Our corporate headquarters are located in Southfield, MI, where we lease approximately 20,000 square feet. We have approximately 25,000 square feet of additional office space in Southfield, MI in a building owned by FMIC. We also lease office space in Irvine, CA, Los Angeles, CA, Atlanta, GA, Chicago, IL, Boston, MA, New York, NY, Allen, TX, Seattle, WA, Conway, AR, and Scottsdale, AZ. We believe our current space is adequate for our current operations.
On August 17, 2005, we completed a transaction in which we formed a holding company (“Holdings”) to purchase shares of our common stock from certain FMFC stockholders, and to exchange shares and options with the remaining stockholders of FMFC. As a result of this transaction, Glencoe Capital, LLC became the majority stockholder of Holdings and Holdings became the controlling stockholder of FMFC. The purchase and exchange of shares was financed by the issuance of $65.0 million aggregate principal amount of senior rate notes by Holdings. As a result of this acquisition and resulting purchase accounting adjustments, the results of operations for periods prior to August 17, 2005 are not comparable to periods subsequent to that date. Holdings was merged into FMFC on October 16, 2006 and the senior notes were repaid in full with a portion of the net proceeds from our initial public offering.
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the consolidated financial statements and the related notes included elsewhere in this Form 10-K. The discussion and analysis below includes certain forward-looking statements that are subject to risks, uncertainties and other factors described in “Risk Factors” under Item 1A and elsewhere in this report that could cause actual results to differ materially from those expected in, or implied by, those forward looking statements.
We are a provider of insurance products and services to the specialty commercial insurance markets, primarily focusing on niche and underserved segments where we believe that we have underwriting expertise and other competitive advantages. During our 35 years of underwriting security risks, we have established CoverX (R) as a recognized brand among insurance agents and brokers and have developed significant underwriting expertise and a cost-efficient infrastructure. Over the last eight years, we have leveraged our brand, expertise and infrastructure to expand into other specialty classes of business, particularly focusing on smaller accounts that receive less attention from competitors.
On February 1, 2008, we acquired 100% of the issued and outstanding common stock of American Management Corporation. AMC is a managing general agency writing primarily commercial lines package policies focused primarily on the niche fuel-related marketplace. AMC distributes these insurance policies through a nationwide distribution system of independent general agencies. AMC underwrites these policies for third party
While net premiums earned is the related GAAP measure used in the statements of earnings, gross premiums written is the component of net premiums earned that measures insurance business produced before the impact of ceding reinsurance premiums, but without respect to when those premiums will be recognized as actual revenue. We use this measure as an overall gauge of gross business volume in our insurance underwriting operations with some indication of profit potential subject to the levels of our retentions, expenses, and loss costs.
We take into consideration the facts and circumstances for each claim filed as then known by our claims department, as well as actuarial estimates of aggregate unpaid losses and loss expenses based on our experience and industry data, and expected future trends in loss costs. The amount of unpaid losses and loss adjustment expense for reported claims, which we refer to as case reserves, is based primarily upon a claim by claim evaluation of coverage, and an evaluation of the following factors:
The Loss Development Method - based on paid and reported losses and loss adjustment expenses and loss and loss adjustment expense reporting and payment and reporting patterns; and
The Expected Loss Ratio Method - based on historical or industry experience, adjusted for changes in premium rates, coverage restrictions and estimated loss cost trends; and
For the specialty, contract underwriting and FM Emerald classes, we have relied primarily on the Bornhuetter-Ferguson Method in calculating our semi-annual reserve estimates. Although we use the Loss Development Method, we have not relied significantly on it as we are still building our experience database. We have also used the Expected Loss Ratio Method, which we have developed from industry loss cost information, adjusted for changes in premium rates, coverage restrictions, and estimated loss cost trends.
Commissions and Fees. Wholesale agency commissions and fee income from unaffiliated companies are earned at the effective date of the related insurance policies produced or as services are provided under the terms of the service provider contracts. Related commissions to retail agencies are concurrently expensed at the effective date of the related insurance policies produced. Profit sharing commissions due from certain insurance companies, based on losses and loss adjustment expense experience, are earned when determined and communicated by the applicable insurance company.
As mentioned above, the Company considers its intent and ability to hold a security until the value recovers as part of the process of evaluating whether a security’s unrealized loss represents an other-than-temporary decline. The Company’s ability to hold such securities is supported by sufficient cash flow from its operations and from maturities within its investment portfolio in order to meet its claims payment and other disbursement obligations arising from its underwriting operations without selling such investments. With respect to securities where the decline in value is determined to be temporary and the security’s value is not written down, a subsequent decision may be made to sell that security and realize a loss. Subsequent decisions on security sales are made within the context of overall risk monitoring, changing information and market conditions. Management of the Company’s investment portfolio is outsourced to third party investment managers, which is directed and monitored by the investment committee. While these investment managers may, at a given point in time, believe that the preferred course of action is to hold securities with unrealized losses that are considered temporary until such losses are recovered, the dynamic nature of the portfolio management may result in a subsequent decision to sell the security and realize the loss, based upon a change in market and other factors described above. The Company believes that subsequent decisions to sell such securities are consistent with the classification of the Company’s portfolio as available-for-sale.
are deferred, subject to ultimate recoverability, and expensed over the period in which the related premiums are earned. Investment income is included in the calculation of ultimate recoverability.
Premiums produced, which consists of all of the premiums underwritten by the Company’s underwriting platforms for which we take risk, for the year ended December 31, 2008 were $321.3 million, a $45.3 million, or 16%, increase over $276.0 million in premiums produced during the year ended December 31, 2007. Our three new niche specialty liability classes added during the second quarter of 2007 generated an increase of approximately $11.6 million in premiums produced. In addition, our new E&S underwriting platform, FM Emerald generated approximately $42.1 million in premiums produced, a $40.8 million increase over the $1.3 million produced during the year ended December 31, 2007. AUIC contributed approximately $6.7 million of premiums produced. These increases were offset by a decrease of $13.8 million in premiums produced from the Company’s specialty underwriting offices.
Ceded written premiums decreased $14.6 million, or 13%, and ceded earned premiums increased $29.4 million, or 39%, for the year ended December 31, 2008 compared to the year ended December 31, 2007. Ceded written premiums decreased principally due to purchasing 10% quota share reinsurance during the first quarter of 2008 and purchasing 15% quota share reinsurance during the remainder of 2008, while the Company purchased 35% quota share reinsurance from January 1, 2007 through September 30, 2007 and 25% quota share reinsurance from October 1, 2007 through December 31, 2007, offset somewhat by the purchase of 50% quota share reinsurance on a portion of the new niche specialty premiums and by the cutoff of two of the Company’s quota share reinsurance contracts whereby the reinsurers returned approximately $6.0 million in ceded unearned premiums. Ceded earned premiums increased primarily due to ceded written premiums continuing to be earned on the Company’s 2007 35% quota share reinsurance treaties, which were amended to 25% on October 1, 2007, while there were no ceded earned premiums related to the Company’s 2006 50% reinsurance treaties during the year months ended December 31, 2007 due to the termination of the 2006 50% quota share reinsurance treaties on a “cutoff” basis at December 31, 2006. The effect of the December 31, 2006 50% quota share cut-off reinsurance termination was to reduce ceded earned premiums for the year ended December 31, 2007 by approximately $39.6 million, and to increase net earned premiums by the same amount.
Losses and loss adjustment expenses incurred increased $19.8 million, or 22%, for the year ended December 31, 2008 compared to the year ended December 31, 2007. This increase was primarily due to the increase in net earned exposures reflected in the 15% increase in net earned premiums, an increase in the accident year loss and loss adjustment expense ratio from decreased premium rates and an increase in the expected loss ratio in a contract underwriting class of business, and $2.9 million from the impact of Hurricane Ike, reduced by $4.8 million in favorable development of December 31, 2007 and prior years’ loss and loss adjustment expense reserves. Losses and loss adjustment expenses for the year ended December 31, 2007 included approximately $0.8 million of favorable development of December 31, 2006 prior years’ loss and loss adjustment expense reserves.
During the year ended December 31, 2008, other operating expenses increased $34.5 million, or 84%, from the year ended December 31, 2007. Amortization of deferred acquisition expenses increased by $10.5 million, or 34%. Ceded reinsurance commissions decreased $8.2 million, or 20%, principally due to the effect of purchasing 10% quota share reinsurance from January 1, 2008 through March 31, 2008, and 15% quota share reinsurance from April 1, 2008 through December 31, 2008 compared to purchasing 35% quota share reinsurance from January 1, 2007 through September 30, 2007, and 25% quota share reinsurance from October 1, 2007 through December 31, 2007 and the return of $2.2 million of ceding commissions related to the cutoff of two of the Company’s quota share reinsurance contracts, offset by changes in ceding commission rates. Other underwriting and operating expenses, which consist of commissions, other acquisition costs, and general and underwriting expenses, net of acquisition cost deferrals, increased by $15.8 million, or 31%, principally due to an increase in commissions and other acquisition costs, offset by acquisition cost deferrals, and an increase in general and underwriting expenses during the year ended December 31, 2007.
Our effective tax rates were approximately 26.6% and 33.4% for the years ended December 31, 2008 and 2007, respectively. The decrease in the effective tax rate was primarily due to tax exempt income comprising a larger portion of our overall pre-tax income during the year ended December 31, 2008 compared to 2007.
The following table summarizes our results for the years ended December 31, 2007 and 2006:
Three new niche specialty liability classes added during the second quarter of 2007 and one new underwriter of an existing class added during the second quarter of 2007 generated approximately $30.1 million in premiums produced;
Assumed written premiums increased $8.3 million, or 192%, and assumed earned premiums increased $5.6 million or 150% for the year ended December 31, 2007 compared to the year ended December 31, 2006. These increases were primarily attributable to the admitted legal liability business written through a fronting insurer and the related increase in the assumed quota share from 30% to 100% on this fronted business.
Earned but unbilled premiums increased $1.9 million, or 132%, primarily due to the recognition of increased audit premium collection experience and growth in net retained earned premiums subject to premium audits.
Insurance underwriting commissions and fees decreased $1.1 million or 17% from the year ended December 31, 2006 to the year ended December 31, 2007. This was primarily the result of decreases in commissions on fronted programs.
During the year ended December 31, 2007, other operating expenses increased $14.7 million, or 56%, from the year ended December 31, 2006. Amortization of deferred acquisition expenses increased by $14.3 million, or 88%, including a $12.9 million increase related to the approximately $39.6 million in net premiums earned due to the termination on a “cut-off” basis of the 2006 50% quota share reinsurance treaties on December 31, 2006 and by an increase of $1.4 million related to remaining net earned premiums during the year ended December 31, 2007. Ceded reinsurance commissions increased $16.9 million, or 72%, principally due to the effect of the return in 2006 of $12.9 million related to the December 31, 2006 reinsurance “cut-off” transaction, the growth in ceded written premiums, and an increase in ceding commission rates offset by the effect of purchasing less quota share reinsurance during 2007. Other underwriting and operating expenses, which consist of commissions, other acquisition costs, and general and underwriting expenses, offset by acquisition cost deferrals, increased by $17.3 million, or 52%, principally due to an increase in commissions and other acquisition costs, and an increase in general and underwriting expenses during the year ended December 31, 2007.
Interest expense decreased $11.6 million, or 70%, from 2006 to 2007. This decrease was principally attributable to a decrease of $14.7 million related to the $65.0 million senior notes issued in August 2005 and repaid in October 2006. This decrease was offset by a $2.5 million increase in interest expense related to the junior subordinated debentures, of which $25.8 million were issued in December 2006 and $20.6 million were issued in September 2007 and an increase of $0.6 million in the change in fair value of the interest rate swap on junior subordinated debentures as is discussed in “Liquidity and Capital Resources.”
No dividends were paid to FMFC by our insurance subsidiaries during the years ended December 31, 2008, 2007 or 2006. Our insurance subsidiaries retained all of their earnings in order to support the increase of their written premiums, and we expect this retention of earnings to continue. Our insurance subsidiaries are restricted by statute as to the amount of dividends that they may pay without the prior approval of their domiciliary state insurance departments. Based on the policyholders’ surplus and the net income of our insurance subsidiaries as of December 31, 2008, FMIC, FMCC and AUIC may pay dividends in 2009, if declared, of up to $33.8 million without regulatory approval.
For 2007, net cash used in investing activities from continuing operations totaled $155.0 million, and was primarily invested in short-term, debt and equity securities. The $62.0 million increase in net cash used in investing activities for the year ended December 31, 2007 compared to the year ended December 31, 2006 was a result of $13.6 million less cash available from financing activities, a $73.8 million increase in operating cash flow, and an increase of $4.1 million in change in cash and cash equivalents.
For 2006, net cash used in investing activities from continuing operations totaled $93.0 million, and was primarily invested in short-term, debt and equity securities. The $6.2 million decrease in net cash used in investing activities for the year ended December 31, 2006 compared to the year ended December 31, 2005 was a result of $5.4 million less cash available from financing activities, a $0.7 million increase in operating cash flow, and an increase of $1.6 million in change in cash and cash equivalents.
For 2006, the $46.0 million of net cash provided by financing activities for the year ended December 31, 2006 was primarily attributable to the proceeds from our initial public offering, offset by the repurchase of common stock and the retirement of the senior notes.
Senior Notes. We had $65.0 million aggregate principal amount of senior notes outstanding, which were issued by Holdings in August 2005 in connection with the Holdings Transaction. The senior notes were set to mature on August 15, 2012, and bore interest at an annual rate, reset quarterly, equal to the three month LIBOR plus 8%. Interest was payable quarterly with $11.2 million of interest paid during the year ended December 31, 2006. On October 23, 2006, we repurchased all of the outstanding senior notes for $69.9 million, including accrued interest of $1.6 million and a prepayment penalty of $3.3 million.
Credit Facility. In October 2006, we entered into a credit facility which provided for borrowings of up to $30.0 million. Borrowings under the credit facility bear interest at our election as follows: (i) at a rate per annum equal to the greater of the lender’s prime rate and the federal funds rate less 0.5%, each minus 0.75%; or, (ii) a rate per annum equal to LIBOR plus an applicable margin which is currently 0.75% or 1.0% based on our leverage ratio. The obligations under the credit facility are guaranteed by our material non-insurance subsidiaries. The maturity date of borrowings made under the credit facility is September 2011. The credit facility contains covenants which, among other things, restrict our ability to incur indebtedness, grant liens, make investments and sell assets. The credit facility also has certain financial covenants. At December 31, 2008, there were no borrowings under the agreement. We are not required to comply with the financial-related covenants until we borrow under the credit facility. However, at December 31, 2008, the Company was in compliance with all of the covenants related to the credit facility.
In keeping with these goals, we maintain an investment portfolio consisting primarily of high grade fixed income securities. Our investment policy is developed by the investment committee of the board of directors of our insurance companies and is designed to comply with the regulatory investment requirements and restrictions to which our insurance subsidiaries are subject.
We utilize five investment managers, each with its’ own specialty. Each of these managers has authority and discretion to buy and sell securities subject to guidelines established by our investment committee. Management monitors the investment managers as well as our investment results with the assistance of an investment advisor that has been advising us since early 1990. Our investment advisor is independent of our investment managers and the funds in which we invest. Each manager is measured against a customized benchmark on a monthly basis. Investment performance and market conditions are continually monitored. The investment committee reviews our investment results at a minimum quarterly.
The majority of our portfolio consists of AAA or AA rated securities with a Standard and Poor’s weighted average credit quality for our aggregate fixed income portfolio of AA at December 31, 2008. The majority of the investments rated BBB and below are convertible securities and high yield corporate fixed income securities. Consistent with our investment policy, we review any security if it falls below BBB- and assess whether it should be
The Company invests in residential collateralized mortgage obligations (“CMO”) that typically have high credit quality, offer good liquidity and are expected to provide an advantage in yield compared to U.S. Treasury securities. The Company’s investment strategy is to purchase CMO tranches which offer the most favorable return given the risks involved. One significant risk evaluated is prepayment sensitivity. While prepayment risk (either shortening or lengthening of duration) and its effect on total return cannot be fully controlled, particularly when interest rates move dramatically, the investment process generally favors securities that control this risk within expected interest rate ranges. The Company does not purchase residual interests in CMO’s.
The Company’s fixed maturity investment portfolio included asset-backed securities and collateralized mortgage obligations collateralized by sub-prime mortgages and alternative documentation mortgages (“Alt-A”) with market values of $0.1 million and $1.5 million at December 31, 2008, respectively. The Company defines sub-prime mortgage-backed securities as investments with weighted average FICO scores below 650. Alt-A securities are defined by above-prime interest rates, high loan-to-value ratios, high debt-to-income ratios, low loan documentation (e.g., limited or no verification of income and assets), or other characteristics that are inconsistent with conventional underwriting standards employed by government-sponsored mortgage entities. The average credit rating on these securities at December 31, 2008 was BBB+.
The Company’s fixed maturity investment portfolio at December 31, 2008 included securities issued by numerous municipalities with a total carrying value of $210.4 million. Approximately $31.5 million, or 15%, were pre-refunded (escrowed with Treasuries). Approximately $104.9 million, or 49.8%, of the securities were enhanced by third-party insurance for the payment of principal and interest in the event of an issuer default (excluding those that are pre-refunded). Such insurance may result in a rating of AAA being assigned by independent ratings agencies to those securities. The downgrade of credit ratings of insurers of these securities could result in a corresponding downgrade in the ratings of the securities from AAA to the underlying rating of the respective security without giving effect to the benefit of insurance. Of the total $104.9 million of insured municipal securities
in the Company’s investment portfolio) at December 31, 2008 (excluding those that are pre-refunded), approximately 99.0% were rated at A- or above, and approximately 76.4% were rated at AA- or above, without the benefit of insurance. The average underlying credit rating of the entire municipal bond portfolio was AA at December 31, 2008. The Company believes that a loss of the benefit of insurance would not result in a material adverse impact on the Company’s results of operations, financial position or liquidity, due to the underlying credit strength of the issuers of the securities, as well as the Company’s ability and intent to hold the securities.
The most significant risk or uncertainty inherent in our assessment methodology is that the current credit rating of a particular issue changes over time. If the rating agencies should change their rating on a particular security in our portfolio, it could lead to a reclassification of that specific issue. The vast majority of our unrecognized impairment losses are investment grade and “AAA” or “AA” rated securities. Should the credit quality of individual issues decline for whatever reason then it would lead us to reconsider the classification of that particular security. Within the non-investment grade sector, we continue to monitor the particular status of each issue. Should prospects for any one issue deteriorate, we would potentially alter our classification of that particular issue.
The table below illustrates the breakdown of impaired securities by investment grade and non investment grade as well as the duration that these sectors have been trading below amortized cost. The average duration of the impairment has been greater than 12 months. The unrealized loss of impaired securities as a percent of the amortized cost of those securities is 8.1% as of December 31, 2008.
The majority of these securities are “AAA” or “AA” rated. These issues are continually monitored and may be classified in the future as being other than temporarily impaired.
The largest concentration of temporarily impaired securities is Commercial MBS at approximately 33.8% of the total loss. These securities are all AAA rated and have been affected primarily by the widening of spreads within this sector and/or the general level of interest rates. The next highest concentration of temporarily impaired securities is Corporate Bonds at 30.6% of the total loss. Within Corporate Bonds 99.4% are rated investment grade BBB or better, and their temporary impairment results primarily from the widening of credit spreads. The next highest concentration of temporarily impaired securities is CMOs at 15.8% of the total loss. Within CMOs 98.6% are rated AAA including the 73.4% of the CMO exposure that is agency issued, and have primarily been affected by the general level of interest rates as well.
For the year ended December 31, 2008, we sold approximately $17.3 million of market value of fixed income securities excluding convertibles, which were trading below amortized cost while recording a realized loss of $0.6 million. This loss represented 3.3% of the amortized cost of the positions. These sales were unique opportunities to sell specific positions due to changing market conditions. These situations were exceptions to our general assertion regarding our ability and intent to hold securities with unrealized losses until they mature or recover in value. This position is further supported by the insignificant losses as a percentage of amortized cost for the respective periods.
Losses and loss adjustment expenses. We maintain reserves to cover our estimated ultimate losses under all insurance policies that we write and our loss adjustment expenses relating to the investigation and settlement of policy claims. The reserves for losses and loss adjustment expenses represent our estimated ultimate costs of all reported and unreported losses and loss adjustment expenses incurred and unpaid at the balance sheet date. Our reserves reflect our estimates at a given time of amounts that we expect to pay for losses that have been reported, which are referred to as case reserves, and losses that have been incurred but not reported and the expected development of losses and allocated loss adjustment expenses on reported cases, which are referred to as IBNR reserves. In evaluating whether the reserves are reasonable for unpaid losses and loss adjustment expenses, it is necessary to project future losses and loss adjustment expense payments. Our reserves are carried at the total
Our reserves consist of reserves for property and liability losses, consistent with the coverages provided for in the insurance policies directly written or assumed by us under reinsurance contracts. In many cases, several years may elapse between the occurrence of an insured loss, the reporting of the loss to us and our payment of the loss. The estimation of ultimate liability for losses and loss adjustment expenses is an inherently uncertain process, requiring the use of informed estimates and judgments. Our loss and loss adjustment expense reserves do not represent an exact measurement of liability, but are estimates. Although we believe that our reserve estimates are reasonable, it is possible that our actual loss experience may not conform to our assumptions and may, in fact, vary significantly from our assumptions. Accordingly, the ultimate settlement of losses and the related loss adjustment expenses may vary significantly from the estimates included in our financial statements. We continually review our estimates and adjust them as we believe appropriate as our experience develops or new information becomes known to us. Such adjustments are included in current results of operations. For a further discussion of how we determine our loss and loss adjustment expense reserves and the uncertainty surrounding those estimates, see “- Critical Accounting Policies - Loss and Loss Adjustment Expense Reserves”.
During 2008, the Company experienced $4.8 million of favorable development in net prior accident year reserves. During 2008, favorable development of $2.4 million in our security classes consisted of $5.7 million of favorable development in the 2006-2007 accident years and unfavorable development of $3.3 million in the 2005 and prior accident years. The favorable development in the 2006-2007 accident years was attributable to lower than projected frequency and severity and favorable settlements on certain large claims. The unfavorable development in the 2000-2005 accident years was largely attributable to increases in Incurred But Not Reported reserves on these years to reflect anticipated development from construction defect exposures. During 2008, favorable development of $3.8 million in our specialty classes consisted of $9.5 million of favorable development in the 2006-2007 accident years and unfavorable development of $5.7 million in the 2005 and prior accident years. The favorable development in the 2006-2007 accident years was attributable to lower than projected frequency and severity and
favorable settlements on certain large claims. The unfavorable development in the 2000-2005 accident years was attributable to increases in Incurred But Not Reported reserves on these years to reflect anticipated development from construction defect exposures. During 2008, adverse development of $1.3 million in our contract underwriting classes consisted of $2.5 million of adverse development in the 2006-2007 accident years and favorable development of $1.2 million in the 2005 accident year. The adverse development in the 2006-2007 accident years was attributable to higher than projected severity. The favorable development in the 2005 accident year was attributable to lower than projected severity. Net adverse development of $0.1 million in unallocated loss adjustment expenses was recorded for the 2000-2007 accident year.
During 2006, the Company experienced approximately $1.1 million in net prior year reserve development principally in the 2000 accident year, offset somewhat by favorable development on prior years unallocated loss adjustment expense reserves. The development on accident year 2000 reserves was concentrated primarily in the safety equipment class as a result of obtaining new information on several high severity cases.
The first line of the table shows, for the years indicated, the net reserve liability including the reserve for incurred but not reported losses as originally estimated. For example, as of December 31, 1998 it was estimated that $32.0 million would be a sufficient reserve to settle all claims not already settled that had occurred prior to December 31, 1998, whether reported or unreported to our insurance subsidiaries.
The next section of the table sets forth the re-estimates in later years of incurred losses, including payments, for the years indicated. For example, as reflected in that section of the table, the original reserve of $32.0 million was re-estimated to be $19.3 million at December 31, 2008. The increase/decrease from the original estimate would generally be a combination of factors, including:
more or fewer claims being reported after December 31, 1998 than had been reported before that date.
The “cumulative redundancy (deficiency)” represents, as of December 31, 2008, the difference between the latest re-estimated liability and the reserves as originally estimated. A redundancy means that the original estimate was higher than the current estimate for reserves; a deficiency means that the current estimate is higher than the original estimate for reserves. For example, because the reserves established as of December 31, 1998 at
The next section of the table shows, by year, the cumulative amounts of losses and loss adjustment expenses paid as of the end of each succeeding year. For example, with respect to the net losses and loss expense reserve of $32.0 million as of December 31, 1998 by December 31, 2008 (ten years later) $19.1 million actually had been paid in settlement of the claims which pertain to the reserve as of December 31, 1998.
From 2000 through 2004, the reserves gave greater weight to loss development patterns from our historical experience through 1998, and were adjusted for differences between actual and expected development as losses and loss adjustment expenses emerged. During 2005, a significant amount of adverse development occurred related to accident years 2000 through 2002, and our insurance subsidiaries increased their reserves accordingly. In addition, we increased our reserves applicable to other specialty classes, principally as a result of using updated industry loss development factors, which became available during 2005, in the calculations of ultimate expected losses and reserves on other specialty classes.
During 2006, the Company experienced approximately $1.1 million in net prior year reserve development primarily in the 2000 accident year, offset somewhat by favorable development on prior years unallocated loss adjustment expense reserves. The development on accident year 2000 reserves was concentrated primarily in the safety equipment class as a result of obtaining new information on several high severity cases.
During 2008, the Company experienced approximately $4.8 million of favorable development in net prior year reserves, with $12.6 million of favorable development in the 2006 and 2007 accident years due to lower than expected claim frequency along with lower than expected severity, offset somewhat by increases in Incurred But Not Reported reserves in the 2005 and prior accident years to reflect anticipated loss development from construction defect exposures.
American Constantine Insurance Company (“ACIC”) does not carry an A.M. Best rating. The net amount of recoverables from ACIC at December 31, 2008 is fully collateralized by a grantor trust and irrevocable letter of credit.
In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS 157”), which defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. This statement is effective for fiscal years beginning after November 15, 2007. However, on February 12, 2008, the FASB issued FASB Staff Position No. FAS 157-2, “Effective Date of FASB Statement No. 157” (“FSP FAS 157-2”), which delays the effective date of SFAS 157 for nonfinancial assets and nonfinancial liabilities, except for items that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually). FSP FAS 157-2 defers the effective date of SFAS 157 to fiscal years beginning after November 15, 2008, and interim periods within those fiscal years for items within the scope of FSP FAS 157-2. The Company adopted the applicable portions of SFAS 157 on January 1, 2008 (See Note 17 to the consolidated financial statements, which is incorporated herein by reference) and is currently assessing the potential impact that the deferred portions of SFAS 157 will have on its financial statements. In October 2008, the FASB issued FSP FAS 157-3, “Determining the Fair Value of a Financial Asset When the Market For That Asset Is Not Active” (“FSP FAS 157-3”), with an immediate effective date, including prior periods for which financial statements have not been issued. FSP FAS 157-3 amends FAS 157 to clarify the application of fair value in inactive markets and allows for the use of management’s internal assumptions about future cash flows with appropriately risk-adjusted discount rates when relevant observable market data does not exist. The objective of FAS 157 has not changed and continues to be the determination of the price that would be received in an orderly
In December 2007, the FASB issued SFAS No. 141(R), “Business Combinations” (“SFAS 141(R)”). SFAS 141(R) establishes principles and requirements for how an acquirer recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, any noncontrolling interest in the acquiree, and the goodwill acquired. SFAS 141(R) also establishes disclosure requirements to enable the evaluation of the nature and financial effects of the business combination. SFAS 141(R) is effective for fiscal years beginning after December 15, 2008. The adoption of SFAS 141(R) will change our accounting treatment for business combinations on a prospective basis beginning January 1, 2009.
In March 2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities - an amendment of FASB Statement No. 133” (“SFAS 161”). SFAS 161 changes the disclosure requirements for derivative instruments and hedging activities. Entities are required to provide enhanced disclosures about a) how and why an entity uses derivative instruments, b) how derivative instruments and related hedged items are accounted for under Statement 133 and its related interpretations, and c) how derivative instruments and related hedged items affect an entity’s financial position, financial performance, and cash flows. Companies are required to adopt SFAS 161 for fiscal years beginning after November 15, 2008. The Company is currently evaluating the potential impact, if any, of the adoption of SFAS 161 on its financial statements.
In January 2009, the FASB issued FASB Staff Position (FSP) EITF 99-20-1, “Amendments to the Impairment Guidance of EITF Issue No. 99-20” (FSP EITF 99-20-1), which is effective for interim and annual periods ending after December 15, 2008. FSP EITF 99-20-1 amends EITF 99-20,“Recognition of Interest Income and Impairment
on Purchased Beneficial Interests and Beneficial Interests That Continue to Be Held by a Transferor in Securitized Financial Assets”(EITF 99-20), to align the impairment guidance in EITF 99-20 with the impairment guidance in FAS 115, “Accounting for Certain Investments in Debt and Equity Securities.” FSP EITF 99-20-1 amends the cash flows model used to analyze an other-than-temporary impairment under EITF 99-20 by replacing the market participant view with management’s assumption of whether it is probable that there is an adverse change in the estimated cash flows. The adoption of FSP EITF 99-20-1 in the fourth quarter did not have a material effect on the Company’s results of operations, financial position or liquidity.
Consolidated Statements of Income For the years ended December 31, 2008, 2007 and 2006
Consolidated Statements of Cash Flows For the years ended December 31, 2008, 2007 and 2006
We have audited the accompanying consolidated balance sheets of First Mercury Financial Corporation and Subsidiaries as of December 31, 2008 and 2007 and the related consolidated statements of income, stockholders’ equity and cash flows for each of the three years in the period ended December 31, 2008. In connection with our audits of the financial statements, we have also audited the financial statement schedules listed in the accompanying index. These financial statements and schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), First Mercury Financial Corporation and Subsidiaries’ internal control over financial reporting as of December 31, 2008, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and our report dated March 10, 2009 expressed an unqualified opinion thereon.
The consolidated financial statements include the results of FMFC and its subsidiaries. FMFC’s subsidiaries are First Mercury Insurance Company (“FMIC”), First Mercury Casualty Company (“FMCC”) (formerly All Nation Insurance Company (“ANIC”)), CoverX Corporation (“CoverX”), Quantum Direct Service Corporation (“QDSC”), Questt Agency, Inc. (“Questt”), First Mercury Emerald Insurance Services, Inc. (“FM Emerald”) (formerly Quantum Insurance Agency, Inc. (“QIA”)), Van-American Insurance Services, Inc. (“VAIS”) and American Management Corporation (“AMC”) and its subsidiaries, American Underwriters Insurance Company (“AUIC”) and AMC Re, Inc. (“AMC Re”), collectively referred to as “the Company.” All significant intercompany transactions have been eliminated upon consolidation
CoverX (incorporated in the State of Michigan) is a wholesale insurance agency producing commercial lines (primarily general liability) business on primarily an excess and surplus lines basis for non-affiliated insurers and for FMIC and FMCC. VAIS (incorporated in the State of Alabama) is an inactive retail and wholesale insurance agency.
FM Emerald (incorporated in the State of Illinois) is a wholesale insurance agency producing commercial lines business on primarily an excess and surplus lines basis for CoverX via a producer agreement.
Credit Risk is the risk that issuers of securities owned by the Company will default or other parties, including reinsurers, which owe the Company money, will not pay. The Company minimizes this risk by adhering to a conservative investment strategy and by maintaining sound reinsurance and credit and collection policies.
Interest Rate Risk is the risk that interest rates will change and cause a decrease in the value of an insurer’s investments or an increase in the Company’s interest expense due on its long-term debt. The Company mitigates this risk related to investments by attempting to match the maturity schedule of its assets with the expected payout of its liabilities. To the extent that liabilities come due more quickly than assets mature, the Company would have to sell assets prior to maturity and recognize a gain or loss. At December 31, 2008 and 2007, the estimated market value of the Company’s bond portfolio was lower than its cost. The Company mitigates this risk related to its floating rate junior subordinated debentures by entering into interest rate swap agreements, which fix the interest rate on long-term debt (see Note 8).
The Company considers all short-term investments with a maturity date of three months or less from the date of purchase to be cash equivalents. The carrying amount approximates market value because of the short maturity of those instruments.
On January 1, 2007, the Company elected to adopt the fair value provisions of SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments” (“SFAS 155”) for all of its convertible securities which were previously accounted for as embedded derivatives in accordance with SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”). The Company adopted SFAS 155 in order to simplify the accounting for these convertible securities. SFAS No. 155 permits entities to account for financial instruments with an embedded derivative at fair value, thus negating the need to bifurcate the instrument between its host and the embedded derivative. The changes in fair value related to the designated hybrid instruments are recorded in Net realized gains (losses) on investments in the Consolidated Statements of Income.
During 2008, the company invested $10.0 million in a high yield convertible securities limited partnership and $5.0 million in a distressed structured finance products limited partnership. The Company elected the fair value
Components of intangible assets at December 31, 2008 and 2007 consist of the following:
On June 27, 2008, the Company sold all of the outstanding capital stock of ARPCO Holdings, Inc. and its subsidiaries. The Company disposed of the net intangible assets related to ARPCO, which were $7.2 million at December 31, 2007.
Our non-amortizing intangible assets consist of the trade name for CoverX and the state/jurisdiction licenses to conduct insurance operations, as it is expected that these intangibles will contribute to cash flows indefinitely. The trade name and the state/jurisdiction licenses have been in existence for many years and there is no foreseeable limit on the period of time over which they are expected to contribute cash flows. Aggregate amortization expense related to intangible assets was $2.0 million, $0.7 million, and $0.7 million for the years ended December 31, 2008, 2007, and 2006, respectively. Approximately $0.3 million, $0.5 million, and $0.6 million of amortization expense for the years ended December 31, 2008, 2007, and 2006, respectively, related to ARPCO was reclassified to Discontinued Operations. The weighted-average remaining useful life is 13.9 years. Estimated amortization expense for each of the next five years is as follows:
The calculation of federal income taxes involves dealing with uncertainties in the application of complex tax regulations. On January 1, 2007, the Company adopted FASB Interpretation No. 48 “Accounting for Uncertainty in Income Taxes, an Interpretation of SFAS No. 109” (“FIN 48”). As a result of the implementation of FIN 48, we
recognize liabilities for uncertain tax positions based on the two-step process prescribed in the interpretation. The first step is to evaluate the tax position for recognition by determining if the weight of available evidence indicates that it is more likely than not that the position will be sustained on audit, including resolution of related appeals or litigation processes, if any. The second step requires us to estimate and measure the tax benefit as the largest amount that is more than 50% likely to be realized upon ultimate settlement. It is inherently difficult and subjective to estimate such amounts, as we have to determine the probability of various possible outcomes. We reevaluate these uncertain tax positions on a quarterly basis. This evaluation is based on factors including, but not limited to, changes in facts or circumstances, changes in tax law, effectively settled issues under audit, and new audit activity. Such a change in recognition or measurement would result in the recognition of a tax benefit or an additional charge to the tax provision.
In December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements - an amendment of Accounting Research Bulletin No. 51” (“SFAS 160”). SFAS 160 establishes accounting and reporting standards for ownership interests in subsidiaries held by parties other than the parent, the amount of consolidated net income attributable to the parent and to the noncontrolling interest, changes in a parent’s ownership interest, and the valuation of retained noncontrolling equity investments when a subsidiary is deconsolidated. SFAS 160 also establishes disclosure requirements that clearly identify and distinguish between the interests of the parent and the interests of the noncontrolling owners. SFAS 160 is effective for fiscal years beginning after December 15, 2008. The Company does not expect the adoption of SFAS 160 to have a material impact on its consolidated financial statements.
In January 2009, the FASB issued FASB Staff Position (FSP) EITF 99-20-1, “Amendments to the Impairment Guidance of EITF Issue No. 99-20” (FSP EITF 99-20-1), which is effective for interim and annual periods ending after December 15, 2008. FSP EITF 99-20-1 amends EITF 99-20, “Recognition of Interest Income and Impairment on Purchased Beneficial Interests and Beneficial Interests That Continue to Be Held by a Transferor in Securitized Financial Assets” (EITF 99-20), to align the impairment guidance in EITF 99-20 with the impairment guidance in FAS 115, “Accounting for Certain Investments in Debt and Equity Securities.” FSP EITF 99-20-1 amends the cash flows model used to analyze an other-than-temporary impairment under EITF 99-20 by replacing the market participant view with management’s assumption of whether it is probable that there is an adverse change in the estimated cash flows. The adoption of FSP EITF 99-20-1 in the fourth quarter did not have a material effect on the Company’s results of operations, financial position or liquidity.
The following table represents the preliminary allocation of the purchase price to assets acquired and liabilities assumed at the acquisition date:
The amortized cost, gross unrealized gains and losses, and market value of marketable investment securities classified as available-for-sale at December 31, 2008 by major security type were as follows:
The amortized cost and market value of debt securities classified as available-for-sale, by contractual maturity, as of December 31, 2008 are shown below. Actual maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Additionally, the expected maturities of the Company’s investments in putable bonds fluctuate inversely with interest rates and therefore may also differ from contractual maturities.
At December 31, 2008, 25.3% of the Company’s total investment portfolio was in an unrealized loss position and was determined by management to be temporarily impaired. Of the securities which were impaired, 20.5% had been impaired for more than 12 months, and the unrealized losses on these investments was 13.6% of their total market value. Positive evidence considered in reaching the Company’s conclusion that the investments in an unrealized loss position are not other-than temporarily impaired consisted of: (1) there were no specific events which caused concerns; (2) there were no past due interest payments or other significant credit related events; (3) the Company’s ability and intent to retain the investment for a sufficient amount of time to allow an anticipated
recovery in value; and (4) the Company also determined that the changes in market value were considered normal in relation to overall fluctuations in interest rates.
The fair value and amount of unrealized losses segregated by the time period the investment had been in an unrealized loss position is as follows at December 31, 2008:
Our income tax rate percentage on income from continuing operations is reconciled to the U.S. federal statutory tax rate as follows:
The Company has arranged for the sale of trust preferred securities (“Trust Preferred Securities”) through First Mercury Capital Trust I, First Mercury Capital Trust II, First Mercury Capital Trust III, and First Mercury Capital Trust IV (each a “Trust”; collectively the “Trusts”). Each trust was created solely for the purpose of issuing Trust Preferred Securities. In accordance with FASB Interpretation No. 46, “Consolidation of Variable Interest entities, an interpretation of ARB No. 51”, (“FIN 46”), the Trusts have not been consolidated with the Company in these financial statements.
Trust Preferred Securities are the sole liabilities of each Trust. The Company purchased all of the outstanding common stock of the Trusts, and the Company’s investment in the Trusts is included in other assets in the accompanying Consolidated Balance Sheets.
The Trust Preferred Securities are subject to mandatory redemption in a like amount (1) upon repayment of all of the Junior Subordinated Debt on the stated maturity date, (2) contemporaneously with the optional prepayment of all of the Junior Subordinated Debt by the Company in conjunction with a special event (as defined) and (3) five years or more after the issue date, contemporaneously with the optional prepayment, in whole or in part, of the Junior Subordinated Debt.
No borrowings were outstanding under the revolving credit agreement at December 31, 2008 or 2007.
The Company has entered into two interest rate swap agreements in order to fix the interest rate on its First Mercury Capital Trust I and First Mercury Capital Trust II and thereby reduce the exposure to interest rate fluctuations. At December 31, 2008, the interest rate swaps had a combined notional amount of $20.0 million. Under these agreements, the Company will pay the counterparty interest at a fixed rate of 4.12%, and the counterparty will pay the Company interest at a variable rate equal to three months LIBOR until expiration in August 2009. The notional amount does not represent an amount exchanged by the parties, and thus is not a measure of exposure of the Company. The variable rate is subject to change over time as LIBOR fluctuates. The Company does not account for these swap agreements as a cash flow hedge, thus the change in the fair value of these agreements are included in Change in Fair Value of Derivative Instruments on the Consolidated Statements of Income, which is not a significant amount for each of the periods presented.
The Company accounts for this third interest rate swap as a cash flow hedge whereby the change in fair value of the interest rate swap is recorded in other comprehensive income, net of taxes. The fair values of the interest rate swap liabilities were $2.8 million and $1.0 million as of December 31, 2008 and 2007, respectively.
Neither the Company nor the counterparty, which is a major U.S. bank, is required to collateralize its obligation under these three swap agreements. The Company is exposed to loss if the counterparty should default. At December 31, 2008, the Company had no exposure to credit loss on the interest rate swaps. The Company does not believe that any reasonably likely change in interest rates would have a materially adverse effect on the financial position, the results of operations or cash flows of the Company.
During 2008, the Company experienced approximately $4.8 million of favorable development in net prior year reserves, with favorable development in the 2006 and 2007 accident years offset somewhat by increases in Incurred But Not Reported reserves in the 2005 and prior accident years.
The Company manages its credit risk on reinsurance recoverables by reviewing the financial stability, A.M. Best rating, capitalization, and credit worthiness of prospective and existing risk-sharing partners. The Company customarily collateralizes reinsurance balances due from non-admitted reinsurers through funds withheld trusts or stand-by letters of credit issued by highly rated banks. The largest unsecured reinsurance recoverable is due from an admitted reinsurer with an A.M. Best rating of “A+” and accounts for 40.0% of the total recoverable from reinsurers.
Interest cost on reinsurance contracts accounted for on a funds withheld basis is incurred during all periods in which a funds withheld liability exists or as otherwise specified under the terms of the contract and is included in Underwriting, agency and other expenses. The amount subject to interest crediting rates was $21.6 million and $18.1 million at December 31, 2008 and 2007, respectively.
and paid $1.1 million in full satisfaction of all amounts owed under the consulting agreement. The Company recorded consulting expense of $1.8 million and $1.0 million for the years ended December 31, 2008 and 2007 related to this agreement.
In connection with the Company’s initial public offering, the Company increased the number of authorized shares of par value $0.01 Series A Convertible Preferred Stock to 10,000,000. None of these shares were issued or outstanding at December 31, 2008 or 2007.
The Company’s insurance company subsidiaries, FMIC, FMCC and AUIC, are limited in their ability to pay dividends to FMFC. FMIC may declare and pay dividends according to the provisions of the Illinois Insurance Holding Company Systems Act, which provides that, without prior approval of the Illinois Insurance Department, dividends may not exceed the greater of 10% of FMIC’s policyholders’ surplus on the most recent annual statutory financial statement filed with the State of Illinois or net income after taxes for the prior year. In 2009, FMIC’s dividends may not exceed approximately $30.1 million.
AUIC may declare and pay dividends according to the provisions of the Arkansas Insurance Holding Company Systems Act, which provides that, without prior approval of the Arkansas Insurance Department, dividends may not exceed the greater of 10% of AUIC’s policyholders’ surplus on the most recent annual statutory financial statement filed with the State of Arkansas or net income, excluding capital gains, for the current year. AUIC can pay dividends of approximately $0.5 million in 2009.
During the twelve months ended December 31, 2008, the Company granted 55,500 shares of restricted stock to employees under the Omnibus Plan. The stock options and shares of restricted stock vest in three equal installments over a period of three years. Stock-based compensation will be recognized over the expected vesting period of the stock options and shares of restricted stock. During the twelve months ended December 31, 2008, the Company granted 12,124 shares of restricted stock to non-employee directors under the Omnibus Plan. These shares of
restricted stock vested immediately, but are not transferable for one year after the grant date, and stock-based compensation was recognized immediately. For the year ended December 31, 2007, the Company granted 323,688 stock options to employees and 20,148 shares of restricted stock to non-employee directors and employees under the Omnibus Plan. Shares available for future grants under the Omnibus Plan totaled 476,740 at December 31, 2008.
A summary of the Company’s stock option activity was as follows:
The number of stock option awards outstanding and exercisable at December 31, 2008 by range of exercise prices was as follows:
For 2008 and 2007, the expected term of options was determined based on the simplified method from SEC Staff Accounting Bulletin 107 (“SAB 107”), as amended by Staff Accounting Bulletin 110 (“SAB 110”). Expected stock price volatility was based on an average of the volatility factors utilized by companies within the Company’s peer group with consideration given to the Company’s historical volatility. Prior to the adoption of FASB Statement No. 123(R), “Share-Based Payments” (“SFAS 123(R)”) the expected term was based on the contractual term of the award and price volatility was not utilized in the Company’s calculation. The risk-free interest rate is based on the yield of U.S. Treasury securities with an equivalent remaining term. The Company has not paid dividends in the past.
The assumptions used to calculate the fair value of options granted are evaluated and revised, as necessary, to reflect market conditions and the Company’s historical experience and future expectations. The calculated fair value is recognized as compensation cost in the Company’s financial statements over the requisite service period of the entire award. Compensation cost is recognized only for those options expected to vest, with forfeitures estimated at the date of grant and evaluated and adjusted periodically to reflect the Company’s historical experience and future expectations. Any change in the forfeiture assumption is accounted for as a change in estimate, with the cumulative effect of the change on periods previously reported being reflected in the financial statements of the period in which the change is made. The Company recognized stock-based compensation expense of $2.2 million, $1.1 million, and $0.8 million, for the years ended December 31, 2008, December 31, 2007, and December 31, 2006, respectively.
The National Association of Insurance Commissioners (NAIC) has established risk-based capital models to measure the adequacy of capitalization for insurance companies. The model calculates minimum capital requirements for each insurer based on certain criteria, including investment risk, underwriting profitability and losses and loss adjustment expense risk. As of December 31, 2008, 2007, and 2006, FMIC, FMCC and AUIC exceeded the minimum capital requirements determined by the NAIC’s risk-based capital models.
The Company maintains an employer-sponsored 401(k) plan. All employees are eligible to participate in the plan on the first day of the calendar quarter following 30 days of service and having attained 21 years of age. Employer contributions are voluntary and are allocated based upon the participants’ compensation and contribution levels. Vesting in the plan is immediate. The Company’s expense for this plan was approximately $0.5 million for the year ended December 31, 2008, $0.3 million for the year ended December 31, 2007, and $0.3 million for the year ended December 31, 2006.
Our available-for-sale investment portfolio consists of fixed maturity and equity securities and short-term investments, and is recorded at fair value in the accompanying Consolidated Balance Sheets in accordance with FASB Statement No. 115, “Accounting for Certain Investments in Debt and Equity Securities” (“SFAS 115”). The change in the fair value of these investments is recorded as a component of Other comprehensive income (loss).
Level 1 - Valuations based on unadjusted quoted market prices in active markets for identical securities. The fair values of fixed maturity and equity securities and short-term investments included in the Level 1 category were based on quoted prices that are readily and regularly available in an active market. The Level 1 category includes publicly traded equity securities, highly liquid U.S. Government notes, treasury bills, highly liquid cash management funds, and short-term certificates of deposit.
from Level 2 to Level 3. In addition, one asset-backed security collateralized by home equity loans was internally valued and was transferred from Level 2 to Level 3.
The Company uses derivatives to hedge its exposure to interest rate fluctuations. For these derivatives, the Company uses quoted market prices to estimate fair value and includes the estimate as a Level 2 measurement.
The Company’s financial instruments include investments, cash and cash equivalents, premiums and reinsurance balances receivable, reinsurance recoverable on paid losses and long-term debt. At December 31, 2008, the carrying amounts of the Company’s financial instruments, including its derivative financial instruments, approximated fair value, except for the $67.0 million of the Company’s junior subordinated debentures. The fair value of these junior subordinated debentures is estimated to be $28.6 million at December 31, 2008. The estimate of fair value for the Company’s junior subordinated debentures is a Level 3 measurement. We used a discounted cash flow model based on the contractual terms of the junior subordinated debentures and a discount rate of 15%, which was based on yields of comparable securities. The fair values of the Company’s investments, as determined by quoted market prices, are disclosed in Note 3.
The operating results of discontinued operations included in the accompanying Consolidated Statements of Income are as follows: