building approximated $12.0 million, which was paid in full at the closing on January 19, 2005. Previously, we leased our corporate offices from an unaffiliated third party.
The GAAP combined ratio is the sum of the GAAP loss and loss adjustment expense ratio and the GAAP expense ratio. The GAAP loss and loss adjustment expense ratio is the unconsolidated net loss and loss adjustment expense in relation to net earned premiums. The GAAP expense ratio is the unconsolidated policy acquisition and other underwriting expenses in relation to net earned premiums. The statutory combined ratio is the sum of the statutory loss and loss adjustment expense ratio and the statutory expense ratio. The statutory loss and loss adjustment expense ratio is the statutory net loss and loss adjustment expense in relation to net earned premiums. The statutory expense ratio is the statutory policy acquisition and other underwriting expenses in relation to net written premiums.
lines, life, and accident and health insurance, for more than fifty unaffiliated insurance carriers. The agency produces an immaterial amount of business for our affiliated Insurance Company Subsidiaries.
In certain circumstances, we are required to make estimates and assumptions that affect amounts reported in our consolidated financial statements and related footnotes. We evaluate these estimates and assumptions on an on-going basis based on a variety of factors. There can be no assurance, however, the actual results will not be materially different than our estimates and assumptions, and that reported results of operation will not be affected by accounting adjustments needed to reflect changes in these estimates and assumptions. We believe the following policies are the most sensitive to estimates and judgments.
We establish a liability for losses and LAE, which represent case base estimates of reported unpaid losses and LAE and actuarial estimates of incurred but not reported losses (“IBNR”) and LAE. Such liabilities, by necessity, are based upon estimates and, while we believe the amount of our reserves is adequate, the ultimate liability may be greater or less than the estimate. As of December 31, 2005 and 2004, we have accrued $458.7 million and $378.2 million of gross loss and LAE reserves, respectively.
The following table sets forth our gross and net reserves for losses and LAE based upon an underlying source of data, at December 31, 2005 (in thousands):
In reference to the above table, the reserves related to our direct business and assumed business which we manage directly, are established through transactions processed through our internal systems and related controls. Accordingly, the case reserves are established on a current basis, therefore there is no backlog, and IBNR is determined utilizing various actuarial methods based upon historical data. Ultimate reserve estimates related to assumed business from residual markets are provided by individual states on a two quarter lag and include an estimated reserve based upon actuarial methods for this lag. Assumed business which is subsequently 100% retroceded to participating reinsurers relates to business previously discontinued and now is in run-off. Lastly, in relation to assumed business from other sources, we receive case and paid loss data within a forty-five day reporting period and develop our estimates for IBNR based on both current and historical data.
To date, in the aggregate, there have been no material disputes with our reinsurers. No assurance can be given, however, regarding the future willingness or ability of any of our reinsurers to meet their obligations.
Our reserves are reviewed by internal and independent actuaries for adequacy on a quarterly basis. When reviewing reserves, we analyze historical data and estimate the impact of various factors such as: (1) per claim information; (2) industry and our historical loss experience; (3) legislative enactments, judicial decisions, legal developments in the imposition of damages, and changes in political attitudes; and (4) trends in general economic conditions, including the effects of inflation. This process assumes that past experience, adjusted for the effects of current developments and anticipated trends, is an appropriate basis for predicting future events. There is no precise method, however, for subsequently evaluating the impact of any specific factor on the adequacy of reserves, because the eventual deficiency or redundancy is affected by multiple factors.
The key assumptions we use in our selection of ultimate reserves include underlying actuarial methodologies, a review of current pricing and underwriting initiatives, an evaluation of reinsurance costs and retention levels, and a detailed claims analysis with an emphasis on how aggressive claims handling may be impacting the paid and incurred loss data trends embedded in the traditional actuarial methods. With respect to the ultimate estimates for losses and LAE, the key assumptions remained consistent for the years ended December 31, 2005 and 2004.
Reinsurance recoverables represent (1) amounts currently due from reinsurers on paid losses and LAE, (2) amounts recoverable from reinsurers on case basis estimates of reported losses and LAE, and (3) amounts recoverable from reinsurers on actuarial estimates of IBNR losses and LAE. Such recoverables, by necessity, are based upon estimates. Reinsurance does not legally discharge us from our legal liability to our insureds, but it does make the assuming reinsurer liable to us to the extent of the reinsurance ceded. Instead of being netted
Our investment securities are classified as available for sale. Investments classified as available for sale are available to be sold in the future in response to our liquidity needs, changes in market interest rates, tax strategies and asset-liability management strategies, among other reasons. Available for sale securities are reported at fair value, with unrealized gains and losses reported in the accumulated other comprehensive income component of shareholders’ equity, net of deferred taxes, and, accordingly have no effect on net income. However, if there is a decline in the fair value of an investment below its cost and the decline is considered other than temporary, the amount of decline below cost is charged to earnings.
At December 31, 2005 and 2004, we had 267 and 124 securities that were in an unrealized loss position, respectively. These investments all had unrealized losses of less than ten percent. At December 31, 2005, thirty-nine of those investments, with an aggregate $29.9 million and $1.2 million fair value and unrealized loss, respectively, have been in an unrealized loss position for more than eighteen months. At December 31, 2004, two investments, with an aggregate $2.7 million and $75,000 fair value and unrealized loss, respectively,
were in an unrealized loss position for more than eighteen months. As of December 31, 2005 and 2004, gross unrealized losses on available for sale securities were $5.5 million and $1.3 million, respectively.
We recognize premiums written as earned on a pro rata basis over the life of the policy term. Unearned premiums represent the portion of premiums written that are applicable to the unexpired terms of an in force policy. Provisions for unearned premiums on reinsurance assumed from others are made on the basis of ceding reports when received and actuarial estimates.
For the year ending December 31, 2005, total assumed written premiums were $67.7 million, of which $56.0 million, relates to assumed business we manage directly, and therefore, no estimation is involved. The related transactions of this business are processed through our internal systems and related controls and therefore, the assumed written premiums are on a current basis and no estimate is required. Furthermore, commission and related expenses are recorded on a current basis through our internal systems and controls. The remaining $11.7 million of assumed written premiums represents $10.9 million related to residual markets, of which $148,000 relates to the change in lag estimate, which is estimated utilizing actuarial methods, and $800,000 related to other business.
In addition, certain premiums are subject to retrospective premium adjustments. Premium is recognized over the term of the insurance contract.
We review, on an ongoing basis, the collectibility of our receivables and establish an allowance for estimated uncollectible accounts. As of December 31, 2005 and 2004, the allowance for uncollectibles on receivables was $3.9 million and $4.3 million, respectively.
We are subject at times to various claims, lawsuits and proceedings relating principally to alleged errors or omissions in the placement of insurance, claims administration, consulting services and other business transactions arising in the ordinary course of business. Where appropriate, we vigorously defend such claims, lawsuits and proceedings. Some of these claims, lawsuits and proceedings seek damages, including consequential, exemplary or punitive damages, in amounts that could, if awarded, be significant. Most of the claims, lawsuits and proceedings arising in the ordinary course of business are covered by errors and omissions insurance or other appropriate insurance. In terms of deductibles associated with such insurance, we have established provisions against these items, which are believed to be adequate in light of current information and legal advice. In accordance with SFAS No. 5, “Accounting for Contingencies,” if it is probable that an asset has been impaired or a liability has been incurred as of the date of the financial statements and the amount of loss is estimable; an accrual for the costs to resolve these claims is recorded in our consolidated balance sheets. Period expenses related to the defense of such claims are included in other operating expenses in the accompanying consolidated statements of income. We, with the assistance of outside counsel, adjust such provisions according to new developments or changes in the strategy in dealing with such matters. On the basis of current information, we do not expect the outcome of the claims, lawsuits and proceedings to which we are subject to, either individually, or in the aggregate, will have a material adverse effect on our financial condition. However, it is possible that future results of operations or cash flows for any particular quarter or annual period could be materially affected by an unfavorable resolution of any such matters.
During 2005, we experienced continued overall improvement in underwriting results in comparison to 2004. This improvement is primarily the result of our controlled growth of premiums written and the impact of rate increases in 2004 and 2005. Growth of net income demonstrates our ongoing commitment to strong underwriting discipline, our consistent focus on growing our profitable specialty and fee-for-service programs, the leveraging of fixed costs, as well as our overall expense reduction initiatives. In addition, we continued to achieve operational efficiencies and enhancements in 2005. As a result, our generally accepted accounting principles (“GAAP”) combined ratio improved 2.7 percentage points to 98.7% in 2005 from 101.4% in 2004.
In April 2005, we announced an upgrade to the rating from A.M. Best of certain of our Insurance Company Subsidiaries from B+ (Very Good), with a positive outlook to B++ (Very Good). The ratings upgrade applies to Star Insurance Company (“Star”), Savers Property and Casualty Insurance Company, and Williamsburg National Insurance Company. Additionally, A.M. Best reaffirmed the rating for Ameritrust Insurance Corporation as B+ (Very Good), with a positive outlook.
Net income improved $3.8 million, or 27.4%, to $17.9 million, or $0.60 per diluted share, in 2005, from net income of $14.1 million, or $0.48 per diluted share, in 2004. This improvement is primarily the result of our controlled growth of premiums written, the impact from rate increases in 2004 and 2005, overall expense initiatives, and the continued leveraging of fixed costs. As previously indicated, we increased our retention levels on certain reinsurance treaties, which favorably impacted net earned premiums and net income. These year over year improvements manifested, despite the favorable effect in the third quarter of 2004, from the acceleration of $3.5 million in deferred revenue, less approximately $500,000 in expenses and $1.0 million in taxes, relating to the early termination of a specific multi-state claims run-off contract. In addition, net income was favorably impacted by approximately $814,000 from profit-sharing commissions received in 2005, partially offset by continuing expenses primarily related to implementation and compliance with Section 404 of the Sarbanes-Oxley Act. Net income was also favorably impacted as a result of a $386,000 increase in the deferred tax asset relating to the increase in the statutory federal tax rate from 34% to 35%.
Revenues increased $33.7 million, or 12.5%, to $304.0 million for the year ended December 31, 2005, from $270.3 million for the comparable period in 2004. This increase reflects a $35.5 million, or 16.5%, increase in net earned premiums. The increase in net earned premiums is the result of our controlled growth in written premiums from various existing programs and new programs implemented in 2004, a higher retention on certain reinsurance treaties effective in 2005, and the impact of an overall 8.4% rate increase in 2004. Partially offsetting these increases in revenue was an approximate $5.5 million decrease in managed fee revenue, which was primarily the result of an acceleration of $3.5 million in deferred claim fee revenue recognized in the third quarter of 2004. This comparative decrease in managed fee revenue in 2005 is due to the acceleration of deferred claim fee revenue in 2004, as the result of the earlier than anticipated termination of two limited duration administrative services and multi-state claims run-off contracts. These contracts had been terminated by the liquidator for the companies during the third quarter of 2004. Therefore, the revenues that we anticipated earning in the first nine months of 2005 were accelerated into the third quarter of 2004. In addition, the increase in revenue reflects a $3.1 million increase in investment income, primarily the result of an increase in average invested assets and a slight increase in yield.
Net income improved $4.0 million, or 39.2%, to $14.1 million, or $0.48 per diluted share, in 2004, from a net income of $10.1 million, or $0.35 per diluted share, in 2003. This improvement reflects an improvement in underwriting results, as a result of the controlled growth of written premiums in profitable programs written in 2004, continued rate increases, growth in agency commission, control over expenses, and leveraging of fixed costs. In addition, this improvement in net income reflects an after-tax benefit of approximately $1.4 million from the acceleration of deferred claim fee revenue, net of expenses, as the result of the earlier than
As previously indicated, during 2004, we accelerated the recognition of $3.5 million in deferred claim revenue related to a multi-state claims run-off service contract. The acceleration of this revenue was a result of the earlier than anticipated termination of the contracts. These contracts were terminated by the liquidator for the companies during the third quarter of 2004. At the time of termination, we had $3.5 million of deferred revenue related to the claims contract. The revenue had been paid to us pursuant to an agreed upon schedule. However, we had previously adopted a more conservative revenue recognition pattern, which was consistent with our historically claims handling pattern; therefore, resulting in the establishment of deferred revenue. At the termination of the contract, pursuant to the contract terms, we were no longer obligated to handle the related claims.
Our specialty risk management operations now exclude an allocation of corporate overhead, which is attributable to our agency operations. Prior to January 1, 2005, corporate overhead was only reflected in the specialty risk management operations segment. This reclassification for the allocation of corporate overhead more accurately presents our segments as a result of improved cost allocation information. As a result, the segment information for the years ended December 31, 2004 and 2003 have been adjusted to reflect this allocation. For the years ended December 31, 2005, 2004, and 2003, the allocation of corporate overhead from the specialty risk management operations to the agency operations segment was $3.1 million, $3.5 million, and $2.8 million, respectively.
In addition to the reclassification for the allocation of corporate overhead as described above, we reclassified 2004 and 2003 revenues related to the conversion of a west-coast commercial transportation program, which was converted to a specialty risk program with one of our subsidiaries, from the agency operations segment to the specialty risk management operations segment. Accordingly, the agency operations revenue and intersegment revenue have been reclassified. In addition, the overall net income related to this subsidiary was reclassified from the agency operations to the specialty risk management operations segment. As a result, pre-tax net income of $3.2 million and $2.0 million related to this subsidiary was reclassified to the specialty risk management operations pre-tax income from the agency operations segment for the years ended December 31, 2004 and 2003, respectively.
During 2004, we accelerated the recognition of $3.5 million in deferred claim revenue, as a result of an earlier than anticipated termination of two limited duration administrative services and multi-state claims run-off contracts. These contracts had been terminated by the liquidator for the companies during the third quarter of 2004. Had the contract not been terminated, we would have received additional claims fee revenue for continued claims handling services.
Revenues from specialty risk management operations increased $32.7 million, or 12.5%, to $294.5 million for the year ended December 31, 2005, from $261.8 million for the comparable period in 2004.
Management fees increased $488,000, or 3.0%, to $16.8 million, for the year ended December 31, 2005, from $16.3 million for the comparable period in 2004. Management fees were impacted by an anticipated shift in fee-for-service revenue previously generated from a third party contract to internally generated fee revenue from a specific renewal rights agreement that is eliminated upon consolidation. Due to the earlier than anticipated termination of this third party contract, the revenues that we anticipated earning in 2005 were accelerated into the third quarter of 2004. Excluding revenue generated from this third party contract, management fee revenue increased approximately $1.7 million, or 11.1%, in comparison to 2004. This increase is primarily the result of a new Florida based program implemented in the second quarter of 2005, as well as growth in a specific existing New England based program.
Specialty risk management operations generated pre-tax income of $29.4 million for the year ended December 31, 2005, compared to pre-tax income of $23.2 million for the year ended December 31, 2004. This increase in pre-tax income demonstrates a continued improvement in underwriting results as a result of our controlled growth in premium volume and our continued focus on leveraging of fixed costs. Offsetting a portion of this year over year improvement, was a $3.0 million pre-tax benefit, recognized in the third quarter of 2004, from the previously mentioned acceleration of revenue recognition, net of expenses, relating to the
termination of a specific multi-state claims run-off contract. The GAAP combined ratio was 98.7% for the year ended December 31, 2005, compared to 101.4% for the comparable period in 2004.
Net losses and loss adjustment expenses (“LAE”) increased $15.6 million, or 11.5%, to $151.5 million for the year ended December 31, 2005, from $135.9 million for the same period in 2004. Our loss and LAE ratio decreased 2.7 percentage points to 65.2% for the year ended December 31, 2005, from 67.9% for the same period in 2004. This ratio is the unconsolidated net loss and LAE in relation to net earned premiums. This overall improvement in the loss and LAE ratio reflects the impact of earned premiums from the controlled growth of profitable programs which have had favorable underwriting experience, as well as our intended shift in the balance from workers’ compensation to the general liability line of business. Historically, the general liability line of business has a lower loss ratio and a higher external producer commission. Additional discussion of our reserve activity is described below within the Other Items - Reserves section. In addition, there was a 0.8 percentage point decrease in the net loss and LAE ratio as a result of efficiencies realized within our claims handling activities. Development on prior accident year reserves, added $4.9 million, or 2.0 percentage points, to net loss and LAE in 2005, compared to $4.5 million or 2.1 percentage points in 2004. The development on prior accident years in comparison to 2004 was the result of an increase of $900,000, or 0.4 percentage points, related to one specific 2003 workers’ compensation claim. This claim exceeded our then applicable $5.0 million per claimant limit in our 2003 workers’ compensation treaty and is now reserved at $5.9 million. In addition, the development on prior accident years was also attributable to an increase to an exposure allowance of $1.5 million, specific to reinsurance recoverables for a discontinued surety program and a discontinued workers’ compensation program. During 2005, in relation to the discontinued surety program, we received updated financial information from the liquidator of the reinsurer on that program. Based upon this information, we increased the allowance to 100% of the uncollateralized exposure as of June 30, 2005. In relation to the discontinued workers’ compensation program, we received updated information relating to the collectibility of this asset. As a result, we increased our exposure allowance to 75% of the uncollateralized exposure as of December 31, 2005. Although, we increased our allowance for these specific exposures, the actual exposures did not increase. The remaining $3.4 million of development represents 1.5% of net reserves at December 31, 2004. Our accident year loss ratio improved 2.5 percentage points to 63.3% for the year ended December 31, 2005, from 65.8% for the same period in 2004. The accident year loss and LAE ratio is the unconsolidated GAAP loss and LAE ratio, excluding development on prior accident years.
Net earned premiums increased $63.3 million, or 41.9%, to $214.5 million in the year ended December 31, 2004, from $151.2 million in the comparable period in 2003. This increase primarily reflects the earning pattern resulting from the controlled growth of programs written in 2004.
Specialty risk management operations generated pre-tax income of $23.2 million for the year ended December 31, 2004, compared to pre-tax income of $16.7 million for the comparable period in 2003. This increase in pre-tax income demonstrates improvement in underwriting results and the further leveraging of fixed costs as we continue to experience controlled growth of premium volume. In addition, this improvement in pre-tax income reflects an approximate $2.1 million pre-tax favorable impact in relation to the previously mentioned acceleration of deferred claim revenue, net of related expenses, relating to the termination of a specific multi-state claims run-off contract. The GAAP combined ratio was 101.4% for the year ended December 31, 2004, compared to 104.4% for the comparable period in 2003.
Net losses and LAE increased $37.4 million, or 38.0%, to $135.9 million for the year ended December 31, 2004, from $98.5 million for the same period in 2003. Our loss and LAE ratio decreased 2.2 percentage points to 67.9% for the year ended December 31, 2004, from 70.1% for the same period in 2003. This ratio is the unconsolidated net loss and LAE in relation to net earned premium. The improvement in the loss and LAE ratio reflects the impact of earned premium on profitable programs from the controlled growth in programs with profitable underwriting experience, the impact of rate increases in 2003 and 2004, and to a lesser extent, a reduction in reinsurance costs. These improvements were partially offset by the effect of a commutation of the 2000 and 2001 surplus relief reinsurance agreement and a reclassification between losses and expenses on one inactive program. The impact of these settlements resulted in an increase to the loss and LAE ratio of 0.8 percentage points and a corresponding 0.8 percentage point decrease to the GAAP expense ratio. The 2004 loss ratio reflects an increase in net ultimates of $4.5 million, of which $1.7 million is from the previously mentioned commutation and reclassification. The remaining $2.8 million, or 1.5% of $192.0 million, is from a small number of old claims in an isolated group of programs.
Our agency operations include an allocation of corporate overhead, which includes expenses associated with accounting, information services, legal, and other corporate services. The corporate overhead allocation excludes those expenses specific to the holding company. Prior to January 1, 2005, corporate overhead was only reflected in the specialty risk management operations segment. This reclassification for the allocation of corporate overhead more accurately presents our segments as a result of improved cost allocation information. As a result, the segment information for the years ended December 31, 2004 and 2003 have been adjusted to reflect this allocation. For the years ended December 31, 2005, 2004, and 2003, the allocation of corporate overhead to the agency operations segment was $3.1 million, $3.5 million, and $2.8 million, respectively.
Revenue from agency operations, which consists primarily of agency commission revenue, increased $1.5 million, or 15.3%, to $11.3 million for the year ended December 31, 2005, from $9.8 million for the comparable period in 2004. This increase is primarily the result of profit sharing commissions received in the first and third quarter of 2005. In addition, the agency operations experienced an increase in new business and renewal retentions in comparison to 2004, which was partially offset by a reduction in renewal rates.
Revenue from agency operations, which consists primarily of agency commissions, increased $427,000, to $9.8 million for the year ended December 31, 2004, from $9.4 million for the comparable period in 2003. This increase is primarily the result of increases in new business, rate increases, higher retention levels, and profit sharing commissions.
Agency operations generated pre-tax income, after the allocation of corporate overhead, of $2.3 million for the year ended December 31, 2004, compared to $2.1 million for the comparable period in 2003. The improvement in the pre-tax margin is primarily attributable to the overall increase in revenue.
At December 31, 2005, our best estimate for the ultimate liability for loss and LAE reserves, net of reinsurance recoverables, was $271.4 million. We established a reasonable range of reserves of approximately $251.4 million to $288.9 million. This range was established primarily by considering the various indications derived from standard actuarial techniques and other appropriate reserve considerations. The following table sets forth this range by line of business (in thousands):
The commercial multiple peril line and general liability line of business had an increase in net ultimate loss estimates of $392,000, or 0.9% of net commercial multiple peril and general liability reserves. The net increase reflects a reduction of $662,000 in the ultimate loss estimate for accident year 2004. The improvement in the accident year reflected better than expected claim emergence on several programs. The decreases in the 2003 and 2002 accident years were $1.1 million and $237,000, respectively. These decreases reflect the impact of a reclassification from the general liability line of business to the commercial automobile line of business. This reclassification of $1.2 million was the result of actual claims emergence on three commercial automobile claims that are subject to our core casualty reinsurance program. Prior to the actual claims emergence the reserves for this exposure were carried in the general liability reinsurance line of business as IBNR. These decreases were offset by increases of $858,000, $827,000, and $499,000, in accident years 2001, 2000, and 1999, respectively. The increase in the 2001 accident year loss ratio reflects slightly higher than expected emergence of claim activity in several different programs. The increases in the 2000 and 1999 accident years reflect slightly higher than expected emergence of claim activity in two discontinued programs. The change in ultimate loss estimates for all other accident years was insignificant.
The workers’ compensation residual market line of business had an increase in net ultimate loss estimates of $179,000, or 0.9% of net reserves on the workers’ compensation residual market line of business. The change reflects an increase of $545,000 in accident year 2003, offset by decreases of $212,000 and $357,000 in accident years 2004 and 2002, respectively. We record loss reserves as reported by the National Council on Compensation Insurance (“NCCI”), plus an estimate for the reserves incurred but not yet analyzed and reported to us due to a two quarter lag in reporting. These changes reflect a difference between our estimate of
the lag incurred but not reported and the amounts reported by the NCCI in the quarter. The change in ultimate loss estimates for all other accident years was insignificant.
Salary and employee benefits decreased $966,000, or 1.8%, to $51.3 million in 2005, from $52.3 million for the comparable period in 2004. This decrease primarily reflects a decrease in performance and profit-based variable compensation, as a result of raising the performance targets for achievement. This decrease was partially offset by merit increases for associates. In addition, this decrease was partially due to a slight reduction in staffing levels in comparison to 2004 as a result of our expense control initiatives.
Other administrative expenses increased $2.8 million, or 11.8%, to $26.0 million in 2004, from $23.2 million in 2003. This increase is primarily attributable to an increase in policyholder dividends for 2004 as opposed to a $1.8 million reduction in anticipated policyholder dividends reflected in 2003, due to management’s evaluation of the appropriateness of dividend payments in conjunction with overall underwriting results. Partially offsetting this decrease was a reduction in overall bad debt expense in 2004 as compared to increases in related allowances recorded in 2003 on previously discontinued programs.
Salary and employee benefits and other administrative expenses include both corporate overhead and the holding company expenses included in the reconciling items of our segment information.
Interest expense for 2005, 2004, and 2003 was $3.9 million, $2.3 million, and $977,000, respectively. Interest expense is primarily attributable to our debentures and current lines of credit, which are described within the Liquidity and Capital Resources section of Management’s Discussion and Analysis. Interest expense increased $1.7 million as a result of the senior debentures issued in the second quarter of 2004 and the junior subordinated debentures issued in the third quarter of 2005, as well as an overall increase in the average interest rates. Interest expense related to our lines of credit remained relatively consistent in comparison to 2004. This is the result of a decrease in the average outstanding balance, offset by an increase in the average interest rate. The average outstanding balance was $9.0 million, $14.8 million, and $26.0 million in 2005, 2004, and 2003, respectively. The average interest rate, excluding the debentures, was approximately 4.8%, 5.2%, and 4.0%, in 2005, 2004, and 2003, respectively.
Our principal sources of funds, which include both regulated and non-regulated cash flows, are insurance premiums, investment income, proceeds from the maturity and sale of invested assets, risk management fees, and agency commissions. Funds are primarily used for the payment of claims, commissions, salaries and employee benefits, other operating expenses, shareholder dividends, share repurchases, and debt service. Our regulated sources of funds are insurance premiums, investment income, and proceeds from the maturity and sale of invested assets. These regulated funds are used for the payment of claims, policy acquisition and other underwriting expenses, and taxes relating to the regulated portion of net income. Our non-regulated sources of funds are in the form of commission revenue, outside management fees, and intercompany management fees. These non-regulated sources of funds are used to service debt, shareholders dividends, and other operating expenses of the holding company and non-regulated subsidiaries. The following table illustrates net income, excluding interest, depreciation, and amortization, between our regulated and non-regulated subsidiaries, which reconciles to our consolidated statement of income and statement of cash flows (in thousands):
Cash flow provided by operations was $81.9 million in 2005, compared to $70.7 million in 2004. Cash flow provided by operations in 2003 was $47.5 million.
Regulated subsidiaries’ cash flow provided by operations for the year ended December 31, 2005, was $76.3 million, compared to $62.1 million for the comparable period in 2004. This increase was the result of improved underwriting results and an increase in investment income, offset by a tax benefit reduction from the utilization of the net operating loss carryforward in 2004.
We anticipate a temporary increase in cash outflows related to investments in technology as we continue to enhance our operating systems and controls.
Non-regulated subsidiaries’ cash flow provided by operations for the year ended December 31, 2004, was $8.6 million, compared to $17.9 million for the comparable period in 2003. The decrease in non-regulated cash flow from operations primarily reflects the inflow of cash related to the previously mentioned limited duration administrative services and multi-state claims run-off contracts, which were entered into at the beginning of 2003. At inception, these contracts resulted in a higher inflow of cash. As anticipated, for the duration of the remaining life of the contracts, there would be a decrease in the associated inflow of cash in comparison to prior periods. In addition, the decrease in cash flow from operations was the result of intercompany tax payments made during 2004 to the regulated subsidiaries in accordance with the tax sharing agreement. These intercompany tax payments were made to compensate the regulated subsidiaries for the utilization of our net operating loss carryforward. These intercompany tax payments also contributed to the increase in regulated cash flow from operations. Although the non-regulated cash flow from operations significantly decreased in comparison to 2003, which was mainly the result of timing variances associated with the inflow of cash; net income, excluding interest, depreciation, and amortization, increased $2.4 million in comparison to 2003. This improvement reflects the acceleration of the previously mentioned deferred revenue recognition, net of expenses, relating to the earlier than anticipated termination of the two limited duration administrative services and claims run-off contracts. In addition, this improvement reflects an increase in intercompany fees from growth in risk bearing programs.
In May 2004, we issued senior debentures in the amount of $12.0 million. The senior debentures mature in thirty years and provide for interest at the three-month LIBOR, plus 4.2%, which is non-deferrable. At December 31, 2005, the interest rate was 8.59%. The senior debentures are callable at par after five years from the date of issuance. Associated with this transaction, we incurred $360,000 of commissions paid to the placement agents. These issuance costs have been capitalized and are included in other assets on the balance sheet, which are being amortized over seven years as a component of interest expense.
used to support future premium growth through further contributions to our Insurance Company Subsidiaries and general corporate purposes.
At December 31, 2005 and 2004, we had an outstanding balance of $5.0 million and $9.0 million, respectively, on the revolving line of credit.
The revolving line of credit provides for interest at a variable rate based, at our option, upon either a prime based rate or LIBOR-based rate. In addition, the revolving line of credit also provides for an unused facility fee. On prime based borrowings, the applicable margin ranges from 75 to 25 basis points below prime. On LIBOR-based borrowings, the applicable margin ranges from 125 to 175 basis points above LIBOR. The margin for all loans is dependent on the sum of non-regulated earnings before interest, taxes, depreciation, amortization, and non-cash impairment charges related to intangible assets for the preceding four quarters, plus dividends paid or payable to us from subsidiaries during such period (“Adjusted EBITDA”). As of December 31, 2005, the average interest rate for LIBOR-based borrowings was 4.7%.
In addition, our non-insurance premium finance subsidiary maintains a line of credit with a bank, which permits borrowings up to 75% of the accounts receivable, which collateralize the line of credit. At December 31, 2005 and 2004, this line of credit had an outstanding balance of $2.0 million and $3.1 million, respectively. On April 26, 2005, the terms of this line of credit were modified. The modifications included a decrease in the line of credit from $8.0 million to $6.0 million. The interest terms of this line of credit provide for interest at the prime rate minus 0.5%, or a LIBOR-based rate, plus 2.0%. At December 31, 2005, the average interest rate on this line of credit was 5.2%.
As of December 31, 2005 and 2004, the recorded values of our investment portfolio, including cash and cash equivalents, were $460.2 million and $402.2 million, respectively. The debt securities in the investment portfolio, at December 31, 2005, were 96.4% investment grade A or above bonds as defined by Standard and Poor’s.
In November 2004, our Board of Directors authorized us to repurchase up to 1,000,000 shares of our common stock in market transactions for a period not to exceed twenty-four months. At our regularly scheduled board meeting on October 28, 2005, our Board of Directors authorized us to purchase up to 1,000,000 shares, or approximately 3% of our common stock in market transactions for a period not to exceed twenty-four months, replacing our current share repurchase program originally authorized in November 2004. For the year ended December 31, 2005, we purchased and retired 772,900 shares of common stock for a total cost of approximately $4.2 million. We did not repurchase any common stock during 2004. As of December 31, 2005, the cumulative amount we have repurchased and retired under the current share repurchase plan was 772,900 shares of common stock for a total cost of approximately $4.2 million.
The following table is a summary of our contractual obligations and commitments as of December 31, 2005 (in thousands):
The loss and loss adjustment expense payments do not have contractual maturity dates and the exact timing of payments cannot be predicted with certainty. However, based upon historical payment patterns, we have included an estimate of our gross losses and loss adjustment expenses. In addition, we have anticipated cash receipts on reinsurance recoverables on unpaid losses and loss adjustment expenses of $187.3 million, of which we estimate that these payments to be paid for losses and loss adjustment expenses for the periods less than one year, one to three years, three to five years, and more than five years, to be $51.8 million, $71.7 million, $32.9 million, and $30.8 million, respectively, resulting in net losses and loss adjustment expenses of $101.8 million, $108.2 million, $35.2 million, and $26.2 million, respectively.
At December 31, 2005, all of the Insurance Company Subsidiaries were in compliance with RBC requirements. Star reported statutory surplus of $141.1 million and $120.7 million at December 31, 2005 and 2004, respectively. The calculated RBC was $37.3 million in 2005 and $28.4 million in 2004. The threshold requiring the minimum regulatory involvement was $74.5 million in 2005 and $56.9 million in 2004.
In 2005, our Insurance Company Subsidiaries generated certain ratios that varied from the “usual value” range. The variations and reasons for these variations are set forth below:
The low investment yield is affected by an interest environment where rates are still relatively low. During March 2005, Star transferred $84.0 million in invested assets to its subsidiaries pursuant to an Intercompany Reinsurance Agreement. As a result of this transfer, the average invested assets used in the calculation were higher than the monthly weighted average. Monthly weighted average invested assets would produce a yield of 3.02%. Also contributing to the low yield was a shift in investment strategy toward greater allocation to municipal bonds, which have lower yields than taxable bonds.
The Liabilities to Liquid Assets ratio increase to 108% was primarily related to the transfer by Star of $84.0 million in invested bond assets to its subsidiaries pursuant to an Intercompany Reinsurance Agreement, which therefore reduced liquid assets. Ceded premium payables increased $18.9 million as a result of the intercompany pooling activity. Excluding the effect of intercompany pooling, the ratio would have been 99.5%, below the threshold of 105%. Also contributing to the high ratio was an increase in the provision for reinsurance of $3.7 million in 2005.
Effective January 1, 2005, the Insurance Company Subsidiaries began participating in an Intercompany Reinsurance Agreement, whereby each participating affiliate cedes 100% of its business to Star. Thereafter, Star cedes to each participating affiliate based on their respective participation percentages, from which each affiliate has agreed to reinsure Star. Excluding the intercompany pooling activity, the Change in Net Writings ratio would have been within the normal range for 2005. In addition, Savers ratio was impacted by an increase of $4.4 million in commercial multi-peril written premium for 2005 as a result of retention of existing business and new business.
In April 2005, we announced an upgrade from A.M. Best of certain of our Insurance Company Subsidiaries from B+ (Very Good), with a positive outlook to B++ (Very Good). The ratings upgrade applies to Star, Savers Property and Casualty Insurance Company, and Williamsburg National Insurance Company. Additionally, A.M. Best reaffirmed the rating for Ameritrust Insurance Corporation as B+ (Very Good), with a positive outlook. We believe that as we continue to show improvement in our balance sheet and operating performance our rating will remain at least at its current level, if not at an upgraded level. However, there can be no assurance that A.M. Best will not change its rating of our Insurance Company Subsidiaries in the future.
During 2005, in relation to a discontinued surety program, we received updated financial information from the liquidator of the reinsurer on that program. Based upon this information, we increased the allowance to 100% of the uncollateralized exposure as of June 30, 2005. In relation to a discontinued workers’ compensation program, we received updated information relating to the collectibility of the asset. As a result, we increased our exposure allowance to 75% of the uncollateralized exposure as of December 31, 2005. Although, we increased our allowance for these specific exposures, the actual exposures did not increase. While we believe this allowance to be adequate, no assurance can be given, however, regarding the future ability of any of our risk-sharing partners to meet their obligations.
In June 2003, we entered into a guaranty agreement with a bank. We are guaranteeing payment of a $1.5 million term loan issued by the bank to an unaffiliated insurance agency. In the event of default on the term loan by the insurance agency, we are obligated to pay any outstanding principal (up to a maximum of $1.5 million), as well as any accrued interest on the loan, and any costs incurred by the bank in the collection process. In exchange for our guaranty, the president and member of the insurance agency pledged 100% of the common shares of two other insurance agencies that he wholly owns. In the event of default on the term loan by the insurance agency, we have the right to sell any or all of the pledged insurance agencies’ common shares and use the proceeds from the sale to recover any amounts paid under the guaranty agreement. Any excess proceeds would be paid to the president and member of the insurance agency who is the sole shareholder. As of December 31, 2005, no liability has been recorded with respect to our obligations under the guaranty agreement, since no premium exists in excess of the guaranteed amount. On January 30, 2006, the unaffiliated insurance agency paid off the term loan in full. As such, our legal obligations under the guaranty agreement terminated.
In September 2005, the American Institute of Certified Public Accountants issued Statement of Position (“SOP”) 05-1, Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection with Modifications or Exchanges of Insurance Contracts, effective for contract replacements occurring in fiscal years beginning after December 15, 2006. The SOP 05-1 defines an internal replacement of an insurance contract as a modification in product features, rights, or coverages that occurs by the exchange of an existing contract for a new contract, or by amendment endorsement, or rider to a contract, or by the election of a feature or coverage with a contract. Insurance contracts meeting this replacement criteria should be accounted for as an extinguishment of the replaced contract. We will review the guidance during 2006 and determine the applicability to any of our various insurance contracts.