in the future. We view as our critical accounting policies the estimates and assumptions used in establishing our loss reserves, reinsurance, reinsurance recoverables, premium revenues, deferred policy acquisition costs, valuation of investments and dividends to policyholders.
o future claim payments and LAE in addition to case reserves due to unforeseen or unknown events;
o claims that have not yet been reported to us; and
Our internal actuaries and the independent actuarial consulting firm we have retained prepare estimates of our insurance subsidiaries' IBNR reserves by state and loss year using generally accepted actuarial techniques. These estimates are currently prepared quarterly. Our independent actuarial firm participates in our IBNR estimation process three times annually (as of June 30, September 30 and December 31). These estimates are analyzed on a gross of reinsurance basis and on a net of all reinsurance recoverables basis. Estimation of loss reserves is subject to variation as a result of factors such as inflation, claims settlement patterns, legislative activity and litigation trends. Our IBNR estimates are affected by the results of nine separate actuarial reserving methods, our assumptions regarding the adequacy of case reserves, the impact of future wage and medical inflation, litigation trends, the quality of recent underwriting standards and actuarial judgment. Consistent with industry practices, the actuarial judgment of our management plays a significant part in the reserving process. Actuarial judgment takes into account our assumptions regarding future claims emergence, the number of claims to be closed in the future with or without payment, amounts that may be collected from subrogation and any other changes expected to occur in the future. Changes in the assumptions we employ or our estimates associated with such assumptions could result in materially different amounts being reported as reserves. If necessary, we will increase or decrease the level of our reserves, with a corresponding change in our expenses in the period in which the increase or decrease occurs, as experience develops or new information becomes known in the period in which changes to the estimates are determined. As of December 31, 2006, our case reserves and IBNR net of reinsurance were $172.4 million and $89.7 million, respectively. Gross of reinsurance, these amounts were $196.8 million and $137.6 million, respectively.
We arrive at our estimate of company-wide reserves and IBNR by separately analyzing loss information for each state and each accident year. In addition, in some cases we analyze our loss data on an even more refined basis whenever required to calculate the IBNR recoverable under our reinsurance agreements.
We develop our IBNR estimate separately, for each state and accident year, based on our review of the results of nine separate actuarial methods (five separate methods for accident years prior to 1998) and actuarial judgment. After reviewing the nine actuarial methods for each state and accident year, we select an estimate of ultimate losses (the "point estimate") for each state and
accident year. Our point estimate of IBNR is the compilation of the estimate of ultimate losses by state for each accident year and equals the total ultimate loss estimate minus the incurred losses. We book to this point estimate. We observe that the selected estimate ultimate loss is most sensitive to four of the nine actuarial methods examined:
2. Incurred Bornhuetter-Ferguson Method - A method assigning partial weight to the initial expected losses (calculated from the initial expected loss ratio) and partial weight to observed incurred losses. The weights assigned to the initial expected losses decrease as the accident year matures.
All of the methods described above utilize expected loss payment and reporting patterns for losses and our actual paid and reported losses and LAE to estimate the reserve. The expected payment and reporting patterns are based on state specific industry patterns as well as our historical patterns. The expected payment and reporting patterns can change whenever there is new information that leads the consulting actuary to believe that the pattern of future loss payments will be different from what has historically been expected. In addition, the first two methods utilize our initial expected loss ratio (the ratio of losses and LAE incurred to net premiums earned) to estimate the reserve. The initial expected loss ratio is estimated based on the average premium level of our risks relative to industry expected losses for the size and types of risks we write. The initial expected loss ratio will change between accident years depending on our pricing in those accident years, but generally will not change between successive evaluations of losses.
Historically, our point estimate closely follows a weighting of the four methods described above. The weights we observe are:
Accident Years Method Weight --------------- ------ ------ 2001 to 2006.......... Paid Bornhuetter-Ferguson Method 25% 2001 to 2006.......... Incurred Bornhuetter-Ferguson Method 25% 2001 to 2006.......... Paid Loss Development Method 25% 2001 to 2006.......... Incurred Loss Development Method 25% 1982 to 2000.......... Paid Bornhuetter-Ferguson Method 0% 1982 to 2000.......... Incurred Bornhuetter-Ferguson Method 0% 1982 to 2000.......... Paid Loss Development Method 50% 1982 to 2000.......... Incurred Loss Development Method 50%
We believe the weightings displayed above are appropriate for a long-tailed line of business such as workers' compensation insurance. Initially, when loss experience is very immature and the ultimate payout of our largest claims is still unknown, the expected loss ratio should carry relatively more weight than after experience has developed more fully. As loss experience matures, the initial expected loss ratio becomes less important as it does not consider all of the new loss information that has become available. As a result,
the weighting of the Bornhuetter-Ferguson methods decreases from 25% to 0% after five years and the weighting of the loss development methods increases from 25% to 50% after 5 years. The 0% weight of the Bornhuetter-Ferguson methods for accident years older than five years should not suggest that the Bornhuetter-Ferguson methods are not considered, but rather that they are typically not given significant weight when selecting our estimate of ultimate losses for older accident years. In the future, as we compare the actual losses with the different estimates of losses for recent accident years, we may change the relative weightings of these and other actuarial methods.
Reserve estimates derived using the Bornhuetter-Ferguson methods are driven by our assumptions related to the expected loss ratio and the expected reporting or payment pattern for losses, while reserve estimates derived using the loss development methods are solely driven by our assumptions related to the expected reporting and payment patterns, and are not at all affected by our assumptions related to the expected loss ratio. Reporting and payment pattern refers to the estimated percentage of the ultimate losses for a particular state that have been reported or paid at a particular valuation date. The table below quantifies the impact that reasonably likely changes in these three variables--the expected loss ratio, the expected payment pattern and the expected reporting pattern for losses--would have on the recorded net and gross reserves for losses and LAE at December 31, 2006. Due to the selection of weights in the table above, changes in the initial expected loss ratio do not have an effect on accident years prior to 2000.
SENSITIVITY OF NET LOSS RESERVES TO CHANGES IN ACTUARIAL ASSUMPTIONS as of December 31, 2006 (all dollar amounts in thousands) Change in Net Loss Change in Assumptions Reserves -------------------------------------------------------- ------------------ Improve Expected Loss Ratio by 10% $ (7,943)
Improve Expected Loss Ratio by 10% and Improve Loss Development Patterns by 10% (29,725)
Deteriorate Expected Loss Ratio by 10% and Improve Loss Development Patterns by 10% (9,554)
Deteriorate Expected Loss Ratio by 10% and Deteriorate Loss Development Patterns by 10% 30,558
3. Changes in the incurred loss development pattern--We varied the incurred loss development pattern by + / - 5% (e.g., if incurred losses were expected to develop by 30% for a particular state and accident year, we calculated the sensitivity of reserves to a change in incurred loss development factors of 1.5% = 5% x 30%). Changes in the incurred loss development factors affect the results of the Incurred Loss Bornhuetter-Ferguson Method and the Incurred Loss Development Method.
We believe that loss ratios 10% above or below our expected loss ratio constitute a reasonable range of expectations for each state and accident year in which we have loss reserves. In addition, we believe the adjustments (5%) that we made to improve or deteriorate the paid and incurred loss development patterns are also reasonably likely outcomes. Assumptions about loss development patterns are made based on our entire claim history back to 1982, while assumptions about expected loss ratios are made based on our current pricing and only up to two years of aggregated industry data. As a result of the longer relevant history of loss patterns, loss development patterns are considerably more stable and warrant a smaller variation. Such changes in the net reserves for losses and loss adjustment expense 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 is paid.
Fixed maturity investments are designated at purchase as held-to-maturity or available-for-sale. Held-to-maturity investments are reported at amortized cost. Securities classified as available-for-sale are reported at fair value with unrealized appreciation and depreciation, net of deferred taxes, on our
We continuously monitor our portfolio to preserve principal values whenever possible. All securities in an unrealized loss position are reviewed to determine whether the impairment is other-than-temporary. An investment in a fixed maturity security is impaired if its fair value falls below its book value. Factors considered in determining whether a decline is considered to be other-than-temporary include length of time and the extent to which fair value has been below book value, the financial condition and near-term prospects of the issuer, and our ability and intent to hold the security until its expected recovery. If an impairment of a security is determined to be other-than-temporary, such impairment will result in a charge to net income in the period in which such other-than-temporary determination is made. For details on our investments in an unrealized loss position, see "Business--Investments."
We evaluate our operations by monitoring key measures of growth and profitability. We measure our growth by examining our gross premiums written. We measure our operating results by examining our net income, return on equity, and our loss, expense, dividend and combined ratios. The following provides further explanation of the key measures that we use to evaluate our results:
We analyze our calendar year loss ratio to measure our profitability in a particular year and to evaluate the adequacy of our premium rates charged in a particular year to cover expected losses and LAE from all periods, including development (whether favorable or unfavorable) of reserves established in prior periods. In contrast, we analyze our accident year loss ratios to evaluate our underwriting performance and the adequacy of the premium rates we charged in a particular year in relation to ultimate losses and LAE from insured events occurring during that year.
DIVIDEND RATIO. The dividends to policyholders ratio equals policy dividends incurred in the current year divided by net premiums earned for the year.
RETURN ON EQUITY. This percentage is the sum of return on equity (ROE) from underwriting, ROE from investing, the ROE impact of debt and ROE from other income, multiplied by one minus the effective tax rate. ROE from underwriting is calculated as one minus the combined ratio, representing our underwriting profit percentage, multiplied by our operating leverage (annualized net premiums earned divided by average equity). ROE from investing is calculated by multiplying the investment yield for the period by our investment leverage (average investments divided by average equity). The ROE impact of debt is calculated by multiplying the effective interest rate on debt for the period by our financial leverage (average debt divided by average equity). We use return on equity to measure our growth and profitability. We can compare our return on equity to that of other companies in our industry to see how we are performing compared to our competition.
GROSS PREMIUMS WRITTEN decreased $3.4 million, or 1.2% in 2006 as compared to 2005. Direct premiums written decreased $3.5 million, while assumed premiums written increased $0.1 million. The decrease in direct premiums written is primarily driven by decreases in direct written premiums in Florida ($8.4 million), Indiana ($6.8 million), and Tennessee ($3.3 million), offset by increases in Texas ($5.0 million), Illinois ($3.3 million), Wisconsin ($2.9 million), North Carolina ($2.5 million), and Virginia ($1.5 million). All other states decreased by $0.2 million. The decrease in Florida premiums is the result of a rate decrease during the year, with the number of policies written in Florida remaining relatively flat. For all other states with significant changes in direct premiums written, the change in the number of policies was consistent with the change in direct premiums written. The overall number of policies written decreased 2.2% during the year.
NET INVESTMENT INCOME increased $6.7 million or 61.7% in 2006 as compared to 2005. The increase is attributable to two factors. First, the investment portfolio increased $94.1 million over December 31, 2005. The additional funds available for investment were provided by $48.0 million of net initial public offering proceeds, and $54.2 million of net cash provided by operating activities. Additionally, at December 31, 2006, the yield to maturity on the portfolio increased to 5.4% from 4.9% in the prior year.
Net investment income increased $4.7 million, or 77.7% in 2005 as compared to 2004. The increase in investment income was the result of the increase in our investment portfolio due to the commutation of two of our reinsurance treaties, an increase in our net operating cash flow as a result of the elimination of the use of quota share reinsurance, and an increase in the size of our investment portfolio. Additionally, at December 31, 2005 the market yield to maturity increased to 4.9% from 3.6% in 2004.
NET REALIZED INVESTMENT LOSS was $0.3 million in 2006, as compared to $0.4 in 2005. As the Company sells few securities the amount of loss recorded is relatively small as a percentage of net income. During the year ended December 31, 2006, three other-than-temporary impairments totaling approximately $0.2 million were recorded on our investments, which are included in the current year realized loss.
LOSSES AND LOSS ADJUSTMENT EXPENSES increased $20.0 million, or 13.9% in 2006 as compared to 2005. Loss and loss adjustment expenses were 61.4% and 56.0% of net premiums earned in 2006 and 2005, respectively. The primary causes of the increased loss ratios are the reduction of the redundancy as well as an increase in catastrophic claims and an overall increase in severity during 2006. Reflected in our losses and LAE in 2006, is a $14.2 million redundancy, net of reinsurance, for years prior to 2006. Excluding assumed business, this redundancy was attributable to prior year reserve decreases in Florida ($10.9 million), Tennessee ($7.2 million), Indiana ($4.3 million), and Texas ($3.7 million), offset by increases in North Carolina ($4.7 million), and Wisconsin ($3.8 million), with the remaining offset being attributable to other states and assumed business. Reflected in our losses and LAE in 2005, was a $24.7 million redundancy, net of reinsurance, for years prior to 2005. Additionally, as of December 31, 2006, the current accident year loss ratio, excluding the involuntary pool and ULAE, increased to 63.4% from 61.3% for the prior accident year. Contributing to the higher accident year loss ratio were increases in South Carolina (to 124.2% from 66.9% at December 31, 2005), Virginia (to 95.1% from 56.5%), Georgia (to 80.3% from 60.7%), and North Carolina (to 91.5% from 67.5%). These increases were offset by decreases in net accident year loss ratios for Tennessee (to 79.3% from 101.6%) and Texas (to 39.2% from 44.6%). Loss and LAE on involuntary pools increased to 1.2% of net earned premiums from 0.8% as of December 31, 2005. Additionally, ULAE was 3.9% of net earned premium for the year ended December 31, 2006, and 3.7% for the year ended December 31, 2005.
Losses and loss adjustment expenses increased $24.5 million, or 20.6% in 2005 as compared to 2004. Loss and loss adjustment expenses were 56.0% and 65.7% of net premiums earned in 2005 and 2004, respectively. Reflected in our losses and LAE in 2005, is a $24.7 million redundancy, net of reinsurance, for years prior to 2005. Reflected in our losses and LAE in 2004, was a $8.3 million redundancy, net of reinsurance, for years prior to 2004. The loss development we have experienced in recent years has been significantly lower than our selected development factors. Because of the Company's extensive history in Florida, Florida loss development factors significantly influence the results of our actuarial reserving methods. The results of these methods, in turn, influence the IBNR estimate. In recent years, Florida loss development experience has decreased from previous levels.
Policy acquisition expenses increased $32.0 million, or 164.2% in 2005 as compared to 2004. Policy acquisition expenses were 20.1% and 10.8% of net premiums earned in 2005 and 2004, respectively. Policy acquisition expenses are recorded net of ceding commissions. In 2005, as a result of the elimination of quota share reinsurance, ceding commission decreased $17.5 million to $7.4 million. Direct commissions as a percent of direct premiums earned increased to 9.4% 2005 from 8.7% for 2004. The increase is due to the change in geographic mix of our book of business. Florida, which had an average commission rate of 10.2% (the highest of the states), accounted for 40.3% of direct premiums written as compared to only 35.5% for the prior year. Georgia, North Carolina, South Carolina and Virginia, which had an average commission rate of only 7.7%, accounted for only 13.0% of direct premiums written for 2005, down from 17.6% in the prior year. Assessments increased to 6.8% of direct premiums earned for 2005 from 3.8% for the prior year due primarily to the doubling of the South Carolina Second Disability Trust Fund assessment rate in the third quarter of 2005. The impact of this rate increase was a pre-tax charge of $3.3 million in the third quarter of 2005. Premium tax expense increased to 1.6% from 1.4% of direct premiums earned during 2005 and 2004, respectively. This is due to Florida's increased effective rate from the reduction of the credits allowed for the administrative assessment. Administrative assessments paid in Florida are allowed as a credit against premium taxes. The administrative assessment rate decreased in 2005 thereby reducing the amount of credit allowed and resulting in an increase in the Florida premium tax effective rate.
UNDERWRITING AND OTHER EXPENSES decreased $2.3 million, or 6.6% in 2006 as compared to 2005. Underwriting and other expenses were 12.1% and 13.4% of net premiums earned in 2006 and 2005, respectively. The decrease in underwriting and other expense is primarily attributable to decreases in agent incentives of $1.0 million and litigation reserve expenses of $1.4 million. In 2005 we recorded a $1.3 million accrual in connection with outstanding litigation, as discussed in Note 10, with no similar amount recorded in 2006. Also in 2006, the positive premiums receivable collection trend continued, resulting in a reduced bad debt expense. These decreases in underwriting and other expenses were partially offset by increases in expenses associated with being a public company including increases in auditing, actuarial, investor relations, Sarbanes Oxley compliance readiness, and directors and officers insurance.
Underwriting and other expenses increased $2.2 million, or 6.7% in 2005 as compared to 2004. Underwriting and other expenses were 13.4% and 17.8% of net premiums earned in 2005 and 2004, respectively. The increase in net premiums earned in the 2005 period significantly reduced the net expense ratio. The $2.2 million increase in underwriting and other expenses was attributable to an increase in human resource expenses by $1.0 million in 2005 from 2004 attributable to additional employees and higher compensation costs. The continued improvement in our collection practices in 2005 enabled us to lower the allowance for doubtful accounts by approximately $1.4 million in 2005.
FEDERAL AND STATE INCOME TAXES decreased $1.1 million, or 11.5% in 2006 as compared to 2005. Federal and state income taxes were 33.3% of pretax income in 2006, and 35.7% in 2005. The primary causes of the decrease are a change in the tax rate applied to the deferred tax assets, and a decrease in state income taxes. In 2006, the federal effective rate used in calculating the value of the deferred tax assets was increased to 35% from 34%. This adjustment in the rate was made to more accurately reflect the federal tax rate at which the Company is expected to be taxed when the deferred tax asset is utilized. The decrease in state tax expense is a result of amending the 2005 and 2004 Florida state income tax returns to apportion interest income between states in which we operate. These amended returns resulted in additional state tax refund amounts recorded in the current period related to prior years. These decreases were partially offset by other increases, including a provision to return adjustment.
NET INCOME decreased $0.2 million or 1.3% in 2006 as compared to 2005. Increases in net premiums earned and net investment income of $9.9 million and $6.7 million respectively, and a decrease in underwriting and acquisition expenses of $4.2 million, were offset by an increases in loss and loss adjustment expenses and dividends of $20.0 million and $1.3 million, respectively .
Net income increased $11.8 million or 233.7% in 2005 as compared to 2004. Net income was significantly impacted by our losses and LAE relative to the net premiums earned as indicated by net loss ratios of 56.0 % and 65.7% in 2005 and 2004, respectively.
RETURN ON EQUITY - Our annualized return on equity for the years ended December 31, 2006 and 2005 is 15.7% and 25.8%, respectively.
The primary source of cash flow for Pinnacle Benefits and Pinnacle Administrative is service fees paid by our insurance subsidiaries. Our insurance subsidiaries' primary cash sources are insurance premiums, investment income and the proceeds from the sale, redemption or maturity of invested assets. The cash requirements of the insurance subsidiaries are primarily for the payment of losses and LAE, guaranty fund and second-injury fund assessments, commissions, reinsurance premiums, premium taxes, services fees, interest on surplus notes and purchase of investment securities. We maintain cash reserves to meet our obligations that comprise current outstanding loss and LAE, reinsurance premiums and administrative expenses. Due to the uncertainty regarding the timing and amount of settlement of unpaid losses, the liquidity requirements of the insurance subsidiaries vary. The insurance subsidiaries' investment guidelines and investment portfolio take into account historical payout patterns. If loss payments were to accelerate beyond our ability to fund them from current operating cash flows, we would need to liquidate a portion of our investment portfolio and/or arrange for financing. For example, several catastrophic injuries occurring in a relatively short period of time could cause such a liquidity strain. Our insurance subsidiaries have historically purchased excess reinsurance to mitigate the effects of large losses and to help stabilize liquidity. These reinsurance agreements require initial outlays of reinsurance premiums, based on premiums written, which is in advance of our receipt of cash premiums, and the reinsurers reimburse us after losses and LAE are paid by us. These reinsurance agreements exclude coverage for losses arising out of terrorism and nuclear, biological and chemical attacks.
In October 2000, we entered into a credit facility with AmSouth Bank under which we borrowed $11.3 million. In April 2003, the loan was amended and the aggregate borrowing increased to $12.5 million. The loan calls for monthly payments of principal and of interest at the 30-day LIBOR rate plus a margin. At December 31, 2006, the principal balance of the loan was $6.2 million and the annual interest rate was 7.85%. The loan contains various restrictive covenants generally pertaining to levels of indebtedness and limitations on incurrence of capital expenditures. Additionally, our insurance subsidiaries must comply with financial covenant restrictions, including ratios of leverage, debt service, current maturity coverage, net premiums written to surplus and risk based capital. The loan is collateralized by $25.5 million of internal surplus notes issued to us by our insurance subsidiaries and the stock of AmCOMP Preferred. The surplus notes bear interest, in the case of $10.0 million principal amount, at an annual rate of 100 basis points in excess of the prime rate, in the case of $10.5 million principal amount, at an annual rate of 450 basis points in excess of LIBOR, and in the case of $5.0 million principal amount, at an annual rate of 10.0%. Interest and principal payments on the surplus notes require prior approval by the Florida OIR.
In 2004, AmCOMP Preferred issued surplus notes to third parties as part of three securitizations of pooled surplus notes of insurance companies. The following table summarizes the terms of these surplus notes:
Optional Redemption by Amcomp Frequency Principal Preferred of Interest Issue Date Amount Maturity Date On or After Interest Rate Payments ------------- ----------------- ----------------- ---------------------- ----------- April 30, 2004 $10.0 million April 29, 2034 April 29, 2009 Three-month LIBOR plus Quarterly 425 basis points May 26, 2004 $12.0 million May 24, 2034 May 24, 2009 Three-month LIBOR plus Quarterly 425 basis points September 14, 2004 $10.0 million December 15, 2034 December 15, 2009 Three-month LIBOR plus Quarterly 405 basis points
We consummated our initial public offering on February 15, 2006 with the sale by the Company of 6,000,000 shares of common stock. Our net proceeds, after deducting underwriting discounts and commissions and other expenses relating to the offering, were approximately $48.0 million. We utilized substantially all of the proceeds to further capitalize our insurance subsidiaries which enables us to underwrite additional insurance in the states where we currently operate. We are evaluating a number of states in the near term including Arkansas and Maryland, subject to compliance with applicable licensing requirements. The balance of the net proceeds we received from the initial public offering is being used for working capital and general corporate purposes.
Our insurance subsidiaries are also subject to statutory insurance laws and regulations that limit the amount of dividends or distributions that may be paid by an insurance company to its stockholders. Pursuant to the Florida Insurance Code, our insurance subsidiaries may not, without the prior approval of the Florida OIR, pay to us dividends or other distributions of cash or property, the total fair market value of which generally exceeds the lesser of 10% of their surplus as of the prior December 31 or net income for the calendar year then ended, excluding realized capital gains, plus a two-year carryback of realized capital gains. At December 31, 2006, our insurance subsidiaries were authorized to pay approximately $15.6 million in dividends without additional regulatory approval. No dividends were paid by the insurance subsidiaries during 2006, 2005 or 2004.
As a result of raising $32.0 million from surplus notes issued by one of our insurance subsidiaries, we have eliminated the need for quota share reinsurance on new and renewal business since July 1, 2004. In addition, we increased our retention in our excess of loss reinsurance program to $2.0 million in 2005 and thereafter from $1.0 million in 2004.
Our insurance subsidiaries employ an investment strategy that emphasizes asset quality to minimize the credit risk of our investment portfolio. As economic conditions change, our insurance subsidiaries' investment committees recommend strategy changes and adjustments to our investment portfolio. We have maintained a high portion of our portfolio in short-term investments recently to mitigate the risk of falling prices for fixed maturity securities if rates should rise. Changes in interest rates impact our investment income and cause fluctuations in the carrying values of the majority of our investments (these changes are reflected as changes in stockholders' equity).
Our insurance subsidiaries employ AmSouth Bank to act as their independent investment advisor. AmSouth Bank follows the insurance subsidiaries' written investment guidelines based upon strategies approved by our insurance subsidiaries' board of directors. Our insurance subsidiaries have no investments in common stock (other than AmCOMP Preferred's investment in AmCOMP Assurance and certain institutional money market accounts), preferred stock, real estate, asset-backed securities (other than mortgages) or derivative securities. AmSouth Bank has discretion to enter into investment purchase transactions within our insurance subsidiaries' investment guidelines. In the case of sales of securities prior to maturity or the acquisition of securities that differ from the types of securities already present in the portfolio, AmSouth Bank is required to obtain approval from our insurance subsidiaries' executive officers, who report regularly to our insurance subsidiaries' investment committees, prior to executing the transactions. AmSouth Bank's fee is based on the amount of assets in the portfolio and is not dependent upon investment results or portfolio turnover.
Years to maturity (1): One or less $ 54,066 $ 53,708 -- -- After one through five 172,036 168,968 -- -- After five through ten 102,968 101,636 -- -- After ten 12,601 13,389 -- -- Mortgage-backed securities 7,816 7,617 76,198 75,933 -------- -------- -------- -------- Total $349,487 $345,318 $ 76,198 $ 75,933 ======== ======== ======== ========
(1) Based on the stated maturities of the securities. Actual maturities may differ as obligors may have the right to call or prepay obligations.
We continuously monitor our portfolio to preserve principal values whenever possible. An investment in a fixed maturity security is impaired if its fair value falls below its book value. All securities in an unrealized loss position are reviewed to determine whether the impairment is
other-than-temporary. Factors considered in determining whether a decline is considered to be other-than-temporary include length of time and the extent to which fair value has been below book value, the financial condition and near-term prospects of the issuer, and our ability and intent to hold the security until its expected recovery.
We believe our future cash flow generated by operations, and our cash and investment will be sufficient to fund continuing operations, service our outstanding obligations and provide for required capital expenditures for at least the next 12 months.
AmCOMP and both of our insurance subsidiaries are defendants in an action commenced in Florida by the Insurance Commissioner of Pennsylvania, acting in its capacity as liquidator of Reliance Insurance Company. The complaints in those actions allege that preferential payments were made to us by Reliance under the formerly existing reinsurance agreement with the insurance subsidiaries and seeks damages in the amount of approximately $2.3 million. We have answered the complaint and we expect the matter to be scheduled for trial. We believe that we have multiple factual and legal defenses to the claim made in this action, including a right of recoupment related to the statement of claim filed by us in the Reliance liquidation proceeding for the recovery of approximately $9.9 million under the reinsurance agreement. Although the ultimate results of these legal actions and related claims cannot presently be determined, the Company had an accrued liability of $1.2 million and $1.3 million as of December 31, 2006 and 2005, respectively, related to those matters.
The following table identifies our long-term debt and contractual obligations as of December 31, 2006:
Payment Due by Period ------------------------------------------------------------ Less Than More Than Total 1 Year 1-3 Years 4-5 Years 5 Years -------- -------- --------- --------- -------- (Dollars in thousands) Long Term Debt Obligations(1) $123,465 $ 5,282 $ 10,143 $ 7,035 $101,005 Operating Leases 8,333 3,229 3,962 1,061 81 Loss Reserves(2) 334,363 111,642 94,999 22,091 105,631 -------- -------- -------- -------- -------- Total Contractual Obligations $466,161 $120,153 $109,104 $ 30,187 $206,717 ======== ======== ======== ======== ========
Fluctuations in rates of inflation also influence interest rates, which in turn impact the market value of our investment portfolio and yields on new investments. Operating expenses, including payrolls, are impacted to a certain degree by the inflation rate.
We have audited the accompanying consolidated balance sheets of AmCOMP Incorporated and subsidiaries (the "Company") as of December 31, 2006 and 2005, and the related consolidated statements of operations, changes in stockholders' equity, and cash flows for each of the three years in the period ended December 31, 2006. Our audits also included the financial statement schedules listed in the index at Item 15. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of AmCOMP Incorporated and subsidiaries at December 31, 2006 and 2005 and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2006, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein.
ASSETS 2006 2005 --------- --------- Investments: Fixed maturity securities available-for-sale at fair value (amortized cost of $349,487 in 2006 and $300,274 in 2005) ............................................................ $ 345,318 $ 295,664 Fixed maturity securities held-to-maturity at amortized cost (fair value of $75,933 in 2006 and $31,326 in 2005) ................................................................ 76,198 31,793 --------- --------- Total investments ...................................................................... 421,516 327,457 Cash and cash equivalents ..................................................................... 15,259 11,089 Restricted cash ............................................................................... -- 10 Accrued investment income ..................................................................... 5,120 3,992 Premiums receivable--net ...................................................................... 106,270 104,522 Assumed reinsurance premiums receivable ....................................................... 1,822 -- Reinsurance recoverable: On paid losses and loss adjustment expenses ................................................ 3,064 5,202 On unpaid losses and loss adjustment expenses .............................................. 72,296 78,659 On ceding commissions ...................................................................... -- 19 Prepaid reinsurance premiums .................................................................. 3,326 5,368 Deferred policy acquisition costs ............................................................. 20,749 19,413 Property and equipment--net ................................................................... 2,705 2,658 Income taxes recoverable ...................................................................... 3,102 1,166 Deferred income taxes--net .................................................................... 21,613 20,871 Goodwill--net ................................................................................. 1,260 1,260 Other assets .................................................................................. 6,395 8,001 --------- --------- TOTAL ......................................................................................... $ 684,497 $ 589,687 ========= ========= LIABILITIES AND STOCKHOLDERS' EQUITY LIABILITIES: Policy reserves and policyholders' funds: Unpaid losses and loss adjustment expenses ............................................... $ 334,363 $ 309,857 Unearned and advance premiums ............................................................ 115,218 115,574 Policyholders' deposits .................................................................. -- 10 Policyholder retention dividends payable ................................................. 8,504 6,636 --------- --------- Total policy reserves and policyholders' funds ......................................... 458,085 432,077 Reinsurance payable ........................................................................ 3,774 668 Accounts payable and accrued expenses ...................................................... 39,416 38,565 Notes payable .............................................................................. 38,250 40,036 Other liabilities .......................................................................... 5,684 6,360 --------- --------- Total liabilities ...................................................................... 545,209 517,706 ========= ========= COMMITMENTS AND CONTINGENCIES STOCKHOLDERS' EQUITY: Common stock (par value $.01; 45,000 and 28,000 authorized shares in 2006 and 2005, respectively; 15,893 in 2006 and 5,502 in 2005 issued; 15,758 in 2006 and 5,367 in 2005 outstanding) ........................................................... 158 54 Convertible preferred stock series A ....................................................... -- 23,098 Additional paid-in capital ................................................................. 73,952 536 Retained earnings .......................................................................... 67,990 51,428 Accumulated other comprehensive loss (net of deferred taxes of $1,553 in 2006 and $1,674 in 2005) .......................................................................... (2,613) (2,936) Treasury stock (135 shares in 2006 and 2005) ............................................... (199) (199) --------- --------- Total stockholders' equity ............................................................. 139,288 71,981 --------- --------- TOTAL ......................................................................................... $ 684,497 $ 589,687 ========= =========
2006 2005 2004 --------- --------- --------- REVENUE: Net premiums earned ........................................ $ 266,456 $ 256,603 $ 181,186 Net investment income ...................................... 17,461 10,798 6,077 Net realized investment (losses) gains ..................... (307) (385) 982 Other income ............................................... 333 285 332 --------- --------- --------- Total revenue ............................................. 283,943 267,301 188,577 --------- --------- --------- EXPENSES: Losses and loss adjustment expenses ........................ 163,670 143,663 119,121 Dividends to policyholders ................................. 9,926 8,612 6,983 Underwriting and acquisition expenses ...................... 81,722 85,955 51,779 Interest expense ........................................... 3,807 2,960 1,389 --------- --------- --------- Total expenses ............................................ 259,125 241,190 179,272 --------- --------- --------- Income before income taxes ................................... 24,818 26,111 9,305 Income tax expense ........................................... 8,256 9,326 4,275 --------- --------- --------- Net income ................................................... $ 16,562 $ 16,785 $ 5,030 ========= ========= ========= Earnings per common share--basic ............................. $ 1.15 $ 3.13 $ 0.94 ========= ========= ========= Earnings per common share--diluted ........................... $ 1.11 $ 1.76 $ 0.53 ========= ========= ========= Weighted average number of common shares outstanding Basic ..................................................... 14,452 5,367 5,368 ========= ========= ========= Diluted ................................................... 14,931 9,562 9,564 ========= ========= =========
AMCOMP INCORPORATED AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004 (In thousands)
AMCOMP INCORPORATED AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004 (In thousands)
2006 2005 2004 --------- --------- --------- OPERATING ACTIVITIES: Net income ..................................................... $ 16,562 $ 16,785 $ 5,030 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization ................................. 1,711 2,144 2,396 Amortization of investment premiums/discounts ................. 2,466 3,069 2,415 Excess tax benefits from stock option exercise................. (162) -- -- Stock option expense .......................................... 545 -- -- Provision for deferred income taxes ........................... (859) (1,434) 2,661 Net realized losses (gains) on investments .................... 307 385 (982) Gain on sale of property and equipment ........................ 20 -- -- Policy acquisition costs deferred ............................. (50,746) (47,673) (28,938) Policy acquisition costs amortized ............................ 49,410 42,955 19,145 Change in operating assets and liabilities: Restricted cash ............................................... -- -- 944 Accrued investment income ..................................... (1,128) (962) (1,217) Premiums receivable ........................................... (1,748) (2,884) (4,820) Reinsurance balances .......................................... 11,846 41,888 948 Other assets .................................................. 1,606 (2,015) (1,657) Unpaid losses and loss adjustment expenses .................... 24,506 12,159 46,576 Unearned and advance premiums and policyholder deposits ..................................................... (366) 1,339 10,487 Policyholder retention dividends payable ...................... 1,868 351 (1,482) Accounts payable and accrued expenses ......................... 851 13,464 4,936 Income taxes recoverable ...................................... (1,859) 1,959 (1,683) Other liabilities ............................................. (676) 2,072 4,288 --------- --------- --------- Net cash provided by operating activities .................... 54,154 83,602 59,047 INVESTING ACTIVITIES: Securities available-for-sale: Purchases ..................................................... (98,578) (152,524) (150,070) Sales and maturities .......................................... 46,369 63,531 59,952 Securities held-to-maturity: Purchases ..................................................... (53,687) (22,814) (10,069) Redemptions and maturities .................................... 9,504 3,224 265 Purchases of property and equipment ............................ (1,795) (1,193) (2,041) Sale of property and equipment ................................. 17 -- -- Regulatory restricted deposit .................................. 10 899 (899) --------- --------- --------- Net cash used in investing activities ........................ (98,160) (108,877) (102,862) FINANCING ACTIVITIES: Proceeds from initial public offering, net of offering costs of $2,341 ............................................... 47,972 -- -- Proceeds from borrowings ....................................... -- -- 32,000 Proceeds from stock option exercise ............................ 1,828 -- -- Excess tax benefits from stock option exercise ................. 162 -- -- Payment of note payable ........................................ (1,786) (1,785) (1,786) Purchase of treasury stock ..................................... -- (4) -- --------- --------- --------- Net cash provided by (used in) financing activities .......... 48,176 (1,789) 30,214 --------- --------- --------- Net increase (decrease) in cash and cash equivalents ......... 4,170 (27,064) (13,601) CASH AND CASH EQUIVALENTS AT BEGINNING OF YEAR ................... 11,089 38,153 51,754 --------- --------- --------- CASH AND CASH EQUIVALENTS AT END OF YEAR ......................... $ 15,259 $ 11,089 $ 38,153 ========= ========= ========= SUPPLEMENTAL CASH FLOW DATA: Cash paid--interest ............................................ $ 3,786 $ 2,872 $ 1,232 Cash paid--income taxes ........................................ $ 11,282 $ 8,795 $ 3,288
o AmCOMP Incorporated ("AmCOMP"), a holding company incorporated on December 28, 1995;
o Pinnacle Administrative, Inc. ("Pinnacle Administrative"), a wholly owned administrative services company providing sales and marketing, underwriting, policyholder service, data processing, and accounting services;
The Company's long-term source of consolidated earnings is principally the income from its workers' compensation insurance business and investment income from its investment portfolio. Workers' compensation insurance provides coverage for the statutorily prescribed benefits that employers are required to provide to their employees injured in the course of employment. The Company is licensed to provide workers' compensation insurance in 23 states, but currently focuses its resources in 15 states that it believes provide greater opportunity for near-term profitable growth, with the most significant concentrations in Florida, Wisconsin, Texas, Indiana and Tennessee.
USE OF ESTIMATES--The preparation of consolidated financial statements requires management to make estimates and assumptions that affect amounts reported in the consolidated financial statements and the accompanying notes. Such estimates and assumptions could change in the future as more information becomes known that could affect the amounts reported herein.
INVESTMENTS--Fixed maturity investments are designated at purchase as held-to-maturity or available-for-sale. Held-to-maturity fixed maturity investments are reported at amortized cost. Securities classified as available-for-sale are reported at fair value with unrealized appreciation and depreciation, net of deferred taxes, included as a component of accumulated other comprehensive income. The Company has the intent and ability to hold securities that have fair value below cost until their expected recovery and to hold to maturity securities designated as held-to-maturity.
Single class and multiclass mortgage-backed/asset-backed securities are valued at amortized cost using the interest method including anticipated prepayments. Changes in anticipated prepayment assumptions are accounted for using the retrospective method. Prepayment assumptions are obtained from dealer surveys or internal estimates and are based on the current interest rate and economic environment.
Debt and equity securities are exposed to various risks such as interest rate, market, and credit risk. Fair values of securities fluctuate based on the magnitude of changing market conditions; significant changes in market conditions could materially affect portfolio value in the near term. The Company
CASH AND CASH EQUIVALENTS--The Company considers all highly liquid investments with a maturity of three months or less when purchased to be cash equivalents.
PREMIUMS RECEIVABLE--Premiums receivable consist primarily of premium-related balances due from policyholders. The balance is shown net of the allowance for doubtful accounts. Receivables due from insureds are written off when a determination has been made that a specific balance will not be collected based upon the collection efforts of Company personnel. An estimate of amounts that are likely to be written off is established as an allowance for doubtful accounts as of the balance sheet date. The estimate is primarily comprised of specific balances that are considered probable to be written off after all collection efforts have ceased, as well as historical trends and an analysis of the aging of the receivables.
2006 2005 -------- -------- Gross deferred policy acquisition costs ........... $ 20,749 $ 21,101 Reduction for ceding allowances received .......... -- (1,688) -------- -------- Net deferred policy acquisition costs ............. $ 20,749 $ 19,413 ======== ========
IMPAIRMENT OF LONG-LIVED ASSETS--The Company's policy is to record an impairment charge against the balance of a long-lived asset in accordance with Statement of Financial Accounting Standards No. 144, ACCOUNTING FOR THE IMPAIRMENT OR DISPOSAL OF LONG-LIVED ASSETS ("SFAS No. 144"), in the period when it is determined that the carrying amount of the asset may not be recoverable. This determination is based on an evaluation of such factors as the occurrence of a significant event or a significant change in the environment in which the business assets operate. The Company considers assets to be impaired when the expected future undiscounted cash flows of the assets are determined to be less than the carrying value. If impairment is deemed to exist, the related asset is written down to fair value. Management also evaluates events and circumstances to determine whether revised estimates of useful lives are warranted. As of December 31, 2006, management expects the carrying value of its remaining long-lived assets to be fully recoverable.
POLICYHOLDER DIVIDENDS--Policyholder dividends are recognized over the effective period of the related policies and are restricted in certain instances to limitations imposed by the Board of Directors (see Note 9).
Prior to January 1, 2006, the Company accounted for stock-based compensation to employees using the intrinsic value method as prescribed by Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees ("APB No. 25"), and related interpretations and disclosure requirements established by SFAS No. 123, Accounting for Stock-Based Compensation ("SFAS 123"), as amended by SFAS No. 148, Accounting for Stock-Based Compensation - Transitions and Disclosures ("SFAS 148"). Accordingly, compensation cost for stock options issued to employees was measured as the excess, if any, of the estimated market price of the Company's stock at the date of grant over the amount an employee must pay for the stock.
2005 2004 ---------- --------- Net income ............................................ $ 16,785 $ 5,030 Deduct: total stock-based employee compensation expense determined under fair value based method for all awards--net of related tax effects .................. (35) (113) Pro forma net income .................................. $ 16,750 $ 4,917 Basic earnings per share--as reported ................. $ 3.13 $ 0.94 Basic earnings per share--pro forma ................... 3.12 0.92 Diluted earnings per share--as reported ............... 1.76 0.53 Diluted earnings per share--pro forma ................. 1.75 0.51
The Company has adopted SFAS 123R using the modified prospective transition method. Under this transition method, compensation cost recognized in 2006 includes:
o Compensation cost for all share based awards (expected to vest) granted prior to, but not yet vested as of January 1, 2006, based upon grant-date fair value estimated in accordance with the original provisions of SFAS 123; and
Upon adoption of SFAS 123R, the Company continued to use the Black-Scholes option pricing model for valuing all stock options. Compensation for non-vested stock awards is measured at fair value on the grant-date based upon the number of shares expected to vest and the quoted market price of the underlying common stock. Compensation cost for all awards will be recognized in earnings, net of
estimated forfeitures, on a straight-line basis over the requisite service period. As a result of the adoption of SFAS 123R, the Company recognized approximately $0.6 million of stock option compensation expense in the year ended December 31, 2006. Basic and diluted earnings per share for the year ended December 31, 2006 were reduced by $0.04. Additionally, as a result of adoption, cash flows from financing increased $162,000 and cash flows from operations decreased by the same amount.
AmCOMP Preferred and AmCOMP Assurance are required to periodically submit financial statements prepared in accordance with prescribed or permitted statutory accounting practices ("SAP") to the Florida Department of Financial Services ("FDFS"). Such practices vary from GAAP. Prescribed SAP includes state laws, regulations, and general administrative rules, as well as a variety of publications of the National Association of Insurance Commissioners ("NAIC"). Permitted SAP encompasses all accounting practices that are not specifically prescribed, but have been permitted by the regulatory authority; such practices may differ from company to company and may not necessarily be permitted in subsequent reporting periods.
AmCOMP Preferred and AmCOMP Assurance are subject to comprehensive supervision and regulation by the FDFS. Florida statute Section 624.408 requires AmCOMP Preferred and AmCOMP Assurance to maintain minimum capital and surplus of the greater of $4.0 million or 10% of total liabilities. Florida statute Section 624.4095 requires AmCOMP Preferred and AmCOMP Assurance to maintain a ratio of written premiums times 1.25 to surplus of no greater than 10-to-1 for gross written premiums and 4-to-1 for net written premiums. During the years ended December 31, 2006 and 2005, AmCOMP Preferred and AmCOMP Assurance were in compliance with these statutes.
As of December 31, 2006 and 2005, AmCOMP Preferred's and AmCOMP Assurance's total adjusted capital is above all regulatory action levels.
2006 2005 -------- -------- AmComp Preferred(a) ...................... $155,509 $ 96,175 AmComp Assurance ......................... 84,817 55,337 (a) includes AmCOMP Preferred's equity ownership in AmCOMP Assurance's capital and surplus
Under Florida insurance regulations, the maximum dividend to stockholders that may be paid without prior approval by the FDFS is specifically defined by the Florida insurance laws and regulations and is generally based on operating results and capital and surplus. For AmCOMP Preferred and AmCOMP Assurance, no dividends were paid during 2006 and 2005. As of December 31, 2006 and 2005, AmCOMP Preferred had $15.6 million and $9.6 million, respectively, available to pay dividends without prior approval. As of December 31, 2006 and 2005, AmCOMP Assurance had $7.4 million and $1.4 million, respectively, available to pay dividends without prior approval. These amounts represent 10% of statutory surplus, not to exceed unassigned funds.
The Company submits claims to the appropriate state's second injury fund for recovery of applicable claims paid on behalf of the Companay's insureds. Because of the uncertainty of the collectibility of such amounts, second injury fund recoverables are reported in the accompanying consolidated financial statements when received. Cash collections from the second injury funds were approximately $1.4 million, $2.2 million, and $3.4 million in the years ended December 31, 2006, 2005 and 2004, respectively.
OTHER ASSESSMENTS-- Various other assessments are levied by states in which the Company transacts business, and are primarily based on premiums written or collected in the applicable state. The total expense related to these assessments was $1.2 million, $1.3 million, and $1.9 million for the years ended December 31, 2006, 2005 and 2004, respectively. The Company has deferred approximately $0.3 million and $0.3 million as of December 31, 2006 and 2005, respectively, related to these assessments, which are included in deferred policy acquisition costs.
The Company's investments in available-for-sale securities and held-to-maturity securities are summarized as follows at December 31, 2006 and 2005 (in thousands):
At December 31, 2006 and 2005, bonds with an amortized cost of $13.2 million and $19.2 million and a fair value of $14.0 million and $20.2 million, respectively, were on deposit with various states' departments of insurance in accordance with regulatory requirements. Additionally, at December 31, 2006 and 2005, bonds with an amortized cost of $6.0 million and $6.0 million, respectively, were held in a reinsurance trust to the benefit of members of the Orion Insurance Group in accordance with the terms of a reinsurance agreement between the Company and the Orion Companies.
Major categories of the Company's net investment income for the years ended December 31, 2006, 2005 and 2004 are summarized as follows (in thousands):
Unrealized Number Fair Value Losses of Issues ---------- -------- --------- Less than 12 months: U.S. Treasury securities $ 1,097 $ 12 5 Agency 7,966 25 4 Municipalities 15,669 132 7 Corporate debt securities 33,493 230 17 Mortgage-backed securities 28,930 54 11 -------- -------- -------- Total $ 87,155 $ 453 44 ======== ======== ======== Greater than 12 months: U.S. Treasury securities $ 27,148 $ 695 22 Agency 21,676 422 15 Municipalities 36,116 687 26 Corporate debt securities 134,240 2,967 102 Mortgage-backed securities 28,160 666 20 -------- -------- -------- Total $247,340 $ 5,437 185 ======== ======== ======== Total fixed maturity securities: U.S. Treasury securities $ 28,245 $ 707 27 Agency 29,642 447 19 Municipalities 51,785 819 33 Corporate debt securities 167,733 3,197 119 Mortgage-backed securities 57,090 720 31 -------- -------- -------- Total fixed maturity securities $334,495 $ 5,890 229 ======== ======== ========
Major categories of the Company's premiums receivable at December 31, 2006 and 2005 are summarized as follows (in thousands):
Certain premiums and losses are ceded to other insurance companies under quota share reinsurance arrangements and various aggregate and specific excess of loss reinsurance agreements. The ceded reinsurance agreements are intended to provide the Company with the ability to maintain its exposure to loss within its capital resources. Losses ceded under these treaties are estimated based on ultimate losses. These estimates are subject to the effects of trends in loss severity. Although considerable variability is inherent in such estimates, management believes that their estimates of losses ceded under these treaties are reasonable. These estimates are continually reviewed and adjusted as necessary as experience develops or new information becomes known; such adjustments are included in current operations. Effective July 2004, the Company has discontinued the use of quota share reinsurance on new and renewal business.
Insurance premiums for the years ended December 31, 2006, 2005 and 2004 are summarized as follows (in thousands):
Reinsurance recoverables on paid and unpaid losses and loss adjustment expenses were $75.4 million and $83.9 million at December 31, 2006 and 2005, respectively, of which $39.1 million and $45.6 million, respectively, was recoverable from one reinsurer. Management evaluates the financial condition of its reinsurers and monitors concentrations of credit risk to minimize its exposure to significant losses from reinsurer insolvencies. Reinsurance contracts do not relieve the Company from its obligations to policyholders. Failure of reinsurers to honor their obligations could result in losses to the Company.
The effective federal income tax rates on income before income taxes differ from the maximum statutory rates as follows for the years ended December 31, 2006, 2005 and 2004 (in thousands):
2006 % 2005 % 2004 % ------- ------- ------- ------- ------- ------- Income tax at statutory rate ........... $ 8,687 35.0% $ 9,139 35.0% $ 3,164 34.0% Permanent differences: State income taxes ................... 255 1.1 844 3.2 159 1.7 Tax-exempt interest .................. (942) (3.8) (584) (2.2) (199) (2.1) Non-deductible meals and entertainment 197 0.8 350 1.3 152 1.6 Change in deferred tax rate .......... (513) (2.0) -- -- 1,216 13.1 Provision to return adjustment ....... 278 1.1 (4) -- (381) (4.1) Non-deductible option expense ........ 133 0.5 -- -- -- -- Other expense--net ................... 161 0.6 (419) (1.6) 164 1.8 ------- ------- ------- ------- ------- ------- Effective income tax expense ........... $ 8,256 33.3% $ 9,326 35.7% $ 4,275 46.0% ======= ======= ======= ======= ======= =======
The Company records deferred federal income taxes on certain temporary differences between the amounts reported in the accompanying consolidated financial statements and the amounts reported for federal and state income tax reporting purposes.
The following table provides a reconciliation of the beginning and ending balances for unpaid losses and LAE, reported in the accompanying consolidated balance sheets as of December 31, 2006 and 2005 (in thousands):
The Company's estimate for losses and LAE related to prior years, net of related reinsurance recoverables, decreased during the years ended December 31, 2006 and 2005 by $14.2 million and $24.7 million, respectively, as a result of actual loss development emerging more favorably than expected. Management believes the historical experience of the Company is a reasonable basis for estimating future losses. However, future events beyond the control of management, such as changes in law, judicial interpretations of law, and inflation may favorably or unfavorably impact the ultimate settlement of the Company's loss and loss adjustment expenses.
YEAR ENDED DECEMBER 31, 2007 ..................................................... $3,229 2008 ..................................................... 2,383 2009 ..................................................... 1,579 2010 ..................................................... 746 2011 and thereafter ...................................... 396 ------ $8,333 ======
EMPLOYMENT CONTRACTS--The Company has entered into employment contracts with certain of its executives. These contracts generally provide for continuing compensation for a period of 12 to 18 months if the executives are released without cause, except the contract of the chief executive officer provides for compensation for a period equal to the greater of 18 months or the number of months then remaining in the term of the contract.
SFAS No. 107, DISCLOSURE ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS, requires disclosure of the estimated fair value of all financial instruments, including both assets and liabilities, unless specifically exempted.
INVESTMENT SECURITIES--Fair values for fixed maturity securities and other invested assets are based on quoted market prices where available. For fixed maturity securities not actively traded, fair values are estimated using values obtained from independent pricing services (see Note 4).
NOTES PAYABLE--The Company's note payable is a floating rate long-term debt. Accordingly, the carrying amount is estimated to approximate the fair value.
On October 12, 2000, the Company entered into a credit facility (the "Loan") with a financial institution under which the Company borrowed $11.3 million. The Loan calls for monthly interest payments at the 30-day LIBOR rate plus a margin. The expiration date on the loan is April 10, 2010. The Loan is collateralized by $25.5 million of surplus notes issued by AmCOMP Preferred and AmCOMP Assurance and the stock of AmCOMP Preferred. During 2003, the remaining balance of the Loan was refinanced and the Company borrowed an additional $5.5 million. At December 31, 2006 and 2005, the principal balance was $6.3 million and $8.0 million respectively. The interest rate was 7.85% at December 31, 2006. Interest paid during 2006 and 2005 totaled $558,000 and $495,000, respectively.
On April 30, 2004, AmCOMP Preferred issued a $10 million surplus note in return for $10 million in cash to Dekania CDO II, Ltd., as part of a pooled transaction. The note matures in 30 years and is callable by the Company after five years. The terms of the note provide for quarterly interest payments at a rate 425 basis points in excess of the 90-day London Interbank Offered Rate ("LIBOR"). Both the payment of interest and repayment of the principal under this note and the surplus notes described in the succeeding two paragraphs are subject to the prior approval of the Florida Department of Financial Services. Interest paid through December 31, 2006 and 2005 totaled $0.9 million and $0.7, million respectively. Interest acrrued as of December 31, 2006 and 2005 was $120,000 and $107,000, respectively. This interest was paid subsequent to year end.
On September 14, 2004, AmCOMP Preferred issued a $10 million surplus note, in return for $10 million in cash, to Alesco Preferred Funding V, LTD, as part of a pooled transaction. The note matures in approximately 30 years and is callable by the Company after approximately five years. The terms of the note provide for quarterly interest payments at a rate 405 basis points in excess of the 90-day LIBOR. Interest paid through December 31, 2006 and 2005 totaled $0.9 million and $0.7, million respectively. Interest unpaid as of December 31, 2006 and 2005 was $39,000 and $38,000, respectively. This interest was paid subsequent to year end.
2007......................................................... $1,786 2008......................................................... 1,786 2009......................................................... 1,786 2010......................................................... 892 2011 and thereafter.......................................... 32,000 ------- Total........................................................ $38,250 =======
CONVERTIBLE PREFERRED STOCK SERIES A--At December 31, 2005, 2.4 million shares of $1.00 par value, voting, participating, convertible preferred stock ("CPS") was authorized, issued, and outstanding. If the Company declared and paid a dividend on the common stock, the CPS stockholders were entitled to a dividend equal to the dividend that would have been payable to such holder if the shares had been converted. The CPS had a liquidation preference of $10 per share and was convertible, at the holder's option, into 1.7464 shares of the Company's common stock for each share of CPS held. The CPS automatically converted into 4,191,399 shares of common stock upon consummation of the qualified public offering.
UNDESIGNATED PREFERRED STOCK--At December 31, 2006, the board or directors had the authority to issue up to 5,000,000 shares of undesignated preferred stock and to determine the rights, preferences and privileges of the shares, without stockholder approval.
As of December 31, 2006, 1,442,239 shares of common stock were issuable and reserved for future issuance under employee stock option plans and to executives granted options outside of option plans.
Effective January 1, 2006, the Company adopted SFAS No. 123R, using the modified prospective application transition method. Under this method, all outstanding employee stock options are being expensed over the remaining vesting period based on the fair value of the options at the date they were granted. Additionally, SFAS No. 123R requires the estimation of forfeitures in
calculating the expense related to stock-based compensation. As a result of the adoption of SFAS No. 123R, the Company recognized approximately $0.6 million of stock option compensation expense and $0.1 million of related tax benefit in the year ended December 31, 2006. The recognition of the expense reduced 2006 earnings per share by $0.04. As of December 31, 2006, total unrecognized compensation expense related to non-vested stock options was approximately $1.8 million. This cost is expected to be recognized over the weighted average period of 2.7 years.
In February 2006, the Company granted three executives options to purchase 384,217 shares of common stock outside of existing plans. These options vest over a three-to-four year period and are exercisable over a five-year period after the date of grant for an exercise price of $9 per share.
For the years ended December 31, 2005 and prior, the Company has elected to follow APB No. 25, Accounting for Stock Issued to Employees, and related interpretations in accounting for its stock options granted to employees and directors. Under APB No. 25, because the exercise price of the Company's employee stock options equals or is greater than the estimated fair value of the underlying stock on the date of grant, no compensation expense is recognized.
Employees, Directors, and Executives ----------------------------- Average Number of Exercise Price Shares ----------------------------- Outstanding-December 31, 2003 $ 10.97 741,301 Granted 9.30 43,660 Exercised -- -- Forfeited 9.71 (111,258) --------- --------- Outstanding- December 31, 2004 11.09 673,703 Granted -- -- Exercised -- -- Forfeited 10.13 (28,124) --------- --------- Outstanding- December 31, 2005 11.12 645,579 Granted 9.03 818,442 Exercised 9.32 (239,757) Forfeited 8.89 (132) Expired 9.26 (2,574) --------- --------- Outstanding- December 31, 2006 $ 10.08 1,221,558 ========= =========
As of December 31, 2006, 2005 and 2004, options to purchase 360,505, 588,453 and 463,212 shares were exercisable. The weighted average remaining contractual life of the exercisable options was 0.6 years and 1.4 years as of December 31, 2006 and 2005, respectively. The per-share weighted average grant date fair value of options granted in the years ended December 31, 2006 and 2004 were $3.05 and $1.53, respectively. The fair value of stock options granted was estimated on the dates of grant using the Black-Scholes option pricing model. The following weighted average assumptions were used to perform the calculation of 2006 grant date fair value: zero expected dividend yield, 4.56% risk-free interest rate, 5 year expected life, and 28.2% volatility. The expected life was based on historical exercise behavior and the contractual life of the options. Due to the unavailability of historical company information, volatility was based on average volatilities of similar entities for the appropriate period. Forfeitures were estimated at 20% for board members, 5% for executives and 10% for all remaining employees. No options were granted in 2005. The weighted-average grant date fair value of options vesting during 2006, 2005 and 2004 was $1.48, $1.68 and $1.70, respectively. As of December 31, 2006 the aggregate intrinsic value of options outstanding and options exercisable was approximately $772,000 and $77,000, respectively. The total aggregate intrinsic value of options exercised during 2006 was approximately $298,000. No options were exercised in 2005 or 2004.
Summary information for option awards expected to vest is as follows:
The following table sets forth the computation of basic and diluted earnings per share for the years ended December 31, 2006, 2005 and 2004 (in thousands, except per share data):
2006 2005 2004 ------- ------- ------- Numerator: Net income attributable to common stockholders .......... $16,562 $16,785 $ 5,030 ======= ======= ======= Denominator: Weighted-average shares outstanding (denominator for basic earnings per share) .............................. 14,452 5,367 5,368 Plus effect of dilutive securities: Convertible preferred stock ............................ 459 4,191 4,191 Employee stock options ................................. 20 4 5 ------- ------- ------- Weighted-average shares outstanding and assumed conversions (denominator for diluted earnings per share) 14,931 9,562 9,564 ======= ======= ======= Basic earnings per share .................................. $ 1.15 $ 3.13 $ 0.94 Diluted earnings per share ................................ $ 1.11 $ 1.76 $ 0.53
For the years ended December 31, 2006, 2005 and 2004, outstanding employee stock options of 1,134,979, 558,483 and 585,767 have been excluded from the computation of diluted earnings per share since they are anti-dilutive.
The National Council on Compensation Insurance ("NCCI") submitted its annual workers' compensation rate filing to the Florida Office of Insurance Regulation (the "Florida OIR"), which called for a statewide average 13.3% rate decrease. Significant declines in claim frequency and an improvement in loss development since the legislature enacted the 2003 reforms are the two main reasons for the proposed premium level decrease. On October 17, 2006, the OIR issued an order requesting that NCCI make an amended filing for an overall workers' compensation rate decrease of 15.7%. On October 24, 2006, NCCI submitted an amended filing calling for a statewide decrease of 15.7% as requested, which was approved by the Florida OIR on October 31, 2006. The new rates will apply to all new and renewal policies as of January 1, 2007. The effect of the approved decrease cannot currently be ascertained.
The Company, through outside regulatory counsel, has submitted their amended filings to Florida OIR for the years 2002, 2003 and 2004. The amended filings report no excessive profits for the reporting periods. In the event Florida OIR does not agree with the amended filings as submitted by the Company, there would be a disputed issue of material fact and law regarding the calculation of excessive profits. The Company has preserved its right to an administrative hearing under the provisions of the Notice and Florida Statute Chapter 120 (the Florida Administrative Procedures Act). Under Chapter 120, the Company is entitled to a DE NOVO proceeding on the issues described above. If the administrative ruling is adverse to the Company, the Company would have further appellate rights to the District Court of Appeal. Management of the Company believes, in part based on input from legal counsel, that "excessive profits" were not, in fact, earned in Florida for the years 2002, 2003, and 2004. No accrual for excessive profits has been provided as of December 31, 2006.
First Second Third Fourth Quarter Quarter Quarter Quarter ------- ------- ------- ------- Revenues $70,099 $72,524 $72,572 $68,748 Expenses 60,769 65,428 65,376 67,552 Net income 5,975 5,007 4,324 1,256 Basic earnings per share 0.54 0.31 0.28 0.08 Diluted earnings per share 0.46 0.31 0.28 0.08
Revenues $63,122 $66,759 $68,457 $68,963 Expenses 54,902 57,659 66,353 62,276 Net income 5,327 5,220 1,579 4,659 Basic earnings (loss) per share 0.99 0.97 0.29 0.87 Diluted earnings (loss) per share 0.56 0.55 0.17 0.49