We provide, through our wholly-owned subsidiaries, (1) insurance services, specifically medical professional liability insurance in Texas and (2) financial services, including brokerage and investment services to institutions and high net worth individuals.
The fair values of the reserves for losses and loss adjustment expenses and related reinsurance recoverables (the net loss reserves) acquired in the API transaction were estimated as of the date of acquisition based on the present value of the expected underlying net cash flows, and includes a risk premium and a profit margin. In determining the fair value estimate, management discounted API’s historical undiscounted loss reserves, to present value assuming discounting patterns actuarially developed from the historical loss data of API. The discount rate used of 4.64% approximates the risk-free treasury rate on the acquisition date for maturities similar to the estimated duration of the reserves being valued. A risk premium was applied to the discounted net loss reserves to reflect management’s estimate of the cost API would incur to reinsure the full amount of its net loss reserves with a third-party reinsurer. This risk premium is based upon management’s assessment of the inherent uncertainty in reserving for net loss reserves and their knowledge of the reinsurance marketplace and was confirmed by a reinsurance intermediary. The calculation resulted in a fair value estimate which was not materially different than the historical loss reserves and therefore did not result in an adjustment to the historical reserve amount.
The following table sets forth selected historical financial and operating data for the Company. Our results of operations for the year ended December 31, 2007 include the historical financial and operating results of the Company prior to and subsequent to the acquisition of API on April 1, 2007. The selected historical financial and operating data is derived from our consolidated financial statements which management believes incorporate all of the adjustments necessary for the fair presentation of the financial condition and results of operations for such periods. All information is presented in accordance with GAAP, but may not be comparable as data stated for periods 2006 and later were impacted by the implementation of SFAS No. 123(R). Actual financial results through December 31, 2007 may not be indicative of future financial performance. Equity compensation expense of approximately $1,200,000 related to our acquisition of API is included in the year ended December 31, 2007 results from operations.
Realized capital gains decreased by $2,948,000 (95%) to $155,000 from $3,103,000 for the year ended December 31, 2006 as compared to 2005 primarily due to the sale of a much larger number of available-for-sale equity securities in 2005 compared to sales in 2006. Sales of these securities are down in 2006 as a result of fewer shares held by us and a decline in their market price.
Other revenue decreased $33,000 (27%) from $122,000 in 2005 compared to $89,000 in 2006. The decline in 2006 was primarily the result of lower contractual payments received from a former affiliate.
Management service expenses from our Insurance Services segment increased $1,000,000 (10%) to $11,262,000 from $10,262,000 for the year ended December 31, 2006 compared to 2005. Payroll expense increased $291,000 (9%) to $3,448,000 from $3,157,000 in 2006 compared to 2005 due in part to merit increases, the addition of new managerial positions, additional staff positions for business development and physician services departments and expensing stock options as required by SFAS No. 123(R). Options expense totaled $144,000 in 2006, the first year that we expensed stock options. Professional fees increased $165,000 (65%) to $419,000 from $254,000 in 2006 compared to 2005 due primarily to consulting costs incurred in the analysis of new policy and claims software. Pass through commissions expense increased $270,000 (6%) in 2006 compared to 2005 due to the above-mentioned increase in commissions paid to third party independent agents. Lastly, advertising expense increased $65,000 (72%) to $155,000 from $90,000 in 2006 compared to 2005 due to consulting costs associated with increased marketing efforts.
Financial Services expenses decreased $1,116,000 (7%) to $15,157,000 from $16,273,000 in 2006 compared to 2005. Reflecting the above-mentioned lower commission revenue, commission expense, which includes commissions from secondary market trading, as well as placement fees for investment banking and referral fees for bank debt trading, were down $1,512,000 (14%) to $9,391,000 from $10,903,000 in 2006 compared to 2005. Partially offsetting this decrease in 2006 expenses was an increase in payroll which was up $195,000 (11%) to $2,013,000 from $1,818,000 in 2006 due largely to the hiring of additional personnel in the investment banking and bank debt trading areas as the firm continued to ramp up these business efforts. Also adding to the payroll variance was an increase in performance-related forgivable loans granted to a high-producing broker and which are expensed upon his continued employment with us. In addition, options expense totaled $44,000 in 2006, the first year that we expensed stock options.
The primary sources of our liquidity for the year ended December 31, 2007, are funds provided by insurance premiums collected, net investment income, recoveries from reinsurers, proceeds from the maturity and sale of invested assets, and payments received on our mortgage-backed securities as well as revenue from our Financial Services segment. In addition, a large non-recurring source of funds in 2007 resulted from our secondary common stock offering of 2,315,000 common shares. The primary uses of cash are losses and loss adjustment expenses from insurance claims, operating expenses, the acquisition of invested assets and fixed assets, reinsurance premiums, Financial Services expenses, software purchases, common stock buybacks, shareholder dividends and federal income taxes.