In November 2003, we moved our corporate headquarters to a newly-constructed approximately 44,000 square foot office building located in Westerville, Ohio. We lease this building pursuant to a lease agreement with an initial term of ten years and have an option to renew the lease agreement for two five-year terms.
The following table sets forth selected consolidated financial information for the periods ended and as of the dates indicated. The selected data presented below under the captions “Operating Data” and “Balance Sheet Data” for, and as of the end of, each of the periods in the five-year period ended December 31, 2005 are derived from our consolidated financial statements, which financial statements have been audited by KPMG LLP, an independent registered public accounting firm. The consolidated financial statements as of December 31, 2005 and 2004 and for each of the periods in the three-year period ended December 31, 2005, and the report thereon, are included elsewhere in this 10-K filing. These historical results are not necessarily indicative of results to be expected from any future period. You should read this selected consolidated financial information together with our consolidated financial statements and related notes and the section of this report entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”
The following discussion of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and the notes to those statements included in this report. The discussion and analysis below includes certain forward-looking statements that are subject to risks, uncertainties and other factors described in “Risk Factors” and elsewhere in this report that could cause our actual growth, results of operations, performance and business prospects and opportunities in 2005 and beyond to differ materially from those expressed in, or implied by, those forward-looking statements. See “Forward-Looking Statements.”
ProCentury is a holding company that underwrites selected property and casualty and surety insurance through its subsidiaries collectively known as Century Insurance Group®. As a “niche” company, we offer specialty insurance products designed to meet specific insurance needs of targeted insured groups. The excess and surplus lines market provides an alternative market for customers with hard-to-place risks and risks that insurance companies licensed by the state in which the insurance policy is sold, which are also referred to as “admitted insurers,” specifically refuse to write. When we underwrite within the excess and surplus lines market, we are selective in the lines of business and types of risks we choose to write. Typically, the development of these specialty insurance products is generated through proposals brought to us by an agent or broker seeking coverage for a specific group of clients.
Gross Written Premiums. Gross written premiums are the sum of direct written premiums and assumed written premiums. We use gross written premiums, which excludes the impact of premiums ceded to reinsurers, as a measure of the underlying growth of our insurance business from period to period.
Net Written Premiums. Net written premiums are the sum of direct written premiums and assumed written premiums less ceded written premiums. We use net written premiums, primarily in relation to gross written premiums, to measure the amount of business retained after cessions to reinsurers.
Earned Premiums. Earned premiums are the portion of a premium paid by an insured that has been allocated to our revenue, loss experience, expenses, and profit year to date.
It is important to understand our accounting policies in order to understand our financial statements. Management considers certain of these policies to be critical to the presentation of our financial results, since they require management to make estimates and assumptions. These estimates and assumptions affect the reported amounts of assets, liabilities, revenues, expenses and related disclosures at the financial reporting date and throughout the period being reported upon. Certain of the estimates result from judgments that can be subjective and complex and consequently actual results may differ from these estimates, which would be reflected in future periods.
Impairment of Investments. Impairment of investment securities results in a charge to operations when a market decline below cost is deemed to be other-than-temporary. Under the Company’s accounting policy for equity securities and fixed-maturity securities, an impairment is deemed to be other-than-temporary unless the Company has both the ability and intent to hold the investment for a reasonable period until the security’s forecasted recovery and evidence exists indicating that recovery will occur in a reasonable period of time.
We utilize the asset and liability method of accounting for income tax. Under this method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and
In addition, we reported a 44.2% increase in net investment income from $10.0 million in 2004 to $14.5 million in 2005. This increase is a result of our operating cash flows and higher pretax investment yields. In addition, we continued our efforts in 2005 to increase our after tax yield by increasing our allocation to tax exempt municipal bonds. As a result of the relationship between our pretax income, which was adversely affected by the 2005 hurricane losses, and increase in our tax exempt municipal bonds, we reported an annual effective tax rate of 24.6% in 2005 compared to 32.4% in 2004.
Premiums include insurance premiums underwritten by Century (which are referred to as direct premiums) and insurance premiums assumed from other insurers generally in states where Century is not licensed (which are referred to as assumed premiums). We refer to direct and assumed premiums together as gross premiums.
Written premiums are the total amount of premiums billed to the policyholder less the amount of premiums returned, generally as a result of cancellations, during a given period. Written premiums become premiums earned as the policy ages. Barring premium changes, if an insurance company writes the same mix of business each year, written premiums and premiums earned will be equal, and the unearned premium reserve will remain constant. During periods of growth, the unearned premium reserve will increase, causing premiums earned to be less than written premiums. Conversely, during periods of decline, the unearned premium reserve will decrease, causing premiums earned to be greater than written premiums.
Gross written premium for the other (including exited lines) segment increased $3.2 million for the year ended December 31, 2005 compared to the year ended December 31, 2004. This increase represents surety business written in order to maintain the Company’s U.S. Treasury listing.
In addition, gross written premium for the other (including exited lines) segment was $814,000 for 2004, which represents surety premium amounts directly written and assumed by us and then ceded under a 100% quota share agreement with Evergreen. The 2003 amounts for the surety were reclassified as discontinued operations as a result of the disposition of Evergreen in 2004.
Year Ended December 31, 2005 Compared to Year Ended December 31, 2004. Net written premiums for the year ended December 31, 2005 were $189.5 million, representing an increase of 14.2% compared to the same period in 2004. Net written premiums were 87.7% of gross written premiums for the year ended December 31, 2005, which is consistent with the year ended December 31, 2004. Net premiums earned, a function of net written premiums, amounted to $177.6 million for the year ended December 31, 2005 and equaled 93.7% of net written premiums compared to 89.6% in 2004. This increase directly relates to a stabilization of the rate of growth in 2005.
Our investment portfolio generally consists of liquid, readily marketable and investment-grade fixed-maturity and equity securities. Net investment income is primarily comprised of interest and dividend earned on these securities, net of related investment expenses.
Year Ended December 31, 2004 Compared to Year Ended December 31, 2003. Net investment income increased to $10.0 million for the year ended December 31, 2004, compared to $6.5 million for the same period in 2003. The increase was due primarily to an increase in investments and cash, which was
The following table presents our incurred losses and loss expenses (net of the effects of reinsurance) from the most current accident year and from re-estimation of ultimate losses on prior accident years and provides a summary of losses incurred to premiums earned (loss and loss expense ratio) for the periods indicated.
Our gross reserves for loss and loss expenses were $211.6 million and $153.2 million (before the effects of reinsurance) at December 31, 2005 and 2004, respectively. In 2005, we determined that the December 31, 2004 net reserve for losses and loss expenses of $123.8 (after the effects of reinsurance) was deficient by $5.4 million.
period in 2003, as a result of the factors discussed below. Net loss and loss expense ratios for the year ended December 31, 2004 and 2003 were 59.9% and 74.8%, respectively.
An explanation of significant components of reserve development by segment (net of reinsurance unless otherwise indicated) for the years ended December 31, 2005, 2004 and 2003 is as follows:
Casualty. Our changes in the reserve estimates related to prior accident years for the years ended December 31, 2005, 2004 and 2003 for the casualty lines resulted in increases in incurred losses and loss expenses of $7.4 million, $12.8 million, and $22.2 million respectively. A significant portion of our casualty reserves development relate to construction defect claims in certain states. See “Business - General.” Starting with California in December 2000, we began to exit contractors’ liability business written on an occurrence form. By the end of the first quarter of 2001, we had significantly reduced our contractors’ liability written on an occurrence form underwriting in all states, and completely eliminated contractors’ liability written on an occurrence form in Arizona, California, Colorado, Hawaii, Louisiana, Nevada, New Jersey, North Carolina, Oregon, South Carolina and Washington. Reserves and claim frequency on this business may be impacted by decisions by California and other states’ courts affecting insurance law and tort law. They may also be impacted by legislation enacted in California. This legislation continues to impact claim severity, frequency and time to settlement assumptions underlying our reserves. Accordingly, our ultimate liability may exceed or be less than current estimates due to this variable, among others.
During 2003, the Company’s newly reported construction defect claims were 118.8% greater than expected as of December 31, 2002. Based on the Company’s experience during 2003 and industry information, the Company substantially increased its projected ultimate construction defect claim count as of December 31, 2003.
Of our construction defect net loss and loss expense reserves at December 31, 2005, 52.6% was for incurred but not reported losses (which are referred to as IBNR) and 61.0% of our construction defect net loss and loss expense reserves at December 31, 2004 was for IBNR. As of December 31, 2005, we had 480 open claims relating to construction defects, compared to 566 open claims as of December 31, 2004. During 2005, 840 new claims were reported and 926 existing claims were settled or dismissed. Our net loss and loss expense reserves for construction defects as of December 31, 2005 were $17.7 million. The re-estimation of construction defect reserves primarily affected the 1996 and 1997 accident years and the 1999 to 2001 accident years.
In addition, we have also experienced development above expectations on our non-construction defect casualty reserves for the 2000 to 2002 accident years that led to reassessments of the initial loss ratio expectations and the claim reporting and settlement patterns.
As of December 31, 2005, the projected loss and loss expense ratios, after the effects of reinsurance, for the casualty lines were 57.3%, 48.7% and 43.4% for accident periods 2005, 2004, and 2003, respectively.
For claim liabilities other than construction defect, our internal actuaries apply multiple traditional actuarial techniques to compute loss and loss expense reserve estimates. Each technique produces a unique loss and loss expense reserve estimate for the line being analyzed. The set of techniques applied produces a
For construction defect claim liabilities, our internal actuaries apply one actuarial technique, under various sets of assumptions, which considers the factors that influence ultimate claim costs. The actuarial technique for construction defect claim liabilities includes several variables relating to the number of IBNR claims and the average cost per IBNR claim. In addition to computing best estimate parameter values for the actuarial projection, the actuaries also consider the impact on resulting IBNR related to reasonably foreseeable fluctuations in these variables, which is used to quantify a range of techniques of loss and loss expense reserves for construction defect. As of December 31, 2005, for construction defect claims the low end of the range of techniques was 16.1% below the actuarial best estimate and the high end of the range of techniques was 21.5% above the actuarial best estimate. These low and high loss and loss expense reserve estimates reflect the uncertainty in estimating the parameter values, and these estimates do not constitute the range of all possible outcomes. It is important to note that actual claim costs will vary from the selected estimate, perhaps by substantial amounts, due to the inherent variability of these types of claims, the potentially significant claim settlement lags and the fact that not all events affecting future claim costs can be estimated at this time.
Property. Our changes in reserve estimates for the years ended December 31, 2005, 2004 and 2003 for the property lines resulted in (decreases) increases of ($2.4) million, ($3.2) million and $2.3 million, respectively. These amounts primarily relate to changes in the selected development patterns on multiple accident years, as the number of claims and claim severity were below expectations at December 31, 2004 and 2005 and exceeded expectations at December 31, 2003.
Our internal actuaries apply multiple actuarial techniques utilizing the same factors discussed above under “Casualty” to compute loss and loss expense reserve estimates for property claim liabilities. Each technique produces a unique loss and loss expense reserve estimate for the line being analyzed. The set of techniques applied produces a range of loss and loss expense reserve estimates. From these estimates, the actuaries form a best estimate that considers assumptions and factors, as discussed above, that influence ultimate claim costs. As of December 31, 2005, for property lines the low end of the range of techniques was 22.6% below the actuarial best estimate and the high end of the range of techniques was 3.0% above the actuarial best estimate. These low and high loss and loss expense reserve estimates reflect the fact that the methodologies applied do not produce identical estimates, and these estimates do not constitute the range of all possible outcomes. It is important to note that actual claim costs will vary from the selected estimate, perhaps by substantial amounts, due to the inherent variability of the business written, the potentially significant claim settlement lags and the fact that not all events affecting future claim costs can be estimated at this time.
We offered workers’ compensation coverage from 1997 through January 2002. We exited this line of business beginning January 1, 2002 due to unsatisfactory underwriting results and the lack of availability of acceptable reinsurance. Until July 2000, we purchased 100% quota share reinsurance on this book of business. Beginning in 2000, we started to retain some risk. No new policies have been written since the first quarter of 2002. Of our net loss and loss expense reserves at December 31, 2005, 57.6% related to workers’ compensation claims IBNR, and 49.8% of our net loss and loss expense reserves at December 31, 2004 was for workers’ compensation IBNR. As of December 31, 2005, we had 199 open claims relating to workers’ compensation compared to 257 open claims as of December 31, 2004. During 2005, 11 new claims were reported, and 69 existing claims were settled or dismissed. Our net loss and loss expense reserves for workers’ compensation as of December 31, 2004 were $2.7 million.
Year Ended December 31, 2004 Compared to Year Ended December 31, 2003. Operating expenses increased $10.9 million, or 28.2%, to $49.4 million in 2004 from $38.5 million for the same period in 2003. The increase was primarily attributable to an $8.6 million increase in amortized deferred policy acquisition costs, including commission expenses, associated with the increase in the volume of insurance written and other increases to support future growth. For the year ended December 31, 2004, the increase is offset by $655,000 of reductions to amortization expense that related to the termination of the inter-company pooling agreement and the implementation of the loss portfolio transfers that occurred on January 1, 2004.
We have historically filed a consolidated federal income tax return that has included all of our subsidiaries. However, Evergreen filed a separate federal income tax return in 2003. The statutory rate used in calculating our tax provision was 35.0% in 2005, 2004 and 2003. Income tax expense (benefit) differed from the amounts computed at the statutory rate as demonstrated in the following table:
Century is restricted by statute as to the amount of dividends it may pay without the prior approval of regulatory authorities. Century may pay dividends to ProCentury without advance regulatory approval only from unassigned surplus and only to the extent that all dividends in the current twelve months do not exceed the greater of 10% of total statutory surplus as of the end of the prior fiscal year or statutory net income for the prior year. Using these criteria, the available ordinary dividend payable by Century to ProCentury during 2006 is $12.1 million. Century paid ordinary dividends of $2.5 million in 2005, $6.0 million in 2004, and $3.0 million in 2003. In addition, Century paid $3.1 million of extraordinary dividend in 2004 related to the dividend distribution of Evergreen. Century’s ability to pay future dividends to ProCentury without advance regulatory approval is dependent upon maintaining a positive level of unassigned surplus, which in turn, is dependent upon Century generating net income in excess of dividends to ProCentury.
Century is required by law to maintain a certain minimum level of surplus on a statutory basis. Surplus is calculated by subtracting total liabilities from total admitted assets. The National Association of Insurance Commissioners (“NAIC”) has a risk-based capital standard designed to identify property and casualty insurers that may be inadequately capitalized based on inherent risks of each insurer’s assets and liabilities and its mix of net written premiums. Insurers falling below a calculated threshold may be subject to varying degrees of regulatory action. As of December 31, 2005, the statutory surplus of Century was in excess of the prescribed risk-based capital requirements that correspond to any level of regulatory action. Century’s statutory surplus at December 31, 2005 was $121.8 million and the authorized control level was $33.6 million.
Consolidated net cash provided by operating activities was $63.7 million for the year ended December 31, 2005, compared to $81.0 million for the year ended December 31, 2004. This decrease was primarily attributable to the decrease in receivable from subsidiary available-for-sale that was received in 2004. No such amounts were received in 2005.
Net cash used by investing activities was $141.5 million for the year ended December 31, 2004, compared to $52.0 million for the year ended December 31, 2003. This increase was primarily attributable to the proceeds from the IPO and improved operating cash flows noted above that were used to purchase fixed maturities and equity securities.
operations and investment maturities, that are available for reinvestment during periods of rising or falling interest rates.
Amounts include interest payments associated with these obligations using applicable interest rates as of December 31, 2005.
In connection with the adoption of FIN 46R, ProCentury has deconsolidated the trusts established in connection with the issuance of trust preferred securities effective December 31, 2003. As a result, ProCentury reports as a component of long term debt the junior subordinated debentures payable by ProCentury to the trusts. See Note 8(b) to our audited consolidated financial statements included in Item 8 of this Annual Report on Form 10-K.
Line of Credit. ProCentury has a $5.0 million line of credit. Interest on the note is payable quarterly and is based on a floating rate of LIBOR plus 2.5%. The note matures on September 8, 2006. Under the terms of the line of credit, 100% of the common shares of Century are pledged as collateral. In April 2005, we made a $2.3 million draw on the line of credit for general corporate purposes. The $2.3 million draw was paid off on May 17, 2005. Interest paid on the line of credit was $5,000. Due to the late filing of the Quarterly Report on Form 10-Q for the quarter ended June 30, 2005, we became non-compliant with the debt covenants in its line of credit. On September 7, 2005, we received a waiver from the bank and now have the ability to draw on the line of credit. We do not have any borrowings outstanding under the line of credit at December 31, 2005.
Our investment strategy is designed to capitalize on our ability to generate positive cash flow from our underwriting activities. Preservation of capital is our first priority, with a secondary focus on maximizing appropriate risk adjusted return. We seek to maintain sufficient liquidity from operations, investing and financing activities to meet our anticipated insurance obligations and operating and capital expenditure needs. The majority of our fixed-maturity portfolio is rated investment grade to protect investments. Our investment portfolio is managed by three outside independent investment managers that operate under investment guidelines approved by Century’s investment committee. Century’s investment committee meets at least quarterly and reports to ProCentury’s board of directors. In addition, we employ stringent diversification rules and balance our investment credit risk and related underwriting risks to minimize total potential exposure to any one security. In limited circumstances, we will invest in non-investment grade fixed maturity securities that have an appropriate risk adjusted return, subject to satisfactory credit analysis performed by us and our investment managers. Our cash and investment portfolio totaled $366.4 million as of December 31, 2005 and is summarized by type of investment as follows:
At December 31, 2005, our investment portfolio contained corporate fixed-maturity and corporate equity securities with a fair value of $58.2 million. The following is a summary of these securities by industry segment at December 31, 2005:
At December 31, 2005, the investment portfolio contained $106.6 million of mortgage-backed, asset-backed and collateralized mortgage obligations. Of these securities, 79.8% were rated “AA” or better and 78.7% were rated “AAA” by Standard & Poor’s or the equivalent rating by Moody’s. These securities are publicly registered and had fair values obtained from independent pricing services. Changes in estimated cash flows due to changes in prepayment assumptions from the original purchase assumptions are revised based on current interest rates and the economic environment. We had no derivative financial instruments, real estate or mortgages in the investment portfolio at December 31, 2005.
Under our accounting policy for equity securities and fixed-maturity securities an impairment is deemed to be other-than-temporary unless we have both the ability and intent to hold the investment for a reasonable period until the security’s forecasted recovery and evidence exists indicating that recovery will occur within a reasonable period of time.
Market risk is the potential economic loss principally arising from adverse changes in the fair value of financial instruments. The major components of market risk affecting us are credit risk, equity price risk and interest rate risk.
Credit Risk. Credit risk is the potential economic loss principally arising from adverse changes in the financial condition of a specific debt issuer. We attempt to address this risk by investing in fixed-maturity securities that are either investment grade, which are those bonds rated “BBB-” or higher by Standard & Poor’s or securities that although not investment grade, meet our credit requirements and targeted risk adjusted return. We also independently and through our outside independent investment managers, monitor the financial condition of all of the issuers of fixed-maturity securities in our portfolio. We utilize a rating change report, a rating watch report and a focus list as part of this process. Finally, we employ stringent diversification rules that limit our credit exposure to any single issuer.
Equity Price Risk. Equity price risk is the potential that we will incur economic loss due to decline in common stock prices. We attempt to manage this risk by focusing on a long-term, conservative, value oriented, dividend driven investment philosophy for our equity portfolio. The equity securities in our portfolio are primarily mid-to-large capitalization issues with strong dividend performance. Our strategy remains one of value investing, with security selection taking precedence over market timing. We also employ stringent diversification rules that limit our exposure to any individual stock.
The table below summarizes our interest rate risk. It illustrates the sensitivity of the fair value of fixed-maturity, preferred share and bond mutual fund investments to selected hypothetical changes in interest rates at December 31, 2005. The selected scenarios are not predictions of future events, but rather illustrate the effect that such events may have on the fair value of the fixed-maturity, preferred share and bond mutual fund portfolio and shareholders’ equity.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 15, 2006 expressed an unqualified opinion on management’s assessment of, and the effective operation of, internal control over financial reporting.
In our opinion, management’s assessment that ProCentury Corporation and subsidiaries maintained effective internal control over financial reporting as of December 31, 2005, is fairly stated, in all material respects, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Also, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of ProCentury Corporation and subsidiaries as of December 31, 2005 and 2004, and the related consolidated statements of operations, shareholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2005, and our report dated March 15, 2006 expressed an unqualified opinion on those consolidated financial statements.
Immediately prior to the completion of the IPO, each outstanding Class A common share was converted into 500 common shares. After the conversion, but prior to the completion of the IPO, the Company had 4,999,995 Class A common shares outstanding. The share conversion is reflected for all periods presented;
The Company issued 6,000 and 12,000 options to the Board of Directors on March 22, 2005 and June 1, 2005, respectively.
Credit Risk is the risk that issuers of securities owned by the Company will default or other parties, including reinsurers that owe the Company money, will not pay. The Company attempts to minimize this risk by adhering to a conservative investment strategy and by maintaining reinsurance and credit and collection policies.
The accompanying consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles (GAAP).
In 2003 the Company owned a controlling interest of Evergreen and therefore, consolidated 100% of Evergreen’s assets, liabilities, revenues, and expenses, with reductions on the balance sheets and statements of operations for the minority shareholders’ proportionate interest in Evergreen’s equity and earnings (see Note 3). As of the IPO, Evergreen is no longer a subsidiary of the Company (see Note 1(a)).
The Company classifies its fixed maturity and equity securities into one of two categories: held-to-maturity or available-for-sale. Held-to-maturity securities are those securities that the Company has the ability and intent to hold the security until maturity. All securities not classified as held-to-maturity are classified as available-for-sale.
Under the Company’s accounting policy for equity securities and fixed-maturity securities, an impairment is deemed to be other-than-temporary unless the Company has both the ability and intent to hold the investment for a reasonable period until the security’s forecasted recovery and evidence exists indicating that recovery will occur in a reasonable period of time.
The Company defers commissions, premium taxes and certain other costs that vary with and are primarily related to the acquisition of insurance contracts. These costs are capitalized and charged to expense in proportion to premium revenue recognized. The method followed in computing deferred policy acquisition
In the ordinary course of business, Century reinsures certain risks, generally on an excess-of-loss basis, with other insurance companies which primarily are rated “A” or higher by A.M. Best. Such reinsurance arrangements serve to limit the Company’s maximum loss.
Reinsurance recoverables are determined based in part on the terms and conditions of reinsurance contracts. Reinsurance recoverables on paid and unpaid losses, net, are established for the portion of our loss and loss expense reserves that are ceded to reinsurers and are reported separately as assets, net of any valuation allowance. Reinsurance recoverables on paid and unpaid losses are accounted for and reported separately as assets, net of any valuation allowance, while ceded premiums payable are reported separately as liabilities. Reinsurance premiums paid and reinsurance recoveries on claims incurred are deducted from the respective revenue and expense accounts. The estimated valuation allowance on reinsurance recoverables on paid losses at December 31, 2005 and 2004 was $1.3 million.
On June 1, 2005, Century acquired 100% of the outstanding shares of the Fireman’s Fund of Texas (FFTX) for $5.9 million. FFTX is a Texas domiciled property and casualty company licensed in Texas, Oklahoma and California. The acquisition is part of the Company’s long-term plan to develop business that requires admitted status, as well as its continued focus on growing its excess and surplus lines business. On August 16, 2005, FFTX was renamed ProCentury Insurance Company. The total purchase price of the acquisition was allocated to the assets and the liabilities acquired based upon the respective fair values as of the date of acquisition. Intangible assets included in the purchase were valued at $375,000. The excess of the fair value of the net identifiable assets acquired over the purchase price was $240,000 and was recorded as non-deductible goodwill. In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets,” the amortization of goodwill and indefinite-lived intangible assets is not permitted. Goodwill and indefinite-lived intangible assets remain on the balance sheet and are tested for impairment on an annual basis, or when there is reason to suspect that their values may have been diminished or impaired. The indefinite-life intangible assets and goodwill are included in other assets in the Consolidated Balance Sheets.
ProCentury and its subsidiaries file a consolidated federal income tax return in accordance with a tax sharing agreement. Each entity within the consolidated group pays its share of federal income taxes primarily based on separate return calculations. ProCentury’s tax sharing agreement with its subsidiaries allowed it to make certain code elections in its consolidated federal tax return. In the event such code elections are made, any benefit or liability is the responsibility of ProCentury and is not accrued or paid by the subsidiary.
Pursuant to disclosure requirements contained in SFAS No. 128, Earnings per Share, the following information represents a reconciliation of the numerator and denominator of the basic and diluted EPS computations contained in the Company’s consolidated financial statements.
The Company, in estimating its fair value disclosures for financial instruments, uses the following methods and assumptions:
No share option or restricted common share-based compensation expense is included in reported net income for 2003, as the Company had no common share equivalents granted during 2003.
The fair values of the share options are estimated on the date of grant using the Black Scholes option pricing model with the following weighted average assumptions:
In December 2004, the FASB revised Statement No. 123 (SFAS 123R), “Share-Based Payment,” which requires companies to expense the estimated fair value of employee stock options and similar awards, for all options vesting, granted, or modified after the effective date of this revised statement. The accounting provisions of SFAS 123R were to become effective for interim periods beginning after June 15, 2005. In April 2005, the Securities and Exchange Commission (SEC) adopted a final rule amending Rule 4-01(a) of Regulation S-X regarding the compliance date for SFAS 123R. This ruling delays the effective date of SFAS 123R to the first interim or annual reporting period of the registrant’s first fiscal year beginning on or after June 15, 2005. As a result, the accounting provisions of SFAS 123R will become effective beginning in 2006 for our financial statements. The Company continues to evaluate the impact of implementing SFAS 123R and anticipates that it will not differ materially from the SFAS 123 proforma information provided under Note 1(p).
In May of 2005, the FASB issued SFAS 154, “Accounting Changes and Error Corrections.” This Statement replaces, APB 20, “Accounting Changes,” and SFAS 3, “Reporting Accounting Changes in Interim Financial Statements”, and changes the requirements for the accounting for and reporting of a change in accounting principle. This Statement applies to all voluntary changes in accounting principle. It also applies to changes required by an accounting pronouncement in the unusual instance that the pronouncement does not include specific transition provisions. When a pronouncement includes specific transition provisions, those provisions should be followed. This statement applies to accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. The Company will adopt this guidance prospectively.
Late in 2005, the FASB issued FSP FAS 115-1 and FAS 124-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.” This FASB Staff Position (FSP) addresses the determination as to when an investment is considered impaired, whether that impairment is other than temporary, and the measurement of an impairment loss. This FSP also includes accounting considerations subsequent to the recognition of an other-than-temporary impairment and requires certain disclosures about unrealized losses that have not been recognized as other-than-temporary impairments. The guidance in this FSP amends FASB Statements No. 115, “Accounting for Certain Investments in Debt and Equity Securities”, and No. 124, “Accounting for Certain Investments Held by Not-for-Profit Organizations,” and APB Opinion No. 18, “The Equity Method of Accounting for Investments in Common Stock.” The Company will adopt the provisions of this guidance in 2006 as required.
Certain 2004 and 2003 amounts have been reclassified in order to conform to the 2005 presentation.
Other-than-temporary impairment losses result in a permanent reduction to the cost basis of the underlying investment and are recorded as a realized gain (loss) in the consolidated statement of operations. For the year ended December 31, 2005, the Company determined that two of the fixed maturity securities were other than temporarily impaired and were written down in the amount of $35,000 and $115,000, respectively which were included as realized losses in the consolidated statements of operations. No other-than-temporary declines were realized in the year ended December 31, 2004. For the year ended December 31, 2003, one fixed maturity security was written down in the amount of $87,000 which was included as a realized loss in the accompanying consolidated statements of operations for that period.
At December 31, 2005, the Company had 104 fixed income securities and 10 equity securities that have been in an unrealized loss position for one year or longer. Of the fixed income securities, 103 are investment grade, of which 101 of these securities are rated A1/ A or better (including 70 securities which are rated AAA). The one remaining non-investment grade fixed income security is rated BB- and has a fair value equal to 99.8% of its book value as of December 31, 2005. One of the equity securities that has been in an unrealized loss position for one year or longer relates to a closed end preferred stock fund, which continues to pay its regular dividend on a monthly basis and has an underlying net asset value per share that exceeds its price per share as of December 31, 2005. One of the equity securities relates to an investment in an open end, high quality short duration bond fund, of which the underlying assets are all rated AAA. Finally, the eight remaining equity securities that have been in an unrealized loss position for one year or longer relate to
All investments in fixed-maturity securities were income producing during 2005, 2004 and 2003. Net realized investment gains, including other-than-temporary impairments, were as follows:
For the years ended December 31, 2005, 2004 and 2003, net income tax (benefit) expense on net realized investment (losses) gains was ($114,000), $18,000, and $676,000, respectively.
Proceeds from the sale of fixed maturity securities available-for-sale were $48.3 million, $28.0 million, and $72.6 million for the years ended December 31, 2005, 2004 and 2003, respectively.
At December 31, 2005 and 2004, Century maintained a trust fund (consisting of cash and investments) with a combined carrying value of approximately $236,000 and $234,000, respectively. The assets of the trust are recorded as cash and investments and are held as security for unearned premiums and outstanding loss reserves under an assumed reinsurance contract.
(b) The Class C shareholders are entitled to receive (on a pro rata basis) the lesser of the amount of liquation proceeds (net of the first distribution as defined in (a) above) or $5 million per Class C share plus 5% per annum simple interest thereon between the date of issuance of such Class C share and the date of the liquidation event.
In May of 2003 management of the Company began discussions and contemplation of adopting a formal plan of reorganization which included the disposition of the remaining interests of Evergreen. At this point, the Company determined that the result of all subsequent sales of subsidiary stock would be required to be reflected directly in shareholders’ equity, rather than in the statement of operations. This plan was formalized and approved at the November 2003 board meeting. As part of this plan, in August 2003 Century sold 299.5 Class A shares and 2,088.5 Class B shares for net proceeds of $2.8 million. Simultaneously, Evergreen issued to the acquirer of the shares .5 Class C share for net proceeds of $2.5 million. In addition, in December 2003, Century sold 299.5 Class A shares and 2,088.5 Class B shares for net proceeds of $2.8 million. Simultaneously, Evergreen issued to the acquirer .5 Class C share for net proceeds of $2.5 million. These transactions resulted in a pretax gain of $625,000 ($406,250 after tax gain), which is included as additional paid in capital in the accompanying 2003 consolidated balance sheet. In addition, transaction fees related to these sales of $600,000 are recorded in the 2003 consolidated statement of operations. The remaining interest in Evergreen was distributed as a dividend to existing shareholders in 2004.
The Company increased incurred loss and loss expenses attributable to insured events of prior periods by approximately $5.4 million, $11.1 million and $27.0 million in 2005, 2004 and 2003, respectively.
A significant portion of the loss and loss expenses attributable to insured events of prior periods for 2005 resulted from construction defect claims in the other liability line. As a result of court decisions that further defined the legal environment in California, the Company decided to enhance its defense strategy for certain types of construction defect claims. As a result, the Company revised the construction defect defense team by retaining appellate and new trial counsel and restaffing the in-house team responsible for management of the
litigation. Once the new legal teams were established late in 2004 and into 2005, it was determined that there were certain cases that should be settled and the defense budgets for the remaining cases had to be revised to reflect the added resources, resulting in higher than expected loss and defense costs in 2005. In 2004 and 2003, the Company received an unanticipated increase in the number of construction defect claims which led to an increase in the number of future expected claims.
During 2004 and 2003, the Company also incurred development above expectations on our non-construction defect casualty, commercial automobile and workers’ compensation that led to reassessments of the initial loss ratio expectations and the claim reporting and settlement patterns.
During 2004, the Company lost binding arbitration with one of the reinsurers. This reinsurer was the only reinsurer on the quota share agreements and was a participant on the excess of loss treaties. The arbitration centered on the quota share agreements and did not fully contemplate evidence related to the excess of loss treaties. As such, the Company is pursuing further litigation on the collection of the excess of loss treaties and has fully reserved the collectibles related to the recoverable amounts on the quota share agreements. In addition, the Company has established an additional $200,000 reserve on the amounts recoverable related to the excess of loss treaties. The Company believes that it will ultimately prevail on the collection of the excess of loss recoverable amounts and are beginning to pursue collection related to the other two reinsurers.
In addition, in 2005, the Company had given notice of a potential claim against our reinsurers for $4.0 million for which coverage is disputed by certain reinsurers. The company’s liability on the underlying loss has not been finally adjusted; therefore, the Company has not begun arbitration on this claim. If the claim must be arbitrated, the Company believes that it will ultimately prevail.
The following table displays net reinsurance balances recoverable, from our top ten reinsurers, as of December 31, 2005. All other reinsurance balances recoverable, when considered by individual reinsurer, are less than 3 percent of shareholders’ equity.
We are closely monitoring the financial status of Gerling Global Reinsurance Corporation (which is not rated as it is no longer accepting new business) and SCOR Reinsurance Company, each of which is continuing to pay claims.
Beginning April 5, 2003, principal payments recommenced with principal and interest payments due quarterly with a maturity date of October 5, 2012. From October 5, 2002 to October 4, 2003, interest on the outstanding principal balance accrued at a floating rate of interest equal to the prime rate of interest at any given time. Beginning on October 4, 2003, the rate is adjusted annually to the current prime rate on October 5 until final maturity of the note on October 5, 2012. All of the stock of Century and PIA secure the loan. The loan was paid in full in April 2004 with a portion of the proceeds from the Company’s IPO.
The Company’s special purpose entities where the Company is the primary beneficiary are the trusts that were established in connection with the issuance of mandatorily redeemable preferred securities. As a result of the adoption of FIN 46R, the Company has deconsolidated these trusts as of December 31, 2003 This resulted in the Company classifying the trust preferred securities as long term debt and recording an increase of $733,000 in other assets and long term debt, both of which were previously eliminated when consolidating the trust. The $733,000 recorded in other assets is being amortized over the remaining life of the trusts. There was no other impact to the Company’s consolidated financial statements as a result of the adoption of FIN 46R.
The Trust Preferred Securities have a 30 year maturity and are redeemable by the Company at par on or after December 15, 2007 and May 15, 2008, respectively. Holders of the Trust Preferred Securities are entitled to receive cumulative cash distributions accruing from the date of issuance and payable quarterly in arrears at a rate of 400 and 410 basis points, respectively, over the three-month London Interbank Offered Rates (“LIBOR”). The maximum distribution rate is 12.5% through December 4, 2007 and May 15, 2008, respectively. Under certain circumstances, the Company has the right to defer distributions and interest on the Trust Preferred Securities for up to five years. The obligations of the Trust are guaranteed by the Company with respect to distributions and payments of the Trust Preferred Securities. These distributions are recorded as interest expense in the accompanying consolidated statements of operations, as the Trust Preferred Securities are considered a debt instrument. Interest paid totaled $1.9 million, $1.4 million and $1.1 million in 2005, 2004 and 2003, respectively.
Of the proceeds from the sale of the Trust Preferred Securities, ProCentury contributed and/or settled outstanding amounts with Century in the amounts of $9.0 million in 2003.
The Company has a $5.0 million line of credit with a maturity date of September 8, 2006, and interest only payments due quarterly based on LIBOR plus 2.5% multiplied times the outstanding balance. All of the outstanding shares of Century are pledged as collateral. In April 2005, the Company made a $2.3 million draw on the line of credit for general corporate purposes. The $2.3 million draw was paid off on May 17, 2005. Interest paid on the line of credit was $5,000. Due to the late filing of the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2005, the Company became non-compliant with the debt covenants
The income tax expense (benefit) differed from the amounts computed by applying the U.S. federal income tax rate of 35% in 2005, 2004 and 2003 to income before minority interest and income taxes as a result of the following:
The tax effects of temporary differences that give rise to significant portions of the net deferred federal income tax asset/liability were as follows:
During 2004, the Company adopted and the shareholders approved a stock option plan that provided tax-favored incentive stock options (qualified options), non-qualified share options to employees and qualified board members that do not qualify as tax-favored incentive share options (non-qualified options), time-based restricted shares that vest solely on service provided and restricted shares that vest based on achieved performance metrics. The Company accounts for this plan in accordance with APB Opinion No. 25. Any compensation cost recorded in accordance with APB No. 25 is recorded in the same captions as the salary expense of the employee (i.e. the compensation cost for the Chief Investment Officer is recorded in net investment income).
With respect to qualified options, an employee may be granted an option to purchase shares at the grant date fair market value, payable as determined by the Company’s board of directors. An optionee must exercise an option within 10 years from the grant date. Full vesting of options granted occurs at the end of four years.
The time-based restricted shares are granted to key executives and vest in equal installments upon the lapse of a period of time, typically over, four and five year periods and include both monthly and annual vesting periods. Compensation expense for time-based restricted shares is measured on the grant date at the current market value and then recognized over the respective service period, which typically matches the vesting period.
A summary of the status of the option plan at December 31, 2005 and 2004, and changes during the years then ended are presented in the following table:
Transitional Administrative Agreement. Prior to the Evergreen and Continental dispositions, the Company provided Evergreen and Continental with all executive, managerial, supervisory, administrative, technical, claims handling, investment management, regulatory affairs, legal, accounting, financial reporting, professional and clerical services necessary to operate their respective businesses. In order to provide Evergreen and Continental with a transition period before the cessation of these services, the Company entered into a Transitional Administrative Agreement with Evergreen and Continental pursuant to which the Company continues to provide these services to Evergreen and Continental for an initial term of 18 months.
This agreement was renewed for one six-month term to expire on December 31, 2005, without any changes in the terms thereof. On December 29, 2005, the agreement was amended to extend the term thereof to June 30, 2006, reduce the administrative fee to $75,000 per calendar quarter payable during the first month of each quarter and providing for termination upon not less than thirty (30) days advance written notice to the Company. For the year ended December 31, 2005 and 2004, the Company received $690,000 and $900,000 under this agreement, respectively.
Reinsurance Agreements. The Company entered into loss portfolio transfer reinsurance contracts that provided for Century to reinsure Evergreen and Continental for business that was written in Century’s name prior to December 31, 2003 and transferred to one of the other companies in connection with the termination of an intercompany pooling agreement among the parties and for Evergreen to reinsure Century in the same manner. For example, Century will reinsure property business transferred to it in connection with the termination of the intercompany pooling agreement that had been written for it in Evergreen’s name. These contracts will remain in force until all outstanding loss and assignable loss adjustment expense covered has been settled or commuted in accordance with the provisions of the applicable contract. The Company ceded $423,000 reserves and assumed $2.9 million reserves under this contract in 2005.
In addition, in 2005, the Company entered into 50% quota share agreement with Evergreen whereby, the Company would assume certain special surety bonds (including closure and post closure solid waste industry bonds). During 2005, the Company recorded approximately $2.4 million of assumed bonds.
Accretive Agreements. These agreements were entered into as of July 1, 2002. Pursuant to these agreements, the Company’s shareholders assisted the Company in developing financial products and services to be offered to and through the community banks. Pursuant to these agreements the Company paid approximately $241,000 and $966,000 in 2004 and 2003, respectively.
No amounts were accrued at December 31, 2005 or December 31, 2004 related to these agreements. Approximately, $483,000 was accrued at December 31, 2003.
The following table summarizes information about contractual obligations and commercial commitments. The minimum payments under these agreements as of December 31, 2005 were as follows:
Five of the Company’s 119 agents contributed, on a combined basis, approximately 41.7% of the Company’s 2005 consolidated direct and assumed premiums written. One of the Company’s agents individually contributed an amount greater than 10% of the Company’s direct and assumed premiums written and combined represented approximately 19.3% of the Company’s 2005 consolidated direct and assumed premiums written. There was no concentration of revenue with respect to geographic area as of December 31, 2005.
Century is regulated by its state of domicile, Ohio, and the states in which it does business. Such regulations, among other things, limit the payment of dividends without prior regulatory approval. ProCentury is dependent on dividends from Century for operating expenses and interest and principal on long term debt and the Debentures. The maximum dividend that may be paid without prior approval of the Director of Insurance is limited to the extent that all dividends in the past 12 months do not exceed the greater of the statutory income of the preceding calendar year or 10% of total statutory surplus as of the prior December 31. As a result, the maximum dividend Century may pay to ProCentury in 2006 without prior approval is approximately $12.1 million. Dividends paid to ProCentury from Century were $2.5 million, $9.1 million (of which $6.0 million were ordinary dividends and $3.1 million were extraordinary dividends), and $3.0 million in 2005, 2004 and 2003, respectively.
The National Association of Insurance Commissioners (NAIC) has developed property and casualty risked based capital (RBC) standards that relate an insurer’s reported statutory surplus to the risks inherent in overall operations. The RBC formula uses the statutory annual statement to calculate the minimum indicated capital level required to support asset and underwriting risk. The NAIC calls for various levels of regulatory action based on the magnitude of an indicated RBC capital deficiency, if any. Century regularly monitors capital requirements along with the NAIC’s RBC developments. Century has determined that its capital levels are in excess of the minimum capital requirements for all RBC action levels as of December 31, 2005.
Century maintains its accounts in conformity with accounting practices prescribed or permitted by the Ohio Department of Insurance that vary in certain respects from GAAP. In converting from statutory to GAAP, typical adjustments include deferral of policy acquisition costs, the inclusion of statutory nonadmitted assets, and the inclusion of net unrealized holdings gains or losses in shareholders’ equity relating to fixed maturity securities. The statutory capital and surplus of Century as of December 31, 2005 and 2004 was approximately $121.8 million and $115.8 million, respectively. The statutory net (loss) income of Century for the years ended December 31, 2005, 2004 and 2003, was approximately $7.8 million, $13.8 million and $(2.4) million, respectively.
The Company primarily operates in the Property and Casualty Lines (P/ C) (including general liability, multi-peril, commercial property and garage liability).
The Company’s other (including exited lines) include the surety business and the Company’s exited lines such as workers’ compensation and commercial auto (trucking). A limited amount of surety business is written in order to maintain Century’s U.S. Treasury listing.