In the independent agency distribution channel and the unaffiliated managing general agency (MGA) distribution channel, the effect of competitive conditions is the same as in our owned retail store distribution channel. As in our retail stores, independent agents (either working directly with us or through unaffiliated MGAs) not only offer our products but also offer their customers a selection of products by third-party carriers. Therefore, our insurance products must be competitive in pricing, features, commission rates and ease of sale or the independent agents will sell the products of those third-parties instead of our products. We believe that we are generally competitive in the markets we serve, and we constantly evaluate our products relative to those of other carriers.
due to a sliding scale profit commission payable by the reinsurer to us should there be favorable loss development. This profit commission made the likelihood very remote that the reinsurer would have any significant additional gain or loss on this block of business. The reinsurers will ultimately make the same payments, either to us from profit commission or for the full amount of losses and loss adjustment expenses. The combined cost to the reinsurer is the same. Consequently, since no significant risk was transferred, the use of deposit accounting was required and the use of reinsurance accounting was impermissible under SFAS No. 113. At December 31, 2007, there were no deposit assets and $235,000 of deposit liabilities recorded on the balance sheet for this contract.
Loss and loss adjustment expenses for 2006 decreased $5.9 million, or 3.1%, compared with 2005. The decrease was primarily due to favorable loss development in 2006 compared with loss estimates made in 2005. The increase in our overall loss and loss adjustment expense ratio was primarily due to less favorable loss development in 2006 on prior years’ business than we experienced in the prior year. The following table displays the impact of favorable loss development related to prior periods’ business on our loss ratio for the years ended December 31, 2007, 2006 and 2005:
The following table presents the development of reserves for unpaid losses and loss adjustment expenses from 1997 through 2007 for our insurance company subsidiaries, net of reinsurance recoveries or recoverables. The first line of the table presents the reserves at December 31 for each indicated year. This represents the estimated amounts of losses and loss adjustment expenses for claims arising in that year and all prior years that are unpaid at the balance sheet date, including losses incurred but not reported to us. The upper portion of the table presents the cumulative amounts subsequently paid as of successive years with respect to those claims. The lower portion of the table presents the re-estimated amount of the previously recorded reserves based upon the experience as of the end of each succeeding year. The estimates are revised as more information becomes known about the payments, frequency and severity of claims for individual years. A redundancy (deficiency) exists when the reestimated reserves at each December 31 is less (greater) than the prior reserve estimate. The cumulative redundancy (deficiency) depicted in the table, for any particular calendar year, represents the aggregate change in the initial estimates over all subsequent calendar years.
Selling, general and administrative expenses for 2006 decreased $3.3 million, or 2.1%, compared with 2005. Significant costs that impacted comparability of 2006 compared with 2005 were approximately $16.6 million. These items included $7.2 million for the increase to our reserve for doubtful accounts for the uncertainty of collecting a receivable due from VIG, $6.5 million of IT transition expenses related to outsourcing costs, $739,000 in severance for a former executive, $378,000 in severance for IT due to the outsourcing transition, $788,000 for costs related to the Chicago office relocation, $697,000 in costs related to an acquisition that ultimately was not completed, $133,000 for the final installment on a retained executive search contract initiated in 2005 and $125,000 in costs due to the early termination of a lease for office space in Michigan.
The net expense ratio for 2006 increased to 32.6%, compared with 26.3% for 2005 even though our total selling, general and administrative expenses declined in the current year. The increase in our expense ratio is due, in part, to our decision to reduce or eliminate agency fees for policies sold in our retail locations as discussed above, thereby reducing the amount of the revenue offset against expenses.
Depreciation and Amortization. Depreciation and amortization expenses for 2007 increased $6.9 million, or 156.0%, compared with 2006. Depreciation expense increased by $2.5 million and amortization expense increased by $4.4 million for 2007, primarily as a result of the acquisition accounting for USAgencies. The USAgencies-related costs consisted of the amortization for the intangible costs of trade name, non-competition agreement and agency relationships determined as required by purchase accounting. Amortization expense is expected to significantly decrease in 2008 due to the declining amortization associated with agency and customer relationships. It is expected that depreciation expense will increase significantly in 2008 as the components of our new IT strategic platform are implemented.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of the Company as of December 31, 2007 and 2006, and the related consolidated statements of income, stockholders’ equity, comprehensive income, and cash flows for each of the years in the two-year period ended December 31, 2007, and our report dated March 14, 2008 expressed an unqualified opinion on those consolidated financial statements.
Amounts Due from/to Reinsurers • We collect premiums from insureds and after deducting our authorized commissions, we remit these premiums to the appropriate insurance and reinsurance companies. Our obligation to remit these premiums is recorded as amounts due reinsurers in our consolidated balance sheet.
Goodwill and other intangible assets having an indefinite useful life are tested for impairment annually or more frequently if events or changes in circumstances indicate that the assets might be impaired. Intangible assets with finite lives are amortized over their useful lives and are periodically reviewed to ensure that no conditions exist indicating the recorded amount is not recoverable from future undiscounted cash flows.
under the original quota share agreement as of July 31, 2005. The terms of this reinsurance agreement did not meet the risk transfer requirements according to SFAS No. 113; therefore, this contract was accounted for as deposits according to the guidelines of SOP 98-7, Deposit Accounting for Insurance and Reinsurance Contracts that do not Transfer Insurance Risk. If the estimated deposit liabilities are less than the recorded liabilities, we record excess deposit liabilities as income based on a percentage of actual paid losses. We believe that this methodology approximates the effective interest method prescribed in SOP 98-7. Changes in the carrying amount of the deposit liability should be reported as income or expense as appropriate. We received cash in the amount of $14.2 million in relation to this novation. The deferred gain initially totaled $1.8 million, of which we recognized $401,000, $683,000, and $477,000 in income for the years ended December 31, 2007, 2006, and 2005, respectively.
We evaluated the transaction and concluded that we did not assume significant insurance risk because the probability of a significant variation in the amount of payments by the reinsurers was remote. This was primarily due to a sliding scale profit commission payable by the reinsurer to us should there be favorable loss development. This profit commission made the likelihood very remote that the reinsurer would have any significant additional gain or loss on this block of business. The reinsurers will ultimately make the same payments, either to us from profit commission or for the full amount of losses and loss adjustment expenses. The combined cost to the reinsurer is the same. Consequently, since no significant risk was transferred, the use of deposit accounting was required and the use of reinsurance accounting was impermissible under SFAS No. 113. At December 31, 2007, there were no deposit assets and $235,000 of deposit liabilities recorded on the balance sheet for this contract.
In 2007 and 2006, we recognized a realized loss on disposal of assets of $146,000 and $432,000, respectively, and recognized a realized gain of $13,000 in 2005.
We have designated this derivative instrument as a cash flow hedge in accordance with SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, as subsequently amended by SFAS No. 138, Accounting for Certain Derivative Instruments and Certain Hedging Activities - an amendment of SFAS No. 133. The credit risk associated with this contract is limited to the uncollected interest payments and the fair market value of the derivative to the extent it has become favorable to us.