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First Mercury Financial 10-K 2009 Documents found in this filing:Table of Contents
UNITED STATES SECURITIES AND
EXCHANGE COMMISSION
Washington, D.C.
20549
Commission File Number 001-33077
Registrant’s telephone number, including area code:
(800) 762-6837
Securities Registered Pursuant to Section 12(b) of the
Act:
Securities Registered Pursuant to Section 12(g) of the
Act:
None
Indicate by check mark if the registrant is a well-known
seasoned issuer, as defined in Rule 405 of the Securities
Act. Yes o No þ
Indicate by check mark if the registrant is not required to file
reports pursuant to Section 13 or Section 15(d) of the
Act. Yes o No þ
Indicate by check mark whether the registrant (1) has filed all
reports required to be filed by Section 13 or 15(d) of the
Securities Exchange Act of 1934 during the preceding
12 months (or for such shorter period that the registrant
was required to file such reports), and (2) has been subject to
such filing requirements for the past
90 days. Yes þ No o
Indicate by check mark if disclosure of delinquent filers
pursuant to Item 405 of Regulation S-K is not contained herein,
and will not be contained, to the best of registrant’s
knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or
any amendment to this Form
10-K. þ
Indicate by check mark whether the registrant is a large
accelerated filer, an accelerated filer, a non-accelerated
filer, or a smaller reporting company. See the definitions of
“large accelerated filer,” “accelerated
filer” and “smaller reporting company” in Rule
12b-2 of the
Exchange Act. (Check one):
(Do not check if a smaller reporting company)
Indicate by check mark whether the Registrant is a shell company
(as defined in Rule 12b-2 of the Exchange
Act). Yes o No þ
The number of shares of the Registrant’s common stock
outstanding on March 6 , 2009 was 17,929,837.
Portions of the Registrant’s definitive Proxy Statement
pertaining to the 2008 Annual Meeting of Shareholders (the
“Proxy Statement”) are incorporated herein by
reference into Part III.
FIRST
MERCURY FINANCIAL CORPORATION
YEAR ENDED DECEMBER 31, 2008
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This Annual Report on
Form 10-K
contains forward-looking statements that relate to future
periods and includes statements regarding our anticipated
performance. Generally, the words “anticipates,”
“believes,” “expects,” “intends,”
“estimates,” “projects,” “plans”
and similar expressions identify forward-looking statements.
These forward-looking statements involve known and unknown
risks, uncertainties and other important factors that could
cause our actual results, performance or achievements or
industry results to differ materially from any future results,
performance or achievements expressed or implied by these
forward-looking statements. These risks, uncertainties and other
important factors include, among others: recent and future
events and circumstances impacting financial, stock, and capital
markets, and the responses to such events by governments and
financial communities; the impact of catastrophic events and the
occurrence of significant severe weather conditions on our
operating results; our ability to maintain or the lowering or
loss of one of our financial or claims-paying ratings; our
actual incurred losses exceeding our loss and loss adjustment
expense reserves; the failure of reinsurers to meet their
obligations; our inability to obtain reinsurance coverage at
reasonable prices; the failure of any loss limitations or
exclusions or changes in claims or coverage; our ability to
successfully integrate acquisitions that we make such as our
acquisition of AMC; our lack of long-term operating history in
certain specialty classes of insurance; our ability to acquire
and retain additional underwriting expertise and capacity; the
concentration of our insurance business in relatively few
specialty classes; the increasingly competitive property and
casualty marketplace; fluctuations and uncertainty within the
excess and surplus lines insurance industry; the extensive
regulations to which our business is subject and our failure to
comply with those regulations; our ability to maintain our
risk-based capital at levels required by regulatory authorities;
our inability to realize our investment objectives; and the risk
factors set forth in Item 1A of this
Form 10-K.
Given these uncertainties, prospective investors are cautioned
not to place undue reliance on these forward-looking statements.
These forward-looking statements are made as of the date of the
filing of this
Form 10-K.
Except as required by law, we assume no obligation to update or
revise them or provide reasons why actual results may differ.
First Mercury Financial Corporation, which we refer to as the
“Company” or “FMFC”, is a provider of
insurance products and services to the specialty commercial
insurance markets, primarily focusing on niche and underserved
segments where we believe that we have underwriting expertise
and other competitive advantages. During our 35 years of
underwriting security risks, we have established CoverX (R) as a
recognized brand among insurance agents and brokers and
developed significant underwriting expertise and a
cost-efficient infrastructure. Over the last eight years, we
have leveraged our brand, expertise and infrastructure to expand
into other specialty classes of business, particularly focusing
on smaller accounts that receive less attention from competitors.
First Mercury Financial Corporation (“FMFC”) is a
holding company for our operating subsidiaries. Our operations
are conducted with the goal of producing overall profits by
strategically balancing underwriting profits from our insurance
subsidiaries with the commissions and fee income generated by
our non-insurance subsidiaries. FMFC’s principal operating
subsidiaries are CoverX Corporation (“CoverX”), First
Mercury Insurance Company (“FMIC”), First Mercury
Casualty Company (“FMCC”), formerly known as All
Nation Insurance Company, First Mercury Emerald Insurance
Services, Inc. (“FM Emerald”), American Management
Corporation (“AMC”), and American Underwriters
Insurance Company (“AUIC”).
As primarily an excess and surplus, or E&S, lines
underwriter, our business philosophy is to generate an
underwriting profit by identifying, evaluating and appropriately
pricing and accepting risk using customized forms tailored for
each risk. As an E&S lines underwriter, we have more
flexibility than standard property and casualty insurance
companies to set and adjust premium rates and customize policy
forms to reflect the risks being insured.
Our CoverX and FM Emerald subsidiaries are licensed wholesale
insurance brokers that produce and underwrite the insurance
policies for which we retain risk and receive premiums. As
wholesale insurance brokers, CoverX and FM Emerald market our
insurance policies through a nationwide network of wholesale and
retail insurance brokers who then distribute these policies
through retail insurance brokers. CoverX and FM Emerald also
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provide underwriting services with respect to the insurance
policies they market in that they review the applications
submitted for insurance coverage, decide whether to accept all
or part of the coverage requested and determine applicable
premiums. CoverX receives commissions from affiliated insurance
companies, reinsurers, and non-affiliated insurers as well as
policy fees from wholesale and retail insurance brokers. We
participate in the risk on insurance policies sold through
CoverX and FM Emerald, which we refer to as policies produced by
CoverX and FM Emerald, generally by directly writing the
policies through our insurance subsidiaries and then retaining
all or a portion of the risk. The portion of the risk that we
decide not to retain is ceded to, or assumed by, reinsurers in
exchange for paying the reinsurers a proportionate amount of the
premium received by us for issuing the policy. This cession is
commonly referred to as reinsurance. Based on market conditions,
we can retain a higher or lower amount of premiums produced by
CoverX and FM Emerald.
On June 27, 2008, the Company sold all of the outstanding
capital stock of American Risk Pooling Consultants, Inc.
(“ARPCO”). The results of ARPCO’s operations are
presented as Discontinued Operations in the Consolidated
Statements of Income. ARPCO provided third party administrative
services for risk sharing pools of governmental entity risks,
including underwriting, claims, loss control and reinsurance
services. ARPCO is solely a fee-based business and receives fees
for these services and commissions on excess per occurrence
insurance placed in the commercial market with third party
companies on behalf of the pools.
On February 1, 2008, we acquired 100% of the issued and
outstanding common stock of American Management Corporation. AMC
is a managing general agency writing primarily commercial lines
package policies focused primarily on the niche fuel-related
marketplace. AMC distributes these insurance policies through a
nationwide distribution system of independent general agencies.
AMC underwrites these policies for third party insurance
carriers and receives commission income for its services. AMC
also provides claims handling and adjustment services for
policies produced by AMC and directly written for third parties.
In addition, AMC owns and operates American Underwriters
Insurance Company (“AUIC”), a single state,
non-standard auto insurance company domiciled in the state of
Arkansas, and AMC Re, Inc. (“AMC Re”), a captive
reinsurer incorporated under the provisions of the laws of
Arkansas. Effective July 1, 2008, FMIC and AUIC entered
into an intercompany reinsurance agreement wherein all premiums
and losses of AUIC, including all past liabilities, are 100%
assumed by FMIC.
Our current strategy is comprised of the following elements:
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The majority of the insurance companies in the U.S. are
known as standard, or admitted, carriers. Admitted insurance
carriers are often required to be licensed in each state in
which they write business and to file policy forms and fixed
rate plans with these states’ insurance regulatory bodies.
Businesses with unique risks often cannot find coverage
underwritten by admitted insurance companies because admitted
insurance companies do not have the policy form or rate
flexibility to properly underwrite such risks. While some
businesses choose to self-insure when they cannot find
acceptable insurance coverage in the standard insurance market,
many look for coverage in the E&S lines market. E&S
lines insurance companies need state insurance department
authorization to write insurance in most of the states in which
they do business, but they do not typically have to file policy
forms or fixed rate plans. The E&S lines insurance market
fills the insurance needs of businesses with unique risk
characteristics because E&S lines insurance carriers have
the policy form and rate flexibility to underwrite these risks
individually.
Competition in the E&S lines market tends to focus less on
price and more on availability and quality of service. The
E&S lines market is significantly affected by the
conditions of the insurance market in general. During times of
hard market conditions (i.e., those favorable to insurers), as
rates increase and coverage terms become more restrictive,
business tends to move from the admitted market back to the
E&S lines market. When soft market conditions are
prevalent, similar to the current environment, standard
insurance carriers tend to loosen underwriting standards and
seek to expand market share by moving into business lines
traditionally characterized as E&S lines.
UNDERWRITING
OPERATIONS
We underwrite and provide several classes of general liability
insurance for the security industry, including security guards
and detectives, alarm installation and service businesses, and
safety equipment installation and service businesses. In 2008,
$66.7 million of our premiums produced were within security
classes of specialty insurance, which represented 20.7% of our
total premiums produced for that year.
For security classes, we focus on underwriting small (premiums
less than $10,000) and mid-sized (premiums from $10,000 to
$50,000) accounts. Approximately 67.7% of our premiums produced
in 2008 for security classes consisted of premium sizes of
$50,000 or below. In 2008, our average premium size for security
classes was $6,800. Pursuing these smaller accounts helps us
avoid competition from larger competitors. As of
December 31, 2008, we had approximately 9,800 policies in
force for security classes. The majority of these policies have
policy limits of
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$1.0 million per occurrence. Although, we have reinsurance
arrangements in place that would allow us to selectively
underwrite policies with limits of up to $6.0 million per
occurrence, because of our current risk tolerance, less than 5%
of the policies we write for security classes have limits in
excess of $1.0 million. Our policy limits typically do not
include defense costs.
The table below indicates the percentage of our premiums
produced for security classes by each state in 2008.
Security guards and detectives. Approximately
46.9% of our premiums produced for security classes in 2008
consisted of coverages for security guards and detectives.
Coverages are available for security guards, patrol agency
personnel, armored car units, private investigators and
detectives.
Alarm installation and service
businesses. Approximately 29.6% of our premiums
produced for security classes in 2008 were composed of coverages
for security alarm manufacturers and technicians. Coverages are
available for sales, service and installation of residential and
commercial alarm systems as well as alarm monitoring.
Safety equipment installation and service
businesses. Approximately 22.2% of our premiums
produced for security classes in 2008 were composed of coverages
for fire suppression companies. Coverages are available for
sales, service and installation of fire extinguishers and
sprinkler and chemical systems, both on residential and
commercial systems.
We have underwritten various specialty classes of insurance at
different points throughout our history. We have leveraged our
core strengths used to build our business for security classes,
which include our nationally recognized CoverX brand, our broad
wholesale broker distribution through CoverX, and our
underwriting and claims expertise to expand our business into
other specialty classes. For example, we have leveraged our
experience in insuring the security risks of the contractors
that install safety and fire suppression equipment, which often
involves significant plumbing work and exposure, into the
underwriting of other classes of risks for plumbing contractors.
We provide general liability insurance for specialty classes
consisting primarily of contractor classes of business,
including roofing contractors, plumbing contractors, electrical
contractors, energy contractors, and other artisan and service
contractors. Our senior underwriters for the specialty classes
have extensive industry experience and longstanding
relationships with the brokers and agents that produce the
business. In 2008, $142.0 million of our premiums produced
were within specialty classes of insurance, which represented
44.2% of our total premiums produced for the year.
Our underwriting policies and targets for specialty classes are
similar to our policies and targets for security classes. Our
target account premium size is $50,000 and below. Approximately
67.0% of our premiums produced in 2008 for specialty classes
consisted of premium sizes of $50,000 or below. In 2008, we
wrote approximately 5,500 policies with an average premium size
of approximately $25,600. The majority of our policies for
specialty classes have coverage limits of $1.0 million.
Although we have the ability to selectively underwrite policies
with limits of $6.0 million per occurrence, because of our
current risk tolerance, less than 8% of our policies for
specialty classes have limits in excess of $1.0 million.
Our policy limits typically do not include defense costs.
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The table below indicates the percentage of premiums for
specialty classes produced by CoverX in each state in 2008.
We have underwritten various classes of insurance through
contract underwriters since 2004. These are niche and
complementary classes to our Security and Specialty businesses
with significant policy, premium, and loss data. These classes
are underwritten by underwriters with significant track records
through multiple market cycles. We provide liability and
property insurance for the contract underwriting classes
consisting primarily of legal professional liability,
hospitality, employer general liability, habitational, and
outdoor recreation classes of business.
Our underwriting policies and targets for the contract
underwriting classes are similar to our policies and targets for
our security and specialty classes. Our target account premium
size is $25,000 and below. Approximately 80% of our premiums
produced in 2008 for the contract underwriting classes consisted
of premium size of $25,000 or below. In 2008, we wrote
approximately 7,500 policies with an average premium size of
approximately $8,300. The majority of our policies for the
contract underwriting classes have coverage limits of
$1.0 million per occurrence. Due to our current risk
tolerance, less than 6% of our policies for the contract
underwriting classes have limits in excess of $1.0 million.
The table below indicates the percentage of premiums for the
contract underwriting classes produced by CoverX in each state
in 2008.
We have underwritten various classes of insurance through FM
Emerald since late 2007 after attracting a team of experienced
professionals. FM Emerald underwrites E&S risks which are
larger in size and complexity than those traditionally targeted
by CoverX. FM Emerald targets a complementary mix of primary
casualty,
excess/umbrella
casualty, and property lines of business for hard to place risks
and/or
distressed businesses.
Our target account premium size is $75,000 and below.
Approximately 60.1% of our premiums produced in 2008 for FM
Emerald consisted of premium size of $75,000 or below. In 2008,
we wrote approximately 1,100
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policies with an average premium size of approximately $38,100.
The majority of our policies for FM Emerald have the following
coverage limits: primary casualty — $1.0 million
per occurrence, excess and umbrella casualty —
$10.0 million per occurrence, and property —
$5.0 million per risk. As of December 31, 2008, less
than 0.2% or our primary casualty polices have limits in excess
of $1.0 million, less than 8.0% of our property policies
have limits in excess of $5.0 million and none of our
excess and umbrella casualty polices have limits in excess of
$10.0 million.
The table below indicates the percentage of premiums produced by
FM Emerald in each state in 2008.
We generate all of our business for FM Emerald from traditional
E&S lines insurance wholesalers. The lead underwriters in
the offices of FM Emerald often have long standing relationships
with key wholesale brokers.
Our insurance services business provides underwriting, claims
and other insurance services to third parties, including
insurance carriers and customers. We generated
$19.7 million in fee income in 2008 from our insurance
services operations. These insurance services operations are
conducted through CoverX and AMC.
All of the commercial insurance policies that we write or assume
are distributed and underwritten through our subsidiaries,
CoverX and FM Emerald. CoverX and FM Emerald distribute our
products through a nationwide network of licensed E&S lines
wholesalers as well as certain large retail agencies with a
specialty in the markets that we serve. In 2008, we placed
business with approximately 780 brokers and agents for security
classes of general liability insurance, 523 brokers and agents
for specialty classes, and 110 brokers and agents for FM
Emerald. In addition, a portion of our products are distributed
by contract underwriters through producer agreements with CoverX.
CoverX is well known within the security industry due to its
long presence in the marketplace and, as a result, has developed
significant brand awareness. Because an individual broker’s
relationship is with CoverX and not the insurance companies,
CoverX is able to change the insurance carrier providing the
underwriting capacity without significantly affecting its
revenue stream. We typically do not grant our agents and brokers
any underwriting or claims authority. We have entered into
contractual relationships with six underwriters with respect to
our contract underwriting programs. We select our agents and
brokers based on industry expertise, historical performance and
business strategy.
Our longstanding presence in the security industry has enabled
us to write policies within security classes from a variety of
sources. We generate business from traditional E&S lines
insurance wholesalers and specialists that focus on security
guards and detectives, alarm installation and service
businesses, and safety equipment installation and service
businesses. In 2008, our top five wholesale brokers represented
39% of our premiums produced for security classes and no
individual wholesale broker accounted for more than 18% of our
premiums produced.
We generate the majority of our business for specialty classes
from traditional E&S lines insurance wholesalers. The
underwriters in our regional offices often have longstanding
relationships with local and regional wholesale brokers who
provide business to them. In addition, we have leveraged our
CoverX brand to facilitate the development of new relationships
with wholesalers in specialty classes. In 2008, our top five
wholesale brokers
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represented 35.1% of our premiums produced for other specialty
classes and no wholesale broker accounted for more than 16% of
our premiums produced.
We generate all of our FM Emerald business from traditional
E&S lines insurance wholesalers. The underwriters in our
regional offices often have longstanding relationships with
local and regional wholesale brokers who provide business to
them. In 2008, our top five wholesale brokers represented 24.5%
of our premiums produced for FM Emerald and no wholesale broker
accounted for more than 8% of our premiums produced.
Our underwriting personnel regularly visit key agents, brokers,
and contract underwriters (collectively “producers”)
in order to review performance and to discuss our insurance
products. Additionally, we monitor the performance of the
policies produced by each broker and contract underwriter and
generally will terminate the relationship with a producer if the
policies he or she sells produce excessive losses. We typically
pay a flat commission rate of between 14.5% and 17.5% of premium
to our agents and brokers, although commissions can range from
below 12.0% to 20.0%. We pay our contract underwriters a
commission rate in the range of 16.0% to 30.0%. By distributing
a significant amount of our products through CoverX rather than
contract underwriters, we avoid the additional commission
payments of 10.0% or more that many traditional E&S lines
insurance carriers must pay to access this distribution source.
Our name recognition in the industry allows us to use this
strategy without losing the opportunity to generate business. As
of December 31, 2008 we have not entered into any
contingent commission arrangements with agents or brokers.
Our underwriting is an intensive process using policy
applications, our proprietary information and industry data, as
well as inspections, credit reports and other validation
information. Our long-term success depends upon the efforts of
our underwriting department to appropriately understand and
underwrite risks and provide appropriate contract language to
accomplish that. All submissions are reviewed by a company
underwriter with expertise in the class of business being
reviewed. Our policy is to review each file individually to
determine whether coverage will be offered, and, if an offer is
made, to determine the appropriate price, terms, endorsements
and exclusions of coverage. We write most coverage as an
E&S lines carrier, which provides the flexibility to match
price and coverage for each individual risk. We delegate
underwriting authority outside of the Company through contract
underwriter agreements only after an extensive due diligence
process. Our contract underwriters manage established books of
business with long term success over multiple market cycles. We
retain underwriting oversight and subject the contract
underwriters to operational and financial reviews. We have
entered into contractual relationships with six underwriters
with respect to our contract underwriting programs delegating
such authority.
We use industry standard policy forms customized by endorsements
and exclusions that limit coverage to those risks underwritten
and acceptable to us. For example, most security policies have
exclusions
and/or
limitations for operations outside the normal duties identified
by an applicant. The use of firearms might be prohibited,
operations such as work in bars or nightclubs might be
prohibited, or the location of operations of the policyholder
may be restricted. All policies currently being written have
mold, asbestos, and silica exclusions. Many policies also
contain employment practices liability exclusions and
professional services exclusions.
We maintain proprietary loss cost information for security
classes. In order to price policies for other specialty classes,
we begin with the actuarial loss costs published by ISO. We make
adjustments to pricing based on our loss experience and our
knowledge of market conditions. We attempt to incorporate the
unique exposures presented by each individual risk in order to
price each coverage appropriately. Through our monitoring of our
underwriting results, we seek to adjust prices in order to
achieve a sufficient rate of return on each risk we underwrite.
We have more latitude in adjusting our rates as an E&S
lines insurance carrier than a standard admitted carrier. Since
we typically provide coverage for risks that standard carriers
have refused to cover, the demand for our products tends to be
less price sensitive than standard carriers.
An extensive information reporting process is in place for
management to review all appropriate near term and longer term
underwriting results. We do not have production volume
requirements for our underwriters. Incentive compensation is
based on multiple measures representing quality and
profitability of the results.
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We have 15 underwriters that underwrite for security classes out
of our headquarters in Southfield, Michigan. Our strategy is to
receive submissions for as many risks for the security classes
that we target as possible and to quote and bind those risks
which meet our underwriting criteria. In 2008, we received over
16,800 policy submissions within security classes, we quoted
over 12,400 of those submissions, and we bound over 9,700
policies.
We have 21 underwriters that underwrite for specialty classes
out of regional underwriting offices. Because specialty classes
encompass a broader range of classes compared to security
classes, we tend to receive submissions outside of our targeted
specialty classes and are more selective in deciding which
submissions to quote. In 2008, we received over 49,000 policy
submissions within specialty classes and bound approximately
5,500 policies.
We have 20 underwriters that underwrite for FM Emerald out of
regional underwriting offices. In 2008, we received over 20,000
policy submissions within FM Emerald and bound approximately
1,100 policies.
Our claims department consists of 29 people supporting our
underwriting operations and 19 people supporting our
insurance services operations. Since 1985, substantially all of
our claims, including the claims for the years when fronting
companies were utilized, have been handled by our claims
department.
Our claims policy is to investigate all potential claims and
promptly evaluate claims exposure, which permits us to establish
claims reserves early in the claims process. Reserves are set at
an estimate of full settlement value at all times. We attempt to
negotiate all claims to the earliest appropriate resolution.
Our claims department has established authorization levels for
each claims professional, based on experience, capability and
knowledge of the issues. Claims files are regularly reviewed by
management and higher exposure cases are reviewed by a broader
“round-table” group, which may include underwriting
representatives
and/or
senior management, where appropriate. The claims and
underwriting departments frequently meet to discuss emerging
trends or specific case experiences to guide those efforts. A
management information and measurement process is in place to
measure results and trends of the claims department. All claims
operations use imaging technology to produce a paperless
environment with all notes, communications and correspondence
being a part of our files. Claims adjusters have complete access
to the imaged underwriting files, including all policy history,
to enable them to better understand coverage issues, and all
other documentation.
For two of our contract underwriting programs, we have delegated
claims authority to one contract underwriter and a third party
administrator (“TPA”) through claims administration
agreements. The claims administration agreements govern the
claims guidelines for these programs. We retain claims authority
for claims greater than $50,000. We maintain claims oversight
for these programs and subject the service providers to
semi-annual claims reviews.
For the security guard and detective portion of security
classes, we typically receive claims related to negligence,
incompetence or improper action by a security guard or
detective. Alarm claims for security classes include
installation errors by alarm technicians or alarm malfunctions.
Claims related to safety equipment installation and service
business are similar to those of the alarm program. We insure
that the insured’s safety or fire suppression systems
operate as represented by the insured.
The nature of claims on policies for specialty and contract
underwriting classes are similar to those of security classes
because the general liability coverage is essentially the same.
Instead of receiving claims relating to the actions of a
security guard or detective, however, the claims relate to the
negligence or improper action of a contractor, manufacturer, or
owners, landlords and tenants or to the failure of a
contractor’s “completed operations” or a
manufacturer’s product to function properly.
The nature of claims involving FM Emerald policies depends upon
the class of business. FM Emerald writes primary casualty which
is similar to our other general liability classes. They also
write excess and umbrella casualty policies. FM Emerald writes
property policies, most of which are on an all-risk unless
otherwise excluded basis as well as a mix of basic
form — named peril coverage.
There were approximately 4,100 new claims reported to us during
2008, and we had approximately 2,700 pending claims as of
December 31, 2008.
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We enter into reinsurance contracts to diversify our risks and
limit our maximum loss arising from large or unusually hazardous
risks or catastrophic events and so that, given our capital
constraints, we can provide the policy limits that our clients
require. Additionally, we use reinsurance to limit the amount of
capital necessary to support our operations and to facilitate
growth. Reinsurance involves a primary insurance company
transferring, or “ceding”, a portion of its premium
and losses in order to control its exposure. The ceding of
liability to a reinsurer does not relieve the obligation of the
primary insurer to the policyholder. The primary insurer remains
liable for the entire loss if the reinsurer fails to meet its
obligations under the reinsurance contract.
Our treaty reinsurance is contracted under both quota share and
excess of loss reinsurance agreements. On our primary casualty
business, we have historically adjusted our level of quota share
protection on these treaties based upon our premiums produced
and our level of capitalization, as well as our risk appetite
for a particular type of business. On January 1, 2008, we
purchased a 10% quota share on the majority of our primary
casualty business and on April 1, 2008, we added a second
quota share treaty covering an additional 5% of the same lines
of business. Our excess of loss reinsurance is used to limit our
maximum exposure per claim occurrence. We maintained a
$0.5 million excess of $0.5 million per occurrence and
$1.5 million excess of $0.5 million per occurrence
coverages through December 31, 2008. Effective
January 1, 2009, we purchased quota share reinsurance for
our primary casualty business which covers the majority of the
casualty classes underwritten in the Security, Specialty,
Contract Underwriting, and FM Emerald platforms. For our
Security and Specialty classes, we purchased 25.75% quota share
reinsurance coverage. For our Contract Underwriting and FM
Emerald classes, we purchased 31.5% quota share reinsurance
coverage. In addition, for these classes, we purchased
$0.5 million excess of $0.5 million per occurrence for
2009. However, for the Security and Specialty classes, the
excess of loss treaty was only 75% placed. Lastly, we did
not purchase quota share reinsurance for the legal professional
liability class, but we did purchase $0.5 million excess of
$1.5 million per occurrence for 2009, which was 70% placed.
On our umbrella and excess casualty business in 2008, we
maintained quota share reinsurance treaties that provides for a
quota share of 90% of this business, up to a limit of
$10.0 million per occurrence. Effective January 1,
2009, we purchased 90% quota share reinsurance for our umbrella
and excess casualty business, which was similar to our 2008
reinsurance coverage.
On our property business, we renewed our property excess per
risk program at July 1, 2008. These treaties provide for
coverage of $4.7 million excess of $0.3 million per
risk. We also purchased property catastrophe protection for our
property business effective July 1, 2008. The program has
limits of $25.0 million in excess of $4.0 million of
ultimate net loss per occurrence, which represents our modeled
one in 250 year event exposure. Our catastrophe program
provides for reinstatement of coverage upon a catastrophic
event. In 2008, gross written premiums for property business
were less than 7.8% of total gross written premium.
In addition to our treaty reinsurance, we also purchase
facultative reinsurance, which is obtained on a
case-by-case
basis for all or part of the insurance provided by a single
risk, exposure, or policy.
For a more detailed discussion of our reinsurance structure over
time, see “Management’s Discussion and Analysis of
Financial Condition and Results of Operations —
Reinsurance” and “Risk Factors — Risks
Relating to Our Business.”
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The following is a summary of our significant treaty ceded
reinsurance programs at December 31, 2008:
We believe that advanced information processing is important in
order for us to maintain our competitive position. We have
developed an extensive data warehouse of underwriting and claims
data for our business and have implemented advanced management
information systems to run substantially all of our principal
data processing and financial reporting software applications.
We use the Phoenix system by Allenbrook for policy
administration and claims systems. We are also implementing
imaging and workflow systems to eliminate the need for paper
files and reduce processing errors. Our operating systems allow
all of our offices to access files at the same time while
discussing underwriting policies regarding certain accounts.
The property and casualty insurance industry is highly
competitive. We compete with domestic and international
insurers, many of which have greater financial, marketing and
management resources and experience than we do and many of which
have both admitted and E&S lines insurance affiliates and,
therefore, may be able to offer a greater range of products and
services than we can. We also may compete with new market
entrants in the future as the E&S lines market has low
barriers to entry. Competition is based on many factors,
including the perceived market and financial strength of the
insurer, pricing and other terms and conditions, services, the
speed of claims payment, the reputation and experience of the
insurer and ratings assigned by independent rating organizations
such as A.M. Best.
Our primary competitors with respect to security classes are
managing general agents, or MGAs, supported by various insurance
or reinsurance partners. These MGAs include, but are not limited
to, All Risks, Ltd., Brownyard Group, Mechanics Group and
RelMark Program Managers. These MGAs provide underwriting
services similar to CoverX, but they typically do not retain any
insurance risk on the business they produce. These MGAs also
typically do not handle the claims on the business they produce,
as claims handling is retained by the company assuming the
insurance risk or outsourced to third party administrators. We
also face competition from U.S. and
non-U.S. insurers,
including American International Group, Inc. (Lexington
Insurance Company) in the security guard class, The Hartford
Financial Services Group, Inc. in the alarm class, and Travelers
in the safety class.
Our primary competitors with respect to specialty classes tend
to be E&S lines insurance carriers. Competitors vary by
region and market, but include W.R. Berkley Corp. (Admiral
Insurance Company), Argonaut Group
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(Colony Insurance Company), RLI Corp, American International
Group, Inc. (Lexington Insurance Company) and International
Financial Group, Inc. (Burlington Insurance Co.).
Our primary competitors with respect to our Contract
Underwriting and FM Emerald classes of business are similar to
the competitors for our specialty classes.
Competition in the E&S lines market tends to focus less on
price and more on availability of coverage and quality of
service. The E&S lines market is significantly affected by
the conditions of the insurance market in general. During times
of hard market conditions (i.e., those favorable to insurers),
as rates increase and coverage terms become more restrictive,
business tends to move from the admitted market back to the
E&S lines market. When soft market conditions are
prevalent, similar to the current environment, standard
insurance carriers tend to loosen underwriting standards and
seek to expand market share by moving into business lines
traditionally characterized as E&S lines.
Many insurance buyers, agents and brokers use the ratings
assigned by A.M. Best and other rating agencies to assist
them in assessing the financial strength and overall quality of
the companies from which they are considering purchasing
insurance. First Mercury Insurance Company, which we refer to as
FMIC, was assigned a letter rating of “A−” by
A.M. Best in June 2004 and maintained such rating since
that time. An “A−” rating is the fourth highest
of 15 rating categories used by A.M. Best and is the lowest
rating necessary to compete in our targeted markets.
A.M. Best assigns each insurance company a Financial Size
Category, or FSC. The FSC is designed to provide a convenient
indicator of the size of a company in terms of its statutory
surplus and related accounts. There are 15 categories with FSC I
being the smallest and FSC XV being the largest. As of
December 31, 2008, A.M. Best has assigned FMIC an FSC
VIII based on Adjusted Policyholders Surplus between
$100.0 million and $250.0 million. Effective
January 1, 2007, FMIC and FMCC entered into an intercompany
pooling reinsurance agreement wherein all premiums, losses and
expenses of FMIC and FMCC are combined and apportioned between
FMIC and FMCC in accordance with fixed percentages. On
May 4, 2007, A.M. Best assigned the financial strength
rating “A−” to the First Mercury Group pool and
its members, FMIC and FMCC. FMCC’s A.M. Best rating
was upgraded to “A−” as a result. Effective
July 1, 2008, FMIC and AUIC entered into an intercompany
reinsurance agreement wherein all premium and losses of AUIC,
including all past liabilities, are 100% assumed by FMIC.
Subsequent to the reinsurance transaction, AUIC’s
A.M. Best rating was upgraded to “A−”. At
December 31, 2008, FMIC, FMCC and AUIC each maintained an
“A−” rating from A.M. Best. In evaluating a
company’s financial and operating performance,
A.M. Best reviews the company’s profitability,
indebtedness and liquidity, as well as its book of business, the
adequacy and soundness of its reinsurance, the quality and
estimated market value of its assets, the adequacy of its unpaid
loss and loss adjustment expense, the adequacy of its surplus,
its capital structure, the experience and competence of its
management and its market presence. This rating is intended to
provide an independent opinion of an insurer’s financial
strength and its ability to meet ongoing obligations to
policyholders and is not directed toward the protection of
investors. Ratings by rating agencies of insurance companies are
not ratings of securities or recommendations to buy, hold or
sell any security. See “Risk Factors — Risks
Relating to Our Business — Any downgrade in the
A.M. Best rating of FMIC would prevent us from successfully
engaging in direct insurance writing or obtaining adequate
reinsurance on competitive terms, which would lead to a decrease
in revenue and net income.”
As of December 31, 2008, we had 324 full-time
employees and 14 part-time employees. Our employees have no
union affiliations and we believe our relationship with our
employees is good.
Our insurance subsidiaries are subject to regulation under the
insurance statutes of various jurisdictions, including Illinois,
the domiciliary state of FMIC; Minnesota, the domiciliary state
of FMCC; and Arkansas, the domiciliary state of AUIC. In
addition, we are subject to regulation by the state insurance
regulators of other states and foreign jurisdictions in which we
or our operating subsidiaries do business. State insurance
regulations
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generally are designed to protect the interests of
policyholders, consumers or claimants rather than stockholders,
noteholders or other investors. The nature and extent of state
regulation varies by jurisdiction, and state insurance
regulators generally have broad administrative power relating
to, among other matters, setting capital and surplus
requirements, licensing of insurers and agents, establishing
standards for reserve adequacy, prescribing statutory accounting
methods and the form and content of statutory financial reports,
regulating certain transactions with affiliates and prescribing
the types and amounts of investments.
In recent years, the state insurance regulatory framework has
come under increased federal scrutiny, and some state
legislatures have considered or enacted laws that alter and, in
many cases, increase state authority to regulate insurance
companies. Although the federal government is not the primary
direct regulator of the insurance business, federal initiatives
often affect the insurance industry and possible increased
regulation of insurance by the federal government continues to
be discussed by lawmakers.
In addition to state imposed insurance laws and regulations, our
insurance subsidiaries are subject to the statutory accounting
practices and reporting formats established by the National
Association of Insurance Commissioners, or NAIC. The NAIC also
promulgates model insurance laws and regulations relating to the
financial and operational regulation of insurance companies.
These model laws and regulations generally are not directly
applicable to an insurance company unless and until they are
adopted by applicable state legislatures or departments of
insurance. All states have adopted the NAIC’s financial
reporting form, which is typically referred to as the NAIC
“annual statement,” and all states generally follow
the codified statutory accounting practices promulgated by the
NAIC. In this regard, the NAIC has a substantial degree of
practical influence and is able to accomplish certain quasi
legislative initiatives through amendments to the NAIC annual
statement and applicable accounting practices and procedures.
Insurance companies also are affected by a variety of state and
federal legislative and regulatory measures and judicial
decisions that define and qualify the risks and benefits for
which insurance is sought and provided. These include redefining
risk exposure in such areas as product liability, environmental
damage and workers’ compensation. In addition, individual
state insurance departments may prevent premium rates for some
classes of insureds from adequately reflecting the level of risk
assumed by the insurer for those classes. Such developments may
result in adverse effects on the profitability of various lines
of insurance. In some cases, these adverse effects on
profitability can be minimized, when possible, through the
repricing of coverages to the extent permitted by applicable
regulations, or the limitation or cessation of the affected
business, which may be restricted by state law.
FMIC operates on a non-admitted or surplus lines basis and is
authorized in 51 states and jurisdictions. While FMIC does
not have to apply for and maintain a license in those states, it
is subject to meeting and maintaining eligibility standards or
approval under each particular state’s surplus lines laws
in order to be an eligible surplus line carrier. FMIC maintains
surplus line approvals or eligibility in all states in which it
operates and therefore FMIC is not subject to the rate and form
filing requirements applicable to licensed or
“admitted” insurers.
Surplus lines insurance must be written through agents and
brokers who are licensed as surplus lines brokers. The broker or
their retail insurance agents generally are required to certify
that a certain number of licensed admitted insurers had been
offered and declined to write a particular risk prior to placing
that risk with us.
FMCC is licensed and can operate on an admitted basis in its
home state of Minnesota and in 14 other states. Insurers
operating on an admitted basis must file premium rate schedules
and policy forms for review and, in some states, approval by the
insurance regulators in each state in which they do business on
an admitted basis. Admitted carriers also are subject to other
market conduct regulation and examinations in the states in
which they are licensed. Insurance regulators have broad
discretion in judging whether an admitted insurer’s rates
are adequate, not excessive and not unfairly discriminatory.
AUIC is licensed and can operate on an admitted basis in its
home state of Arkansas.
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Our insurance subsidiaries operate as part of an insurance
holding company system and are subject to holding company
regulation in the jurisdictions in which they are licensed.
These regulations require that each insurance company that is
part of a holding company system register with the insurance
department of its state of domicile and furnish information
concerning contracts, transactions, and relationships between
those insurance companies and companies within the holding
company system. Transactions between insurance subsidiaries and
their parents and affiliates generally must be disclosed to the
state regulators, and prior approval or nondisapproval of the
applicable state insurance regulator generally is required for
any material or other specified transactions. The insurance laws
similarly provide that all transactions and agreements between
an insurance company and members of a holding company system
must be fair and reasonable. FMIC, FMCC, and AUIC are parties to
various agreements, including underwriting agreements, a
management service agreement, and a tax sharing agreement with
members of the holding company system and are parties to
reinsurance agreements with each other, all of which are subject
to regulation under state insurance holding company acts.
In addition, a change of control of an insurer or of any
controlling person requires the prior approval of the domestic
state insurance regulator. Generally, any person who acquires
10% or more of the outstanding voting securities of the insurer
or its parent company is presumed to have acquired control of
the insurer. A person seeking to acquire control, directly or
indirectly, of an insurance company or of any person controlling
an insurance company generally must file with the domestic
insurance regulatory authority a statement relating to the
acquisition of control containing certain information about the
acquiring party and the transaction required by statute and
published regulations and provide a copy of such statement to
the insurer and obtain the prior approval of such regulatory
agency for the acquisition. These provisions apply to investors
that acquire 10% or more of the outstanding common stock of FMFC
even if such acquisition of shares is made for investment
purposes and not for the purpose of controlling our insurance
subsidiaries. In such cases, our domestic state insurance
departments require such investors to file a change in control
exemption request or disclaimer of control statement with those
departments. We will work with any such investor to facilitate
this process if so requested.
Our insurance subsidiaries are required to file quarterly and
annual financial reports with state insurance regulators
utilizing statutory accounting practices (“SAP”)
rather than accounting principles generally accepted in the
United States of America (“GAAP”). In keeping with the
intent to assure policyholder protection, SAP emphasizes
solvency considerations. See Note 15 to the consolidated
financial statements, which are incorporated herein by reference.
The insurance departments of our insurance subsidiaries’
states of domicile may conduct
on-site
visits and examinations of the affairs of our insurance
subsidiaries, including their financial condition and their
relationships and transactions with affiliates, typically every
three to five years, and may conduct special or target
examinations to address particular concerns or issues at any
time. Insurance regulators of other states in which we do
business also may conduct examinations. The results of these
examinations can give rise to regulatory orders requiring
remedial, injunctive or other corrective action. Insurance
regulatory authorities have broad administrative powers to
regulate trade practices and to restrict or rescind licenses or
other authorizations to transact business and to levy fines and
monetary penalties against insurers, insurance agents and
brokers found to be in violation of applicable laws and
regulations. During the past five years, the insurance
subsidiaries have had periodic financial reviews and have not
been the subject of market conduct or other investigations nor
required to pay any material fines or penalties.
Risk-based capital, or RBC, requirements laws are designed to
assess the minimum amount of capital that an insurance company
needs to support its overall business operations and to ensure
that it has an acceptably low expectation of becoming
financially impaired. Regulators use RBC to set capital
requirements considering the size and degree of risk taken by
the insurer and taking into account various risk factors
including asset risk, credit risk,
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underwriting risk and interest rate risk. As the ratio of an
insurer’s total adjusted capital and surplus decreases
relative to its risk-based capital, the RBC laws provide for
increasing levels of regulatory intervention culminating with
mandatory control of the operations of the insurer by the
domiciliary insurance department at the so-called mandatory
control level. At December 31, 2008, our insurance
subsidiaries maintained RBC levels in excess of amounts that
would require any corrective actions on our part.
The NAIC Insurance Regulatory Information System, or IRIS, is
part of a collection of analytical tools designed to provide
state insurance regulators with an integrated approach to
screening and analyzing the financial condition of insurance
companies operating in their respective states. IRIS is intended
to assist state insurance regulators in targeting resources to
those insurers in greatest need of regulatory attention. IRIS
consists of two phases: statistical and analytical. In the
statistical phase, the NAIC database generates key financial
ratio results based on financial information obtained from
insurers’ annual statutory statements. The analytical phase
is a review of the annual statements, financial ratios and other
automated solvency tools. The primary goal of the analytical
phase is to identify companies that appear to require immediate
regulatory attention. A ratio result falling outside the usual
range of IRIS ratios is not considered a failing result; rather,
unusual values are viewed as part of the regulatory early
monitoring system. Furthermore, in some years, it may not be
unusual for financially sound companies to have several ratios
with results outside the usual ranges. An insurance company may
fall out of the usual range for one or more ratios because of
specific transactions that are in themselves immaterial. As of
December 31, 2008, FMIC and FMCC each had one IRIS ratio
outside the usual range. AUIC had two IRIS ratios outside the
usual range. An insurance company may become the subject of
increased scrutiny when four or more of its IRIS ratios fall
outside the range deemed usual by the NAIC. The nature of
increased regulatory scrutiny resulting from IRIS ratios that
are outside the usual range is subject to the judgment of the
applicable state insurance department, but generally will result
in accelerated review of annual and quarterly filings. Depending
on the nature and severity of the underlying cause of the IRIS
ratios being outside the usual range, increased regulatory
scrutiny could range from increased but informal regulatory
oversight to placing a company under regulatory control.
FMFC is a holding company with no business operations of our
own. Consequently, our ability to pay dividends to stockholders
and meet our debt payment obligations is dependent on dividends
and other distributions from our subsidiaries. State insurance
laws restrict the ability of our insurance company subsidiaries
to declare stockholder dividends. State insurance regulators
require insurance companies to maintain specified levels of
statutory capital and surplus. Generally, dividends may be paid
only out of earned surplus, and the amount of an insurer’s
surplus following payment of any dividends must be reasonable in
relation to the insurer’s outstanding liabilities and
adequate to meet its financial needs. Further, prior approval
from the insurance departments of our insurance
subsidiaries’ states of domicile generally is required in
order for our insurance subsidiaries to declare and pay
“extraordinary dividends” to us. For FMIC, Illinois
defines an extraordinary dividend as any dividend or
distribution that, together with other distributions made within
the preceding 12 months, exceeds the greater of 10% of
FMIC’s surplus as of the preceding December 31, or
FMIC’s net income for the 12 month period ending the
preceding December 31, in each case determined in
accordance with statutory accounting principles. FMIC must give
the Illinois insurance regulator written notice of every
dividend or distribution, whether or not extraordinary, within
the time periods specified under applicable law. With respect to
FMCC, Minnesota imposes a similar restriction on extraordinary
dividends and requires a similar notice of all dividends after
declaration and before paid. For FMCC, Minnesota defines an
extraordinary dividend as any dividend or distribution that,
together with other distributions made within the preceding
12 months, exceeds the greater of 10% of the insurer’s
surplus as of the preceding December 31, or FMCC’s net
income, not including realized capital gains, for the
12 month period ending the preceding December 31, in
each case determined in accordance with statutory accounting
principles. With respect to AUIC, Arkansas imposes a similar
restriction on extraordinary dividends and requires similar
notice of all dividends after declaration and before payment.
For AUIC, Arkansas defines an extraordinary dividend as any
dividend or distribution that, together with other distributions
made within in the preceding 12 months exceeds the greater
of 10% of the insurer’s surplus as of the preceding
December 31, or AUIC’s net income, not including
realized capital gains, for the 12 month period ending the
preceding December 31, in each case determined in
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accordance with statutory accounting principles. Based on the
policyholders’ surplus and the net income of our insurance
subsidiaries as of December 31, 2008, FMIC, FMCC, and AUIC
may pay dividends in 2009, if declared, of up to
$33.8 million without regulatory approval. In 2008 and
2007, our insurance subsidiaries would have been permitted to
pay up to $19.0 million and $15.7 million,
respectively, in ordinary dividends without the prior regulatory
approval. State insurance regulatory authorities that have
jurisdiction over the payment of dividends by our insurance
subsidiaries may in the future adopt statutory provisions more
restrictive than those currently in effect. No dividends were
paid by FMIC, FMCC or AUIC during the year ended
December 31, 2008.
Our insurance subsidiaries are subject to state laws which
require diversification of their investment portfolios and
impose limits on the amount of their investments in certain
categories. Failure to comply with these laws and regulations
would cause non-conforming investments to be treated as
non-admitted assets in the states in which they are licensed to
sell insurance policies for purposes of measuring statutory
surplus and, in some instances, would require them to sell those
investments. At December 31, 2008, we had no investments
that would be treated as non-admitted assets.
Under state insurance guaranty fund laws, insurers doing
business on an admitted basis in a state can be assessed for
certain obligations of insolvent insurance companies to
policyholders and claimants. The maximum guaranty fund
assessments in any one year typically is between 1.0% to 2.0% of
a company’s net direct written premium written in the state
for the preceding calendar year on the types of insurance
covered by the fund. In most states, guaranty fund assessments
can be recouped at least in part through future premium
increases or offsets to state premium tax liability. In most
states, FMIC is not subject to state guaranty fund assessments
because of its status as a surplus lines insurer.
CoverX is licensed as a resident producer and surplus lines
broker in the State of Michigan and as a non-resident
producer/agency
and/or
surplus lines broker in other states. CoverX and our insurance
subsidiaries have obligations to ensure that they pay
commissions to only properly licensed insurance
producers/brokers.
FM Emerald is licensed as a resident agency in Illinois and as a
non-resident agency in other states. FM Emerald does not hold
any surplus lines licenses.
In certain states in which we operate, insurance claims
adjusters also are required to be licensed and in some states
must fulfill annual continuing education requirements.
In 1999, the United States Congress enacted the Gramm Leach
Bliley Act, which, among other things, protects consumers from
the unauthorized dissemination of certain personal information
by financial institutions. Subsequently, all states have
implemented similar or additional regulations to address privacy
issues that are applicable to the insurance industry. These
regulations limit disclosure by insurance companies and
insurance producers of “nonpublic personal
information” about individuals who obtain insurance or
other financial products or services for personal, family, or
household purposes. The Gramm Leach Bliley Act and the
regulations generally apply to disclosures to nonaffiliated
third parties, subject to specified exceptions, but not to
disclosures to affiliates. The federal Fair Credit Reporting Act
imposes similar limitations on the disclosure and use of certain
types of consumer information among affiliates.
State privacy laws also require FMCC and AUIC to maintain
appropriate procedures for managing and protecting certain
personal information of its applicable customers and to disclose
to them its privacy practices. In 2002, to further facilitate
the implementation of the Gramm Leach Bliley Act, the NAIC
adopted the Standards for Safeguarding Customer Information
Model Regulation. A majority of states have adopted similar
provisions regarding the safeguarding of nonpublic personal
information. FMCC and AUIC have adopted a privacy policy for
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safeguarding nonpublic personal information, and they follow
procedures pertaining to applicable customers to comply with the
Gramm Leach Bliley Act’s related privacy requirements. We
may also be subject to future privacy laws and regulations,
which could impose additional costs and impact our results of
operations or financial condition.
The manner in which insurance companies and insurance agents and
brokers conduct the business of insurance is regulated by state
statutes in an effort to prohibit practices that constitute
unfair methods of competition or unfair or deceptive acts or
practices. Prohibited practices include, but are not limited to,
disseminating false information or advertising, unfair
discrimination, rebating and false statements.
Generally, insurance companies, adjusting companies and
individual claims adjusters are prohibited by state statutes
from engaging in unfair claims practices on a willful basis or
with such frequency to indicate a general business practice.
Unfair claims practices include, but are not limited to,
misrepresenting pertinent facts or insurance policy provisions;
failing to acknowledge and act reasonably promptly upon
communications with respect to claims arising under insurance
policies; and attempting to settle a claim for less than the
amount to which a reasonable person would have believed such
person was entitled.
Many states have laws and regulations that limit the ability of
an insurance company licensed by that state to exit a market.
Some states prohibit an insurer from withdrawing from one or
more lines of business in the state, except pursuant to a plan
approved by the state insurance regulator. Regulators may
disapprove a plan that may lead to market disruption. Some state
statutes explicitly, or by interpretation, apply these
restrictions to insurers operating on a surplus line basis.
The Terrorism Risk Insurance Act of 2002, extended and amended
by the Terrorism Risk Insurance Program Reauthorization Act of
2007, or TRIA, provides insurers with federally funded
reinsurance for “acts of terrorism.” TRIA also
requires insurers to make coverage for “acts of
terrorism” available in certain commercial
property/casualty
insurance policies and to comply with various other provisions
of TRIA. For applicable policies in force on or after
November 26, 2002, we are required to provide coverage for
losses arising from acts of terrorism as defined by TRIA on
terms and in amounts which may not differ materially from other
policy coverages. To be covered under TRIA, aggregate industry
losses from a terrorist act must exceed $100.0 million in
2008, the act must be perpetrated within the U.S. or in
certain instances outside of the U.S. on behalf of a
foreign person or interest and the U.S. Secretary of the
Treasury must certify that the act is covered under the program.
We generally offer coverage only for those acts covered under
TRIA. As of December 31, 2008, approximately 2% or less of
our policyholders in our E&S lines markets had purchased
TRIA coverage.
While the provisions of TRIA and the purchase of terrorism
coverage described above mitigate our exposure in the event of a
large scale terrorist attack, our effective deductible is
significant. Generally, we exclude acts of terrorism outside of
the TRIA coverage, such as domestic terrorist acts. Regardless
of TRIA, some state insurance regulators do not permit terrorism
exclusions for various coverages or causes of loss.
The Treasury Department’s Office of Foreign Asset Control,
or OFAC, maintains various economic sanctions regulations
against certain foreign countries and groups and prohibits
“U.S. Persons” from engaging in certain
transactions with certain persons or entities in or associated
with those countries or groups. One key element of these
sanctions regulations is a list maintained by the OFAC of
“Specifically Designated Nationals and Blocked
Persons,” or the SDN List. The SDN List identifies persons
and entities that the government believes are associated with
terrorists, targeted countries
and/or drug
traffickers.
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OFAC’s regulations, among other things, prohibit insurers
and others from doing business with persons or entities on the
SDN List. If the insurer finds and confirms a match, the insurer
must take steps to block or reject the transaction, notify the
affected person and file a report with OFAC. The focus on
insurers’ responsibilities with respect to the sanctions
regulations compliance has increased significantly since the
terrorist attacks of September 11, 2001.
Risks
Relating to Our Business
The significant financial market volatility experienced
worldwide during the third and fourth quarters of 2008 has
continued in 2009 and the impact on the U.S. and foreign
economies appears to be worsening. Although the U.S. and
other foreign governments have taken various actions to try to
stabilize the financial markets, it is unclear whether those
actions will be effective. Therefore, the financial market
volatility and the resulting negative economic impact could
continue and it is possible that it may be prolonged.
Although we continue to monitor market conditions, we cannot
predict future market conditions or their impact on our stock
price or investment portfolio. Depending on market conditions,
we could incur future additional realized and unrealized losses,
which could have a material adverse effect on our results of
operations and financial condition. These economic conditions
have had an adverse impact on the availability and cost of
capital resources.
The severe downturn in the debt and equity markets, reflecting
uncertainties associated with the mortgage crisis, worsening
economic conditions, widening of credit spreads, bankruptcies
and government intervention in large financial institutions, has
resulted in significant realized and unrealized losses in the
Company’s investment portfolio. Depending on future market
conditions, the Company could incur substantial additional
realized and unrealized losses in its investment portfolio,
which could have a material adverse effect on the Company’s
financial condition
and/or
results of operations.
In addition, the continuing financial market volatility and
economic downturn could have a material adverse affect on our
insureds, agents, claimants, reinsurers, vendors and
competitors. Certain of the actions the U.S. Government has
taken or may take in response to the financial market crisis
have impacted certain property and casualty insurance carriers.
The government is actively taking steps to implement additional
measures to stabilize the financial markets and stimulate the
economy, and it is possible that these measures could further
affect the property and casualty insurance industry and its
competitive landscape.
Third party rating agencies periodically assess and rate the
claims-paying ability of insurers based on criteria established
by the rating agencies. The First Mercury group (FMIC, FMCC and
AUIC) maintains an “A−” rating (the fourth
highest of fifteen ratings) with a stable outlook from
A.M. Best Company, Inc., or A.M. Best, a rating agency
and publisher for the insurance industry. This rating is not a
recommendation to buy, sell or hold our securities but is viewed
by insurance consumers and intermediaries as a key indicator of
the financial strength and quality of an insurer. FMIC currently
has the lowest rating necessary to compete in our targeted
markets as a direct insurance writer because an
“A−” rating or higher is required by many
insurance brokers, agents and policyholders when obtaining
insurance and by many insurance companies that reinsure portions
of our policies.
Our A.M. Best rating is based on a variety of factors, many
of which are outside of our control. These factors include our
business profile and the statutory surplus of our insurance
subsidiaries, which is adversely affected by underwriting
losses, investment losses and dividends paid by them to us.
Other factors include balance sheet strength (including capital
adequacy and loss and loss adjustment expense reserve adequacy)
and operating performance. Any downgrade of our ratings could
cause our current and future brokers and agents, retail brokers
and insureds to choose other, more highly rated, competitors and
increase the cost or reduce the availability of reinsurance to
us. Without at least an “A−” A.M. Best
rating for FMIC, we could not competitively engage in direct
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insurance writing, but instead would be heavily dependent on
fronting carriers to underwrite premiums. These fronting
arrangements would require us to pay significant fees, which
could then cause our earnings to decline. Moreover, we may not
be able to enter into fronting arrangements on acceptable terms,
which would impair our ability to operate our business.
We are liable for losses and loss adjustment expenses under the
terms of the insurance policies issued directly by us and under
those for which we assume reinsurance obligations. As a result,
if we fail to accurately assess the risk associated with the
business that we insure, our loss reserves may be inadequate to
cover our actual losses. In many cases, several years may elapse
between the occurrence of an insured loss, the reporting of the
loss to us and our payment of the loss. In addition, our
policies generally do not provide limits on defense costs, which
could increase our liability exposure under our policies.
We establish loss and loss adjustment expense reserves with
respect to reported and unreported claims incurred as of the end
of each period. Our loss and loss adjustment expense reserves
were $372.7 million, $272.4 million, and
$191.0 million at December 31, 2008, 2007, and 2006,
respectively, all of which are gross of ceded loss and loss
adjustment expense reserves. These reserves do not represent an
exact measurement of liability, but are our estimates based upon
various factors, including:
Most or all of these factors are not directly or precisely
quantifiable, particularly on a prospective basis, and are
subject to a significant degree of variability over time. For
example, insurers have been held liable for large awards of
punitive damages, which generally are not reserved for. In many
cases, estimates are made more difficult by significant
reporting lags between the occurrence of the insured event and
the time it is actually reported to the insurer and additional
lags between the time of reporting and final settlement of
claims. Accordingly, the ultimate liability may be more or less
than the current estimate. While we set our reserves based on
our assessment of the insurance risk assumed, as we have
expanded into new classes of business, we do not have extensive
proprietary loss data for other classes to use to develop
reserves. Instead, we must rely on industry loss information,
which may not reflect our actual claims results. As a result,
our continued expansion into new classes may make it more
difficult to ensure that our actual losses are within our loss
reserves.
If any of our reserves should prove to be inadequate, we will be
required to increase reserves, resulting in a reduction in our
net income and stockholders’ equity in the period in which
the deficiency is identified. In addition, future loss
experience substantially in excess of established reserves could
also have a material adverse effect on future earnings and
liquidity as well as our financial strength rating.
Under accounting principles generally accepted in the United
States of America, or GAAP, we are only permitted to establish
loss and loss adjustment expense reserves for losses that have
occurred on or before the financial statement date. Case
reserves and incurred but not reported, or IBNR, reserves
contemplate these obligations. No contingency reserve allowances
are established to account for future loss occurrences. Losses
arising from future events will be estimated and recognized at
the time the losses are incurred and could be substantial.
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Reinsurance is a practice whereby one insurer, called the
reinsurer, agrees to indemnify another insurer, called the
ceding insurer, for all or part of the potential liability
arising from one or more insurance policies issued by the ceding
insurer. Although reinsurance makes the reinsurer liable to us
to the extent of the risk transferred or ceded to the reinsurer,
this arrangement does not relieve us of our primary liability to
our policyholders. At December 31, 2008, we had
$181.2 million of reinsurance recoverables. Most of our
reinsurance recoverables are from two reinsurers, which are
subsidiaries of ACE Limited and Swiss Re. At December 31,
2008, the balances from ACE Limited and Swiss Re were
$75.0 million and $63.6 million, respectively.
Although we believe that we have high internal standards for
reinsurers with whom we place reinsurance, we cannot assure you
that our reinsurers will pay reinsurance claims on a timely
basis or at all. We cannot predict if the current recession and
financial market crisis will impact or prevent our reinsurers
from being able to fulfill there obligations to us. If
reinsurers are unwilling or unable to pay us amounts due under
reinsurance contracts, we will incur unexpected losses and our
cash flow will be adversely affected, which would have a
material adverse effect on our financial condition and operating
results.
We use significant amounts of reinsurance to manage our exposure
to market and insurance risks and to enable us to write policies
in excess of the level that our capital supports. The
availability and cost of reinsurance are subject to prevailing
market conditions, both in terms of price and available
capacity, which can affect our business volume and
profitability. Without adequate levels of appropriately priced
reinsurance, the level of premiums we can underwrite could be
materially reduced. The reinsurance market has changed
dramatically over the past few years as a result of a number of
factors, including inadequate pricing, poor underwriting and the
significant losses incurred as a consequence of the terrorist
attacks on September 11, 2001. As a result, reinsurers have
exited some lines of business, reduced available capacity and
implemented provisions in their contracts designed to reduce
their exposure to loss. In addition, the historical results of
reinsurance programs and the availability of capital also affect
the availability of reinsurance. Our reinsurance facilities
generally are subject to annual renewal. We cannot provide any
assurance that we will be able to maintain our current
reinsurance facilities or that we will be able to obtain other
reinsurance facilities in adequate amounts and at favorable
rates. In addition, we may underwrite risks that are excluded
from coverage under the terms of our reinsurance agreements due
to an underwriting oversight or differing interpretations of the
reinsurance contracts. In these circumstances, we attempt to
obtain coverage through special acceptance with our reinsurers
or purchase facultative reinsurance. If we cannot obtain
adequate reinsurance protection for these risks, we may be
exposed to greater losses.
Most of our property business is exposed to the risk of severe
weather conditions and other catastrophes. Catastrophes can be
caused by various events, including natural events such as
severe hurricanes, winter weather, tornadoes, windstorms,
earthquakes, hailstorms, severe thunderstorms and fires, and
other events such as explosions, terrorist attacks and riots.
The incidence and severity of catastrophes and severe weather
conditions are inherently unpredictable. Severe weather
conditions and catastrophes can cause losses in all of our
property lines and generally result in an increase in the number
of claims incurred as well as the amount of compensation sought
by claimants because every geographic location in which we
provide insurance policies is subject to the risk of severe
weather conditions. In 2008, we recorded $2.9 million of
pre-tax net losses related to the hurricane season. We use a
model that is commonly used throughout the industry to help us
ensure that we are purchasing sufficient catastrophe reinsurance
limits. Currently, we purchase catastrophe reinsurance to cover
a potential catastrophe that is modeled to only occur once every
250 years. There can be no assurance that this modeled
information will accurately predict catastrophic losses. It is
possible that a catastrophic event or multiple catastrophic
events could cause our loss and loss expense reserves to
increase and our liquidity and financial condition to decline.
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Various provisions of our policies, such as loss limitations,
exclusions from coverage or choice of forum, which have been
negotiated to limit our risks, may not be enforceable in the
manner we intend. At the present time, we employ a variety of
endorsements to our policies in an attempt to limit exposure to
known risks. As industry practices and legal, social and other
conditions change, unexpected and unintended issues related to
claims and coverage may emerge. These issues may adversely
affect our business by either extending coverage beyond our
underwriting intent or by increasing the size or number of
claims. Recent examples of emerging claims and coverage issues
include increases in the number and size of claims relating to
construction defects, which often present complex coverage and
damage valuation questions. The effects of these and other
unforeseen emerging claim and coverage issues are difficult to
predict and could harm our business.
In addition, we craft our insurance policy language to limit our
exposure to expanding theories of legal liability such as those
which have given rise to claims for lead paint, asbestos, mold
and construction defects. Many of the policies we issue also
include conditions requiring the prompt reporting of claims to
us and our right to decline coverage in the event of a violation
of that condition, as well as limitations restricting the period
during which a policyholder may bring a breach of contract or
other claim against our company, which in many cases is shorter
than the statutory limitations for such claims in the states in
which we write business. It is possible that a court or
regulatory authority could nullify or void an exclusion or that
legislation could be enacted which modifies or bars the use of
such endorsements and limitations in a way that would adversely
affect our loss experience, which could have a material adverse
effect on our financial condition or results of operations. In
some instances, these changes may not become apparent until some
time after we have issued insurance policies that are affected
by the changes. As a result, we may not know the full extent of
liability under our insurance contracts for many years after a
contract is issued.
Since 2000, we have expanded our focus on new classes of the
specialty insurance market, which we refer to as specialty
classes, contract underwriting classes and FM Emerald, in
addition to our long-standing business for security classes.
These new classes represented 24.2% of our premiums produced in
2000 and 77.2% of our premiums produced in 2008. As a result of
this expansion, we have a more limited operating and financial
history available for specialty classes when compared to our
data for security classes. This may adversely impact our ability
to adequately price the insurance we write to reflect the risk
assumed and to exclude risks that generate large or frequent
claims and to establish appropriate loss reserves. Because we
rely more heavily on industry data in calculating reserves for
specialty classes, contract underwriting classes, and FM Emerald
than we do for security classes, we may need to further adjust
our reserve estimates for these classes in the future, which
could materially adversely affect our operating results.
Our operating results and future growth depend, in part, on the
acquisition and successful retention of underwriting expertise.
We rely on a small number of underwriters in the specialty
classes for which we write policies. For example, we expanded
our business into new classes in 2007 by hiring the FM Emerald
management team and we introduced new classes by engaging with
contract underwriters. In addition, we intend to continue to
expand into other specialty classes through the acquisition of
key underwriting personnel. While we intend to continue to
search for suitable candidates to augment and supplement our
underwriting expertise in existing and additional classes of
specialty insurance, we may not be successful in identifying,
hiring and retaining candidates. If we are successful in
identifying candidates, there can be no assurance that we will
be able to hire and retain them or, if they are hired and
retained, that they will be successful in enhancing our business
or generating an underwriting profit.
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Our future capital requirements, especially those of our
insurance subsidiaries, depend on many factors, including our
ability to write new business successfully and to establish
premium rates and reserves at levels sufficient to cover losses
and loss adjustment expenses. We may need to raise additional
funds to the extent that our cash flows are insufficient to fund
future operating requirements, support growth and maintain our
A.M. Best rating. Many factors will affect our capital
needs, including our growth and profitability, our claims
experience, our investment performance, and the availability of
reinsurance, as well as possible acquisition opportunities,
market disruptions and other unforeseeable developments. If we
have to raise additional capital, equity or debt financing may
not be available or may be available only on terms, amounts or
time periods that are not favorable to us. Equity financings
could be dilutive to our existing stockholders and debt
financings could subject us to covenants that restrict our
ability to operate our business freely. If we cannot obtain
adequate capital on favorable terms or at all, our business,
financial condition or results of operations could be materially
adversely affected.
We are substantially dependent on a small number of key
employees at our operating companies, in particular Richard H.
Smith, our Chairman and Chief Executive Officer, and our key
underwriting employees. We believe that the experience and
reputation in the insurance industry of Mr. Smith and our
key underwriting employees are important factors in our ability
to attract new business. Our success has been, and will continue
to be, dependent on our ability to retain the services of our
existing key employees and to attract and retain additional
qualified personnel in the future. As we continue to grow, we
will need to recruit and retain additional qualified management
personnel, but we may be unsuccessful in doing so. The loss of
the services of Mr. Smith or any other key employee, or the
inability to identify, hire and retain other highly qualified
personnel in the future, could adversely affect the quality and
profitability of our operations.
Premiums produced for security classes represented 20.7% of our
total direct and assumed written premiums in 2008. As a result,
any changes in the security insurance market, such as changes in
business, economic or regulatory conditions or changes in
federal or state law or legal precedents, could adversely impact
our ability to write insurance for this market. For example, any
legal outcome or other incident could have the effect of
increasing insurance claims in the security insurance market
which could adversely impact our operating results.
For security classes, we generate business from traditional
E&S lines insurance wholesalers and specialists that focus
on security guards and detectives, alarm installation and
service businesses and safety equipment installation and service
businesses. These wholesalers and specialists are not under any
contractual obligation to provide us business. Our top five
wholesale brokers represented 39.0% of the premiums produced
from security classes in 2008. For specialty classes, we
generate business from traditional E&S lines insurance
wholesalers who have a presence in the classes we underwrite.
Our top five wholesale brokers represented 35.1% of the premiums
produced from specialty classes in 2008. In our contract
underwriting classes, we rely on a small number of producers to
generate the insurance that we underwrite. For FM Emerald, we
generate business from E&S lines insurance wholesalers. Out
top five wholesale brokers represent 24.5% of premiums produced
from FM Emerald. The loss of one or more of our top wholesale
brokers for security classes, specialty classes or FM Emerald
producers could have a material adverse effect on our financial
condition or our results of operations.
The insurance industry in general and the markets in which we
compete are highly competitive and we believe that they will
remain so for the foreseeable future. We face competition from
several companies, which include insurance companies,
reinsurance companies, underwriting agencies, contract
underwriters and captive insurance companies. As a result of
this intense competition, prevailing conditions relating to
price, coverage and capacity can change very rapidly. Many of
our competitors are larger and have greater financial, marketing
and management
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resources than we do and may be perceived as providing greater
security to policyholders. There are low barriers to entry in
the E&S lines insurance market, which is the primary market
in which we operate, and competition in this market is
fragmented and not dominated by one or more competitors.
Competition in the E&S lines insurance industry is based on
many factors, including price, policy terms and conditions,
ratings by insurance agencies, overall financial strength of the
insurer, services offered, reputation, agent and broker
compensation and experience. We may face increased competition
in the future in the insurance markets in which we operate, and
any such increased competition could have a material adverse
effect on us.
Several E&S lines insurers and industry groups and
associations currently offer alternative forms of risk
protection in addition to traditional insurance products. These
alternative products, including large deductible programs and
various forms of self-insurance that use captive insurance
companies and risk retention groups, have been instituted to
allow for better control of risk management and costs. We cannot
predict how continued growth in alternative forms of risk
protection will affect our future operations.
Historically, the financial performance of the property and
casualty insurance industry has fluctuated in cyclical periods
of price competition and excess underwriting capacity (known as
a soft market) followed by periods of high premium rates and
shortages of underwriting capacity (known as a hard market).
Although an individual insurance company’s financial
performance is dependent on its own specific business
characteristics, the profitability of most property and casualty
insurance companies tends to follow this cyclical market
pattern. Further, this cyclical market pattern can be more
pronounced in the E&S lines market than in the standard
insurance market due to greater flexibility in the E&S
lines market to adjust rates to match market conditions. When
the standard insurance market hardens, the E&S lines market
hardens even more than the standard insurance market. During
these hard market conditions, the standard insurance market
writes less insurance and more customers must resort to the
E&S lines market for insurance. As a result, the E&S
lines market can grow more rapidly than the standard insurance
market. Similarly, when conditions begin to soften, many
customers that were previously driven into the E&S lines
market may return to the standard insurance market, exacerbating
the effects of rate decreases in the E&S lines market.
Beginning in 2000 and accelerating in 2001, the property and
casualty insurance industry experienced a hard market reflecting
increasing rates, more restrictive coverage terms and more
conservative risk selection. We believe that this trend
continued through 2003. We believe that these trends slowed
beginning in 2004 that the current insurance market has become
more competitive in terms of pricing and policy terms and
conditions. We are currently experiencing some downward pricing
pressure. Because this cyclicality is due in large part to the
actions of our competitors and general economic factors, we
cannot predict the timing or duration of changes in the market
cycle. These cyclical patterns have caused our revenues and net
income to fluctuate and are expected to do so in the future.
We are
subject to extensive regulation, which may adversely affect our
ability to achieve our business objectives. In addition, if we
fail to comply with these regulations, we may be subject to
penalties, including fines and suspensions, which may adversely
affect our financial condition and results of
operations.
Our insurance subsidiaries are subject to extensive regulation,
primarily by insurance regulators in Illinois, Minnesota, and
Arkansas, the states in which our three insurance company
subsidiaries are domiciled and, to a lesser degree, the other
jurisdictions in which we operate. Most insurance regulations
are designed to protect the interests of insurance
policyholders, as opposed to the interests of the insurance
companies or their shareholders. These insurance regulations
generally are administered by a department of insurance in each
state and relate to, among other things, licensing,
authorizations to write E&S lines of business, capital and
surplus requirements, rate and form approvals, investment and
underwriting limitations, affiliate transactions (which includes
the review of services, tax sharing and other agreements with
affiliates that can be a source of cash flow to us, other than
dividends which are specifically regulated by law), dividend
limitations, changes in control, solvency and a variety of other
financial and non-financial aspects of our business. Significant
changes in these laws and regulations could further limit our
discretion to operate our business as we deem appropriate or
make it more expensive to conduct our
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business. State insurance departments also conduct periodic
examinations of the affairs of insurance companies and require
the filing of annual and other reports relating to financial
condition, holding company issues and other matters. These
regulatory requirements may adversely affect our ability to
achieve some or all of our business objectives.
In addition, regulatory authorities have broad discretion to
deny or revoke licenses or approvals for various reasons,
including the violation of regulations. In instances where there
is uncertainty as to the applicability of regulations, we follow
practices based on our interpretations of regulations or
practices that we believe generally to be followed by the
insurance industry. These practices may turn out to be different
from the interpretations of regulatory authorities. If we do not
have the requisite licenses and approvals or do not comply with
applicable regulatory requirements, insurance regulatory
authorities could preclude or temporarily suspend us from
carrying on some or all of our activities or otherwise penalize
us. These actions could adversely affect our ability to operate
our business. Further, changes in the level of regulation of the
insurance industry and changes in laws or regulations themselves
or their interpretations by regulatory authorities could
adversely affect our ability to operate our business.
The National Association of Insurance Commissioners, or NAIC,
has adopted a system to test the adequacy of statutory capital,
known as “risk-based capital.” This system establishes
the minimum amount of risk-based capital necessary for a company
to support its overall business operations. It identifies
property and casualty insurers that may be inadequately
capitalized by looking at certain 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, including
supervision, rehabilitation or liquidation. Failure to maintain
our risk-based capital at the required levels could adversely
affect the ability of our insurance subsidiaries to maintain
regulatory authority to conduct our business.
Insurance Regulatory Information System, or IRIS, ratios are
part of a collection of analytical tools designed to provide
state insurance regulators with an integrated approach to
screening and analyzing the financial condition of insurance
companies operating in their respective states. As of
December 31, 2008, FMIC and FMCC each had one IRIS ratio
outside the usual range. AUIC had two IRIS ratios outside the
usual range. An insurance company may become subject to
increased scrutiny when four or more of its IRIS ratios fall
outside the range deemed usual by the NAIC. The nature of
increased regulatory scrutiny resulting from IRIS ratios that
are outside the usual range is subject to the judgment of the
applicable state insurance department, but generally will result
in accelerated review of annual and quarterly filings. Depending
on the nature and severity of the underlying cause of the IRIS
ratios being outside the usual range, increased regulatory
scrutiny could range from increased but informal regulatory
oversight to placing a company under regulatory control. FMIC
has, in the past, had more than four ratios outside the usual
range. If, in the future, FMIC has four or more ratios outside
the usual range, we could become subject to greater scrutiny and
oversight by regulatory authorities. See “Insurance and
Other Regulatory Matters.”
Our operating results depend in part on the performance of our
investment portfolio. The primary goals of our investment
portfolio are to:
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The ability to achieve our investment objectives is affected by
general economic conditions that are beyond our control. General
economic conditions can adversely affect the markets for
interest rate-sensitive securities, including the extent and
timing of investor participation in such markets, the level and
volatility of interest rates and, consequently, the value of
fixed income securities. Interest rates are highly sensitive to
many factors, including governmental monetary policies, domestic
and international economic and political conditions and other
factors beyond our control. General economic conditions, stock
market conditions and many other factors can also adversely
affect the equities markets and, consequently, the value of the
equity securities we own. We may not be able to realize our
investment objectives, which could significantly reduce our
financial position, stockholders’ equity and net income.
The following financial instruments are carried at fair value in
the Company’s consolidated financial statements: fixed
maturities, equity securities, hybrid securities, freestanding
derivatives, and limited partnerships. The Company has
categorized these securities into a three-level hierarchy, based
on the priority of the inputs to the respective valuation
technique. The fair value hierarchy gives the highest priority
to quoted prices in active markets for identical assets or
liabilities (Level 1) and the lowest priority to
unobservable inputs (Level 3). In many situations, inputs
used to measure the fair value of an asset or liability position
may fall into different levels of the fair value hierarchy. In
these situations, the Company will determine the level in which
the fair value falls based upon the lowest level input that is
significant to the determination of the fair value.
The determination of fair values are made at a specific point in
time, based on available market information and judgments about
financial instruments, including estimates of the timing and
amounts of expected future cash flows and the credit standing of
the issuer or counterparty. The use of different methodologies
and assumptions may have a material effect on the estimated fair
value amounts. During periods of market disruption such as we
are currently experiencing, including periods of rapidly
widening credit spreads or illiquidity, it has been and will
likely continue to be difficult to value certain of our
securities, such as Alt-A, subprime mortgage-backed, CMBS and
ABS securities, if trading becomes less frequent
and/or
market data becomes less observable. There may be certain asset
classes that were in active markets with significant observable
data that become illiquid due to the current financial
environment. In such cases, more securities may fall to
Level 3 and thus require more subjectivity and management
judgment. As such, valuations may include inputs and assumptions
that are less observable or require greater estimation thereby
resulting in values which may differ materially from the value
at which the investments may be ultimately sold. Further,
rapidly changing and unprecedented credit and equity market
conditions could materially impact the valuation of securities
as reported within our consolidated financial statements and the
period-to-period changes in value could vary significantly.
Decreases in value could have a material adverse effect on our
results of operations and financial condition. As of
December 31, 2008, 7.0%, 91.9% and 1.1% of our available
for sale securities were considered to be Level 1, 2 and 3,
respectively.
The evaluation of impairments is a quantitative and qualitative
process, which is subject to risks and uncertainties and is
intended to determine whether declines in the fair value of
investments should be recognized in current period earnings. The
risks and uncertainties include changes in general economic
conditions, the issuer’s financial condition or future
recovery prospects, the effects of changes in interest rates or
credit spreads and the expected recovery period. For securitized
financial assets with contractual cash flows, the Company
currently uses its best estimate of cash flows over the life of
the security under severe recession scenarios. In addition,
estimating future cash flows involves incorporating information
received from third party sources and making internal
assumptions and judgments regarding the future performance of
the underlying collateral and assessing the probability that an
adverse change in future cash flows has occurred. The
determination of the amount of other than temporary impairments
is based upon our quarterly evaluation and assessment of known
and inherent risks
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associated with the respective asset class. Such evaluations and
assessments are revised as conditions change and new information
becomes available.
Additionally, our management considers a wide range of factors
about the security issuer and uses their best judgment in
evaluating the cause of the decline in the estimated fair value
of the security and in assessing the prospects for recovery.
Inherent in management’s evaluation of the security are
assumptions and estimates about the operations of the issuer and
its future earnings potential. Factors considered in evaluating
potential impairment include, but are not limited to, the
current fair value as compared to cost or amortized cost of the
security, as appropriate, the length of time the investment has
been below cost or amortized cost and by how much, our intent
and ability to retain the investment for a period of time
sufficient to allow for an anticipated recovery in value,
specific credit issues related to the issuer and current
economic conditions. During the year ended December 31,
2008, the Company concluded that approximately
$12.1 million of unrealized losses were other than
temporarily impaired. Additional impairments may need to be
taken in the future, which could have a material adverse effect
on our results of operations and financial condition.
Losses
due to nonperformance or defaults by others, including issuers
of investment securities (which include structured securities
such as commercial mortgage-backed securities and residential
mortgage-backed securities or other high yielding bonds) or
reinsurance and derivative instrument counterparties, could have
a material adverse effect on the value of our investments,
results of operations, financial condition and cash
flows.
Issuers or borrowers whose securities or loans we hold,
customers, trading counterparties, counterparties under swaps
and other derivative contracts, reinsurers, clearing agents,
exchanges, clearing houses and other financial intermediaries
and guarantors may default on their obligations to us due to
bankruptcy, insolvency, lack of liquidity, adverse economic
conditions, operational failure, fraud government intervention
or other reasons. Such defaults could have a material adverse
effect on our results of operations, financial condition and
cash flows. Additionally, the underlying assets supporting our
structured securities may deteriorate causing these securities
to incur losses.
Our investment portfolio includes investment securities in the
financial services sector that have experienced nonperformance
or defaults recently. Further nonperformance or defaults could
have a material adverse effect on our results of operations,
financial condition and cash flows. In addition, the value of
our investments in hybrid securities, perpetual preferred
securities, or other equity securities in the financial services
sector may be significantly impaired if the issuers of such
securities defer the payment of optional coupons or dividends,
are forced to accept government support or intervention, or
grant majority equity stakes to their respective governments.
Furthermore, the counterparties to our interest rate swap
agreements may not be able to fulfill their obligations to us.
The Company is not exposed to any credit concentration risk of a
single issuer greater than 10% of the Company’s
stockholders’ equity other than U.S. government and
U.S. government agencies backed by the full faith and
credit of the U.S. government and the Japanese government.
However, if the Company’s creditors are acquired, merge or
otherwise consolidate with other creditors of the
Company’s, the Company’s credit concentration risk
could increase above the 10% threshold, for a period of time,
until the Company is able to sell securities to get back in
compliance with the established investment credit policies.
Our directors and executive officers beneficially own 19.9% of
our outstanding common stock (including options exercisable
within 60 days) as of December 31, 2008, including
11.2% owned by Jerome Shaw, our founder and former Chief
Executive Officer. Accordingly, these directors and executive
officers will have substantial influence, if they act as a
group, over the election of directors and the outcome of other
corporate actions requiring stockholder approval and could seek
to arrange a sale of our company at a time or under conditions
that are not favorable to our other stockholders. These
stockholders may also delay or prevent a change of control, even
if such a change of control would benefit our other
stockholders, if they act as a group. This significant
concentration of stock ownership may adversely affect the
trading price of our common stock due to investors’
perception that conflicts of interest may exist or arise.
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Our business is highly dependent on the successful and
uninterrupted functioning of our information technology and
telecommunications systems. We rely on these systems to process
new and renewal business, provide customer service, make claims
payments, facilitate collections and cancellations and to share
data across our organization. These systems also enable us to
perform actuarial and other modeling functions necessary for
underwriting and rate development. The failure of these systems,
or the termination of a third party software license on which
any of these systems is based, could interrupt our operations or
materially impact our ability to evaluate and write new
business. Because our information technology and
telecommunications systems interface with and depend on third
party systems, we could experience service denials if demand for
such services exceeds capacity or such third party systems fail
or experience interruptions. If sustained or repeated, a system
failure or service denial could result in a deterioration of our
ability to write and process new and renewal business and
provide customer service or compromise our ability to pay claims
in a timely manner.
Risks
Related to our Common Stock
The trading price of shares of our common stock may fluctuate
substantially. The price of the shares of our common stock that
will prevail in the market may be higher or lower than prices
paid by investors, depending on many factors, some of which are
beyond our control and may not be related to our operating
performance. These fluctuations could cause investors to lose
part or all of their investment in shares of our common stock.
Factors that could cause fluctuations include, but are not
limited to, the following:
The results of operations of companies in the insurance industry
historically have been subject to significant fluctuations and
uncertainties. Our profitability can be affected significantly
by:
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In addition, the demand for the types of insurance we will offer
can vary significantly, rising as the overall level of economic
activity increases and falling as that activity decreases,
causing our revenues to fluctuate. These fluctuations in results
of operations and revenues may cause the price of our securities
to be volatile.
If our existing stockholders sell substantial amounts of our
shares of common stock in the public market, the market price of
our shares of common stock could decrease significantly. The
perception in the public market that our existing stockholders
might sell our shares of common stock could also depress our
market price.
The market price of our shares of common stock may drop
significantly. A decline in the price of shares of our common
stock might impede our ability to raise capital through the
issuance of additional shares of our common stock or other
equity securities.
We currently intend to retain any profits to provide capacity to
write insurance and to accumulate reserves and surplus for the
payment of claims. Our board of directors does not intend to
declare cash dividends in the foreseeable future. Any
determination to pay dividends to our stockholders in the future
will be at the discretion of our board of directors and will
depend on our results of operations, financial condition and
other factors deemed relevant by our board of directors.
Consequently, it is uncertain when, if ever, we will declare
dividends to our stockholders. If we do not pay dividends,
investors will only obtain a return on their investment if the
value of our shares of common stock appreciates.
We conduct substantially all of our operations through our
subsidiaries. Our status as a holding company and a legal entity
separate and distinct from our subsidiaries affects our ability
to pay dividends and make other payments. Our principal source
of funds is dividends and other payments from our subsidiaries.
Therefore, our ability to pay dividends depends largely on our
subsidiaries’ earnings and operating capital requirements
and is subject to the regulatory, contractual, rating agency and
other constraints of our subsidiaries, including the effect of
any such dividends or distributions on the A.M. Best rating
or other ratings of our insurance subsidiaries. Our three
insurance subsidiaries are limited by regulation in their
ability to pay dividends. For example, during 2009, FMIC, FMCC
and AUIC may pay in the aggregate dividends to FMFC of up to
$33.8 million without regulatory approval. In addition, the
terms of our borrowing arrangements may limit our ability to pay
cash dividends to our stockholders.
We are incorporated in Delaware. Our certificate of
incorporation and bylaws, as well as Delaware corporate law,
contain provisions that could delay or prevent a change of
control or changes in our management that a stockholder might
consider favorable, including a provision that authorizes our
board of directors to issue preferred stock with such voting
rights, dividend rates, liquidation, redemption, conversion and
other rights as our board of directors may fix and without
further stockholder action. The issuance of preferred stock with
voting rights could make it more difficult for a third party to
acquire a majority of our outstanding voting stock. This could
frustrate a change in the composition of our board of directors,
which could result in entrenchment of current management.
Takeover attempts generally include offering stockholders a
premium for their stock. Therefore, preventing a takeover
attempt may cause you to lose an opportunity to sell your shares
at a premium. If a change of control or change in management is
delayed or prevented, the market price of our common stock could
decline.
Delaware law also prohibits a corporation from engaging in a
business combination with any holder of 15% or more of its
capital stock until the holder has held the stock for three
years unless, among other possibilities, the board of directors
approves the transaction. This provision may prevent changes in
our management or corporate structure. Also, under applicable
Delaware law, our board of directors is permitted to and may
adopt additional anti-takeover measures in the future.
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Our bylaws provide for the division of our board of directors
into three classes with staggered three year terms. The
classification of our board of directors could have the effect
of making it more difficult for a third party to acquire, or
discourage a third party from attempting to acquire, control of
us.
Pursuant to Section 404 of the Sarbanes-Oxley Act of 2002,
we are required to furnish a report by our management on our
internal control over financial reporting. Such report contains,
among other matters, an assessment of the effectiveness of our
internal control over financial reporting as of the end of our
fiscal year, including a statement as to whether or not our
internal control over financial reporting is effective. This
assessment must include disclosure of any material weaknesses in
our internal control over financial reporting identified by
management. Each year we must prepare or update the process
documentation and perform the evaluation needed to comply with
Section 404. During this process, if our management
identifies one or more material weaknesses in our internal
control over financial reporting, we will be unable to assert
such internal control is effective. If we are unable to assert
that our internal control over financial reporting is effective
in the future (or if our auditors are unable to express an
opinion on the effectiveness of our internal controls), we could
lose investor confidence in the accuracy and completeness of our
financial reports, which could have an adverse effect on our
stock price.
None
Our corporate headquarters are located in Southfield, MI, where
we lease approximately 20,000 square feet. We have
approximately 25,000 square feet of additional office space
in Southfield, MI in a building owned by FMIC. We also lease
office space in Irvine, CA, Los Angeles, CA, Atlanta, GA,
Chicago, IL, Boston, MA, New York, NY, Allen, TX, Seattle, WA,
Conway, AR, and Scottsdale, AZ. We believe our current space is
adequate for our current operations.
We are, from time to time, involved in various legal proceedings
in the ordinary course of business, including litigation
involving claims with respect to policies that we write. We do
not believe that the resolution of any currently pending legal
proceedings, either individually or taken as a whole, will have
a material adverse effect on our business, results of operations
or financial condition.
None.
Our common stock has been listed on the New York Stock Exchange
under the trading symbol FMR since October 18, 2006,
following the pricing of our initial public offering. Prior to
that time, there was no public market
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for our common stock. The following table sets forth the high
and low closing sales prices of our common stock, as reported by
the New York Stock Exchange, since October 18, 2006.
On March 6, 2009, the last reported sales price of our
common stock was $13.36 per share.
As of February 20, 2009, there were 17,837,837 shares
of issued and outstanding common stock held by approximately
1,200 known holders of record.
Our board of directors has not declared, and does not intend to
declare, cash dividends on our common stock in the foreseeable
future. We currently intend to retain any profits to provide
capacity to write insurance and to accumulate reserves and
surplus for the payment of claims. Any determination to pay
dividends to our stockholders in the future will be at the
discretion of our board of directors and will depend on our
results of operations, financial condition and other factors
deemed relevant by our board of directors. Consequently, it is
uncertain when, if ever, we will declare dividends to our
stockholders. If we do not pay dividends, investors will only
obtain a return on their investment if the value of our shares
of common stock appreciates.
We conduct substantially all of our operations through our
subsidiaries. Our status as a holding company and a legal entity
separate and distinct from our subsidiaries affects our ability
to pay dividends and make other payments. Our principal source
of funds is dividends and other payments from our subsidiaries.
Therefore, our ability to pay dividends depends largely on our
subsidiaries’ earnings and operating capital requirements
and is subject to the regulatory, contractual, rating agency and
other constraints of our subsidiaries, including the effect of
any such dividends or distributions on the A.M. Best rating
or other ratings of our insurance subsidiaries. Our three
insurance subsidiaries are limited by regulation in their
ability to pay dividends. For example, during 2009, FMIC, FMCC
and AUIC may pay in the aggregate dividends to FMFC of up to
$33.8 million without regulatory approval. There are
generally no restrictions on the payment of dividends by our
non-insurance subsidiaries. In addition, the terms of our
borrowing arrangements may limit our ability to pay cash
dividends to our stockholders.
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The following graph compares the total return, based on share
price, of an investment of $100.00 in our common stock from
October 18, 2006, the date our common stock first became
publicly traded on the New York Stock Exchange, through
December 31, 2008 with the New York Stock Exchange
Composite and the New York Stock Exchange Financial indices. All
values assume reinvestment of the full amount of all dividends,
although dividends were not declared on our common stock. This
information is provided in accordance with Securities and
Exchange Commission requirements and is not necessarily
indicative of future results.
Total
Return to Stockholders
(Includes reinvestment of dividends)
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During the third quarter of 2008, the Board of Directors of the
Company authorized a share repurchase plan to purchase up to
1.5 million shares of common stock through open market or
privately negotiated transactions. The repurchase program
expires on August 18, 2009. During the three months and
year ended December 31, 2008, the Company repurchased
474,042 and 698,577 shares, respectively, of common stock
for $5.3 million and $8.6 million, respectively, at an
average cost of $11.25 and $12.25 per share, respectively.
Shares purchased under the program are retired and returned to
the status of authorized but unissued shares.
The table shown below presents our selected historical
consolidated financial and other data for the five years ended
December 31, 2008, which have been derived from our audited
consolidated financial statements. The historical consolidated
financial data presented below should be read in conjunction
with “Management’s Discussion and Analysis of
Financial Condition and Results of Operations” and the
consolidated annual financial statements and accompanying notes
included elsewhere in this Annual Report on
Form 10-K.
On August 17, 2005, we completed a transaction in which we
formed a holding company (“Holdings”) to purchase
shares of our common stock from certain FMFC stockholders, and
to exchange shares and options with the remaining stockholders
of FMFC. As a result of this transaction, Glencoe Capital, LLC
became the majority stockholder of Holdings and Holdings became
the controlling stockholder of FMFC. The purchase and exchange
of shares was financed by the issuance of $65.0 million
aggregate principal amount of senior rate notes by Holdings. As
a result of this acquisition and resulting purchase accounting
adjustments, the results of operations for periods prior to
August 17, 2005 are not comparable to periods subsequent to
that date. Holdings was merged into FMFC on October 16,
2006 and the senior notes were repaid in full with a portion of
the net proceeds from our initial public offering.
The selected historical consolidated financial and other data
presented below for the year ended December 31, 2004
(Predecessor), for the period from January 1, 2005 through
August 16, 2005 (Predecessor), for the period from
August 17, 2005 through December 31, 2005 (Successor),
and for the years ended December 31, 2006 (Successor),
December 31, 2007 (Successor) and December 31, 2008
(Successor) have been derived from our audited consolidated
financial statements.
On June 27, 2008, the Company sold all of the outstanding
capital stock of American Risk Pooling Consultants, Inc.
(“ARPCO”). The results of ARPCO’s operations are
presented as Discontinued Operations in the Consolidated
Statements of Income.
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34
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The following discussion and analysis of our financial
condition and results of operations should be read in
conjunction with the consolidated financial statements and the
related notes included elsewhere in this
Form 10-K.
The discussion and analysis below includes certain
forward-looking statements that are subject to risks,
uncertainties and other factors described in “Risk
Factors” under Item 1A and elsewhere in this report
that could cause actual results to differ materially from those
expected in, or implied by, those forward looking statements.
We are a provider of insurance products and services to the
specialty commercial insurance markets, primarily focusing on
niche and underserved segments where we believe that we have
underwriting expertise and other competitive advantages. During
our 35 years of underwriting security risks, we have
established CoverX (R) as a recognized brand among insurance
agents and brokers and have developed significant underwriting
expertise and a cost-efficient infrastructure. Over the last
eight years, we have leveraged our brand, expertise and
infrastructure to expand into other specialty classes of
business, particularly focusing on smaller accounts that receive
less attention from competitors.
First Mercury Financial Corporation (“FMFC”) is a
holding company for our operating subsidiaries. Our operations
are conducted with the goal of producing overall profits by
strategically balancing underwriting profits from our insurance
subsidiaries with the commissions and fee income generated by
our non-insurance subsidiaries. FMFC’s principal operating
subsidiaries are CoverX Corporation (“CoverX”), First
Mercury Insurance Company (“FMIC”), First Mercury
Casualty Company (“FMCC), formerly known as All Nation
Insurance Company, First Mercury Emerald Insurance Services,
Inc. (“FM Emerald), and American Management Corporation
(“AMC”).
CoverX produces and underwrites insurance policies for which we
retain risk and receive premiums. As a wholesale insurance
broker, CoverX markets our insurance policies through a
nationwide network of wholesale and retail insurance brokers who
then distribute these policies through retail insurance brokers.
CoverX also provides underwriting services with respect to the
insurance policies it markets in that it reviews the
applications submitted for insurance coverage, decides whether
to accept all or part of the coverage requested and determines
applicable premiums. CoverX receives commissions from affiliated
insurance companies, reinsurers, and non-affiliated insurers as
well as policy fees from wholesale and retail insurance brokers.
FM Emerald is a wholesale insurance agency producing commercial
lines business on primarily an excess and surplus lines basis
for CoverX via a producer agreement. As a wholesale insurance
agency, FM Emerald markets insurance products for CoverX through
a nationwide network of wholesale and retail insurance brokers
who then distribute these products through retail insurance
brokers.
FMIC and FMCC are two of our insurance subsidiaries. FMIC writes
substantially all the policies produced by CoverX. FMCC provides
reinsurance to FMIC. Effective January 1, 2007, FMIC and
FMCC entered into an intercompany pooling reinsurance agreement
wherein all premiums, losses and expenses of FMIC and FMCC,
including all past liabilities, are combined and apportioned
between FMIC and FMCC in accordance with fixed percentages. FMIC
also provides claims handling and adjustment services for
policies produced by CoverX and directly written by third
parties.
On June 27, 2008, the Company sold all of the outstanding
capital stock of American Risk Pooling Consultants, Inc.
(“ARPCO”). The results of ARPCO’s operations are
presented as Discontinued Operations in the Consolidated
Statements of Income. ARPCO provided third party administrative
services for risk sharing pools of governmental entity risks,
including underwriting, claims, loss control and reinsurance
services. ARPCO was solely a fee-based business and received
fees for these services and commissions on excess per occurrence
insurance placed in the commercial market with third party
companies on behalf of the pools.
On February 1, 2008, we acquired 100% of the issued and
outstanding common stock of American Management Corporation. AMC
is a managing general agency writing primarily commercial lines
package policies focused primarily on the niche fuel-related
marketplace. AMC distributes these insurance policies through a
nationwide distribution system of independent general agencies.
AMC underwrites these policies for third party
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insurance carriers and receives commission income for its
services. AMC also provides claims handling and adjustment
services for policies produced by AMC and directly written for
third parties. In addition, AMC owns and operates American
Underwriters Insurance Company (“AUIC”), a single
state, non-standard auto insurance company domiciled in the
state of Arkansas, and AMC Re, Inc. (“AMC Re”), a
captive reinsurer incorporated under the provisions of the laws
of Arkansas. Effective July 1, 2008, FMIC and AUIC entered
into an intercompany reinsurance agreement wherein all premiums
and losses of AUIC, including all past liabilities, are 100%
assumed by FMIC.
We use the operational measure “premiums produced” to
identify premiums generated from insurance policies sold through
our underwriting platforms, including CoverX, on insurance
policies that it produces and underwrites on behalf of our
insurance subsidiaries and under fronting relationships.
Premiums produced includes both our direct written premiums and
premiums directly written by our fronting insurers, all of which
are produced and underwritten by our underwriting platforms,
including CoverX. Although the premiums billed by us under
fronting relationships are directly written by the fronting
insurer, we control the ultimate placement of those premiums, by
either assuming the premiums by our insurance subsidiaries or
arranging for the premiums to be ceded to third party
reinsurers. The operational measure “premiums
produced” is used by our management, reinsurers, creditors
and rating agencies as a meaningful measure of the dollar growth
of our underwriting operations because it represents the
premiums that we control by directly writing insurance and by
our fronting relationships. It is also a key indicator of our
insurance underwriting operations’ revenues, and is the
basis for broker commission expense calculations in our
consolidated income statement. We generate direct and net earned
premium income from premiums directly written by our insurance
subsidiaries, and generate commission income, profit sharing
commission income and assumed written and earned premiums from
premiums directly written by third party insurance companies. We
believe that premiums produced is an important operational
measure of our insurance underwriting operations, and refer to
it in the following discussion and analysis of financial
condition and results of our operations.
GAAP and
Non-GAAP Financial Performance Metrics
Throughout this report, we present our operations in the way we
believe will be most meaningful, useful, and transparent to
anyone using this financial information to evaluate our
performance. In addition to the GAAP (generally accepted
accounting principles in the United States of America)
presentation of net income and certain statutory reporting
information, we show certain non-GAAP financial measures that we
believe are valuable in managing our business and drawing
comparisons to our peers. These measures are gross premiums
written, net premiums written, and combined ratio.
Following is a list of non-GAAP measures found throughout this
report with their definitions, relationships to GAAP measures,
and explanations of their importance to our operations:
While net premiums earned is the related GAAP measure used in
the statements of earnings, gross premiums written is the
component of net premiums earned that measures insurance
business produced before the impact of ceding reinsurance
premiums, but without respect to when those premiums will be
recognized as actual revenue. We use this measure as an overall
gauge of gross business volume in our insurance underwriting
operations with some indication of profit potential subject to
the levels of our retentions, expenses, and loss costs.
While net premiums earned is the related GAAP measure used in
the statements of earnings, net premiums written is the
component of net premiums earned that measures the difference
between gross premiums written and the impact of ceding
reinsurance premiums, but without respect to when those premiums
will be recognized as actual revenue. We use this measure as an
indication of retained or net business volume in our insurance
underwriting operations. It is an indicator of future earnings
potential subject to our expenses and loss costs.
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This ratio is a common industry measure of profitability for any
underwriting operation, and is calculated in two components.
First, the loss ratio is losses and settlement expenses divided
by net premiums earned. The second component, the expense ratio,
reflects the sum of policy acquisition costs and insurance
operating expenses, net of insurance underwriting commissions
and fees, divided by net premiums earned. The sum of the loss
and expense ratios is the combined ratio. The difference between
the combined ratio and 100 reflects the per-dollar rate of
underwriting income or loss. For example, a combined ratio of 85
implies that for every $100 of premium we earn, we record $15 of
pre-tax underwriting income.
The critical accounting policies discussed below are important
to the portrayal of our financial condition and results of
operations and require us to exercise significant judgment. We
use significant judgments concerning future results and
developments in making these critical accounting estimates and
in preparing our consolidated financial statements. These
judgments and estimates affect the reported amounts of assets,
liabilities, revenues and expenses and the disclosure of
material contingent assets and liabilities. We evaluate our
estimates on a continual basis using information that we believe
to be relevant. Actual results may differ materially from the
estimates and assumptions used in preparing the consolidated
financial statements.
In preparing our consolidated financial statements, management
is required to make estimates and assumptions that affect the
reported amounts of assets and liabilities and the disclosures
of contingent assets and liabilities as of the date of the
consolidated financial statements, and revenues and expenses
reported for the periods then ended. Actual results may differ
from those estimates. Material estimates that are susceptible to
significant change in the near term relate primarily to the
determination of the reserves for losses and loss adjustment
expenses and valuation of investments and intangible assets.
The reserves for losses and loss adjustment expenses represent
our estimated ultimate costs of all reported and unreported
losses and loss adjustment expenses incurred and unpaid at the
balance sheet date. Our reserves reflect our estimates at a
given time of amounts that we expect to pay for losses that have
been reported, which are referred to as Case reserves, and
losses that have been incurred but not reported and the expected
development of losses and allocated loss adjustment expenses on
reported cases, which are referred to as IBNR reserves. We do
not discount the reserves for losses and loss adjustment
expenses.
We allocate the applicable portion of our estimated loss and
loss adjustment expense reserves to amounts recoverable from
reinsurers under ceded reinsurance contracts and report those
amounts separately from our loss and loss adjustment expense
reserves as an asset on our balance sheet.
The estimation of ultimate liability for losses and loss
adjustment expenses is an inherently uncertain process,
requiring the use of informed estimates and judgments. Our loss
and loss adjustment expense reserves do not represent an exact
measurement of liability, but are our estimates based upon
various factors, including:
Most or all of these factors are not directly or precisely
quantifiable, particularly on a prospective basis, and are
subject to a significant degree of variability over time. In
addition, the establishment of loss and loss adjustment
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expense reserves makes no provision for the broadening of
coverage by legislative action or judicial interpretation or for
the extraordinary future emergence of new types of losses not
sufficiently represented in our historical experience or which
cannot yet be quantified. Accordingly, the ultimate liability
may be more or less than the current estimate. The effects of
changes in the estimated reserves are included in the results of
operations in the period in which the estimate is revised.
Our reserves consist of reserves for property and liability
losses, consistent with the coverages provided for in the
insurance policies directly written or assumed by the Company
under reinsurance contracts. In many cases, several years may
elapse between the occurrence of an insured loss, the reporting
of the loss to us and our payment of the loss. Although we
believe that our reserve estimates are reasonable, it is
possible that our actual loss experience may not conform to our
assumptions and may, in fact, vary significantly from our
assumptions. Accordingly, the ultimate settlement of losses and
the related loss adjustment expenses may vary significantly from
the estimates included in our financial statements. We
continually review our estimates and adjust them as we believe
appropriate as our experience develops or new information
becomes known to us.
When a claim is reported to us, our claims department completes
a case-basis valuation and establishes a case reserve for the
estimated amount of the ultimate payment as soon as practicable
after receiving notice of a claim and after it has sufficient
information to form a judgment about the probable ultimate
losses and loss adjustment expenses associated with that claim.
We take into consideration the facts and circumstances for each
claim filed as then known by our claims department, as well as
actuarial estimates of aggregate unpaid losses and loss expenses
based on our experience and industry data, and expected future
trends in loss costs. The amount of unpaid losses and loss
adjustment expense for reported claims, which we refer to as
case reserves, is based primarily upon a claim by claim
evaluation of coverage, and an evaluation of the following
factors:
Our claims department updates their case-basis valuations
continuously to incorporate new information. We also use
actuarial analyses to estimate both the costs of losses and
allocated loss adjustment expenses that have been incurred but
not reported to us and the expected development of costs of
losses and loss adjustment expenses on reported cases.
We determine IBNR reserve estimates separately for our security,
specialty, contract underwriting, and FM Emerald classes. For
security classes, our IBNR reserve estimates are determined
using our actual historical loss and loss adjustment expense
experience and reporting patterns from our loss and loss
adjustment expense database which covers the last 24 years.
For specialty, for which we have eight years of historical data,
our estimates give significant weight to industry loss and loss
adjustment expense costs, industry reporting patterns applicable
to our classes in combination with our actual paid and incurred
loss and loss adjustment expense reporting patterns. For
contract underwriting and FM Emerald for which we have three
years or less of historical data, our estimates give significant
weight to industry loss and loss adjustment expense costs,
industry reporting patterns applicable to our classes, and
historical data when available in combination with our actual
paid and incurred loss and loss adjustment expense reporting
patterns. Our estimates also include estimates of future trends
that may affect the frequency of claims and changes in the
average cost of potential future claims.
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We also estimate bulk reserves for our unallocated loss
adjustment expenses not specifically identified to a particular
claim, namely our internal claims department salaries and
associated general overhead and administrative expenses
associated with the adjustment and processing of claims. These
estimates, which are referred to as ULAE reserves, are based on
internal cost studies and analyses reflecting the relationship
of unallocated loss adjustment expenses paid to actual paid and
incurred losses. We select factors that are applied to case
reserves and to IBNR reserve estimates in order to estimate the
amount of unallocated loss reserves applicable to estimated loss
reserves at the balance sheet date.
Our reserves for losses and loss adjustment expenses at
December 31, 2008, 2007, and 2006, gross and net of ceded
reinsurance were as follows:
We utilize accepted actuarial methods to arrive at our loss and
loss adjustment expense IBNR reserve estimates. The
determination of our best estimate of ultimate loss and loss
adjustment expenses and IBNR reserves requires significant
actuarial analysis and judgment, both in application of these
methods and in the use of the results of these methods. The
principal methods we use include:
Our estimates give different weight to each of these methods
based upon the amount of historical experience data we have and
our judgments as to what method will result in the most accurate
estimate. The application of each method for our various classes
may change in the future if we determine a different emphasis
for each method would result in more accurate estimates.
We apply these methods to net paid and incurred loss and loss
adjustment expense and net earned premium information after
ceding reinsurance to determine ultimate net loss and loss
adjustment expense and net IBNR reserves. We determine our
ceded IBNR reserves applicable to quota share reinsurance based
on the ultimate net loss and loss adjustment expense ratios
determined in the estimation of our net IBNR reserves.
Ceded IBNR reserves applicable to excess of loss reinsurance are
based on industry and company experience factors applicable to
the excess coverage layers. Ceded case reserves are allocated
based on monthly or quarterly reinsurance settlement reports
prepared in accordance with the reporting and settlement terms
of the ceded reinsurance contracts.
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For security classes where we have many years of historical
experience data, we perform semi-annual analyses of the payment
and reporting patterns of losses and loss adjustment expenses as
well as reported and closed claims by accident year for security
guard, alarm, and safety equipment sub-classes. We have
generally relied primarily on the Loss Development Method in
calculating ultimate losses and loss adjustment expenses for the
more mature accident years, applying our historical loss and
loss adjustment expense reporting patterns to paid and incurred
losses and loss adjustment expenses reported to date by accident
year to estimate ultimate loss and loss adjustment expense and
IBNR reserves. Our reserve estimates for the more recent, less
mature accident years have relied more on the
Bornhuetter-Ferguson and Cape Cod Methods to calculate ultimate
loss and loss adjustment expense and IBNR reserves. Although we
have calculated the results from the Expected Loss Ratio Method
for the less mature years, we have not relied significantly on
this method due to the more meaningful results of the other
methods we have used for security classes.
For the specialty, contract underwriting and FM Emerald classes,
we have relied primarily on the Bornhuetter-Ferguson Method in
calculating our semi-annual reserve estimates. Although we use
the Loss Development Method, we have not relied significantly on
it as we are still building our experience database. We have
also used the Expected Loss Ratio Method, which we have
developed from industry loss cost information, adjusted for
changes in premium rates, coverage restrictions, and estimated
loss cost trends.
Our reserve analysis determines an actuarial point estimate
rather than a range of reserve estimates. We do not compute
estimated ranges of loss reserves.
We review loss and loss adjustment expense reserves on a
quarterly basis. Actuarial loss reserves analyses and reports
are prepared and are reviewed by management for all business
classes and accident years on a semi-annual basis as of June 30
and December 31. Annual actuarial Statements of Opinion on
the reserves of our insurance subsidiaries are also prepared as
of December 31, in accordance with insurance regulatory
requirements. The carried reserves reflect management’s
best estimate of the outstanding losses and loss adjustment
expense liabilities after review of the actuarial analyses and
Statements of Actuarial Opinion.
During the first two quarters of an accident year, for all
classes, we have used the Expected Loss Ratio Method based on
the previous year end estimates for the previous accident year,
adjusted for estimated changes in premium rates, coverage
restrictions and estimated loss cost trends. We monitor emerging
loss experience monthly and make adjustments to the current
accident year expected loss ratio as we believe appropriate.
Throughout the year we also compare actual emerging loss
development on prior accident years to expected loss development
included in our prior accident years’ loss reserve
estimates and make quarterly interim adjustments to prior
years’ reserve estimates during interim reporting periods
as we believe appropriate.
Our loss and loss adjustment expense reserves do not represent
an exact measurement of liability, but are estimates. Although
we believe that our reserve estimates are reasonable, it is
possible that our actual loss experience may not conform to our
assumptions. The most significant assumptions affecting our IBNR
reserve estimates are expected loss and loss adjustment expense
ratios, and expected loss and loss adjustment expense reporting
patterns. These vary by underwriting class, sub-classes, and
accident years, and are subject to uncertainty and variability
with respect to any individual accident year and sub-class.
Generally, the reserves for the most recent accident years
depend heavily on both assumptions. The most recent accident
years are characterized by more unreported losses and less
information available for settling claims, and have more
inherent uncertainty than the reserve estimates for more mature
accident years. The more mature accident years depend more on
expected loss and loss expense reporting patterns.
The following sensitivity analysis represents reasonably likely
levels of variability in these assumptions in the aggregate.
Individual classes and sub-classes and accident years have
different degrees of variability in both assumptions and it is
not reasonably likely that each assumption for each sub-class
and accident year would vary in the same direction and to the
same extent in the same reporting period. We believe the most
meaningful approach to the sensitivity analysis is to vary the
ultimate loss and loss adjustment expense estimates that result
from application of the assumptions. We apply this approach on
an accident year basis, reflecting the reasonably likely
differences in variability by level of maturity of the
underlying loss experience for each accident year, using
variability factors of plus or minus 10% for the most recent
accident year, 5% for the preceding accident year, and 2.5% for
the second
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preceding accident year. This parameterization of the
sensitivity analysis corresponds to the relative uncertainty, by
accident year, of our reserve estimates.
The following table includes net ultimate loss and loss
adjustment expense amounts by accident year from our statutory
filing for our insurance subsidiaries for the year ended
December 31, 2008, which are equal to the net ultimate loss
and loss adjustment expense amounts by accident year included in
our loss and loss adjustment expense reserve estimates in the
consolidated financial statements at December 31, 2008. The
use of net of ceded reinsurance amounts is most meaningful since
the vast majority of our ceded reinsurance is on a quota share
basis. We have applied the sensitivity factors to each accident
year amount and have calculated the amount of potential net
reserve change and the impact on 2008 reported pre-tax income
and on net income and stockholders’ equity at
December 31, 2008. We do not believe it is appropriate to
sum the illustrated amounts as it is not reasonably likely that
each accident year’s reserve estimate assumptions will vary
simultaneously in the same direction to the full extent of the
sensitivity factor.
Premiums. Premiums are recognized as earned
using the daily pro rata method over the terms of the policies.
When premium rates change, the effect of those changes will not
immediately affect earned premium. Rather, those changes will be
recognized ratably over the period of coverage. Unearned
premiums represent the portion of premiums written that relate
to the unexpired terms of
policies-in-force.
As policies expire, we audit those policies comparing the
estimated premium rating units that were used to set the initial
premium to the actual premiums rating units for the period and
adjust the premiums accordingly. Premium adjustments identified
as a result of these audits are recognized as earned when
identified.
Commissions and Fees. Wholesale agency
commissions and fee income from unaffiliated companies are
earned at the effective date of the related insurance policies
produced or as services are provided under the terms of the
service provider contracts. Related commissions to retail
agencies are concurrently expensed at the effective date of the
related insurance policies produced. Profit sharing commissions
due from certain insurance companies, based on losses and loss
adjustment expense experience, are earned when determined and
communicated by the applicable insurance company.
Our marketable investment securities, including money market
accounts held in our investment portfolio, are classified as
available-for-sale and, as a result, are reported at market
value. Effective January 1, 2008, we adopted
SFAS No. 157, “Fair Value Measurements,”
which resulted in no material changes in valuation
techniques we previously used to measure fair values. See
Note 17 to the Consolidated Financial Statements for a more
complete description. A decline in the market value of any
security below cost that is deemed other than temporary is
charged to earnings and results in the establishment of a new
cost basis for the security. In most cases, declines in market
value that are deemed temporary are excluded from earnings and
reported as a separate component of stockholders’ equity,
net of the related taxes, until realized. The exception to this
rule relates to investments in convertible
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securities with embedded derivatives and our alternative
investments. Convertible securities were accounted for under
FASB Statement No. 155, “Accounting for Certain
Hybrid Financial Instruments”
(“SFAS 155”) for the years ended
December 31, 2008 and December 31, 2007. Alternative
investments consist of our investments in limited partnerships,
which invest in high yield convertible securities and distressed
structured finance products. These alternative investments are
accounted for under FASB Statement No. 159, “The
Fair Value Option of Financial Assets and Financial
Liabilities” (“SFAS 159”), for the year
ended December 31, 2008. There were no alternative
investments for the year ended December 31, 2007.
Premiums and discounts are amortized or accreted over the life
of the related debt security as an adjustment to yield using the
effective-interest method. Dividend and interest income are
recognized when earned. Realized gains and losses are included
in earnings and are derived using the specific identification
method for determining the cost of securities sold.
Impairment of investment securities results in a charge to
operations when a market decline below cost is
other-than-temporary. Management regularly reviews our fixed
maturity securities portfolio to evaluate the necessity of
recording impairment losses for other-than-temporary declines in
the fair value of investments. Factors considered in evaluating
potential impairment include, but are not limited to, the
current fair value as compared to cost or amortized cost of the
security, as appropriate, the length of time the investment has
been below cost or amortized cost and by how much, our intent
and ability to retain the investment for a period of time
sufficient to allow for an anticipated recovery in value,
specific credit issues related to the issuer and current
economic conditions. Other-than-temporary impairment losses
result in a permanent reduction of the cost basis of the
underlying investment. Significant changes in the factors we
consider when evaluating investments for impairment losses could
result in a significant change in impairment losses reported in
the consolidated financial statements.
As mentioned above, the Company considers its intent and ability
to hold a security until the value recovers as part of the
process of evaluating whether a security’s unrealized loss
represents an other-than-temporary decline. The Company’s
ability to hold such securities is supported by sufficient cash
flow from its operations and from maturities within its
investment portfolio in order to meet its claims payment and
other disbursement obligations arising from its underwriting
operations without selling such investments. With respect to
securities where the decline in value is determined to be
temporary and the security’s value is not written down, a
subsequent decision may be made to sell that security and
realize a loss. Subsequent decisions on security sales are made
within the context of overall risk monitoring, changing
information and market conditions. Management of the
Company’s investment portfolio is outsourced to third party
investment managers, which is directed and monitored by the
investment committee. While these investment managers may, at a
given point in time, believe that the preferred course of action
is to hold securities with unrealized losses that are considered
temporary until such losses are recovered, the dynamic nature of
the portfolio management may result in a subsequent decision to
sell the security and realize the loss, based upon a change in
market and other factors described above. The Company believes
that subsequent decisions to sell such securities are consistent
with the classification of the Company’s portfolio as
available-for-sale.
Investment managers are required to notify management of rating
agency downgrades of securities in their portfolios as well as
any potential investment valuation issues at the end of each
quarter. Investment managers are also required to notify
management, and receive prior approval, prior to the execution
of a transaction or series of related transactions that may
result in a realized loss above a certain threshold.
Additionally, investment managers are required to notify
management, and receive approval, prior to the execution of a
transaction or series of related transactions that may result in
any realized loss up until a certain period beyond the close of
a quarterly accounting period.
Policy acquisition costs related to direct and assumed premiums
consist of commissions, underwriting, policy issuance, and other
costs that vary with and are primarily related to the production
of new and renewal business, and
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are deferred, subject to ultimate recoverability, and expensed
over the period in which the related premiums are earned.
Investment income is included in the calculation of ultimate
recoverability.
In accordance with SFAS No. 142, “Goodwill and
Other Intangible Assets,” goodwill and intangible
assets that are not subject to amortization shall be tested for
impairment annually, or more frequently if events or changes in
circumstances indicate that the asset might be impaired. The
impairment test for goodwill shall consist of a comparison of
the fair value of the goodwill with the carrying amount of the
reporting unit to which it is assigned. The impairment test for
intangible assets shall consist of a comparison of the fair
value of the intangible assets with their carrying amounts. If
the carrying amount of the goodwill or intangible assets exceed
their fair value, an impairment loss shall be recognized in an
amount equal to that excess.
In accordance with SFAS No. 144, “Accounting
for the Impairment or Disposal of Long-lived Assets,”
the carrying value of long-lived assets, including amortizable
intangibles and property and equipment, are evaluated whenever
events or changes in circumstances indicate that a potential
impairment has occurred relative to a given asset or assets.
Impairment is deemed to have occurred if projected undiscounted
cash flows associated with an asset are less than the carrying
value of the asset. The estimated cash flows include
management’s assumptions of cash inflows and outflows
directly resulting from the use of that asset in operations. The
amount of the impairment loss recognized is equal to the excess
of the carrying value of the asset over its then estimated fair
value.
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Year
Ended December 31, 2008 Compared to Year Ended
December 31, 2007
The following table summarizes our results for the years ended
December 31, 2008 and 2007:
Premiums produced, which consists of all of the premiums
underwritten by the Company’s underwriting platforms for
which we take risk, for the year ended December 31, 2008
were $321.3 million, a $45.3 million, or 16%, increase
over $276.0 million in premiums produced during the year
ended December 31, 2007. Our three new niche specialty
liability classes added during the second quarter of 2007
generated an increase of approximately $11.6 million in
premiums produced. In addition, our new E&S underwriting
platform, FM Emerald generated approximately $42.1 million
in premiums produced, a $40.8 million increase over the
$1.3 million produced during the year ended
December 31, 2007. AUIC contributed approximately
$6.7 million of premiums produced. These increases were
offset by a decrease of $13.8 million in premiums produced
from the Company’s specialty underwriting offices.
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Operating
Revenue
Direct written premiums increased $44.7 million, or 17%,
primarily due to the three new niche specialty liability
classes, the Company’s new E&S underwriting platform,
FM Emerald, and premiums written by AUIC during the year ended
December 31, 2008 partially offset by a decrease in
premiums written by the Company’s specialty underwriting
offices. Direct earned premiums increased $49.8 million in
the year ended December 31, 2008, or 21%, compared to the
year ended December 31, 2007.
Assumed written premiums increased $5.1 million, or 40%,
and assumed earned premiums increased $7.4 million, or 79%.
The increase in assumed written premiums is primarily due to an
increase in the assumed quota share from 30% to 100% in May 2007
on the admitted legal liability business written through a
fronting insurer.
Ceded written premiums decreased $14.6 million, or 13%, and
ceded earned premiums increased $29.4 million, or 39%, for
the year ended December 31, 2008 compared to the year ended
December 31, 2007. Ceded written premiums decreased
principally due to purchasing 10% quota share reinsurance during
the first quarter of 2008 and purchasing 15% quota share
reinsurance during the remainder of 2008, while the Company
purchased 35% quota share reinsurance from January 1, 2007
through September 30, 2007 and 25% quota share reinsurance
from October 1, 2007 through December 31, 2007, offset
somewhat by the purchase of 50% quota share reinsurance on a
portion of the new niche specialty premiums and by the cutoff of
two of the Company’s quota share reinsurance contracts
whereby the reinsurers returned approximately $6.0 million
in ceded unearned premiums. Ceded earned premiums increased
primarily due to ceded written premiums continuing to be earned
on the Company’s 2007 35% quota share reinsurance treaties,
which were amended to 25% on October 1, 2007, while there
were no ceded earned premiums related to the Company’s 2006
50% reinsurance treaties during the year months ended
December 31, 2007 due to the termination of the 2006 50%
quota share reinsurance treaties on a “cutoff” basis
at December 31, 2006. The effect of the December 31,
2006 50% quota share cut-off reinsurance termination was to
reduce ceded earned premiums for the year ended
December 31, 2007 by approximately $39.6 million, and
to increase net earned premiums by the same amount.
Earned but unbilled premiums decreased $3.2 million, or
93%, primarily due to a modest increase in net premiums earned
subject to audit for the year ended December 31, 2008
compared to a more significant increase in net premiums earned
subject to audit during the year ended December 31, 2007.
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Insurance underwriting commissions and fees decreased
$4.0 million or 75% from the year ended December 31,
2007 to the year ended December 31, 2008. This was
primarily the result of decreases in commissions on fronted
premiums. Insurance services commissions and fees, which were
principally AMC income and not related to premiums produced,
increased $19.7 million as the result of the acquisition of
AMC.
During the year ended December 31, 2008, net investment
income earned was $21.6 million, a $5.3 million, or
33%, increase from $16.3 million reported during the year
ended December 31, 2007. The increase was primarily due to
the increase in invested assets over the period. At
December 31, 2008, invested assets were
$543.0 million, an $83.7 million or 18% increase over
$459.3 million of invested assets at December 31,
2007. This increase was due to increases in net written
premiums, from the cash retained on our quota share reinsurance
contracts on a “funds withheld” basis and the proceeds
from the sale of ARPCO. The annualized investment yield (net of
investment expense) was 4.3% and 4.1% at December 31, 2008
and December 31, 2007, respectively. The tax equivalent
investment yield was 5.0% and 4.8% at December 31, 2008 and
December 31, 2007, respectively.
During the year ended December 31, 2008 net realized
losses on investments were $20.7 million compared to net
realized gains of $0.6 million during the year ended
December 31, 2007. Net realized losses for the year ended
December 31, 2008 were principally due to mark to market
declines in securities carried at market in accordance with
SFAS 155 and SFAS 159 of approximately
$14.6 million and $4.1 million of other-than-temporary
impairments.
Operating
Expenses
Losses and loss adjustment expenses incurred increased
$19.8 million, or 22%, for the year ended December 31,
2008 compared to the year ended December 31, 2007. This
increase was primarily due to the increase in net earned
exposures reflected in the 15% increase in net earned premiums,
an increase in the accident year loss and loss adjustment
expense ratio from decreased premium rates and an increase in
the expected loss ratio in a contract underwriting class of
business, and $2.9 million from the impact of Hurricane
Ike, reduced by $4.8 million in favorable development of
December 31, 2007 and prior years’ loss and loss
adjustment expense reserves. Losses and loss adjustment expenses
for the year ended December 31, 2007 included approximately
$0.8 million of favorable development of December 31,
2006 prior years’ loss and loss adjustment expense reserves.
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During the year ended December 31, 2008, other operating
expenses increased $34.5 million, or 84%, from the year
ended December 31, 2007. Amortization of deferred
acquisition expenses increased by $10.5 million, or 34%.
Ceded reinsurance commissions decreased $8.2 million, or
20%, principally due to the effect of purchasing 10% quota share
reinsurance from January 1, 2008 through March 31,
2008, and 15% quota share reinsurance from April 1, 2008
through December 31, 2008 compared to purchasing 35% quota
share reinsurance from January 1, 2007 through
September 30, 2007, and 25% quota share reinsurance from
October 1, 2007 through December 31, 2007 and the
return of $2.2 million of ceding commissions related to the
cutoff of two of the Company’s quota share reinsurance
contracts, offset by changes in ceding commission rates. Other
underwriting and operating expenses, which consist of
commissions, other acquisition costs, and general and
underwriting expenses, net of acquisition cost deferrals,
increased by $15.8 million, or 31%, principally due to an
increase in commissions and other acquisition costs, offset by
acquisition cost deferrals, and an increase in general and
underwriting expenses during the year ended December 31,
2007.
Interest expense increased $1.1 million, or 22%, from 2007
to 2008. This increase was primarily due to a $1.4 million
increase in interest expense related to junior subordinated
debentures of $20.6 million which were issued in September
2007 offset somewhat by a $0.3 million decrease in the
change in fair value of the interest rate swap on junior
subordinated debentures as is discussed in “Liquidity and
Capital Resources” below.”
Our effective tax rates were approximately 26.6% and 33.4% for
the years ended December 31, 2008 and 2007, respectively.
The decrease in the effective tax rate was primarily due to tax
exempt income comprising a larger portion of our overall pre-tax
income during the year ended December 31, 2008 compared to
2007.
Discontinued
Operations
On June 27, 2008, the Company sold all of the outstanding
capital stock of American Risk Pooling Consultants, Inc.
(“ARPCO”). The results of ARPCO’s operations are
presented as Discontinued Operations in the Consolidated
Statements of Income. For the year ended December 31, 2008,
income from discontinued operations consisted principally of the
$20.9 million gain, net of taxes, on the sale of ARPCO. For
the year ended December 31, 2007, income from discontinued
operations consisted principally of ARPCO’s operating
income, net of taxes.
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Year
Ended December 31, 2007 Compared to Year Ended
December 31, 2006
The following table summarizes our results for the years ended
December 31, 2007 and 2006:
Premiums produced, which consists of all of the premiums billed
by our underwriting platforms for the year ended
December 31, 2007, were $276.0 million, a
$45.9 million or 20% increase over $230.1 million in
premiums produced during the year ended December 31, 2006.
This growth was primarily attributable to:
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Operating
Revenue
Direct written premiums increased $45.0 million, or 21%
while direct earned premiums increased $25.3 million, or
12% in the year ended December 31, 2007 compared to the
year ended December 31, 2006. The increases in direct
written premiums and direct earned premiums were due primarily
to the addition of three new niche specialty liability classes
and one new underwriter of an existing class in the second
quarter of 2007, the opening of the Company’s California
and Georgia underwriting offices during the fourth quarter of
2006 and third quarter of 2007, respectively, and the growth in
premiums produced by existing underwriting offices during the
year ended December 31, 2007.
Assumed written premiums increased $8.3 million, or 192%,
and assumed earned premiums increased $5.6 million or 150%
for the year ended December 31, 2007 compared to the year
ended December 31, 2006. These increases were primarily
attributable to the admitted legal liability business written
through a fronting insurer and the related increase in the
assumed quota share from 30% to 100% on this fronted business.
Ceded written premiums increased $40.7 million, or 54%, and
ceded earned premiums decreased $25.7 million, or 25%, for
the year ended December 31, 2007 compared to the year ended
December 31, 2006. Ceded written premiums increased
principally due to the increase in direct written premiums, the
50% quota share reinsurance on a portion of the new niche
specialty class premiums and the placement of an excess
catastrophe reinsurance contract for a portion of the risks
underwritten in one of the new specialty niche classes, offset
somewhat by purchasing less reinsurance during the year ended
December 31, 2007 compared to the year ended
December 31, 2006. Ceded earned premiums decreased
primarily due to the termination of the Company’s 2006 50%
quota share reinsurance treaties on December 31, 2006 on a
“cut-off” basis, resulting in the previously ceded
unearned premiums being returned to the Company on that date, so
that there were no ceded earned premiums related to the 50%
reinsurance treaties during the year ended December 31,
2007.
Earned but unbilled premiums increased $1.9 million, or
132%, primarily due to the recognition of increased audit
premium collection experience and growth in net retained earned
premiums subject to premium audits.
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Insurance underwriting commissions and fees decreased
$1.1 million or 17% from the year ended December 31,
2006 to the year ended December 31, 2007. This was
primarily the result of decreases in commissions on fronted
programs.
During the year ended December 31, 2007, net investment
income earned was $16.3 million, a $6.6 million, or
68%, increase from $9.7 million reported during the year
ended December 31, 2006. The increase was primarily due to
the increase in invested assets over the period. At
December 31, 2007, invested assets were
$459.3 million, a $161.5 million or 54% increase over
$297.8 million of invested assets at December 31, 2006
due to increases in net written premiums and proceeds from the
issuance of Trust Preferred Securities. Net investment
income earned continued to benefit from higher reinvestment
rates as proceeds from maturing bonds were reinvested at
currently higher interest rates. The annualized investment yield
(net of investment expense) was 4.1% and 3.9% at
December 31, 2007 and December 31, 2006, respectively.
The tax equivalent investment yield was 4.8% and 4.7% at
December 31, 2007 and December 31, 2006, respectively.
During the year ended December 31, 2007, net realized gains
were $0.6 million, a $0.1 million, or 16%, increase
over the net realized gain of $0.5 million during the year
ended December 31, 2006. The net realized gains were due to
mark to market increases of $1.0 million in convertible
bonds carried at market in accordance with SFAS 155 offset
by net realized losses of $0.4 million on
available-for-sale securities.
Operating
Expenses
Losses and loss adjustment expenses incurred during the year
ended December 31, 2007 increased by approximately
$31.9 million, or 57%, over the year ended
December 31, 2006. This increase reflects the growth in net
exposures applicable to the approximately 53% increase in net
earned premiums, and an increase in the accident year loss and
loss adjustment expense ratio due to premium rate and loss cost
trends, somewhat offset by favorable development of prior
years’ reserves of $0.8 million in comparison to
unfavorable development of prior years’ reserves during
2006 of $1.1 million.
During the year ended December 31, 2007, other operating
expenses increased $14.7 million, or 56%, from the year
ended December 31, 2006. Amortization of deferred
acquisition expenses increased by $14.3 million, or 88%,
including a $12.9 million increase related to the
approximately $39.6 million in net premiums earned due to
the termination on a “cut-off” basis of the 2006 50%
quota share reinsurance treaties on December 31, 2006 and
by an increase of $1.4 million related to remaining net
earned premiums during the year ended December 31, 2007.
Ceded reinsurance commissions increased $16.9 million, or
72%, principally due to the effect of the return in 2006 of
$12.9 million related to the December 31, 2006
reinsurance “cut-off” transaction, the growth in ceded
written premiums, and an increase in ceding commission rates
offset by the effect of purchasing less quota share reinsurance
during 2007. Other underwriting and operating expenses, which
consist of commissions, other acquisition costs, and general and
underwriting expenses, offset by acquisition cost deferrals,
increased by $17.3 million, or 52%, principally due to an
increase in commissions and other acquisition costs, and an
increase in general and underwriting expenses during the year
ended December 31, 2007.
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Interest expense decreased $11.6 million, or 70%, from 2006
to 2007. This decrease was principally attributable to a
decrease of $14.7 million related to the $65.0 million
senior notes issued in August 2005 and repaid in October 2006.
This decrease was offset by a $2.5 million increase in
interest expense related to the junior subordinated debentures,
of which $25.8 million were issued in December 2006 and
$20.6 million were issued in September 2007 and an increase
of $0.6 million in the change in fair value of the interest
rate swap on junior subordinated debentures as is discussed in
“Liquidity and Capital Resources.”
Our effective tax rates were approximately 33.4% and 33.9% for
the years ended December 31, 2007 and 2006, respectively.
Liquidity
and Capital Resources
FMFC. FMFC is a holding company with all of
its operations being conducted by its subsidiaries. Accordingly,
FMFC has continuing cash needs for primarily administrative
expenses, debt service and taxes. Funds to meet these
obligations come primarily from management and administrative
fees from all of our subsidiaries, and dividends from our
non-insurance subsidiaries.
Insurance Subsidiaries. The primary sources of
our insurance subsidiaries’ cash are net written premiums,
claims handling fees, amounts earned from investments and the
sale or maturity of invested assets. Additionally, FMFC has in
the past and may in the future contribute capital to its
insurance subsidiaries.
The primary uses of our insurance subsidiaries’ cash
include the payment of claims and related adjustment expenses,
underwriting fees and commissions and taxes and making
investments. Because the payment of individual claims cannot be
predicted with certainty, our insurance subsidiaries rely on our
paid claims history and industry data in determining the
expected payout of claims and estimated loss reserves. To the
extent that FMIC, FMCC and AUIC have an unanticipated shortfall
in cash, they may either liquidate securities held in their
investment portfolios or obtain capital from FMFC. However,
given the cash generated by our insurance subsidiaries’
operations and the relatively short duration of their investment
portfolios, we do not currently foresee any such shortfall.
No dividends were paid to FMFC by our insurance subsidiaries
during the years ended December 31, 2008, 2007 or 2006. Our
insurance subsidiaries retained all of their earnings in order
to support the increase of their written premiums, and we expect
this retention of earnings to continue. Our insurance
subsidiaries are restricted by statute as to the amount of
dividends that they may pay without the prior approval of their
domiciliary state insurance departments. Based on the
policyholders’ surplus and the net income of our insurance
subsidiaries as of December 31, 2008, FMIC, FMCC and AUIC
may pay dividends in 2009, if declared, of up to
$33.8 million without regulatory approval.
Non-insurance Subsidiaries. The primary
sources of our non-insurance subsidiaries’ cash are
commissions and fees, policy fees, administrative fees and
claims handling and loss control fees. The primary uses of our
non-insurance subsidiaries’ cash are commissions paid to
brokers, operating expenses, taxes and dividends paid to FMFC.
There are generally no restrictions on the payment of dividends
by our non-insurance subsidiaries, except as may be set forth in
our borrowing arrangements.
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Our sources of funds have consisted primarily of net written
premiums, commissions and fees, investment income and proceeds
from the issuance of preferred stock and debt. We use operating
cash primarily to pay operating expenses and losses and loss
adjustment expenses and for purchasing investments. A summary of
our cash flows is as follows:
Net cash provided by operating activities from continuing
operations for the year ended December 31, 2008 was
primarily from cash received on net written premiums and less
cash disbursed for operating expenses and losses and loss
adjustment expenses. Net cash provided by operating activities
from continuing operations for the year ended December 31,
2007 was primarily from cash received on net written premiums
and cash received for the unearned premiums related to the 2006
50% quota share reinsurance contract terminated on a
“cut-off” basis on December 31, 2006 less cash
disbursed for operating expenses and losses and loss adjustment
expenses. Net cash provided by operating activities from
continuing operations for the year ended December 31, 2006
was primarily from cash received on net written premiums and
less cash disbursed for operating expenses and losses and loss
adjustment expenses. Cash received from net written premiums for
the years ended December 31, 2008 and 2007 was retained on
a “funds withheld” basis in accordance with the
Company’s 10% from January 1, 2008 through
March 31, 2008, 15% from April 1, 2008 through
December 31, 2008, 35% from January 1, 2007 through
September 30, 2007, and 25% from October 1, 2007
through December 31, 2007, quota share reinsurance
contracts.
Net cash provided by operating activities from discontinued
operations for the years ended December 31, 2008, 2007 and
2006 was primarily from cash received on commissions and service
fees less cash disbursed for operating expenses.
For 2008, net cash used in investing activities from continuing
operations totaled $138.6 million, and was primarily
invested in short-term, debt and equity securities and for the
acquisition of AMC. The $16.5 million decrease in net cash
used in investing activities from continuing operations for the
year ended December 31, 2008 compared to the year ended
December 31, 2007 was a result of $38.9 million less
cash available from financing activities, a $9.0 million
increase due to investments acquired from the AMC acquisition,
and an increase of $13.4 million in change in cash and cash
equivalents.
For 2007, net cash used in investing activities from continuing
operations totaled $155.0 million, and was primarily
invested in short-term, debt and equity securities. The
$62.0 million increase in net cash used in investing
activities for the year ended December 31, 2007 compared to
the year ended December 31, 2006 was a result of
$13.6 million less cash available from financing
activities, a $73.8 million increase in operating cash
flow, and an increase of $4.1 million in change in cash and
cash equivalents.
For 2006, net cash used in investing activities from continuing
operations totaled $93.0 million, and was primarily
invested in short-term, debt and equity securities. The
$6.2 million decrease in net cash used in investing
activities for the year ended December 31, 2006 compared to
the year ended December 31, 2005 was a result of
$5.4 million less cash available from financing activities,
a $0.7 million increase in operating cash flow, and an
increase of $1.6 million in change in cash and cash
equivalents.
Net cash provided by investing activities from discontinued
operations for the year ended December 31, 2008 was from
cash received on the sale of ARPCO less cash disbursed for
transaction costs.
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There were no cash flows from investing activity from
discontinued operations for the years ended December 31,
2007 and 2006.
For 2008, net cash used in financing activities resulted from
the issuance of common stock as a result of the exercise of
stock options and cash retained from the excess tax benefits
related to stock-based compensation, offset by the repurchase of
common stock under the Company’s share repurchase program
and the purchase of common stock by the Company to be held in a
rabbi trust for the benefit of the Company’s Supplemental
Executive Retirement Plan.
For 2007, the $32.4 million of net cash provided by
financing activities resulted primarily from the issuance of
common stock in a secondary offering discussed below as well as
from proceeds from the issuance of trust preferred securities
discussed below.
For 2006, the $46.0 million of net cash provided by
financing activities for the year ended December 31, 2006
was primarily attributable to the proceeds from our initial
public offering, offset by the repurchase of common stock and
the retirement of the senior notes.
Based on historical trends, market conditions, and our business
plans, we believe that our existing resources and sources of
funds will be sufficient to meet our liquidity needs in the
foreseeable future. Because economic, market and regulatory
conditions may change, however, there can be no assurances that
our funds will be sufficient to meet our liquidity needs. In
addition, competition, pricing, the frequency and severity of
losses, and interest rates could significantly affect our
short-term and long-term liquidity needs.
We completed our initial public offering of common stock on
October 23, 2006 in which we sold 11,161,764 shares of
common stock for $189.7 million. In connection with the
offering, on October 23, 2006, we repurchased all of our
outstanding senior notes for $69.9 million, paid the holder
of our convertible preferred stock $58.0 million pursuant
to the terms of our convertible preferred stock, which was also
converted into common stock in connection with the initial
public offering, and repurchased 1,779,336 shares of common
stock. We used the remaining $15.9 million of the net
proceeds from the initial public offering, along with available
cash of $4.1 million, to make a $20.0 million
contribution to the capital of FMIC in October 2006.
On May 25, 2007, the Company filed a registration statement
on
Form S-1
with the Securities and Exchange Commission for the purpose of
making a follow-on offering of common stock. The Company’s
registration statement was declared effective on June 14,
2007. Upon completion of the follow-on offering on June 27,
2007, gross proceeds from the sale of 695,189 shares of
common stock, including 495,189 shares of common stock sold
to the underwriters of the offering pursuant to the
underwriters’ exercise of their over-allotment option, at
an offering price per share of $19.25, totaled
$13.4 million. Costs associated with the follow-on offering
included $0.8 million of underwriting costs and
$0.4 million of other issuance costs.
Senior Notes. We had $65.0 million
aggregate principal amount of senior notes outstanding, which
were issued by Holdings in August 2005 in connection with the
Holdings Transaction. The senior notes were set to mature on
August 15, 2012, and bore interest at an annual rate, reset
quarterly, equal to the three month LIBOR plus 8%. Interest was
payable quarterly with $11.2 million of interest paid
during the year ended December 31, 2006. On
October 23, 2006, we repurchased all of the outstanding
senior notes for $69.9 million, including accrued interest
of $1.6 million and a prepayment penalty of
$3.3 million.
Junior Subordinated Debentures. We have
$67.0 million cumulative principal amount of floating rate
junior subordinated debentures outstanding, $20.6 million
of which were issued in September 2007. The debentures were
issued in connection with the issuance of trust preferred stock
by our wholly-owned, non-consolidated trusts. Cumulative
interest on $46.4 million of the cumulative principal
amount of the debentures is payable quarterly in arrears at a
variable annual rate, reset quarterly, equal to the three month
LIBOR plus 3.75% for $8.2 million, the
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three month LIBOR plus 4.00% for $12.4 million, and the
three month LIBOR plus 3.0% for $25.8 million principal
amount of the debentures. Cumulative interest on
$20.6 million of the cumulative principal amount of the
debentures is payable quarterly in arrears at a fixed annual
rate of 8.25% through December 15, 2012, and a variable
annual rate, reset quarterly, equal to the three month LIBOR
plus 3.30% thereafter. For our floating rate junior subordinated
debentures, we have entered into interest rate swap agreements
to pay a fixed rate of interest. See “Derivative Financial
Instruments” for further discussion. At December 31,
2008, the three month LIBOR rate was 2.22%. We may defer the
payment of interest for up to 20 consecutive quarterly periods;
however, no such deferrals have been made or are expected.
Credit Facility. In October 2006, we entered
into a credit facility which provided for borrowings of up to
$30.0 million. Borrowings under the credit facility bear
interest at our election as follows: (i) at a rate per
annum equal to the greater of the lender’s prime rate and
the federal funds rate less 0.5%, each minus 0.75%; or,
(ii) a rate per annum equal to LIBOR plus an applicable
margin which is currently 0.75% or 1.0% based on our leverage
ratio. The obligations under the credit facility are guaranteed
by our material non-insurance subsidiaries. The maturity date of
borrowings made under the credit facility is September 2011. The
credit facility contains covenants which, among other things,
restrict our ability to incur indebtedness, grant liens, make
investments and sell assets. The credit facility also has
certain financial covenants. At December 31, 2008, there
were no borrowings under the agreement. We are not required to
comply with the financial-related covenants until we borrow
under the credit facility. However, at December 31, 2008,
the Company was in compliance with all of the covenants related
to the credit facility.
Derivative Financial Instruments. Financial
derivatives are used as part of the overall asset and liability
risk management process. We use interest rate swap agreements
with a combined notional amount of $45.0 million in order
to reduce our exposure to interest rate fluctuations with
respect to our junior subordinated debentures. Under two of our
swap agreements, which expire in August 2009, we pay interest at
a fixed rate of 4.12%; under our other swap agreement, which
expires in December 2011, we pay interest at a fixed rate of
5.013%. Under all three swap agreements, we receive interest at
the three month LIBOR, which is equal to the contractual rate
under the junior subordinated debentures. At December 31,
2008, we had no exposure to credit loss on the interest rate
swap agreements.
The following table illustrates our contractual obligations and
commercial commitments as of December 31, 2008:
The reserve for losses and loss adjustment expenses payment due
by period in the table above are based on the reserve of loss
and loss adjustment expenses as of December 31, 2008 and
actuarial estimates of expected payout patterns by type of
business. As a result, our calculation of the reserve of loss
and loss adjustment expenses payment due by period is subject to
the same uncertainties associated with determining the level of
the reserve of loss and loss adjustment expenses and to the
additional uncertainties arising from the difficulty in
predicting when claims, including claims that have been incurred
but not reported to us, will be paid. Actual payments of losses
and loss adjustment expenses by period will vary, perhaps
materially, from the above table to the extent that current
estimates of the reserve for loss and loss adjustment expenses
vary from actual ultimate claims amounts and as a result of
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variations between expected and actual payout patterns. See
“Risk Factors” for a discussion of the uncertainties
associated with estimating the reserve for loss and loss
adjustment expenses.
The above table includes all interest payments through the
stated maturity of the related long-term debt. Variable rate
interest obligations are estimated based on interest rates in
effect at December 31, 2008, and, as applicable, the
variable rate interest included the effects of our interest rate
swaps through the expiration of those swap agreements.
Cash and
Invested Assets
Our invested assets consist of fixed maturity securities,
convertible securities, money market funds and alternative
investments. At December 31, 2008, our investments had a
market value of $543.0 million and consisted of the
following investments:
The following table shows the composition of the investment
portfolio by remaining time to maturity at December 31,
2008. Actual maturities may differ from contractual maturities
because borrowers may have the right to call or prepay
obligations with or without call or prepayment penalties.
Additionally, the expected maturities of our investments in
putable bonds fluctuate inversely with interest rates and
therefore may also differ from contractual maturities.
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The primary goals of our investment portfolio are to:
In keeping with these goals, we maintain an investment portfolio
consisting primarily of high grade fixed income securities. Our
investment policy is developed by the investment committee of
the board of directors of our insurance companies and is
designed to comply with the regulatory investment requirements
and restrictions to which our insurance subsidiaries are subject.
We have structured our investment policy to manage the various
risks inherent in achieving our objectives. Credit-related risk
is addressed by limiting minimum weighted-average portfolio
credit quality to AA, with no more than 30% of the aggregate
portfolio being rated BBB or below. In addition, no more than
10% of the portfolio may be rated non-investment grade at time
of purchase. Per issue credit limits have been set to limit
exposure to single issue credit events. Interest rate risk or
duration risk management was tied to the duration of the
liability reserves. The effective duration of the portfolio as
of December 31, 2008 is approximately 3.1 years and
the tax-effected duration is 2.7 years. Excluding cash,
convertible securities, limited partnerships, and equity the
portfolio duration and tax-effected duration are 3.2 years
and 2.8 years, respectively. The shorter tax-effected
duration reflects the significant portion of the portfolio in
municipal securities. The annualized investment yield (net of
investment expenses) on total investments was 4.3% and 4.1% for
December 31, 2008 and December 31, 2007, respectively.
The tax equivalent investment yield was 5.0% and 4.8% at
December 31, 2008 and December 31, 2007, respectively.
The increase was the result of higher reinvestment yields on new
purchases versus maturing bonds. Additionally, we took advantage
of wider spreads in the high yield corporate market by making an
allocation to this sector. Our investment policy establishes
diversification requirements across various fixed income sectors
including governments, agencies, mortgage and asset backed
securities, corporate bonds, preferred stocks, municipal bonds
and convertible securities. Although our investment policy
allows for investments in equity securities, we have minimal
current exposure and do not have any current plans to add
exposure to equities. Convertible securities are utilized as a
means of achieving equity exposure with lower long-term
volatility than the broad equity market while having the added
benefit of being treated as bonds from a statutory perspective.
We utilize five investment managers, each with its’ own
specialty. Each of these managers has authority and discretion
to buy and sell securities subject to guidelines established by
our investment committee. Management monitors the investment
managers as well as our investment results with the assistance
of an investment advisor that has been advising us since early
1990. Our investment advisor is independent of our investment
managers and the funds in which we invest. Each manager is
measured against a customized benchmark on a monthly basis.
Investment performance and market conditions are continually
monitored. The investment committee reviews our investment
results at a minimum quarterly.
The majority of our portfolio consists of AAA or AA rated
securities with a Standard and Poor’s weighted average
credit quality for our aggregate fixed income portfolio of AA at
December 31, 2008. The majority of the investments rated
BBB and below are convertible securities and high yield
corporate fixed income securities. Consistent with our
investment policy, we review any security if it falls below BBB-
and assess whether it should be
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held or sold. The following table shows the ratings distribution
of our fixed income portfolio as of December 31, 2008 as a
percentage of total market value.
The Company invests in residential collateralized mortgage
obligations (“CMO”) that typically have high credit
quality, offer good liquidity and are expected to provide an
advantage in yield compared to U.S. Treasury securities.
The Company’s investment strategy is to purchase CMO
tranches which offer the most favorable return given the risks
involved. One significant risk evaluated is prepayment
sensitivity. While prepayment risk (either shortening or
lengthening of duration) and its effect on total return cannot
be fully controlled, particularly when interest rates move
dramatically, the investment process generally favors securities
that control this risk within expected interest rate ranges. The
Company does not purchase residual interests in CMO’s.
At December 31, 2008, the Company held CMO’s
classified as available-for-sale with a fair value of
$43.7 million. Approximately 73.4% of those CMO holdings
were guaranteed by or fully collateralized by securities issued
by government sponsored enterprises (“GSE”) such as
GNMA, FNMA or FHLMC. In addition, at December 31, 2008, the
Company held $54.6 million of mortgage-backed pass-through
securities, of which $52.8 million were issued by one of
the GSE’s and classified as available-for-sale.
The Company held commercial mortgage-backed securities
(“CMBS”) of $30.6 million, of which 89.4% are
pre-2006 vintage, at December 31, 2008. The weighted
average credit support (adjusted for defeasance) of our CMBS
portfolio was 41.4% and comprised mainly of super senior
structures. The average loan to value ratio at origination was
68.1%. The average credit rating of these securities was AAA.
The CMBS portfolio was supported by loans that were diversified
across economic sectors and geographical areas. It is not
believed that this portfolio exposes the Company to a material
adverse impact on its results of operations, financial position
or liquidity, due to the underlying credit strength of these
securities.
The Company’s fixed maturity investment portfolio included
asset-backed securities and collateralized mortgage obligations
collateralized by sub-prime mortgages and alternative
documentation mortgages
(“Alt-A”)
with market values of $0.1 million and $1.5 million at
December 31, 2008, respectively. The Company defines
sub-prime mortgage-backed securities as investments with
weighted average FICO scores below 650. Alt-A securities are
defined by above-prime interest rates, high loan-to-value
ratios, high debt-to-income ratios, low loan documentation
(e.g., limited or no verification of income and assets), or
other characteristics that are inconsistent with conventional
underwriting standards employed by government-sponsored mortgage
entities. The average credit rating on these securities at
December 31, 2008 was BBB+.
The Company’s fixed maturity investment portfolio at
December 31, 2008 included securities issued by numerous
municipalities with a total carrying value of
$210.4 million. Approximately $31.5 million, or 15%,
were pre-refunded (escrowed with Treasuries). Approximately
$104.9 million, or 49.8%, of the securities were enhanced
by third-party insurance for the payment of principal and
interest in the event of an issuer default (excluding those that
are pre-refunded). Such insurance may result in a rating of AAA
being assigned by independent ratings agencies to those
securities. The downgrade of credit ratings of insurers of these
securities could result in a corresponding downgrade in the
ratings of the securities from AAA to the underlying rating of
the respective security without giving effect to the benefit of
insurance. Of the total $104.9 million of insured municipal
securities
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in the Company’s investment portfolio) at December 31,
2008 (excluding those that are pre-refunded), approximately
99.0% were rated at A- or above, and approximately 76.4% were
rated at AA- or above, without the benefit of insurance. The
average underlying credit rating of the entire municipal bond
portfolio was AA at December 31, 2008. The Company believes
that a loss of the benefit of insurance would not result in a
material adverse impact on the Company’s results of
operations, financial position or liquidity, due to the
underlying credit strength of the issuers of the securities, as
well as the Company’s ability and intent to hold the
securities.
Cash and cash equivalents consisted of cash on hand of
$31.8 million at December 31, 2008.
The amortized cost, gross unrealized gains and losses, and
market value of marketable investment securities classified as
available-for-sale at December 31, 2008 by major security
type were as follows:
At December 31, 2008 the total unrealized loss of all
impaired securities totaled $12.1 million. This represents
approximately 2.2% of year end invested assets of
$543.0 million. This unrealized loss position is a function
of the purchase of specific securities in a lower interest rate
or spread environment than what prevails as of December 31,
2008. Some of these losses are due to the increase in spreads of
select corporate bonds or structured securities. We have viewed
these market value declines as being temporary in nature. Our
portfolio is relatively short as the duration of the core fixed
income portfolio excluding cash, convertible securities, limited
partnerships and equity is approximately 3.2 years. We
expect to hold the majority of these temporarily impaired
securities until maturity in the event that interest rates do
not decline from current levels. In light of our significant
growth over the past 24 months, liquidity needs from the
portfolio are minimal. As a result, we would not expect to have
to liquidate temporarily impaired securities to pay claims or
for any other purposes. There have been certain instances over
the past year, where due to market based opportunities; we have
elected to sell a small portion of the portfolio. These
situations were unique and infrequent occurrences and in our
opinion, do not reflect an indication that we do not have the
intent and ability to hold these securities until they mature or
recover in value.
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The fair value and amount of unrealized losses segregated by the
time period the investment had been in an unrealized loss
position is as follows at December 31, 2008:
Below is a table that illustrates the unrecognized impairment
loss by sector. The increase in spread relative to US Treasury
Bonds was the primary factor leading to impairment for the year
ended December 31, 2008. All asset sectors were affected by
the overall increase in spreads as can be seen from the table
below. In addition to the general level of rates, we also look
at a variety of other factors such as direction of credit
spreads for an individual issue as well as the magnitude of
specific securities that have declined below amortized cost.
The most significant risk or uncertainty inherent in our
assessment methodology is that the current credit rating of a
particular issue changes over time. If the rating agencies
should change their rating on a particular security in our
portfolio, it could lead to a reclassification of that specific
issue. The vast majority of our unrecognized impairment losses
are investment grade and “AAA” or “AA” rated
securities. Should the credit quality of individual issues
decline for whatever reason then it would lead us to reconsider
the classification of that particular security. Within the
non-investment grade sector, we continue to monitor the
particular status of each issue. Should prospects for any one
issue deteriorate, we would potentially alter our classification
of that particular issue.
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The table below illustrates the breakdown of impaired securities
by investment grade and non investment grade as well as the
duration that these sectors have been trading below amortized
cost. The average duration of the impairment has been greater
than 12 months. The unrealized loss of impaired securities
as a percent of the amortized cost of those securities is 8.1%
as of December 31, 2008.
The majority of these securities are “AAA” or
“AA” rated. These issues are continually monitored and
may be classified in the future as being other than temporarily
impaired.
The largest concentration of temporarily impaired securities is
Commercial MBS at approximately 33.8% of the total loss. These
securities are all AAA rated and have been affected primarily by
the widening of spreads within this sector
and/or the
general level of interest rates. The next highest concentration
of temporarily impaired securities is Corporate Bonds at 30.6%
of the total loss. Within Corporate Bonds 99.4% are rated
investment grade BBB or better, and their temporary impairment
results primarily from the widening of credit spreads. The next
highest concentration of temporarily impaired securities is CMOs
at 15.8% of the total loss. Within CMOs 98.6% are rated AAA
including the 73.4% of the CMO exposure that is agency issued,
and have primarily been affected by the general level of
interest rates as well.
For the year ended December 31, 2008, we sold approximately
$17.3 million of market value of fixed income securities
excluding convertibles, which were trading below amortized cost
while recording a realized loss of $0.6 million. This loss
represented 3.3% of the amortized cost of the positions. These
sales were unique opportunities to sell specific positions due
to changing market conditions. These situations were exceptions
to our general assertion regarding our ability and intent to
hold securities with unrealized losses until they mature or
recover in value. This position is further supported by the
insignificant losses as a percentage of amortized cost for the
respective periods.
During the year ended December 31, 2008 net realized
losses on investments were $20.7 million compared to net
realized gains of $0.6 million during the year ended
December 31, 2007. Net realized losses for the year ended
December 31, 2008 were principally due to mark to market
declines in securities carried at market in accordance with
SFAS 155 and SFAS 159 of approximately
$14.6 million and $4.1 million of other-than-temporary
impairments.
We defer a portion of the costs of acquiring insurance business,
primarily commissions and certain policy underwriting and
issuance costs, which vary with and are primarily related to the
production of insurance business. Deferred policy acquisition
costs totaled $27.4 million, or 27.7% of unearned premiums
(net of reinsurance), at December 31, 2008.
Losses and loss adjustment expenses. We
maintain reserves to cover our estimated ultimate losses under
all insurance policies that we write and our loss adjustment
expenses relating to the investigation and settlement of policy
claims. The reserves for losses and loss adjustment expenses
represent our estimated ultimate costs of all reported and
unreported losses and loss adjustment expenses incurred and
unpaid at the balance sheet date. Our reserves reflect our
estimates at a given time of amounts that we expect to pay for
losses that have been reported, which are referred to as case
reserves, and losses that have been incurred but not reported
and the expected development of losses and allocated loss
adjustment expenses on reported cases, which are referred to as
IBNR reserves. In evaluating whether the reserves are reasonable
for unpaid losses and loss adjustment expenses, it is necessary
to project future losses and loss adjustment expense payments.
Our reserves are carried at the total
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estimate for ultimate expected losses and loss adjustment
expenses. We do not discount the reserves for losses and loss
adjustment expenses.
Our reserves consist of reserves for property and liability
losses, consistent with the coverages provided for in the
insurance policies directly written or assumed by us under
reinsurance contracts. In many cases, several years may elapse
between the occurrence of an insured loss, the reporting of the
loss to us and our payment of the loss. The estimation of
ultimate liability for losses and loss adjustment expenses is an
inherently uncertain process, requiring the use of informed
estimates and judgments. Our loss and loss adjustment expense
reserves do not represent an exact measurement of liability, but
are estimates. Although we believe that our reserve estimates
are reasonable, it is possible that our actual loss experience
may not conform to our assumptions and may, in fact, vary
significantly from our assumptions. Accordingly, the ultimate
settlement of losses and the related loss adjustment expenses
may vary significantly from the estimates included in our
financial statements. We continually review our estimates and
adjust them as we believe appropriate as our experience develops
or new information becomes known to us. Such adjustments are
included in current results of operations. For a further
discussion of how we determine our loss and loss adjustment
expense reserves and the uncertainty surrounding those
estimates, see “— Critical Accounting
Policies — Loss and Loss Adjustment Expense
Reserves”.
Reconciliation
of Unpaid Losses and Loss Adjustment Expenses
We establish a reserve for both reported and unreported covered
losses, which includes estimates of both future payments of
losses and related loss adjustment expenses. The following table
represents changes in our aggregate reserves during 2008, 2007
and 2006:
During 2008, the Company experienced $4.8 million of
favorable development in net prior accident year reserves.
During 2008, favorable development of $2.4 million in our
security classes consisted of $5.7 million of favorable
development in the
2006-2007
accident years and unfavorable development of $3.3 million
in the 2005 and prior accident years. The favorable development
in the
2006-2007
accident years was attributable to lower than projected
frequency and severity and favorable settlements on certain
large claims. The unfavorable development in the
2000-2005
accident years was largely attributable to increases in Incurred
But Not Reported reserves on these years to reflect anticipated
development from construction defect exposures. During 2008,
favorable development of $3.8 million in our specialty
classes consisted of $9.5 million of favorable development
in the
2006-2007
accident years and unfavorable development of $5.7 million
in the 2005 and prior accident years. The favorable development
in the
2006-2007
accident years was attributable to lower than projected
frequency and severity and
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favorable settlements on certain large claims. The unfavorable
development in the
2000-2005
accident years was attributable to increases in Incurred But Not
Reported reserves on these years to reflect anticipated
development from construction defect exposures. During 2008,
adverse development of $1.3 million in our contract
underwriting classes consisted of $2.5 million of adverse
development in the
2006-2007
accident years and favorable development of $1.2 million in
the 2005 accident year. The adverse development in the
2006-2007
accident years was attributable to higher than projected
severity. The favorable development in the 2005 accident year
was attributable to lower than projected severity. Net adverse
development of $0.1 million in unallocated loss adjustment
expenses was recorded for the
2000-2007
accident year.
During 2007, favorable development in our security general
liability classes was $0.9 million, consisting of
$3.7 million in favorable development in accident years
2002-2006,
and unfavorable development of $2.8 million in accident
years
2000-2001.
The favorable development in accident years
2002-2006
was primarily in accident year 2006 as a result of lower than
expected frequency, severity, and incurred losses and loss
adjustment expenses. The unfavorable development in
2000-2001
was due to increases in case reserves on a small number of high
severity claims based on obtaining new information. Unfavorable
development in our specialty general liability classes was
$0.6 million, consisting of $7.6 million in favorable
development in the 2006 accident year, and unfavorable
development of $8.2 million principally in accident years
2003-2005.
The favorable development in accident year 2006 was due to lower
than expected frequency, severity, and incurred losses and loss
adjustment expenses. The unfavorable development in
2003-2005
included three late reported claims received in the fourth
quarter of 2007 for catastrophe (Hurricane Rita) and
thunderstorm related losses. These claims are being contested by
lawsuit and involve severe property damage to commercial
buildings in Port Arthur, Texas. The unfavorable development was
also due to increases in case reserves on a small number of high
severity claims based on obtaining new information. In addition,
these factors caused related increases in estimates of incurred
but not reported losses. Favorable development in unallocated
loss adjustment expenses was $0.5 million across multiple
accident years.
During 2006, the Company experienced approximately
$1.1 million in net prior year reserve development
principally in the 2000 accident year, offset somewhat by
favorable development on prior years unallocated loss adjustment
expense reserves. The development on accident year 2000 reserves
was concentrated primarily in the safety equipment class as a
result of obtaining new information on several high severity
cases.
Loss Development. Below is a table showing the
development of our reserves for unpaid losses and loss
adjustment expenses for us for report years 1998 through 2008.
The table portrays the changes in the loss and loss adjustment
expenses reserves in subsequent years relative to the prior loss
estimates based on experience as of the end of each succeeding
year, on a GAAP basis.
The first line of the table shows, for the years indicated, the
net reserve liability including the reserve for incurred but not
reported losses as originally estimated. For example, as of
December 31, 1998 it was estimated that $32.0 million
would be a sufficient reserve to settle all claims not already
settled that had occurred prior to December 31, 1998,
whether reported or unreported to our insurance subsidiaries.
The next section of the table sets forth the re-estimates in
later years of incurred losses, including payments, for the
years indicated. For example, as reflected in that section of
the table, the original reserve of $32.0 million was
re-estimated to be $19.3 million at December 31, 2008.
The increase/decrease from the original estimate would generally
be a combination of factors, including:
The “cumulative redundancy (deficiency)” represents,
as of December 31, 2008, the difference between the latest
re-estimated liability and the reserves as originally estimated.
A redundancy means that the original estimate was higher than
the current estimate for reserves; a deficiency means that the
current estimate is higher than the original estimate for
reserves. For example, because the reserves established as of
December 31, 1998 at
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$32.0 million were reestablished at December 31, 2008
at $19.3 million, it was re-estimated that the reserves
which were established as of December 31, 1998 included a
$12.7 million redundancy.
The next section of the table shows, by year, the cumulative
amounts of losses and loss adjustment expenses paid as of the
end of each succeeding year. For example, with respect to the
net losses and loss expense reserve of $32.0 million as of
December 31, 1998 by December 31, 2008 (ten years
later) $19.1 million actually had been paid in settlement
of the claims which pertain to the reserve as of
December 31, 1998.
Information with respect to the cumulative development of gross
reserves (that is, without deduction for reinsurance ceded) also
appears at the bottom portion of the table.
Analysis
of Unpaid Loss and Loss Adjustment Expense Development
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Factors contributing to the reserve development in the preceding
table are as follows:
During 1998, our insurance subsidiaries experienced significant
favorable development of their reserves, reflecting redundancies
in that year. This development was significantly influenced by
the police and public officials classes of business which
FMIC’s predecessor organization, First Mercury Syndicate
(“FMS”) began writing in 1991, and FMIC stopped
writing in 1996. Early reported losses and loss adjustment
expense emergence in those classes was worse than industry
experience, and estimated ultimate losses and loss adjustment
expenses and related reserves were based on a continuation of
the adverse trend and use of industry development factors. In
addition, FMS’s loss and loss adjustment experience data
only went back to FMS’s formation in 1985, so greater
weight was given to industry data compared to our claims
experience in establishing IBNR. As our policies in the accident
years matured, the loss trends moderated and ultimate losses and
loss adjustment expenses emerged lower than the industry data
indications.
From 2000 through 2004, the reserves gave greater weight to loss
development patterns from our historical experience through
1998, and were adjusted for differences between actual and
expected development as losses and loss adjustment expenses
emerged. During 2005, a significant amount of adverse
development occurred related to accident years 2000 through
2002, and our insurance subsidiaries increased their reserves
accordingly. In addition, we increased our reserves applicable
to other specialty classes, principally as a result of using
updated industry loss development factors, which became
available during 2005, in the calculations of ultimate expected
losses and reserves on other specialty classes.
During 2006, the Company experienced approximately
$1.1 million in net prior year reserve development
primarily in the 2000 accident year, offset somewhat by
favorable development on prior years unallocated loss adjustment
expense reserves. The development on accident year 2000 reserves
was concentrated primarily in the safety equipment class as a
result of obtaining new information on several high severity
cases.
During 2007, the Company experienced approximately
$0.8 million of favorable development in net prior year
reserves primarily in the 2006 accident year due to lower than
expected loss and allocated loss adjustment expense emergence,
offset by unfavorable development on 2000 to 2005 accident
years’ reserves.
During 2008, the Company experienced approximately
$4.8 million of favorable development in net prior year
reserves, with $12.6 million of favorable development in
the 2006 and 2007 accident years due to lower than expected
claim frequency along with lower than expected severity, offset
somewhat by increases in Incurred But Not Reported reserves in
the 2005 and prior accident years to reflect anticipated loss
development from construction defect exposures.
Because the loss table above is prepared on a reported year
basis, the $3.1 million and $4.8 million in
unfavorable net reserve and gross reserve development,
respectively, on the December 31, 2006 net and gross
reported reserves appears in the applicable reported year that
coincides with the related accident years affected and is
repeated in each subsequent year through 2007.
For policies written from the middle of 2002 through the
present, historical experience for security classes has improved
due to the underwriting initiatives taken in response to the
deterioration in loss experience for the 1999 through 2001
accident years, especially in the safety equipment installation
and service class.
Our insurance subsidiaries cede insurance risk to reinsurers to
diversify their risks and limit their maximum loss arising from
large or unusually hazardous risks or catastrophic events.
Additionally, our insurance subsidiaries use reinsurance in
order to limit the amount of capital needed to support their
operations and to facilitate growth. Reinsurance involves a
primary insurance company transferring, or ceding, a portion of
its premium and losses in order to control its exposure. The
ceding of liability to a reinsurer does not relieve the
obligation of the primary insurer to the policyholder. The
primary insurer remains liable for the entire loss if the
reinsurer fails to meet its obligations under the reinsurance
agreement.
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During 2006, we maintained a 50% quota share on all of our
business other than our legal professional liability class, for
which we maintained a variable 70% to 85% quota share, and our
umbrella policies, for which we maintained a 90% quota share.
On December 31, 2006 we elected the cut-off termination
option available to us on the expiration of our 50% quota share
contracts expiring that day in accordance with the termination
provisions of these quota share contracts. As a result, we
effectively eliminated the 50% quota share reinsurance on the
$39.6 million unearned premiums as of December 31,
2006 that had been ceded prior to contract expiration. This
amount of previously ceded net unearned premium reserve was
returned to the Company as a result of the cut-off termination
election and reported in the Company’s net earned premiums
for the year ended December 31, 2007.
During the first four months of 2007, we maintained a 35% quota
share on the majority of our business other than our legal
professional liability class, for which we maintained a variable
70% to 85% quota share, and our umbrella policies, for which we
maintain a 90% quota share. On May 1, 2007, we amended our
35% quota share reinsurance treaties to include the legal
professional liability class. On October 1, 2007, we
exercised the reset provision in our 35% quota share reinsurance
treaties to increase our retention to 75%.
In 2007, we also maintained two 50% quota share reinsurance
treaties for our hospitality and employer general liability
classes. Our excess of loss reinsurance is used to limit our
maximum exposure per claim occurrence. We maintained a
$0.5 million excess of $0.5 million per occurrence
(Primary Security and Specialty General Liability) and
$1.5 million excess of $0.5 million per occurrence
(Legal Professional Liability) coverage through
December 31, 2007, and we have purchased $0.5 million
excess of $0.5 million per occurrence (Primary Security and
Specialty General Liability) and $1.5 million excess of
$0.5 million per occurrence coverage (Legal Professional
Liability) for 2008. In addition, we maintained
$0.7 million excess of $0.3 million per occurrence
coverage for a portion of the risks in our hospitality class. On
April 1, 2007, we extended the 90% quota share reinsurance
applicable to umbrella policies through March 31, 2008.
On January 1, 2008, we purchased 10% quota share
reinsurance on the majority of our primary casualty business. On
April 1, 2008, we purchased an additional 5% quota share
for the majority of our primary casualty business for a total
cession of 15%. In 2008, we also maintained other quota share
reinsurance contracts for our Contract Underwriting and FM
Emerald classes of business. One of these quota share
reinsurance contracts was terminated on a cutoff basis during
2008 resulting in $2.3 million of ceded unearned premium
being returned to the Company. For the majority of our primary
casualty business in 2008, we maintained a $0.5 million
excess of $0.5 million per occurrence (Primary Security and
Specialty General Liability) and $1.5 million excess of
$0.5 million per occurrence (Legal Professional Liability)
coverage through December 31, 2008. In addition, we
purchased 90% quota share reinsurance for umbrella/excess
policies written in 2008.
On July 1, 2008, we purchased excess per risk reinsurance
for our property business. These treaties provide coverage of
$4.7 million excess of $0.3 million per risk. Prior to
July 1, 2008, the Company purchased a combination of excess
per risk and quota share reinsurance that resulted in similar
net retention per risk. In addition on July 1, 2008, the
Company purchased property catastrophe reinsurance with limits
of $25.0 million excess of $4.0 million in cumulative
net property retentions. We purchased catastrophe coverage to
our one in 250 year event level. Our catastrophe coverage
provides for reinstatement of coverage upon a catastrophic event.
We have historically adjusted our level of quota share
reinsurance based on our premiums produced and our level of
capitalization, as well as our risk appetite for a particular
type of business. We believe that the current reinsurance market
for the lines of business that we insure is stable in both
capacity and pricing. In addition, we do not anticipate
structural changes to our reinsurance strategies, but rather
will continue to adjust our level of quota share and excess of
loss reinsurance based on our premiums produced, level of
capitalization and risk appetite. As a result, we believe that
we will continue to be able to execute our reinsurance
strategies on a basis consistent with our historical and current
reinsurance structures.
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The following table illustrates our direct and ceded written
premiums for the years ended December 31, 2008, 2007 and
2006:
The following table illustrates the effect of our reinsurance
ceded strategies on our results of operations:
Our net cash flows relating to ceded reinsurance activities
(premiums paid less losses recovered and ceding commissions
received) were approximately $43.8 million net cash paid
for the year ended December 31, 2008 compared to net cash
paid of $33.9 million for the year ended December 31,
2007. We paid approximately $48.7 million for the year
ended December 31, 2006.
The assuming reinsurer is obligated to indemnify the ceding
company to the extent of the coverage ceded. The inability to
recover amounts due from reinsurers could result in significant
losses to us. To protect us from reinsurance recoverable losses,
FMIC seeks to enter into reinsurance agreements with financially
strong reinsurers. Our senior executives evaluate the credit
risk of each reinsurer before entering into a contract and
monitor the financial strength of the reinsurer. On
December 31, 2008, substantially all reinsurance contracts
to which we were a party were with companies with A.M. Best
ratings of “A” or better. One reinsurance contract to
which we were a party was with a reinsurer that does not carry
an A.M. Best rating. For this contract, we required full
collateralization of our recoverable via a grantor trust and an
irrevocable letter of credit. In addition, ceded reinsurance
contracts contain trigger clauses through which FMIC can
initiate cancellation including immediate return of all ceded
unearned premiums at its option, or which result in immediate
collateralization of ceded reserves by the assuming company in
the event of a financial strength rating downgrade, thus
limiting credit exposure. On December 31, 2008, there was
no allowance for uncollectible reinsurance, as all reinsurance
balances were current and there were no disputes with reinsurers.
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On December 31, 2008 and December 31, 2007, FMFC had a
net amount of recoverables from reinsurers of
$181.2 million and $157.6 million, respectively, on a
consolidated basis. The following is a summary of our insurance
subsidiaries’ net reinsurance recoverables by reinsurer:
American Constantine Insurance Company (“ACIC”) does
not carry an A.M. Best rating. The net amount of
recoverables from ACIC at December 31, 2008 is fully
collateralized by a grantor trust and irrevocable letter of
credit.
The reinsurance market moves in pricing cycles which are
correlated with the primary insurance market. Thus, after
experiencing adverse reserve development due to inadequate
pricing during the soft market, the amount of capacity in the
reinsurance market has decreased. This has in turn placed upward
pressure on reinsurance prices and restricted terms.
In September 2006, the FASB issued SFAS No. 157,
“Fair Value Measurements”
(“SFAS 157”), which defines fair value,
establishes a framework for measuring fair value in generally
accepted accounting principles, and expands disclosures about
fair value measurements. This statement is effective for fiscal
years beginning after November 15, 2007. However, on
February 12, 2008, the FASB issued FASB Staff Position
No. FAS 157-2,
“Effective Date of FASB Statement No. 157”
(“FSP
FAS 157-2”),
which delays the effective date of SFAS 157 for
nonfinancial assets and nonfinancial liabilities, except for
items that are recognized or disclosed at fair value in the
financial statements on a recurring basis (at least annually).
FSP
FAS 157-2
defers the effective date of SFAS 157 to fiscal years
beginning after November 15, 2008, and interim periods
within those fiscal years for items within the scope of FSP
FAS 157-2.
The Company adopted the applicable portions of SFAS 157 on
January 1, 2008 (See Note 17 to the consolidated
financial statements, which is incorporated herein by reference)
and is currently assessing the potential impact that the
deferred portions of SFAS 157 will have on its financial
statements. In October 2008, the FASB issued FSP
FAS 157-3,
“Determining the Fair Value of a Financial Asset When
the Market For That Asset Is Not Active” (“FSP
FAS 157-3”),
with an immediate effective date, including prior periods
for which financial statements have not been issued. FSP
FAS 157-3
amends FAS 157 to clarify the application of fair value in
inactive markets and allows for the use of management’s
internal assumptions about future cash flows with appropriately
risk-adjusted discount rates when relevant observable market
data does not exist. The objective of FAS 157 has not
changed and continues to be the determination of the price that
would be received in an orderly
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transaction that is not a forced liquidation or distressed sale
at the measurement date. The adoption of FSP
FAS 157-3
in the third quarter did not have a material effect on the
Company’s results of operations, financial position or
liquidity.
In February 2007, the FASB issued SFAS No. 159,
“The Fair Value Option for Financial Assets and
Financial Liabilities” (“SFAS 159”),
which provides reporting entities an option to report
selected financial assets, including investment securities
designated as available for sale, and liabilities, including
most insurance contracts, at fair value. SFAS 159
establishes presentation and disclosure requirements designed to
facilitate comparisons between companies that choose different
measurement attributes for similar types of assets and
liabilities. The standard also requires additional information
to aid financial statement users’ understanding of a
reporting entity’s choice to use fair value on its earnings
and also requires entities to display on the face of the balance
sheet the fair value of those assets and liabilities for which
the reporting entity has chosen to measure at fair value.
SFAS 159 is effective as of the beginning of a reporting
entity’s first fiscal year beginning after
November 15, 2007. We adopted SFAS 159 effective
January 1, 2008. Under this standard, we are permitted to
elect to measure financial instruments and certain other items
at fair value, with the change in fair value recorded in
earnings. On January 1, 2008, we elected not to measure any
eligible items using the fair value option in accordance with
SFAS 159. We believe the current accounting is appropriate
for our available-for-sale investments as we have the intent and
ability to hold our investments, therefore, SFAS 159 did
not have any impact on our consolidated financial condition or
results of operations on the adoption date.
In December 2007, the FASB issued SFAS No. 141(R),
“Business Combinations”
(“SFAS 141(R)”). SFAS 141(R) establishes
principles and requirements for how an acquirer recognizes and
measures in its financial statements the identifiable assets
acquired, the liabilities assumed, any noncontrolling interest
in the acquiree, and the goodwill acquired. SFAS 141(R)
also establishes disclosure requirements to enable the
evaluation of the nature and financial effects of the business
combination. SFAS 141(R) is effective for fiscal years
beginning after December 15, 2008. The adoption of
SFAS 141(R) will change our accounting treatment for
business combinations on a prospective basis beginning
January 1, 2009.
In December 2007, the FASB issued SFAS No. 160,
“Noncontrolling Interests in Consolidated Financial
Statements — an amendment of Accounting Research
Bulletin No. 51” (“SFAS 160”).
SFAS 160 establishes accounting and reporting standards for
ownership interests in subsidiaries held by parties other than
the parent, the amount of consolidated net income attributable
to the parent and to the noncontrolling interest, changes in a
parent’s ownership interest, and the valuation of retained
noncontrolling equity investments when a subsidiary is
deconsolidated. SFAS 160 also establishes disclosure
requirements that clearly identify and distinguish between the
interests of the parent and the interests of the noncontrolling
owners. SFAS 160 is effective for fiscal years beginning
after December 15, 2008. The Company is currently
evaluating the potential impact, if any, of the adoption of
SFAS 160 on its financial statements.
In December 2007, the SEC issued Staff Accounting
Bulletin 110 (“SAB 110”) to amend the
SEC’s views discussed in Staff Accounting Bulletin 107
(“SAB 107”) regarding the use of the
simplified method in developing an estimate of expected life of
share options in accordance with SFAS 123(R). SAB 110
is effective for us beginning January 1, 2008. We will
continue to use the simplified method until we have the
historical data necessary to provide a reasonable estimate of
expected life in accordance with SAB 107, as amended by
SAB 110.
In March 2008, the FASB issued SFAS No. 161,
“Disclosures about Derivative Instruments and Hedging
Activities — an amendment of FASB Statement
No. 133” (“SFAS 161”).
SFAS 161 changes the disclosure requirements for
derivative instruments and hedging activities. Entities are
required to provide enhanced disclosures about a) how and
why an entity uses derivative instruments, b) how
derivative instruments and related hedged items are accounted
for under Statement 133 and its related interpretations, and
c) how derivative instruments and related hedged items
affect an entity’s financial position, financial
performance, and cash flows. Companies are required to adopt
SFAS 161 for fiscal years beginning after November 15,
2008. The Company is currently evaluating the potential impact,
if any, of the adoption of SFAS 161 on its financial
statements.
In January 2009, the FASB issued FASB Staff Position (FSP)
EITF 99-20-1,
“Amendments to the Impairment Guidance of EITF Issue
No. 99-20”
(FSP
EITF 99-20-1),
which is effective for interim and annual periods ending after
December 15, 2008. FSP
EITF 99-20-1
amends
EITF 99-20,“Recognition
of Interest Income and Impairment
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on Purchased Beneficial Interests and Beneficial Interests
That Continue to Be Held by a Transferor in Securitized
Financial
Assets”(EITF 99-20),
to align the impairment guidance in
EITF 99-20
with the impairment guidance in FAS 115,
“Accounting for Certain Investments in Debt and Equity
Securities.” FSP
EITF 99-20-1
amends the cash flows model used to analyze an
other-than-temporary impairment under
EITF 99-20
by replacing the market participant view with management’s
assumption of whether it is probable that there is an adverse
change in the estimated cash flows. The adoption of FSP
EITF 99-20-1
in the fourth quarter did not have a material effect on the
Company’s results of operations, financial position or
liquidity.
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
and interest rate risk.
Credit risk is the potential economic loss principally arising
from adverse changes in the financial condition of a specific
debt issuer or a reinsurer.
We address the risk associated with debt issuers by investing in
fixed maturity securities that are investment grade, which are
those securities rated “BBB-” or higher by
Standard & Poor’s. We monitor the financial
condition of all of the issuers of fixed maturity securities in
our portfolio. Our outside investment managers assist us in this
process. We utilize a variety of tools and analysis as part of
this process. If a security is rated “BBB-” or higher
by Standard & Poor’s at the time that we purchase
it and is then downgraded below “BBB-” while we hold
it, we evaluate the security for impairment, and after
discussing the security with our investment advisors, we make a
decision to either dispose of the security or continue to hold
it. Finally, we employ stringent diversification rules that
limit our credit exposure to any single issuer or business
sector.
We address the risk associated with reinsurers by generally
targeting reinsurers with A.M. Best financial strength
ratings of “A-” or better. In an effort to minimize
our exposure to the insolvency of our reinsurers, we evaluate
the acceptability and review the financial condition of each
reinsurer annually. In addition, we continually monitor rating
downgrades involving any of our reinsurers. At December 31,
2008, all reinsurance contracts were with companies with
A.M. Best ratings of “A” or better except for two
reinsurers with A.M. Best ratings of “A-”.
Interest rate risk is the risk that we may incur economic losses
due to adverse changes in interest rates. The primary market
risk to the investment portfolio is interest rate risk
associated with investments in fixed maturity securities.
Fluctuations in interest rates have a direct impact on the
market valuation of these securities. We manage our exposure to
interest rate risk through an asset and liability matching
process. In the management of this risk, the characteristics of
duration, credit and variability of cash flows are critical
elements. These risks are assessed regularly and balanced within
the context of our liability and capital position. Our outside
investment managers assist us in this process. We have
$46.4 million cumulative principal amount of floating rate
junior subordinated debentures outstanding. We have entered into
interest rate swap agreements through 2009 with a combined
notional amount of $20.0 million and through 2011 with a
notional amount of $25.0 million in order to fix the
interest rate on this debt, thereby reducing our exposure to
interest rate fluctuations with respect to our debentures.
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The table below illustrates the sensitivity of the fair value of
our fixed maturity securities to selected hypothetical changes
in interest rates as of December 31, 2008. The selected
scenarios are not predictions of future events, but rather
illustrate the effect that such events may have on the fair
value of our fixed maturity securities and stockholders’
equity:
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