72,000 square feet and lease the remainder to unaffiliated tenants. We lease office space in Duluth, Georgia; Honolulu, Hawaii; Mechanicsburg, Pennsylvania; and Cayce, South Carolina. These leases account for approximately 14,000 square feet of office space. Most of these leases expire within three to sixty-two months. The monthly rents to lease these facilities currently total approximately $18,000. We believe that these leases could be renewed or replaced at commercially reasonable rates without material disruption to our business.
The statutory policyholder surplus of National Interstate Insurance Company, which includes the statutory policyholder surplus of its subsidiary, National Interstate Insurance Company of Hawaii.
Statutory combined ratio of National Interstate Insurance Company represents the sum of the following ratios: (1) losses and loss adjustment expenses incurred as a percentage of net earned premium and (2) underwriting expenses incurred as a percentage of net written premiums.
The following discussion and analysis of the historical consolidated financial statements of National Interstate should be read in conjunction with our audited consolidated financial statements and the related notes included elsewhere in this Form 10-K. All historical per share amounts reflect a 200-for-1 share split as discussed elsewhere in this Form 10-K and the reclassification of all Class A common shares as common shares effective December 6, 2004. Our actual results could differ materially from those anticipated in these
Operating expense reductions through system investments and a lower cost structure in our captive products.
Future growth rates for any National Interstate insurance product will be impacted by changes in general economic and competitive conditions in the market.
All of our transportation products, traditional or alternate risk transfer, are priced to achieve targeted underwriting margins. Because traditional insurance tends to have a higher operating expense structure, the portion of the premiums available to pay losses tends to be lower for a traditional insurance quote versus an alternate risk transfer insurance quote. We use a cost plus pricing approach that projects future losses based upon the insured’s historic losses and other factors. Operating expenses, premium taxes, expenses and a profit margin are then added to the projected loss component to achieve the total premium to be quoted. The lower the projected losses, expenses and taxes, the lower the total quoted premiums regardless of whether it is a traditional or alternate risk transfer program quotation. Quoted premiums are computed in accordance with our approved insurance department filings in each state.
Our expenses consist primarily of losses and loss adjustment expenses, or LAE; commissions and other underwriting expenses; and other operating and general expenses. Losses and loss adjustment expenses are a function of the amount and type of insurance contracts we write and of the loss experience of the underlying risks. We record losses and loss adjustment expenses based on an actuarial analysis of the estimated losses we expect to be reported on contracts written. We seek to establish case reserves at the maximum probable exposure based on our historical claims experience. Our ability to estimate losses and loss adjustment expenses accurately at the time of pricing our contracts is a critical factor in determining our profitability. The amount reported under losses and loss adjustment expenses in any period includes payments in the period net of the change in the value of the reserves for unpaid losses and loss adjustment expenses between the beginning and the end of the period. Commissions and other underwriting expenses consist principally of brokerage and agent commissions that represent a percentage of the premiums on insurance policies and reinsurance contracts written, and vary depending upon the amount and types of contracts written, and to a lesser extent ceding commissions paid to ceding insurers and excise taxes. Other operating and general expenses consist primarily of personnel expenses (including salaries, benefits and certain costs associated with awards under our equity compensation plans) and other general operating expenses. Other than expenses relating to stock options and other equity grants, our personnel expenses are primarily fixed in nature and do not vary with the amount of premiums written. Interest expenses are disclosed separately from operating and general expenses.
The quarterly reviews of unpaid loss and LAE reserves by Great American Insurance Company actuaries are prepared using standard actuarial techniques. These may include (but may not be limited to):
An important assumption underlying reserve estimates is that the cost trends implicitly built into development patterns will continue into the future. The sensitivity of recorded reserves to an unexpected change in the trends, is estimated by adding 1.0% to the trend that is embedded in the factors used to determine the reserves for ultimate liabilities. This unexpected change could arise from a variety of sources including a general increase in economic inflation, inflation from social programs, new medical technologies, or other factors such as those listed below in connection with our largest lines of business. The estimated
Commercial Auto Liability. In this line of business, we provide coverage protecting busses, limousines, other public transportation vehicles and trucking for accidents causing property damage or personal injury to others. Some of the important variables affecting our estimation of loss reserves for commercial auto liability include:
The level of detail at which data is analyzed varies among the different lines of business. Data is generally analyzed by major product or coverage, using countrywide data. Appropriate segmentation of the data is determined based on data volume, data credibility, mix of business and other actuarial considerations. Best estimates are selected based on test indications and judgment.
Claims we view as potentially significant are subject to a rigorous review process involving the adjuster, claims management and executive management. We seek to establish reserves at the maximum probable exposure based on our historic claims experience. Incurred but not yet reported, or IBNR, reserves are determined separate from the case reserving process and include estimates for potential adverse development of the recorded case reserves. We monitor IBNR reserves monthly with financial management and quarterly with an actuary from Great American Insurance Company. IBNR reserves are adjusted monthly based on historic patterns and current trends and exposures. When a claim is reported, claims personnel establish a “case reserve” for the estimated amount of ultimate payment. The amount of the reserve is based upon an evaluation of the type of claim involved, the circumstances surrounding each claim and the policy provisions relating to the loss. The estimate reflects informed judgment of our claims personnel based on general insurance reserving practices and on the experience and knowledge of the claims personnel. During the loss adjustment period, these estimates are revised as deemed necessary by our claims department based on developments and periodic reviews of the cases. Individual case reserves are reviewed for adequacy at least quarterly by senior claims management.
The changes we have recorded in our reserves in the past three years illustrate the potential for revisions inherent in estimating reserves. In 2004, we experienced favorable development of $2.3 million (1.3% of total reserves) from claims incurred prior to 2004. In 2003, we experienced favorable development of $3.7 million (2.9% of total reserves) from claims incurred in years prior to 2003. In 2002, we experienced unfavorable development of $38,000 (less than 0.1% of total reserves) from claims incurred prior to 2002. We did not change our reserving methodology or our claims settlement process in any of these years. The development reflected settlements that differed from the established case reserves, changes in the case reserves based on new information for that specific claim or the differences in the timing of actual settlements compared to the payout patterns assumed in our accident year IBNR reductions. The types of coverages we offer and risk levels we retain have a direct influence on the development of claims. Specifically, short duration claims and lower risk retention levels generally are more predictable and normally have less development. Future favorable or unfavorable development of reserves from this past development experience should not be assumed or estimated. The reserves reflected in the financial statements are our most accurate estimation.
Underwriting profitability, as opposed to overall profitability or net earnings, is measured by the combined ratio. The combined ratio is the sum of the loss and loss adjustment expense (LAE) ratio and the underwriting expense ratio. A combined ratio under 100% is indicative of an underwriting profit.
Our underwriting approach is to price our products to achieve an underwriting profit even if it requires us to forego volume. Since 2000, our insurance subsidiaries have been increasing their premium rates to offset rising losses and reinsurance costs. Rate increases have continued during 2004, but at a reduced pace and level as compared to 2003.
2004 compared to 2003. Our net earned premiums increased $30.5 million (24.2%) to $156.9 million during the year ended December 31, 2004 compared to $126.4 million for the same period in 2003. Our transportation component accounted for 4.8 points of the growth. Direct premiums written in the transportation component increased by 9.1 points, including approximately 3.9 points due primarily to increased rates on renewed policies and, because in the fourth quarter of 2003, we expanded our community service and paratransit product, which contributed approximately 5.2 points of the growth. Offsetting the 9.1 point increase in the transportation component was a decline in assumed premium from a reinsurance arrangement involving primarily physical damage coverage on trucks, which amounted to 4.3 points. This decrease occurred because the company with whom we had the agreement elected to exit the business. Also favorably impacting the growth in net earned premiums was new insureds in our alternative risk transfer operations, which accounted for 8.6 points of the growth. During this period and prior periods, our alternative risk transfer business was and continues to be one of the fastest growing components of our business, based on premiums. Expanded distribution in specialty personal lines, which accounted for 7.4 points of the growth, will continue to be an important influence in this business component. Our Hawaii component and other component (which is comprised primarily of premium from assigned risk plans from the states in which our insurance company subsidiaries operate) accounted for 0.7 points and 2.7 points of the increase, respectively.
hurricane losses were severe enough to trigger our property catastrophe insurance, which attaches at $2.5 million per occurrence. The unusually low frequency and severity of incurred losses in 2003 was the primary reason for the remaining 4.1 point variance. We believe that the low frequency and severity of losses in 2003 was more favorable than is typical, but not outside expected parameters. Other than the total absence of weather related catastrophes in 2003, we are unaware of any specific events or trends that affected the timing and distribution of 2003 incurred losses. In 2004, incurred losses have been returning to ratios more consistent with historical results.
2004 compared to 2003. Net investment income increased $2.8 million (49.2%) to $8.6 million in 2004 compared to 2003, due primarily to a 42.6% increase in average cash and invested assets. The growth in cash and invested assets reflected the growth in premiums written and the proceeds from borrowing $15.5 million in May 2003 and $15.0 million in June 2004.
2004 compared to 2003. Net realized gains of $1.7 million for 2004 were comparable to $1.5 million for 2003.
Our effective tax rate was 33.9% in 2004, 36.2% in 2003 and 28.1% in 2002. Differences in the effective tax rates are primarily due to the effect of tax exempt investment income and adjustments to the reserve for income taxes related to exposure items. See Note 9 to our audited consolidated financial statements for further analysis of items affecting our effective tax rate.
We will have continuing cash needs for administrative expenses, the payment of principal and interest on borrowings, shareholder dividends and taxes. Funds to meet these obligations will come primarily from dividend and tax payments from our insurance company subsidiaries and from our line of credit. Under the state insurance laws, dividends and capital distributions from our insurance companies are subject to restrictions relating to statutory surplus and earnings. The maximum amount of dividends that our insurance companies could pay to us without seeking regulatory approval in 2005 is $20.5 million. During 2004 and 2003 our insurance subsidiaries paid $2.1 million and $3.0 million, respectively, in dividends without the need for regulatory approval.
Under tax allocation and cost sharing agreements among NIC and its subsidiaries, taxes and expenses are allocated among the entities. The federal income tax provision of our individual subsidiaries is computed as if the subsidiary filed a separate tax return. The resulting provision (or credit) is currently payable to (or receivable from) National Interstate Corporation.
We also have a $2.0 million line of credit (unused at December 31, 2004) that bears interest at the lending institution’s prime rate (5.25% at December 31, 2004 and 4.00% at December 31, 2003) less 50 basis points and requires an annual commitment fee of $1 thousand. In accordance with the terms of the line of credit agreement, interest payments are due monthly and the principal balance is due upon demand. The line of credit is available currently, and has been used in the past, for general corporate purposes, including the capitalization of our insurance company subsidiaries in order to support the growth of their written premiums. We may request an increase in this line of credit in the future based on liquidity and capital needs, although we have no current plans to do so.
We have a term loan that is governed by a four-year, unsecured term loan agreement that was executed in August 2002. The note was originally issued for $5.0 million and bears interest at the lender’s prime rate (5.25% at December 31, 2004 and 4.00% at December 31, 2003) less 50 basis points. The outstanding principal amount at December 31, 2004 was $2.1 million. Payments on the note are due in monthly principal installments of $104,000 plus interest. The term loan agreement contains certain customary covenants for a term loan of this nature including covenants relating to delivery of financial statements, maintenance of insurance, payment of taxes, corporate existence, compliance with laws, maintenance of financial ratios, absence of liens and mergers and liquidations. At December 31, 2004 we were in compliance with all of our loan covenants.
We also had a $15.0 million promissory note payable to Great American, our majority shareholder that was governed by a five-year, unsecured note that we executed in June 2004 in order to fund our growth. The note was issued at a fixed interest rate of 7.0% with interest only payments due quarterly. The principal and accrued interest of this loan was paid off in full in February 2005 with proceeds from our initial public offering.
Dollar amounts and time periods are estimates based on historical net payment patterns applied to the gross reserve and do not represent actual contractual obligations. Actual payments and their timing could differ significantly from these estimates, and the estimates provided do not reflect potential recoveries under reinsurance treaties.
At December 31, 2004 our investment portfolio contained $206.2 million in fixed maturity securities and $16.8 million in equity securities, all carried at fair value with unrealized gains and losses reported as a separate component of shareholders’ equity on an after-tax basis. At December 31, 2004 we had pretax net unrealized gains of $0.5 million on fixed maturities and a pretax unrealized gains of $0.3 million on equity securities.
At December 31, 2004, 99.6% of the fixed maturities in our portfolio were rated “investment grade” (credit rating of AAA to BBB) by Standard & Poor’s Corporation. Investment grade securities generally bear lower yields and lower degrees of risk than those that are unrated or non-investment grade.
Summary information for securities with unrealized gains or losses at December 31, 2004 follows:
The table below sets forth the scheduled maturities of fixed maturity securities at December 31, 2004 based on their fair values:
“Selected Quarterly Financial Data” has been included in Note 18 to the Consolidated Financial Statements.
We conducted our audits 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. We were not engaged to perform an audit of the Company’s internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also 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.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of National Interstate Corporation, and subsidiaries at December 31, 2004 and 2003, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2004, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.
The Company is a 64.0% (on a fully diluted basis as of December 31, 2004) owned subsidiary of Great American Insurance Company (Great American); a wholly-owned subsidiary of American Financial Group, Inc. On January 28, 2005, the Company sold 3,350,000 shares of common stock in an initial public offering at $13.50 a share and began trading its common shares on the Nasdaq National Market under the symbol NATL. Prior to January 28, 2005, no public market existed for the common shares. Following the initial public offering, Great American’s ownership was reduced to 52.9% (on a fully diluted basis). The Company has three property and casualty insurance subsidiaries, National Interstate Insurance Company (NIIC), Hudson Indemnity, Ltd. (HIL) and National Interstate Insurance Company of Hawaii, Inc. (NIIC-HI) and four other agency and service subsidiaries. NIIC is licensed in all 50 states and the District of Columbia. HIL is domiciled in the Cayman Islands and conducts insurance business outside the United States. The Company writes its insurance policies on a direct basis through NIIC and in the state of Hawaii through NIIC-HI. The Company also assumes a portion of premiums written by other affiliate companies whose passenger transportation insurance business it manages. Insurance products are marketed through affiliates and independent agents and brokers. In addition, the Company has agency and service subsidiaries. Approximately 13.7% of the Company’s premiums are written in the state of California, and an additional 24.8%, collectively, in the states of Hawaii, Florida and North Carolina.
Certain amounts in the prior period financial statements have been reclassified to conform to the current period method of presentation. Historical financial statements have been adjusted to give effect to the 200-for-1 common share split effective December 6, 2004 and the reclassification of all Class A common shares as common shares effective immediately prior to the offering.
The preparation of financial statements in accordance with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported
in the financial statements and accompanying notes. Actual results could differ from the estimates and assumptions used.
The costs of acquiring new business, principally commissions and premium taxes and certain underwriting expenses directly related to the production of new business, are deferred and amortized over the period in which the related premiums are earned. Policy acquisition costs, are limited based upon recoverability without any consideration for anticipated investment income and are charged to operations ratably over the terms of the related policies.
Unearned premiums, commissions and service fees are calculated using the daily pro-rata method.
The Company applies the intrinsic value method in accordance with Accounting Principles Board Opinion No. 25 (APB No. 25), Accounting for Stock Issued to Employees, and its related interpretations for its accounting of stock compensation plans for employees. In accordance with the intrinsic value method prescribed by APB No. 25, compensation cost is measured as the excess, if any, of the fair value of the equity instrument awarded at the measurement date over the amount an employee must pay to acquire the equity instrument. Since options are granted at exercise prices equal to the fair value of the shares at the date of grant, no compensation expense is currently recognized.
Statement of Financial Accounting Standard, or SFAS, No. 148, Accounting for Stock-Based Compensations - Transition and Disclosure, permits entities to continue to apply the provisions of APB No. 25 and provide pro forma net income and pro forma earnings per share disclosures for employee stock option grants as
if the fair-value-based method, as defined in SFAS No. 123, Accounting for Stock-Based Compensation, had been applied. SFAS No. 148 provides alternative methods of transitioning to SFAS No. 123’s fair value method of accounting for stock-based employee compensation, but does not require companies to account for employee stock options using the fair value method. The Company has elected to continue to apply provisions of APB No. 25 and provide the pro forma disclosures required by SFAS No. 148.
The following table illustrates the effect on net income and earnings per share if the fair value based method described by SFAS No. 148 had been applied to all outstanding and unvested awards in each period. The fair value of each option granted during 2004, 2003 and 2002 is estimated on the date of grant using the minimum value method and the following assumptions: (a) risk free interest rate from 4.13% to 4.37%, (b) an expected life of 10 years and (c) no expected dividends. The weighted average per share fair value of options granted were $2.15, $0.64 and $0.53 for the years ended December 31, 2004, 2003 and 2002, respectively.
modified retrospective method. Under the modified prospective method, companies are required to record compensation cost for new and modified awards over the related vesting period of such awards prospectively and record compensation cost prospectively for the unvested option, at the date of adoption, of previously issued and outstanding awards over the remaining vesting period of such awards. No change to prior periods presented is permitted under the modified prospective method. Under the modified retrospective method, companies record compensation costs for prior periods retroactively through restatement of such periods using the exact pro forma amounts disclosed in the companies’ footnotes. Also, in the period of adoption and after, companies record compensation cost based on the modified prospective method. SFAS No. 123R is effective for periods beginning after June 15, 2005. Early application of SFAS 123R is encouraged, but not required.
The Company intends to use the modified prospective method to adopt SFAS No. 123R. If the Company were to adopt SFAS No. 123R on July 1, 2005, using the modified prospective method, the Company estimates that total stock-based compensation expense, net of related tax effects, will increase by $100 for the year ending December 31, 2005.
In February 2005, National Interstate Corporation completed an initial public offering in which it issued 3,350,000 shares and selling shareholders sold 1,074,000 shares at an initial offering price of $13.50 per share. Proceeds from the offering totaled approximately $40,600 after a deduction for the underwriting discount and offering expenses. Net proceeds were used to repay a loan from National Interstate’s majority shareholder, Great American Insurance Company, and with the remainder to be used for other general corporate purposes.
The amortized cost and fair value of investments in fixed maturities and preferred and common stocks are as follows:
The line of credit of $2,000 (unused at December 31, 2004) bears interest at the lending institution’s prime rate (5.25% at December 31, 2004 and 4.00% at December 31, 2003) less 50 basis points and requires an annual commitment fee of $1 thousand. In accordance with the terms of the line of credit agreement, interest payments are due monthly and the principal balance is due upon demand. In addition, the Company has agreed to refrain from assigning, conveying or otherwise transferring any security interest in the common shares of NIIC.
The term note is governed by a four-year, unsecured term loan agreement, which was executed in August 2002. The note was originally issued for $5,000 and bears interest at the bank’s prime rate (5.25% at December 31, 2004, 4.00% at December 31, 2003) less 50 basis points. The note is due in monthly principal installments of $104 plus interest. The term loan agreement contains certain covenants. At December 31, 2004 and 2003, the Company was in compliance with all of its loan covenants.
Interest paid in 2004, 2003 and 2002 was $1,380, $570 and $210, respectively.
NIIC is involved in both the cession and assumption of reinsurance. NIIC is a party to a reinsurance agreement, and National Interstate Insurance Agency (NIIA), a wholly-owned subsidiary, is a party to an underwriting management agreement with Great American. The reinsurance agreement calls for the assumption by NIIC of all of the risk on Great American’s net premiums written for public transportation and recreational vehicle risks and the payment by NIIC to Great American of a service fee based on these premiums. NIIA provides administrative services to Great American in connection with its underwriting of public transportation risks.
As of December 31, 2004, the Company had reinsurance recoverables (including prepaid reinsurance premiums) due from the following reinsurers that exceeded 3.0% of consolidated shareholders’ equity:
A reconciliation of federal income tax expense for financial reporting purposes and federal income tax expense calculated at the prevailing federal income tax rates of 35% for 2004 and 2003 and 34% for 2002 are as follows:
Federal income taxes paid for 2004, 2003 and 2002 were $11,600, $14,026 and $5,472.
The insurance company subsidiaries report to the various insurance departments using statutory accounting principles (SAP) prescribed or permitted by the applicable regulatory agency of the domiciliary commissioner. These principles as applied to the insurance subsidiaries of the Company differ principally from accounting principles generally accepted in the United States (GAAP) as follows:
Employees of the Company may participate in the National Interstate Savings and Profit Sharing Plan (the Savings Plan). Contributions to the profit sharing portion of the Savings Plan are made at the discretion of the Company and are based on a percentage of employees’ earnings after their eligibility date and vest after
Total rental expense (which includes utilities where charged by lessor) charged to operations for the years ended December 31, 2004, 2003 and 2002 were $353, $345 and $329, respectively.
Our insurance companies have lawsuits pending where the plaintiff seeks extra-contractual damages from us in addition to damages claimed under an insurance policy. These lawsuits generally mirror similar lawsuits filed against other carriers in the industry. Although we are vigorously defending these lawsuits, the lawsuits are in the early stages of litigation and their outcomes cannot be determined at this time. However, we do not believe these lawsuits will have a material adverse effect on our business, financial condition or results of operations based on our belief that any adverse outcomes have either been provided for in our loss reserves or such unfavorable result would be immaterial.
On August 5, 2004, the Board of Directors of the Company authorized a 200-for-1 common share split effective December 6, 2004. On October 18, 2004, the Board of Directors recommended and the shareholders approved an amendment and restatement of the Company’s Articles of Incorporation effective immediately prior to the Company’s initial public offering (IPO). Pursuant to this action, all Class A common shares were reclassified as common shares and 10 million shares of preferred stock are authorized. Historical financial information presented herein has been adjusted to give effect for these actions.
On October 18, 2004, the Board of Directors of the Company authorized the amendment and restatement of the Stock Option Plan into a Long Term Incentive Plan (LTIP). There were no incentive awards granted under the new LTIP in 2004.
The following are quarterly results of operations for the three years ended December 31, 2004: