Our home office is in Southfield, Michigan, where we occupy approximately 30,000 square feet of office space for use in all of our business segments. In June 2006, we expanded the office space from 10,000 square feet to approximately 12,372 in Jacksonville, Florida for use in our specialty commercial lines business segment. This lease expires in June 2009. We lease nearly 13,000 square feet of office space in Lombard, Illinois, all of which was sublet to unrelated third parties when we closed our Chicago operation in April 2003. We also lease space for small offices in East Lansing, Michigan; Coral Gables and North Palm Beach, Florida (opened September 2006); and Wilmette, Illinois, all of which are used in our specialty commercial lines business segment. During 2006, we closed the Cooper City, Florida office, which was used in our homeowners insurance business. In January 2007, we opened an office in Sacramento, California where we occupy approximately 3,091 square feet for use in our personal lines business. As of December 31, 2006, we believe all of our facilities are suitable and adequate for use.
risks associated with high concentration of our business in certain geographic markets;
our ability to implement and maintain adequate internal controls in our business; and
North Pointe Holdings is an insurance holding company whose insurance company subsidiaries market and service specialty commercial and personal insurance products. We also have non-insurance company subsidiaries that provide administrative, agency and premium finance services.
Net income for the years ended December 31, 2006, 2005 and 2004 was $4.7 million, $3.9 million, and $11.4 million, respectively, resulting in diluted earnings per share of $0.51, $0.64 and $1.95, respectively. Net income before extraordinary item for the years ended December 31, 2006, 2005 and 2004 was $4.7 million, $3.9 million and $8.5 million, respectively, resulting in diluted earnings per share of $0.51, $0.64 and $1.46, respectively.
Our loss ratios for the years 2006, 2005 and 2004 were 43.1%, 50.8% and 52.4%, respectively. The decrease in the loss ratio for both the commercial and personal line segments for 2006 compared to 2005 is primarily due to the significant hurricane related costs that were incurred in 2005.
The decrease in net premiums earned primarily resulted from cancellations and non-renewals in our commercial lines segment and increased reinsurance costs. The cancellations and non-renewals were the result of our prompt reduction of our wind exposure in Florida when it became evident that we could not obtain catastrophe reinsurance coverage for the 2006 hurricane season. We made the decision to reduce our exposure in early June, which was substantially implemented by July 2006 by the cancellation or non-renewal of all policies included in specific classes within our Florida small business line. We expect this will reduce total annualized gross premiums written in our Florida small business line by approximately $18.0 million, or 40.0%, and total insurable value with wind exposure by approximately 75.0%.
In 2006, our gross premiums written increased to $114.6 million from $112.1 million in 2005, an increase of $2.5 million or 2.2%. Our commercial lines gross premiums written increased by $3.3 million, or 4.2%, and our personal lines gross premiums written decreased by $892,000 or 2.7%. The increase in gross premiums written in our commercial lines primarily resulted from crop fronting and flood programs, partially offset by decreased gross premiums written in our Florida small business line as a result of the aforementioned cancellations and non-renewals. The decrease in gross premiums written in our personal lines was attributable to decreased policy counts offset by increased average premium per policy. The decrease in policy count was a result of our efforts to more selectively underwrite the risks.
Unpaid loss and loss adjustment expense reserves represent our best estimate of the ultimate liability for losses and loss adjustment expenses that occurred prior to, but were unpaid at, the end of any given accounting period. At December 31, 2006 and 2005, we had $89.8 million and $117.8 million, respectively, of gross loss and loss adjustment expense reserves. Evaluation of these gross reserves requires the estimation of loss development over an extended period of time. Numerous factors will affect the ultimate settlement values of claims, including tort reform, expected future inflationary trends, medical costs and jury awards. These factors, coupled with the character of the business we write (much of which is small volume specialty commercial lines), continual changes in the mix of business we write, as well as ongoing rate and underwriting modifications, require that significant judgment be used in the reserve setting process. For example, our gross premiums written in our RBT line decreased by 11.4% in 2006; our personal automobile business is now in run-off, and we began writing homeowners in Florida in 2005. These changes in our mix of business, among other less substantial changes, create additional uncertainty in estimating the ultimate loss costs.
We provide for federal incomes taxes based on amounts we believe we will ultimately owe. Inherent in the provision for federal income taxes are estimates regarding the deductibility of certain items and the realizations of certain tax credits. In the event the ultimate deductibility of certain items or the realization of certain tax credits differs from estimates, we may be required to significantly change the provision for federal income taxes recorded in the consolidated financial statements.
In July 2006, the Financial Accounting Standard Board (“FASB”) issued Interpretation No. 48 (“FIN No. 48”) which is effective for fiscal years beginning after December 15, 2006. This Interpretation clarifies the uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with SFAS Statement No. 109, Accounting for Income Taxes (“SFAS 109”). FIN No. 48 requires that we evaluate our tax positions within the scope of SFAS 109 in each tax jurisdiction for all open tax years and determine whether our tax positions are more-likely-than-not of being sustained based solely on technical merits. FIN No. 48 then requires that we measure the tax benefit or liability to be recognized and record an adjustment to income and retained earnings according to the Interpretation. We adopted FIN 48 on January 1, 2007 and have determined that it will not have a material effect on our financial condition or results of operation.
Fixed-income investments with unrealized losses due to the market- or industry-related declines, are not deemed to qualify as other than temporarily impaired where we have the intent and ability to hold the investment for the period of time necessary to recover a significant portion of the investment’s original principal and interest obligation. Our policy for equity securities with market-related declines is to recognize impairment losses on individual securities with losses that are not reasonably expected to be recovered under historical market conditions when the security has been in a loss position for four consecutive quarters. This does not preclude us from recognizing an impairment prior to a security remaining in a loss position for four consecutive quarters if events or evidence would dictate an earlier recognition.
As of December 31, 2006, we had unrealized losses on our investment portfolio of $2.0 million, of which $1.9 million were in unrealized loss positions for more than twelve months. If we decided to write down all securities in an unrealized loss position for one year or longer, we would have recognized an additional $1.9 million of realized losses, reducing net income in 2006 by $1.3 million.
See “Business - Investments,” and Note 4 to our audited consolidated financial statements, all of which are included elsewhere in this annual report on Form 10-K.
Year Ended December 31, 2006 as Compared to Year Ended December 31, 2005. Gross premiums written for 2006 were $114.6 million as compared to $112.1 million for 2005, an increase of $2.5 million, or 2.2%.
While we did not cancel the bowling centers line written in Florida, we have reduced our exposure to catastrophe losses in the bowling line through a combination of certain non-renewals, higher deductibles and other increased underwriting restrictions. In addition, we have taken measures to substantially increase rates on the bowling line, as well as our other Florida commercial lines which we are retaining, including contractor and RBT lines.
Gross premiums written in our personal lines segment for 2006 were $32.7 million as compared to $33.5 million for 2005, a decrease of $892,000 or 2.7%. This decrease was attributable to a decrease in policy count partially offset by an increase in average premium per policy. Policy count in our personal lines segment decreased by 11,000 policies, or 27.4%. Policy count decreased in both our Midwest homeowners and Florida homeowners lines. The decrease in policy count in our Florida homeowners line was a result of our efforts to more selectively underwrite the risks. The decrease in policy count in our Midwest homeowners line was attributable to continuing competitive pressures in that market.
Year Ended December 31, 2005 as Compared to Year Ended December 31, 2004. Gross premiums written for 2005 were $112.1 million as compared to $96.5 million for 2004, an increase of $15.6 million, or 16.2%.
Gross premiums written in our personal lines segment for 2005 were $33.5 million as compared to $23.1 million for 2004, an increase of $10.4 million, or 45.0%. Policy count in our personal lines segment was 35,200 as of December 31, 2005 as compared to 16,700 as of December 31, 2004, an increase of 18,500 policies, or 110.8%. The increase in gross premiums written was primarily attributable to a $27.8 million increase in gross premiums written in our Florida homeowners insurance line in 2005, which business we began writing in December 2004. This increase was partially offset by a $15.6 million decrease in our personal automobile line and a $1.8 million decrease in our Midwest homeowners line. We ceased writing personal automobile policies in October 2004 upon the sale of our renewal rights to that line of business. The average annual premiums per policy for the Florida homeowners insurance line is approximately 50% of the average annual premiums per policy that we obtained from our personal automobile insurance line. The decrease in our Midwest homeowners line was attributable to rate increases implemented in late 2003 and early 2004 in an effort to improve the profitability of our Midwest homeowners line, which led to a reduction in policy count of 14.7% from December 31, 2004 to December 31, 2005.
Year Ended December 31, 2006 as Compared to Year Ended December 31, 2005. Net premiums written for 2006 were $77.6 million as compared to $87.1 million in 2005, a decrease of $9.5 million, or 10.9%. The decrease in net premiums written was primarily attributable to a decrease in gross premiums written in our Florida small business line and an increase in the cost of reinsurance in our Florida homeowners line in the first five months of the year.
catastrophe reinsurance rates increased on our commercial insurance lines as a result of the hurricane losses incurred by the reinsurers during 2004.
Our premiums earned by segment, for the years ended December 31, 2006, 2005 and 2004, are as follows:
The increase in net investment income was attributable to a combination of an increase in our average cash and invested assets balance and an increase in the annualized yield on our portfolio. Average cash and invested assets for 2006 was $154.5 million as compared to $129.1 million for 2005. The increase in average cash and invested assets resulted primarily from the issuance of $20.0 million, mandatorily redeemable trust preferred securities during the first quarter of 2006. Pre-tax yield on our portfolio increased to 4.2% in 2006 from 3.1% in 2005. This increase in pre-tax yield is primarily attributable to an increase in prevailing market interest rates. For example, the three-year
Year Ended December 31, 2005 as Compared to Year Ended December 31, 2004. Net investment income for 2005 was $4.0 million as compared to $2.4 million for 2004, an increase of $1.6 million, or 66.7%.
The increase in net investment income was attributable to a combination of an increase in average cash and invested assets which generated investment income and an increase in the investment yield. Average cash and invested assets for 2005 was $129.1 million as compared to $107.3 million for 2004. The increase in average cash and invested assets resulted primarily from the increase in gross premiums written and proceeds of the initial public offering in September 2005. Pre-tax yield on our portfolio increased to 3.1% in 2005 from 2.2% in 2004. This increase in pre-tax yield is primarily attributable to an increase in prevailing market interest rates. For example, the three-year U.S. Treasury notes increased to 3.9% in 2005 from 2.8% in 2004, which we believe reflected the trend in market interest rates for debt securities with durations similar to our cash and debt securities mix. As of December 31, 2005, we had $34.1 million of unrestricted cash and cash equivalents. The average duration of our cash and debt securities portfolio was 3.3 and 2.5 years as of December 31, 2005 and 2004, respectively. The increase in average duration of our cash and debt securities portfolio also contributed to the increase in the pre-tax yield.
Year Ended December 31, 2006 as Compared to Year Ended December 31, 2005. Realized losses, net of realized gains, on the disposition of investments for 2006 were $231,000 as compared to $168,000 for 2005, an increase of $63,000, or 37.5%. Substantially all of the realized losses were generated from the sales or calls of debt securities which experienced decreases in fair values attributable to increases in prevailing market interest rates.
Year Ended December 31, 2005 as Compared to Year Ended December 31, 2004. Realized losses, net of realized gains, on the disposition of investments for 2005 were $168,000 as compared to realized gains, net of realized losses, of $886,000 for 2004, a decrease in realized gains of $1.1 million or 124.2%. The decrease in net realized gains was primarily attributable to an increase in the prevailing market interest rates, which reduced the amount of unrealized gains carried within our debt securities portfolio.
Other income is substantially composed of the installment fees generated from our Florida homeowners’ line and policy issuance fees. Other income is generated from commissions earned for policies written by one of our wholly-owned managing general agents for unrelated insurance companies, policy or inspection fees charged to obtain certain of our policies, and premium finance charges.
Losses and loss adjustment expenses represent our largest expense item and include payments made to settle claims, estimates for future claim payments and changes in those estimates for current and prior periods, as well as
adjusting costs incurred in connection with settling claims. Losses and loss adjustment expenses for a given period are influenced by the number of exposures covered in the current year, trends in claim frequency and severity, changes in the cost of adjusting claims, changes in the legal environment and the re-estimation of prior years’ reserves in the current year. Gross losses and loss adjustment expenses are those amounts before consideration of ceded losses. See “Business - Reinsurance.” Net losses and loss adjustment expenses are gross losses and loss adjustment expenses less ceded losses and loss adjustment expenses. We report our losses and loss adjustment expenses net of reinsurance.
Losses and loss adjustment expenses include a reduction in those expenses resulting from continued reassessment of reserves established in prior periods. In 2006, 2005, and 2004, losses and loss adjustment expenses included a reduction of $2.5 million, $5.4 million, and $6.0 million, respectively, as a result of favorable development (or redundancies) from reserve changes relating to prior periods. See “Business - Unpaid Losses and Loss Adjustment Expenses,” incorporated elsewhere within this Annual Report on Form 10-K.
Favorable development of prior period estimates reduced losses and loss adjustment expenses in our commercial lines by $4.0 million in 2006 from $28.0 million to $24.0 million. Similar favorable development reduced losses and loss adjustment expenses in our commercial lines by $3.5 million in 2005 from $32.7 million to $29.2 million. Such favorable development reduced our commercial lines loss ratios from 46.5% to 39.9% in 2006 and from 53.5% to 47.8% in 2005.
The loss ratio for our personal lines for 2006 was 55.9% as compared to 62.5% for 2005. This decrease was primarily attributable to a decrease in catastrophic losses arising from hurricanes. We also experienced lower non-catastrophic losses in our Florida homeowners line. For the year ended December 31, 2006, we incurred unfavorable development of $117,000 in 2006 on 2005 hurricane reserves. The $117,000 unfavorable development related to these hurricanes had no impact on our personal loss ratio of 55.9% in 2006, whereas the hurricane losses in 2005 increased our personal lines loss ratio from 30.9% to 62.5%. We did not have any development in 2006 on reserves in our personal lines segment related to 2004 hurricanes.
Favorable development of prior period reserve estimates reduced losses and loss adjustment expenses in our commercial lines by $3.5 million in 2005 from $32.7 million to $29.2 million. Similar favorable development reduced losses and loss adjustment expenses in our commercial lines by $5.4 million in 2004 from $33.6 million to $28.2 million. Such favorable development reduced our commercial lines loss ratios from 53.5% to 47.8% in 2005 and from 60.7% to 50.9% in 2004.
The loss ratio for our personal lines for 2005 was 62.5% as compared to 61.7% for 2004. The increase in our personal lines loss ratio was primarily attributable to hurricane losses in our Florida homeowners line partially
Year Ended December 31, 2006 as Compared to Year Ended December 31, 2005. Policy acquisition costs for 2006 were $22.0 million as compared to $21.8 million for 2005, an increase of $231,000 or 1.1%. The increase was primarily attributable to an increase in gross premiums earned.
expense was primarily attributable to the $20.6 million junior subordinated note, bearing interest at 8.7% per annum, issued in concert with the trust preferred securities in February 2006.
Year Ended December 31, 2005. Federal income tax expense for 2005 was $2.0 million, representing an effective tax rate of 34.5%, which approximates the statutory rate of 34.0%. The federal income tax expense calculation included two offsetting items affecting the effective rate, which were: 1) a $262,000 increase in federal income tax expense attributable to an adjustment to net operating losses, or NOL, carryforwards acquired as a part of the acquisition of North Pointe Casualty and 2) a $284,000 decrease in federal income tax expense relating to a provision to return variance.
Approximately $3.0 million, $4.6 million and $3.9 million of our net income for the years ended December 31, 2006, 2005 and 2004, respectively, was derived from our non-insurance companies which constitute our administrative services segment.
Net cash provided by operating activities for the year ended December 31, 2006 was $7.1 million as compared to $4.8 million for 2005, an increase of $2.3 million. The increase in cash from operations was attributable to a combination of factors including a $20.2 million decrease in net losses and loss adjustment expenses paid (there were no hurricanes in 2006), a $4.8 million decrease in taxes paid, and a $2.3 million increase in investment income. These increases in cash were offset by a $16.0 million reduction in net premiums collected, and $9.0 million increase in cash paid for policy acquisition costs as well as operating and interest expense. The $16.0 million reduction in net premiums collected resulted from receiving cash in the fourth quarter of 2005 relating to Florida homeowners policies renewing in the first quarter of 2006. Because the entire Florida homeowners line was new in the first half of 2005, there were no similar premiums paid in advance in December 2004, thus all premiums from our Florida homeowners policies written in the first quarter of 2005 were collected in the same period while a portion of the Florida homeowners policies written in the first quarter of 2006 were paid in late 2005.
Net cash provided by operating activities for the year ended December 31, 2005 was $4.8 million as compared to $185,000 for 2004, an increase of $4.6 million. The increase in cash from operations was attributable to a combination of factors including an increase in net premiums collected of $7.7 million and an increase in investment income of $1.5 million. These increases in cash were partially offset by an increase in net losses and loss adjustment expenses paid of $1.6 million, an increase in federal income taxes paid of $2.7 million and a $319,000 reduction in cash received from other income. Losses and loss adjustment expenses paid in 2005 and 2004 were significantly impacted by the Florida hurricanes, much of which was recoverable from reinsurers. Our reinsurance recovered on paid losses was $11.5 million and $8.2 million in 2005 and 2004, respectively.
Net cash used in investing activities for the year ended December 31, 2005 was $27.0 million and was attributable to a $24.8 million net decrease in cash from investment portfolio purchases in excess of investment portfolio sales, $1.4 million of net cash used to acquire Northwestern Zodiac and $742,000 used to acquire fixed assets.
In 2006, the Company contributed $5,000,000 and $4,000,000 to North Pointe Casualty and Home Pointe Insurance, respectively, substantially derived from the net proceeds of the issuance of the trust preferred securities.
We believe that existing cash and investment balances, as well as cash flows from operation, will be adequate to meet the capital and liquidity needs of North Pointe Holdings and each of its subsidiaries during the 12-month
Writings to Surplus Ratios: Our ability to write additional insurance policies is largely dependent on the statutory leverage of our insurance company subsidiaries. Michigan insurance regulations require insurance companies to maintain a gross premium writings-to-capital and surplus ratio under 3.0 to 1.0. Florida insurance regulations require insurance companies to maintain a net premiums-to-capital and surplus ratio (rather than a gross premiums-to-capital and surplus ratio) under 4.0 to 1.0. Statutory capital and surplus is defined as total assets less total liabilities of insurance companies determined in accordance with statutory accounting principles.
North Pointe Insurance’s gross premiums written to statutory capital and surplus ratios were 1.27 to 1.0 and 1.40 to 1.0 as of December 31, 2006 and 2005, respectively. North Pointe Casualty’s net premiums written to statutory capital and surplus ratios were 0.77 to 1.0 and 2.76 to 1.0, as of December 31, 2006 and 2005, respectively.
Risk Based Capital: The National Association of Insurance Commissioners, or NAIC, has adopted risk-based capital, or RBC, requirements that require insurance companies to calculate and report information under an RBC formula. The RBC formula attempts to measure statutory capital and surplus needs based on the risks in an insurance company’s mix of products and investment portfolio. The RBC formula is used by state insurance regulators to monitor trends in an insurance company’s statutory capital and surplus, for the purpose, if necessary, of initiating regulatory action. Our insurance companies, except for Midfield, are required to submit a report of their RBC levels to the insurance departments of their states of domicile as of the end of the previous calendar year. As of December 31, 2006, all of our insurance companies had RBC levels in excess of an amount that would require any regulatory intervention.
Regulations on Dividends Paid by Insurance Companies: State insurance laws restrict the ability of our insurance company subsidiaries to declare dividends to us. Michigan and Florida have regulations, outlined below, which provide guidance as to when an insurance company may pay a dividend. The District of Columbia does not have detailed regulations, but provides a broader guideline which leaves much of the judgment in the hands of the insurance commissioner in the District of Columbia. In addition to the regulations outlined below, insurance departments will also look to financial measurements such as writings-to-surplus ratios, RBC levels or IRIS ratios when determining whether to approve a dividend. In 2006, North Pointe Insurance declared a $500,000 stock dividend. In 2005, North Pointe Insurance paid a $3.3 million ordinary dividend. None of our other insurance companies have paid dividends in the last three years.
Under the Florida Holding Company Law, our Florida insurance companies (North Pointe Casualty and Home Pointe Insurance) can only declare or pay dividends out of that part of its available and accumulated surplus funds that is derived from its realized net operating profits on its business and net realized capital gains. In addition, our Florida insurance companies must obtain prior approval from the Florida insurance regulator before it may pay extraordinary dividends or distributions to its shareholder, North Pointe Financial. In Florida, an extraordinary dividend or distribution includes any dividend or distribution that exceeds either of the following two thresholds:
Borrowings under the revolving credit facility bear interest at a floating rate equal to either (1) a Eurodollar rate equal to a stated margin of 1.25% plus the interest rate certain of Comerica’s lending offices offer on deposits to prime banks in the Eurodollar market or (2) a rate based upon Comerica’s prime rate of interest less 1.00% (at December 31, 2006 this rate would have been 7.25%). Interest on Eurodollar-based rate advances is payable on the last day of the interest period applicable thereto. Interest on prime-based rate advances is payable quarterly in arrears. The full amount borrowed under the Credit Agreement will mature on June 30, 2009.
The Credit Agreement provides that Comerica will issue, on our behalf, letters of credit in amounts up to $5.0 million. The amount of any outstanding letters of credit by Comerica will reduce, dollar for dollar, the aggregate amount available under the revolving credit line.
The borrowings under the Credit Agreement may be used to finance certain permitted acquisitions and to fund our working capital needs. The obligations under the Credit Agreement are unconditionally guaranteed by certain of our subsidiaries and are secured by (1) our pledge of 100% of the issued and outstanding stock of our certain subsidiaries and (2) a security interest in substantially all of the tangible and intangible assets of our certain subsidiaries.
The Credit Agreement requires that we comply with various financial and other covenants, including requirements that we maintain an A.M Best rating of no less than “B+” for certain of our insurance company subsidiaries and that we maintain the following financial ratios for each insurance company subsidiary:
adjusted capital and surplus will be in excess of 215% of authorized control level risk-based capital as of each fiscal year end;
Mortgage Obligation. On August 18, 2005, we assumed the mortgage on the office building in Southfield, Michigan after acquiring Northwest Zodiac. The mortgage loan terms include monthly principal and interest payments of $22,000 and a balloon payment of $1.9 million due in June 2011. As of December 31, 2006, the mortgage debt obligation had an outstanding balance of $2.5 million.
The following table summarizes information about our contractual obligations. The minimum future payments, including anticipated interest, under these agreements as of December 31, 2006 are as follows:
The junior subordinated debt agreement requires one $20.6 million principal payment in 2036 and $448,000 quarterly interest payments. The senior credit facility provides for a revolving credit line in the aggregate amount of $25.0 million maturing on June 30, 2009. There was no balance on the revolving credit line as of December 31, 2006. The table reflects facility fee obligations which are due during the term of the revolving credit line. The gross unpaid loss and loss adjustment expense payments were estimated based on historical payment patterns. However, future payments may be different than historical payment patterns. The commitment to purchase other investments is attributable to a limited partnership interest which may request further funding of up to $2.0 million any time through June 2010.