During February 2007, A.M. Best upgraded the financial strength rating of our insurance subsidiaries to A- (Excellent) with a stable outlook from a financial strength rating of B++ (Good) with a stable outlook. During October 2007, Fitch reaffirmed the A- (strong) insurer financial strength rating assigned to our insurance subsidiaries.
Our consolidated net income for 2007 decreased 1 percent compared with 2006. Our consolidated income from continuing operations for 2007 increased 55 percent compared with 2006. See the discussion below of certain factors, including, among other things, the PRI commutation, the sale of our insurance management operations in 2006, favorable prior year loss development and guaranty fund assessments that affect the comparability of our results from different periods.
Book value per common share increased 17 percent to $33.03 as of December 31, 2007 from $28.34 as of December 31, 2006. The statutory surplus of our insurance subsidiaries increased 16 percent to $261.6 million as of December 31, 2007 compared to $226.0 million as of December 31, 2006.
In addition, our insurance subsidiaries may become subject to claims for extra-contractual obligations (“ECO”) or risks in excess of policy limits (“XPL”) in connection with their insurance claims, particularly in Florida. These claims are sometimes referred to as “bad faith” actions as it is alleged that the insurance company acted in bad faith in the administration of a claim against an insured. Bad faith actions generally occur in instances where a jury verdict exceeds the insured’s policy limits. Under such circumstances, it is routinely alleged that the insurance company failed to negotiate a settlement of a claim in good faith within the insured’s policy limit. Our liability for losses and LAE includes an estimate for potential ECO/XPL claims. Within the Florida market for MPL insurance, the magnitude of ECO/XPL payments has increased and is expected to continue to be a significant source of uncertainty in establishing reserves. An award for an ECO/XPL claim against one of our insurance subsidiaries in excess of the applicable reinsurance could have an adverse effect on our consolidated financial condition and results of operations.
We also utilize and evaluate calculations contained in an actuarial study performed by an independent actuarial firm to corroborate the adequacy of our carried reserves. Our best estimate may differ from the selected reserve estimate of our independent actuary because of differences in evaluating such things as the impact of historical experience, legal and regulatory changes, expectations about future claim results and trends and certain other factors as discussed below. While our assessment may differ, our carried reserves remain within a reasonable actuarial range of the independent actuary’s selected reserve estimate. The independent review of our reserves plays an important role in our overall assessment of the adequacy of our reserves. A typical range of reasonable values for MPL business is considered to be as wide as 15 percent. Therefore, in addition to the performance of the business itself, our financial condition, results of operations and cash flows are sensitive to our reserve estimates and judgments. Our range developed for our loss and LAE reserves, net of reinsurance, at December 31, 2007 was $387.5 million to $450.3 million. The reserve opinions of our independent actuary for the year ended December 31, 2007 will be filed with state insurance regulators along with the statutory financial statements of our insurance companies. The reserve opinions of our independent actuary for the year ended December 31, 2006 have been filed with state insurance regulators along with the statutory financial statements of our insurance companies.
In considering the potential sensitivity of the factors and assumptions underlying management’s best estimate of loss and LAE reserves, it is also important to understand that the MPL sector of the property casualty insurance industry is characterized by a relatively small number of claims with a large average cost per claim. For instance:
In 2006, we paid a total of $66.4 million in loss payments (indemnity only), excluding the impact of commuted reinsurance agreements, on 322 claims.
Given the magnitude of our reserves and these characteristics, even a relatively small change in the number of claims we expect to pay (i.e., frequency) or a relatively small percentage change in the average cost per claim (i.e., severity) could have a significant impact on our reserves and, correspondingly, our financial position, results of operations and cash flows. This is the case for other key assumptions as well, such as the frequency of reported claims and incidents that will ultimately close with an indemnity payment versus those that will close without an indemnity payment. In addition, due to the relatively small number of claims ultimately resulting in an indemnity payment and the average cost per claim, any change in the trends assumed in the ultimate values for these factors could result in a significant change in our reserve estimates. Because our aggregate loss and LAE reserves are so large, this also means that virtually any change in the level of our carried reserves will be material to our results of operations and may be material to our financial position.
During May 2005, First Professionals and APAC entered into agreements to commute their percent quota share reinsurance ceded to American Professional Assurance, Ltd. (“APAL”). Under the terms of the agreement, First Professionals and APAC assumed loss and LAE reserves previously ceded of approximately $10.2 million and received a comparable amount of assets in the form of cash and investments, resulting in no material gain or loss on the transaction.
As the table below indicates, our reserve estimates can vary over time based on actual results and our assessment of the impact of recent conditions and trends. For example, the cumulative net reserves carried at the end of calendar years 1997 and 1998 have been higher than subsequent payments and re-estimates and have developed downward (i.e., redundantly). In contrast, net reserves at the end of calendar years 1999 through 2003 have increased from the amounts initially carried and have developed upward (i.e., deficiently). Improvements in recent years have resulted in a redundancy in the cumulative net reserves carried at the end of 2007 as compared to our prior estimates. The following factors have contributed to the variation in our historical loss development:
For accident years 1998 through 2004, we experienced adverse development related to an assumed reinsurance program. This reinsurance program has been in run-off since 2004 and was commuted effective January 1, 2007 as discussed in Note 4, Liability for Loss and LAE and Note 5, Reinsurance to the notes to the consolidated financial statements presented elsewhere herein.
Investments - Our invested assets comprise our largest single asset class and consist primarily of investment securities in the form of fixed income securities. Our fixed income securities, equity investments and short-term investments are carried at their fair values and accounted for $705.6 million or 99 percent of our total investments and 66 percent of our total assets as of December 31, 2007, compared to $720.7 million or 99 percent of our total investments and 59 percent of our total assets as of December 31, 2006. Fair value is determined using the quoted market price of these securities provided by either independent pricing services, or when such prices are not available, by reference to broker or underwriter bid indications. Unrealized gains or losses in their fair values are recorded directly in shareholders’ equity, net of tax effects, as a component of accumulated other comprehensive (loss) income. Gross unrealized investment gains were $5.2 million and gross unrealized investment losses were $5.5 million as of December 31, 2007.
GAAP requires that the book value of investments be written down to fair value when declines in value are considered other-than-temporary. When such impairments occur, the decrease in value is reported in net income as a realized investment loss and a new cost basis is established. For the years ended December 31, 2007 and 2005, we recorded pre-tax charges to earnings for investments that were other-than-temporarily impaired of $1.1 million and $0.7 million, respectively. Approximately $0.8 million of the other-than-temporary impairment in 2007 related to an investment in a limited partnership, with the remaining $0.3 million relating to certain fixed income securities. The impairment in 2005 related solely to fixed income securities. No investment impairments were recorded during 2006. We evaluate our investment portfolio on a quarterly basis to identify securities that may be other-than-temporarily impaired. Our analysis takes into account relevant factors, both quantitative and qualitative in nature. Among the factors we consider are the following:
Issuer-specific considerations, including an issuer’s short-term prospects and financial condition, recent news that may have an adverse impact on its results, and an event of missed or late payment or default;
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. If we do not expect a security’s decline in fair value to be fully recovered prior to the expected time of sale, we would record an other-than-temporary impairment in the period in which the decision to sell is made.
We file income tax returns in the U.S. federal jurisdiction and various state jurisdictions. With few exceptions, we are no longer subject to U.S. federal or state income tax examinations by tax authorities for years prior to 2004. The Internal Revenue Service (the “IRS”) commenced an examination of our 2004 U.S. income tax return during 2006. The examination was closed in February 2007 with no significant adjustments. Our continuing practice is to recognize interest accrued related to unrecognized tax benefits and any applicable penalties in income tax expense.
Reinsurance - Reinsurance does not relieve us from our primary obligations to policyholders. Therefore, the failure of reinsurers to honor their obligations could result in losses to us. The amounts recoverable from reinsurers on our unpaid losses and LAE are calculated by applying the terms of the respective reinsurance contracts to our estimates of the underlying loss and LAE reserves that are subject to reinsurance. Thus, to the extent our reinsured reserves change or are adjusted, so will the related reinsurance recoverable and our exposure.
Expected volatility and dividends are based on historical factors related to our common stock. Expected term represents the estimated weighted-average time between grant and employee exercise. The risk-free rate is based on U.S. Treasury rates appropriate for the expected term.
For additional information on our share-based compensation plans, see Note 9, Share-Based Compensation Plans to the consolidated financial statements included elsewhere herein.
The discount rate used in calculating our pension benefit obligations as of December 31, 2007, is 6.3%, which represents a 1.0 percentage-point increase from our December 31, 2006, rate of 5.3%. The discount rate for our defined benefit plans is based on a yield curve constructed from a portfolio of high quality corporate bonds for which the timing and amount of cash flows approximate the estimated payouts of the plans.
Revenue Recognition - Premium income, which is our main source of revenue, is generally recognized pro-rata over the respective period of each policy. Premium receivables are recorded net of an estimated allowance for uncollectible amounts. Unearned premiums represent the portion of the premium applicable to the unexpired period of the insurance policy. In the event it is determined that the unearned premium reserve for a book of business will not be sufficient to recover the future expected losses and LAE and acquisition costs, including consideration of related investment income, recognition of a premium deficiency would be required through a write down of deferred policy acquisition costs and a corresponding charge to income. In the event deferred policy acquisition costs are written off entirely, any remaining premium deficiency would be accounted for as a liability with a corresponding charge to income.
Consolidated net income was $50.9 million for 2007, or $5.21 per diluted common share, a decrease of 1 percent and an increase of 8 percent, respectively, compared to $51.6 million, or $4.83 per diluted common share, for 2006. Included in net income for 2007 was a loss from discontinued operations of $0.2 million. Included in net income for 2006 was income from discontinued operations of $18.6 million, including an after-tax gain of $11.6 million as a result of the disposition of our insurance management operations. Other changes in net income are due to the factors discussed in the paragraph above with regard to income from continuing operations.
Consolidated income from continuing operations was $32.9 million, or $3.09 per diluted common share, for 2006, an increase of 29% and 30%, respectively, compared with $25.5 million, or $2.37 per diluted common share, for 2005. Consolidated income from continuing operations increased primarily due to higher net investment income and a decline in net losses and LAE. Partially offsetting these improvements were higher other underwriting expenses and interest expense. Underwriting profits for 2006 include favorable prior year loss development of $5.1 million and other underwriting expenses of $9.4 million ($5.8 million after-tax) for a state levied guaranty fund assessment with respect to the insolvency of the subsidiaries of Poe Financial Group.
Net premiums written declined for 2007 compared to 2006. Net premiums written for 2007 reflects a reduction of $54.5 million in assumed premiums written as a result of the commutation of the PRI reinsurance treaties. Excluding the impact of the PRI commutation, net premiums written declined 18 percent during 2007. The decline in net premiums written is primarily due to the reasons discussed in the preceding paragraph on direct premiums written.
Net losses and LAE decreased for 2007 compared to 2006. Net losses and LAE for 2007 include a $14.0 million reduction in net losses and LAE as a result of the PRI commutation. Excluding the impact of the PRI commutation, net losses and LAE declined 22 percent for 2007 compared to 2006. Excluding the impact of the PRI commutation, our loss ratio (defined as the ratio of net losses and LAE to net premiums earned) was 59.3 percent for 2007. The decline in net losses and LAE and our loss ratio for 2007 reflects a lower current year loss ratio and an increase in favorable prior year development compared to 2006 due to the continuation of favorable loss trends. The favorable prior year development ($16.0 million in 2007 and $5.1 million in 2006) reflects reductions in our estimates of incident to claim development, payment frequency and payment severity, principally for the 2004 through 2006 accident years.
Information concerning our combined ratio is summarized in the table below.
The 2007 calendar year loss ratio and underwriting expense ratio include the impact of the reinsurance commutation between First Professionals and PRI effective January 1, 2007. Excluding the impact of the commutation, the 2007 calendar year loss ratio and underwriting expense ratio would be 59.3 percent and 23.4 percent, respectively. The underwriting expense ratio for 2007 and 2006 also include the impact of guaranty fund assessments by the Florida OIR. Excluding the impact of the assessments, including recoveries, and the PRI commutation, our underwriting expense ratio would be 21.7 percent and 18.3 percent for 2007 and 2006, respectively.
The closed with indemnity payment (“CWIP”) ratio is defined as the ratio of total professional liability claims with indemnity payment to the sum of total professional liability claims with indemnity payment and total professional liability claims closed without indemnity payment.
Hannover Re Net Account Quota Share Reinsurance Agreement - Our results include the effects of a net account quota share reinsurance agreement with the Hannover Re companies for the years ended December 31, 2006 and 2005. Effective December 31, 2006, First Professionals commuted the agreement with Hannover Re. Under the terms of the commutation, First Professionals assumed loss and LAE reserves previously ceded of approximately $84.0 million and in exchange Hannover Re released to First Professionals the funds withheld under the agreement of $84.0 million. No gain or loss was recognized on the transaction. Amounts ceded under the Hannover Re net account quota share reinsurance agreement are summarized in the table below.
Other underwriting expenses increased 40% for 2006 compared to 2005. The increase in other underwriting expenses during 2006 is primarily due to state guaranty fund assessments of $9.4 million related to the insolvency of the insurance subsidiaries of Poe Financial Group and a decrease in ceding commissions resulting from the termination of the Hannover Re net account quota share reinsurance agreement. In addition, during 2005, we received return management fees of $1.7 million because of a litigation settlement, which did not recur during 2006. Finally, share-based compensation increased $1.7 million during 2006, compared to 2005. Approximately $1.1 million of the increase in share-based compensation is the result of adopting FAS 123(R), effective January 1, 2006. For 2006, our expense ratio was 22% compared to 16% for the same period in 2005. Excluding the impact of the items discussed above, our expense ratio for 2006 was nearly unchanged compared to 2005.
Other expenses are comprised primarily of finance charges associated with funds withheld under the Hannover Re net account quota share reinsurance agreement, which were $5.2 million for 2006, compared to $6.6 million for 2005. The decrease in these finance charges corresponds with the decrease in the amount of funds withheld for business ceded under the agreement as we exercised our option to terminate future cessions as of June 30, 2004. We commuted our net account quota share reinsurance agreement with Hannover Re effective December 31, 2006. Because of the commutation, we will not incur finance charges related to funds withheld during 2007. In addition, other expenses for 2006 and 2005 include charges for compensation and benefits costs associated with the resignation of certain former officers in accordance with the terms of their respective employment agreements. Finally, during 2005, we recorded an impairment charge of $0.4 million related to one of our intangible assets.
Income tax expense for 2006 increased because of lower tax-exempt interest as a percentage of income before taxes. Our effective tax rate was 30% for 2006 compared to 29% for 2005. During 2005, we reached a settlement with the IRS with regard to the examination of our income tax returns for the years ended December 31, 2000 and 2001. The settlement was approved by the Congressional Joint Committee on Taxation during the first quarter of 2006. We had previously accrued for income tax liabilities related to the examination, and consequently there was no income tax impact to our consolidated financial statements because of the settlement. During 2006, the IRS commenced an examination of our 2004 tax return. The examination was closed in February 2007 with no significant adjustments.
Our insurance management operations were comprised of our subsidiaries in New York and Pennsylvania that provided insurance management services to other MPL insurers. The aggregate purchase price for these operations was $39.1 million in cash, which reflects cash proceeds of $40.0 million and a post-closing working capital adjustment of $0.9 million. In connection with this transaction, we also received approximately $5.9 million in cash from these operations prior to the sale. We recognized an $11.6 million after-tax gain on disposition of these operations in 2006. During the third quarter of 2007, we recorded a loss on the sale of these operations of $0.2 million related to the finalization of our 2006 tax return, which reflected the sale of our former insurance management operations. The results of operations and gain on sale of our former insurance management operations are reported as discontinued operations.
For additional information on our discontinued operations, see Note 17, Discontinued Operations to the consolidated financial statements included elsewhere herein. Financial data related to our discontinued operations is summarized in the table below.
Unexpected changes in operating costs, including new guarantee fund assessments or increased taxes;
Sources of liquidity include cash from operations, proceeds from the sale of subsidiaries, routine sales of investments and financing arrangements. As reported in the consolidated statement of cash flows, net cash used in operating activities was $31.4 million for 2007 compared to net cash provided by operating activities of $75.4 million and $90.4 million for 2006 and 2005, respectively. A portion of the decline in cash provided by operating activities was the result of higher net paid losses and LAE that was primarily due to the commutation of the reinsurance agreements between First Professionals and PRI. Also contributing to the decline were lower premiums received associated with the decline in written premiums and higher income tax deposits.
Net cash flows used in financing activities was $48.5 million for 2007 compared to $16.0 million for 2006 and net cash flows provided by financing activities of $2.1 million for 2005. The increase in net cash used in financing activities for 2007 was primarily due to the repurchase of common shares under our stock repurchase program, which totaled $50.7 million compared to $24.6 million in 2006.
As of December 31, 2007, we had cash and investments of $781.3 million. Included within cash and investments were cash and cash equivalents of $70.2 million and short-term investments, equity securities and fixed income securities, available-for-sale, with a fair value of approximately $705.6 million. Approximately $58.8 million of our fixed income securities and short-term investments have scheduled maturities during the next 12 months. We believe that our cash and investments as of December 31, 2007, combined with expected cash flows from operating activities and the scheduled maturities of investments, will be sufficient to meet our cash needs for operating purposes for at least the next 12 months.
The securities are uncollateralized and bear floating interest rates equal to the three-month LIBOR plus spreads ranging from 3.85 percent to 4.20 percent (the interest rates ranged from 8.86 percent to 9.32 percent as of December 31, 2007). The floating interest rates are adjustable quarterly with changes in the three-month LIBOR, and in the case of two offerings, the maximum rate that may be charged under the securities within the first five years is 12.50 percent. We have also purchased interest rate collars designed to maintain the ultimate floating rate interest cost on all of these securities within a stated range for five years from closing. We have the option to call the trust-preferred securities and senior notes at par or its equivalent beginning five years from closing. The trust-preferred securities also contain features that allow us the option, under certain conditions, to defer interest payments for up to 20 quarters and to redeem the securities before the first optional call date in five years. In the case of the potential earlier call date, the redemption or call price payable by us may be different than par. The securities have stated maturities of 30 years and are due in May and October 2033.
Reinsurance recoverable on paid losses declined 80 percent to $3.5 million as of December 31, 2007, from $17.1 million as of December 31, 2006. The decline in reinsurance recoverable on paid losses is primarily due to the collection of amounts under our primary excess of loss reinsurance treaty.
We purchase reinsurance from a number of companies to mitigate concentrations of credit risk. Our reinsurance broker assists us in the analysis of the credit quality of our reinsurers. We base our reinsurance buying decisions on an evaluation of the then current financial strength and stability of prospective reinsurers. However, the financial strength of our reinsurers and their corresponding ability to pay us may change in the future due to forces or events we cannot control or anticipate. At December 31, 2007 our receivables from reinsurers totaled $157.6 million. We have not experienced difficulty in collecting amounts from reinsurers due to the financial condition of the reinsurers. Should future events lead us to believe that any reinsurer is unable to meet its obligation, adjustments to the amounts recoverable would be reflected in the results of current operations. We hold collateral in the form of letters of credit or trust accounts for amounts recoverable from reinsurers that are not designated as authorized reinsurers by the applicable departments of insurance of the states that have jurisdiction over the underlying business. The table below identifies our reinsurers from which our recoverables (net of amounts due to the reinsurer) are $5.0 million or more as of December 31, 2007.
Ceded unearned premiums declined 16 percent to $9.8 million as of December 31, 2007 from $11.6 million as of December 31, 2006. The decline in ceded unearned premiums is associated with a decline in ceded premiums under our reinsurance programs, which is being driven by a decline in direct premiums written.
Unearned premiums declined 40 percent to $108.9 million as of December 31, 2007 from $181.7 million as of December 31, 2006. Approximately $54.5 million of the decline in unearned premiums is due to the reinsurance commutation between First Professionals and PRI effective January 1, 2007. In addition, unearned premiums declined as a result of lower direct premiums written.
Reinsurance payable declined 88 percent to $1.3 million as of December 31, 2007 from $10.7 million as of December 31, 2006. Approximately $9.3 million of the decline in reinsurance payable is due to the reinsurance commutation between First Professionals and PRI effective January 1, 2007.
Other liabilities declined 25 percent to $29.1 million as of December 31, 2007 from $38.9 million as of December 31, 2006. The decline in other liabilities is primarily due to declines in amounts accrued for guarantee fund assessments and liabilities associated with the PRI commutation. These transactions were paid or settled subsequent to December 31, 2006.
We have various contractual obligations that are recorded as liabilities in our consolidated financial statements. We also have items that represent contractual obligations, commitments and contingent liabilities that are not recorded or that are considered to possess off-balance sheet risks beyond their respective amounts otherwise reflected in our consolidated financial statements. These include: (1) derivative financial instruments, which are used to hedge interest rate risk, (2) employee benefit plans, and (3) guarantees by us and contractual obligations related to the trust-preferred securities issued by separately created, unconsolidated trusts. These items are discussed further below. We were not a party to any unconsolidated arrangement or financial instrument with special purpose entities or other vehicles at December 31, 2007 that would give rise to previously undisclosed market, credit or financing risk.
(1) Derivative financial instruments - As noted above, we use interest rate collars as a hedge to maintain the total borrowing costs of our long-term debt (interest expense on the debt instruments, plus or minus cash flows under the interest rate collar instruments) to within specified ranges. Our total borrowing costs on long-term debt combined with the corresponding cash flows under the related interest rate collars, including the amortization of the initial costs of the hedging instruments, can fluctuate between $2.3 million and $4.5 million annually, until the interest rate collars expire. During 2008, the interest rate collars will expire on dates corresponding with the first dates under the respective long-term debt agreements at which they can be retired by us at our option.
(2) Employee benefit plans - We provide pension benefits to eligible employees through various defined benefit plans that we sponsor. For additional information about our employee benefit plans, see Note 13, Employee Benefit Plans to the consolidated financial statements included elsewhere herein.
The following table illustrates the sensitivity to a change in the discount rate for our defined benefit plans as of December 31, 2007:
(3) Guarantees and contractual obligations of our trust-preferred securities - We guarantee the floating rate interest and principal obligations under the trust-preferred securities issued by three separately created, unconsolidated trusts. In addition, the indenture agreements relating to our junior subordinated debentures and trust-preferred securities contain limitations, under certain circumstances, as to (i) the declaration or payment of dividends, or distributions thereon, or the redemption, purchase, acquisition or liquidation with respect to any capital stock of FPIC or its affiliates; (ii) the payment, in certain circumstances, of principal, premium or interest on, or the repayment, repurchase or redemption of, debt securities of FPIC or its affiliates that rank in equal standing with or are junior in interest to the debentures; or (iii) the payment, in certain circumstances, under any guarantees of FPIC or its affiliates that rank in equal standing with, or are junior in interest to, capital securities guarantees relating to the issuance of the debentures. Circumstances that would result in such limitations include a continuing event of default, as defined by the indenture agreements, a default with respect to payment of any obligations under capital securities guarantees, or a continuing interest deferral election by FPIC. See Note 10, Long-term debt to the consolidated financial statements included elsewhere herein for additional disclosures about our trusts and junior subordinated debentures.