National Interstate 10-K 2007
Documents found in this filing:
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
For the Fiscal Year Ended December 31, 2006
Commission File No. 000-51130
3250 Interstate Drive
Richfield, Ohio 44286-9000
Securities Registered Pursuant to Section 12(b) of the Act:
Securities registered pursuant to Section 12(g) of the Act:
Other securities for which reports are submitted pursuant to Section (d) of the Act:
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, 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 registrants 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. o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer or a non-accelerated filer. See definition of accelerated filer and large accelerated filer in Rule 12b-2 of the Exchange Act. (Check One): Large Accelerated Filer o Accelerated Filer þ Non-Accelerated Filer o
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
State the aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold, or the average bid and asked price of such common equity, as of the last business day of the registrants most recently completed second fiscal quarter: $145.4 million (based upon non-affiliate holdings of 5,363,000 shares and a market price of $27.12 at June 30, 2006).
As of March 1, 2007 there were 19,182,308 shares of the Registrants Common Shares ($0.01 par value) outstanding.
Proxy Statement for 2007 Annual Meeting of Shareholders (portions of which are incorporated by reference into Part III hereof).
National Interstate Corporation
This document, including information incorporated by reference, contains forward-looking statements (within the meaning of Private Securities Litigation Reform Act of 1995). All statements, trend analyses and other information contained in this Form 10-K relative to markets for our products and trends in our operations or financial results, as well as other statements including words such as may, target, anticipate, believe, plan, estimate, expect, intend, project, and other similar expressions, constitute forward-looking statements. We made these statements based on our plans and current analyses of our business and the insurance industry as a whole. We caution that these statements may and often do vary from actual results and the differences between these statements and actual results can be material. Factors that could contribute to these differences include, among other things:
The forward-looking statements herein are made only as of the date of this report. We assume no obligation to publicly update any forward-looking statements.
ITEM 1 Business
Please refer to Forward-Looking Statements following the Index in the front of this 10-K.
National Interstate Corporation (the Company, we, our) and its subsidiaries operate as an insurance holding company group that underwrites and sells traditional and alternative property and casualty insurance products primarily to the passenger transportation industry and the trucking industry, general commercial insurance to small businesses in Hawaii and Alaska, and personal insurance to owners of recreational vehicles, commercial vehicles and watercraft throughout the United States. We were organized in Ohio in January 1989. In December 1989, Great American Insurance Company (Great American), a wholly-owned subsidiary of American Financial Group, Inc., became our majority shareholder. Our principal executive offices are located at 3250 Interstate Drive, Richfield, Ohio, 44286 and our telephone number is (330) 659-8900. SEC filings, news releases, our Code of Ethics and Conduct and other information may be accessed free of charge through our website at www.NationalInterstate.com. Information on the website is not part of this Form 10-K.
As of December 31, 2006, Great American owned 53.2% of our outstanding shares. On February 2, 2005, we completed an initial public offering in which we issued 3,350,000 of our shares at $13.50 per share and began trading our common shares on the Nasdaq Global Market under the symbol NATL. Prior to our initial public offering, no public market existed for our common shares.
We have four property and casualty insurance subsidiaries: National Interstate Insurance Company (NIIC), Hudson Indemnity, Ltd. (HIL), National Interstate Insurance Company of Hawaii, Inc. (NIIC-HI) and Triumphe Casualty Company (TCC) and six other agency and service subsidiaries. NIIC is licensed in all 50 states and the District of Columbia. HIL is domiciled in the Cayman Islands and conducts insurance business outside the United States. We write our insurance policies on a direct basis through NIIC, NIIC-HI and TCC. We purchased TCC effective January 1, 2006. TCC, a Pennsylvania domiciled company, holds licenses for multiple lines of authority, including auto-related lines, in 24 states and the District of Columbia. We also assume a portion of premiums written by other affiliate companies whose passenger transportation insurance business we manage. Insurance products are marketed through multiple distribution channels, including independent agents and brokers, affiliated agencies and agent internet initiatives. Approximately 19.9% of our premiums are written in the state of California, and an additional 26.5%, collectively, in the states of Hawaii, Florida, North Carolina and Texas. We use our six other agency and service subsidiaries to sell and service our insurance business. This includes Hudson Management Group, Ltd. (HMG), a U.S. Virgin Islands corporation based in St. Thomas, which commenced operations in the first quarter of 2006.
Property and Casualty Insurance Operations
We are a specialty property and casualty insurance company with a niche orientation and a focus on the transportation industry. Founded in 1989, we have had an uninterrupted record of profitability in every year since 1990, our first full year of operation. We have also reported an underwriting profit in 16 of the 18 years we have been in business. We have grown our fully diluted net income per share from $0.49 in 2002 to $1.85 in 2006. For the year ended December 31, 2006, we had gross written premiums (direct and assumed) of $305.5 million and net income of $35.7 million.
We believe, based upon an informal survey of brokers specializing in transportation insurance, that we are the largest writer of insurance for the passenger transportation industry in the United States. We focus on niche insurance markets where we offer insurance products designed to meet the unique needs of targeted insurance buyers that we believe are underserved by the insurance industry. We believe these niche markets typically are too small, too remote or too difficult to attract or sustain most competitors. Examples of products that we write for these markets include traditional property and casualty insurance for transportation companies (29.3% of 2006 gross written premiums), captive programs for transportation companies that we refer to as our alternative risk transfer
operations (44.3%), specialty personal lines, primarily recreational vehicle coverage (17.0%) and transportation and general commercial insurance in Hawaii and Alaska (7.6%).
While many companies write property and casualty insurance for transportation companies, we believe, based on financial responsibility filings with the Federal Motor Carrier Safety Administration, that few write passenger transportation coverage nationwide. We know of only one or two other insurance companies that have offered high limits coverage to motorcoach, school bus and limousine operators in all states or nearly all states for more than a few years. We believe that we have been one of the only two insurance companies to consistently provide passenger transportation insurance across all passenger transportation classes and all regions of the country for at least the past ten years. In addition to being one of only two national passenger transportation underwriters, we also believe, based on our discussions with brokers and customers in the passenger transportation insurance market, that we are the only insurance company offering homogeneous (i.e., to insureds in the same industry) group captive insurance programs to this industry.
Product Management Organization. We believe we have a competitive advantage in our major lines of business as a result, in part, of our product management focus. Each of our product lines is headed by a manager solely responsible for achieving that product lines planned results. We believe that the use of a product management organization provides the focus required to successfully offer and manage a diverse set of product lines. For example, we are willing to design custom insurance programs, such as unique billing plans and deductibles, for our large transportation customers based on their needs. Our claims, accounting, information technology and other support functions are organized to align their resources with specific product line initiatives and needs. We know of only one other insurance company that uses this type of hybrid product management organization. We believe that most insurance companies rely upon organization structures aligned around functional specialties such as underwriting, actuarial, operations, marketing and claims. The managers of each of these functions typically provide service and support to multiple insurance products under the traditional functional organization. Our product managers are responsible for the underwriting, pricing and marketing and they are held accountable for underwriting profitability of a specific insurance product. Other required services and support are provided across product lines by functional managers.
We offer over 30 product lines in the specialty property and casualty insurance market, which we group into four general business components (transportation, alternative risk transfer, specialty personal lines and Hawaii and Alaska) based on the class of business, insureds risk participation or geographic location. The following table sets forth an analysis of gross premiums written by business component during the periods indicated:
For 2006, the range of premiums for our business components and their annual premium average were as follows:
Transportation. We believe that we are the largest writer of insurance for the passenger transportation industry in the United States. In our transportation component, we underwrite commercial auto liability, general liability, physical damage and motor truck cargo coverages for truck and passenger operators. Passenger transportation operators include charter and tour bus companies, municipal transit systems, school transportation contractors, limousine companies, inter-city bus services and community service and paratransit operations. No one customer in our transportation component accounted for 10.0% or more of the revenues of this component during 2006. We also assume a majority of the net risk related to policies for transportation risks underwritten by us and issued by Great American, which accounted for 1.5% of our gross premiums written for the year ended December 31, 2006. We do not have similar arrangements with any other companies.
Alternative Risk Transfer. Additionally we underwrite, market and distribute primarily truck and passenger transportation alternative risk insurance products, also known as captives, as well as workers compensation coverage. Captives are insurance or reinsurance companies that are owned or rented by the participants in the group captive insurance program. Program participants share in the underwriting profits or losses and the investment results associated with the risks being insured by the captive insurance company. Participants in these programs typically are interested in the improved risk control, increased participation in the claims settlement process and asset investment features associated with a captive insurance program.
We support two forms of captive programs member-owned and rented. In a member-owned captive, the participants form, capitalize and manage their own reinsurance company. In a rental captive, the reinsurance company is formed, capitalized and managed by someone other than the participants. The participants in a rental captive program pay a fee to the reinsurance company owner to use the reinsurance facility in their captive program; in other words, the participants rent it. In both member-owned and rented captives, we underwrite and price the risk, issue the policies and adjust the claims. A portion of the risk and premium is ceded to the captive insurance company. That captive insurance company serves the same purpose for the captive participants regardless of whether they own the reinsurance company or rent it.
The revenue we earn, our profit margins and the risks we assume are substantially consistent in member-owned captives and rented captives. The primary differences to us are the expenses associated with these programs and who ultimately bears those expenses. In a member-owned captive, the participants own and manage their own reinsurance company. Managing an off-shore insurance company includes general management responsibilities, financial statement preparation, actuarial analysis, investment management, corporate governance, regulatory management and legal affairs. If the actual expenses associated with managing a member-owned captive exceed the funded projections, the participants pay for these added expenses outside the insurance transaction. Included in the premium we charge participants in our rental captive programs is a charge to fund our expenses related to the managing of our Cayman Island reinsurer used for this purpose. Investment management expenses also are included in the premium and we cap the participants expense contribution regardless of whether or not we collect adequate funds to operate the off-shore reinsurance company.
All other loss, expense and profit margin components are substantially the same for our member-owned or rental captive insurance programs. The advantage of a member-owned captive program to the participants is the ability to change policy issuing companies and service providers without changing the makeup of their group. Rented captive participants are not obligated to capitalize their own reinsurer. They generally enjoy a slightly lower expense structure and their captive program expenses are fixed for the policy year regardless of the amount of expenses actually incurred to operate the reinsurer and facilitate participant meetings.
The premiums generated by each of the captive insurance programs offered by us are developed in a similar manner. The most important component of the premium charged is the development of the participants loss fund. The loss fund represents the amount of premium needed to cover the participants expected losses in the layer of risk being ceded to the captive reinsurer. This loss layer typically involves the first loss layer and, depending on the captive program, currently ranges from the first $50,000 to the first $350,000 of loss per occurence. Once the participants loss fund is established, all other expenses related to the coverages and services being provided are derived by a formula agreed to in advance by the captive participants and the service providers. We are the primary or only service provider to every rental captive program we support. The service providers issue policies, adjust claims, provide loss control consulting services, assume the risk for losses exceeding the captive program retention, and either manage the member-owned reinsurance company needed to facilitate the transfer of risk to the participants or provide the rental reinsurance facility that serves the same purpose. In our captive programs, these fees that are charged to the insured as part of their premium range from approximately 30.0% to 70.0% of a $1 million policy premium depending on the program structure and the loss layer ceded to the captive.
We entered the alternative risk transfer market in 1995 through an arrangement with an established captive insurance consultant. Together, we created what we believe, based on our discussions with brokers and customers in the passenger transportation insurance market, was the first homogeneous, member-owned captive insurance program, known as TRAX Insurance, Ltd., for passenger transportation operators. Since 1996, we have established additional group captives for passenger and commercial transportation, including, but not limited to rental cars, taxi cabs, liquefied petroleum gas distributors, buses, crane and rigging haulers and trucks. We expect to introduce additional transportation captives in 2007. As of December 31, 2006, we insured more than 180 transportation companies in captive insurance programs. No one customer in our alternative risk transfer business accounted for 10.0% or more of the revenues of this component of our business during 2006. We also have partnered with insureds and agents in captive programs, whereby the insured or agent shares in underwriting results and investment income with our Cayman Islands-based reinsurance subsidiary.
Specialty Personal Lines. We believe our specialty recreational vehicle, or RV insurance program, differs from those offered by traditional personal auto insurers because we offer coverages written specifically for RV owners, including those who live in their RV full-time. We offer coverage for campsite liability, vehicle replacement coverage and coverage for trailers, golf carts and campsite storage facilities. In addition to our RV product, we also offer companion personal auto coverage to RV policyholders. This product covers the automobiles owned by our insured RV policyholders. One feature of our companion auto product that we believe is not generally available from other insurers is the application of a single deductible when an insured RV and the insured companion auto being towed are both damaged in an accident. We also assume all of the net risk related to policies for recreational vehicle risks underwritten by us and issued by Great American, our majority shareholder. Also included in the specialty personal lines component are the watercraft product (introduced in November 2004) and the commercial vehicle product that was introduced in the fourth quarter of 2006.
Hawaii and Alaska. We entered the Hawaii transportation insurance market in 1995. In 1995, following the withdrawal of Pacific Insurance, Ltd., a major insurance provider in that market, we established a physical presence in Hawaii, by employing several of Pacifics former employees and assuming the agency relationships left by Pacific. The major insurance product managed by this new office was general commercial insurance sold to Hawaiian small business owners, which is still an important part of our business. Since 1996, we have expanded our transportation insurance business in Hawaii and believe that we have become the leading writer of transportation insurance in that state. Through our office in Hawaii, we entered the Alaska insurance market in 2005, offering similar products to those we offer in Hawaii. Alaska produced a nominal contribution to our operations in 2006, but is expected to increase in future years.
The following table sets forth the geographic distribution of our direct premiums written for the years indicated:
The following table sets forth our direct premiums written by statutory line of business for the periods indicated:
We employ a pricing segmentation approach that makes extensive use of proprietary data and pricing models. Our pricing strategy enables our product managers to change the rate structure by evaluating detailed policyholder information, such as loss experience based on driver characteristics, financial responsibility scores (where legally permissible) and the make/model of vehicles. This pricing segmentation approach differs by product line and requires extensive involvement of product managers, who are responsible for the underwriting profitability of a specific product line with direct oversight of product design and rate level structure by our most senior managers. Individual product managers work closely with our pricing and database managers to generate rate level indications and other relevant data. We use this data coupled with the actuarial loss costs obtained from the Insurance Services Office, an insurance industry advisory service organization, as a benchmark in the formulation of pricing for our products. We believe the quality of our proprietary data combined with our rigorous approach has permitted us to
respond more quickly than our competitors to adverse trends such as the continuing increase in auto liability loss severity, and to obtain accurate pricing and risk selection for each individual account.
Risk selection and pricing decisions are discussed regularly by product line underwriters and product managers. We believe this group input and deliberation on pricing and risk selection reaffirms our philosophy and underwriting culture, and aids in avoiding unknown exposures. Underwriting files at both our regional and corporate offices are audited by senior management on a regular basis for compliance with our price and risk selection criteria. Product managers are responsible for the underwriting profitability resulting from these risk selection and pricing decisions and the incentive-based portion of their compensation is determined in part on that profitability.
We offer our products through multiple distribution channels including independent agents and brokers, through affiliated agencies and through agent internet initiatives. During the year ended December 31, 2006, approximately 85.7% of our direct and assumed premiums written were generated by independent agents and brokers and approximately 14.3% were generated by our affiliated agencies. Together, our top two independent agents/brokers accounted for an aggregate of 14.3% of our direct premiums written during 2006. Our top two independent brokers during the year ended December 31, 2006, were Aon Risk Services Inc. and Aon Insurance Agency, Inc.
We are involved in both the cession and assumption of reinsurance. We reinsure a portion of our business to other insurance companies. Ceding reinsurance permits diversification of our risks and limits our maximum loss arising from large or unusually hazardous risks or catastrophic events. We are subject to credit risk with respect to our reinsurers, because the ceding of risk to a reinsurer generally does not relieve us of liability to our insureds until claims are fully settled. To mitigate this credit risk, we cede business only to reinsurers if they meet our credit ratings criteria of an A.M. Best rating of A− or better. If a reinsurer is not rated by A.M. Best or their rating falls below A−, our contract with them generally requires that they secure outstanding obligations with cash or a trust or letter of credit that we deem acceptable.
The following table sets forth our six largest reinsurers in terms of amounts receivable as of December 31, 2006. Also shown are the premiums written ceded by us to these reinsurers during 2006.
We are party to agreements with Great American pursuant to which we assume a majority of the premiums written by Great American for transportation and RV risks and we pay Great American a service fee based on these premiums. Great American also participates in several of our commercial transportation reinsurance programs. Ceded premiums written with Great American were $3.8 million, $5.1 million and $0.3 million for the years ended December 31, 2006, 2005 and 2004, respectively. We also provide administrative services to Great American in connection with the public transportation risks that we underwrite on their policies.
We believe that effective claims management is critical to our success and that our process is cost efficient, delivers the appropriate level of claims service and produces superior claims results. We are focused on controlling claims from their inception with thorough investigation, accelerated communication to insureds and claimants and compressing the cycle time of claim resolution to control both loss cost and claim handling cost. In 2006, approximately 63% of our first party comprehensive and collision claims were closed within 30 days and approximately 61% of third party property damage claims were investigated and closed within 60 days.
Claims arising under our insurance policies are reviewed, supervised, and handled by our internal claims department. As of December 31, 2006, our claims organization employed 76 people (24% of our employee group) and operated out of two regional offices. All of our claims employees have been trained to handle claims according to our customer-focused claims management processes and procedures and are subject to periodic audit. We systematically conduct continuing education for our claims staff in the areas of best practices, fraud awareness, legislative changes and litigation management. We do not delegate liability settlement authority to third party administrators. All large claim reserves are reviewed on a monthly basis by executive claims management, and adjusters frequently participate in audits and large loss reviews with participating reinsurers. We also employ a formal large loss review methodology that involves senior company management, executive claims management and adjusting staff in a quarterly review of all large loss exposures.
We provide 24-hour, 7 days per week, toll-free service for our policyholders to report claims. In 2006, adjusters were able to initiate contact with approximately 93% of policyholder claimants within 24 hours of first notice of a loss and approximately 85% of third-party claimants. When we receive the first notice of loss, our claims personnel open a file and establish appropriate reserving to maximum probable exposure (based on our historical claim settlement experience) as soon as practicable and continually revise case reserves as new information develops. We maintain and implement a fraud awareness program designed to educate our claims employees and others throughout the organization of fraud indicators. Potentially fraudulent claims are referred for special investigation and fraudulent claims are contested.
Our physical damage claims processes involve the utilization and coordination of internal staff, vendor resources and property specialists. We pay close attention to the vehicle repair process, which we believe reduces the amount we pay for repairs, storage costs and auto rental costs. During 2006, our physical damage settlements in the continental United States averaged savings of approximately 11%, and savings of 8.2% in Hawaii for the same periods when compared to claimed damages.
Our captive programs have dedicated claims personnel and claims services tailored to each captive program. Each captive program has a dedicated claims manager, receives extra communications pertaining to reserve changes and/or payments, and has dedicated staff resources. In the captive programs, approximately 98% of customers completing our survey in 2006 rated us as timely in our claims handling, and over 97% for the same period rated their claims as thoroughly investigated.
We employ highly qualified and experienced liability adjusters who are responsible for overseeing all injury-related losses including those in litigation. We identify and retain specialized outside defense counsel to litigate such matters. We negotiate fee arrangements with retained defense counsel and attempt to limit our litigation costs. The liability focused adjusters manage these claims by placing a priority on detailed file documentation and emphasizing investigation, evaluation and negotiation of liability claims.
Reserves for Unpaid Losses and Loss Adjustment Expenses (LAE)
We estimate liabilities for the costs of losses and LAE for both reported and unreported claims based on historical trends adjusted for changes in loss costs, underwriting standards, policy provisions, product mix and other factors. Estimating the liability for unpaid losses and LAE is inherently judgmental and is influenced by factors that are subject to significant variation. We monitor items such as the effect of inflation on medical, hospitalization, material repair and replacement costs, general economic trends and the legal environment. While the ultimate liability may be greater than recorded loss reserves, the reserve tail for transportation coverage is generally shorter than that associated with many other casualty coverages and, therefore, generally can be established with less uncertainty than coverages having longer reserve tails.
We review loss reserve adequacy and claims adjustment effectiveness quarterly. We focus significant management attention on claims reserved above $50,000. Further, our reserves are certified by accredited actuaries from Great American to state regulators annually. Reserves are routinely adjusted as additional information becomes known. These adjustments are reflected in current year operations.
The following tables present the development of our loss reserves, net of reinsurance, on a U.S. generally accepted accounting principles (GAAP) basis for the calendar years 1996 through 2006. The top line of each table shows the estimated liability for unpaid losses and LAE recorded at the balance sheet date for the indicated years. The next line, Liability for Unpaid Losses and Loss Adjustment Expenses As re-estimated at December 31, 2006, shows the re-estimated liability as of December 31, 2006. The remainder of the table presents intervening development from the initially estimated liability. This development results from additional information and experience in subsequent years. The middle line shows a net cumulative (deficiency) redundancy which represents the aggregate percentage (increase) decrease in the liability initially estimated. The lower portion of the table indicates the cumulative amounts paid as of successive periods.
The following is a reconciliation of our net liability to the gross liability for unpaid losses and LAE:
These tables do not present accident or policy year development data. Furthermore, in evaluating the re-estimated liability and cumulative (deficiency) redundancy, it should be noted that each amount includes the effects of changes in amounts for prior periods. Conditions and trends that have affected development of the liability in the past may not necessarily exist in the future. Accordingly, it may not be appropriate to extrapolate future redundancies or deficiencies based on this table.
The preceding table shows our calendar year development or savings for each of the last ten years resulting from reevaluating the original estimate of the loss and LAE liability on both a net and gross basis. Gross reserves are liabilities for direct and assumed losses and LAE before a reduction for amounts ceded. At December 31, 2006, our liability on a gross basis was $266.0 million and the asset for ceded reserves was $84.1 million. The difference between gross development and net development is ceded loss and LAE reserve development. The range of dollar limits ceded by us is much greater and therefore more volatile than the range of dollar limits we retain, which could cause more volatility in estimates for ceded losses. Therefore, ceded reserves are more susceptible to development than net reserves. Net calendar year reserve development or savings affects our income for the year while ceded reserve development or savings affects the income of reinsurers.
We employ a conservative approach to investment and capital management with the intention of supporting insurance operations by providing a stable source of income to offset underwriting risk and growing income to offset inflation. The priority of goals of our investment policy are to preserve principal, generate income, maintain adequate liquidity and achieve capital appreciation. Our Board of Directors has established investment guidelines and reviews the portfolio performance quarterly for compliance with its established guidelines.
The following tables present the percentage distribution and yields of our investment portfolio for the dates given:
The table below compares total returns on our fixed maturities and equity securities to comparable public indices. In prior periods, we have compared our fixed maturity returns to the Lehman Brothers U.S. Universal Bond Index, which is a broad based index that includes some sectors not represented in our portfolio and several Merrill Lynch indices. We removed the Lehman Brothers U.S. Universal Index and added the Merrill Lynch Corporate A-AAA Index, 3-5 years. The Merrill Lynch U.S. Bond Indices presented are more representative of the current composite of our fixed maturity portfolio. However, comparisons of our fixed maturity portfolio to the Merrill Lynch indices may be affected by the particular weighting of the sectors. The total return for our equity portfolio includes preferred stock and common stock. The Standard & Poors 500 (Common) and Merrill Lynch Preferred Stock Index (Preferred) presented are representative of the composition of our equity portfolio. Both our performance and the indices include changes in unrealized gains and losses.
Fixed Maturity Investments
Our fixed maturity portfolio is invested primarily in investment grade bonds. The National Association of Insurance Commissioners, or NAIC, assigns quality ratings that range from Class 1 (highest quality) to Class 6 (lowest quality). The following table shows our bonds by NAIC designation and comparable Standard & Poors Corporation rating as of December 31, 2006:
The maturity distribution of fixed maturity investments held as of December 31, 2006 and 2005 is as follows (actual maturities may differ from scheduled maturities due to the borrower having the right to call or prepay obligations):
Fixed income investment funds are generally invested in securities with short-term and intermediate-term maturities with an objective of optimizing total return while allowing flexibility to react to changes in market conditions and maintaining sufficient liquidity to meet policyholder obligations. At December 31, 2006, the weighted average modified duration (unadjusted for call provision) was approximately 4.0 years, the weighted average effective duration was 2.4 years and the average maturity was 4.7 years. The concept of weighted average
effective duration takes into consideration the probability of the exercise of the various call features associated with many of the fixed-income securities we hold. Fixed income securities are frequently issued with call provisions that provide the option of accelerating the maturity of the security at the option of the issuer.
The commercial transportation insurance industry is highly competitive and, except for regulatory considerations, there are relatively few barriers to entry. We compete with numerous insurance companies and reinsurers, including large national underwriters and smaller niche insurance companies. In particular, in the specialty insurance market we compete against, among others, Lancer Insurance Company, Lincoln General Insurance Company (a subsidiary of Kingsway Financial Services, Inc.), RLI Corporation, Progressive Corporation, Northland Insurance Company (a subsidiary of St. Paul Travelers Corporation), Island Insurance Company, Great West Casualty Company (a subsidiary of Old Republic International Corporation) and American Modern Home Insurance Company (a subsidiary of the Midland Company). We compete in the property and casualty insurance marketplace with other insurers on the basis of price, coverages offered, product and program design, claims handling, customer service quality, agent commissions where applicable, geographic coverage, reputation and financial strength ratings by independent rating agencies. We compete by developing product lines to satisfy specific market needs and by maintaining relationships with our independent agents and customers who rely on our expertise. This expertise, along with our reputation for offering specialty underwriting products, is our principal means of distinguishing ourselves from our competitors.
We believe we have a competitive advantage in our major lines of business as a result of the extensive experience of our management, our superior service and products, our willingness to design custom insurance programs for our large transportation customers and the extensive use of technology with respect to our insureds and independent agent force. However, we are not top-line oriented and will readily sacrifice premium volume during periods that we believe exhibit unrealistic rate competition. Accordingly, should competitors determine to buy market share with unprofitable rates, our insurance subsidiaries will generally experience a decline in business until market pricing returns to what we view as profitable levels.
In June 2004, A.M. Best assigned our current group rating of A (Excellent) to our domestic insurance companies. According to A.M. Best, A ratings are assigned to insurers that have, on balance, excellent balance sheet strength, operating performance and business profile when compared to the standards established by A.M. Best and, in A.M. Bests opinion, have a strong ability to meet their ongoing obligations to policyholders. The objective of A.M. Bests rating system is to provide potential policyholders and other interested parties an opinion of an insurers financial strength and ability to meet ongoing obligations, including paying claims. This rating reflects A.M. Bests analysis of our balance sheet, financial position, capitalization and management. This rating is subject to periodic review and may be revised downward, upward, or revoked at the sole discretion of A.M. Best. Any changes in our rating category could affect our competitive position.
Our insurance subsidiaries are subject to regulation in all fifty states, Washington D.C. and the Cayman Islands. The extent of regulation varies, but generally derives from statutes that delegate regulatory, supervisory and administrative authority to a department of insurance in each state in which the companies transact insurance business. These statutes and regulations generally require each of our insurance subsidiaries to register with the state insurance department where the company is domiciled and to furnish annually financial and other information about the operations of the company. Certain transactions and other activities by our insurance companies must be approved by Ohio, Hawaii, Pennsylvania or Cayman Islands regulatory authorities before the transaction takes place.
The regulation, supervision and administration also relate to statutory capital and reserve requirements and standards of solvency that must be met and maintained, the payment of dividends, changes of control of insurance companies, the licensing of insurers and their agents, the types of insurance that may be written, the regulation of market conduct, including underwriting and claims practices, provisions for unearned premiums, losses, LAE, and other obligations, the ability to enter and exit certain insurance markets, the nature of and limitations on investments, premium rates, or restrictions on the size of risks that may be insured under a single policy, privacy practices, deposits of securities for the benefit of policyholders, payment of sales compensation to third parties, and the approval of policy forms and guaranty funds.
State insurance departments also conduct periodic examinations of the business affairs of our insurance companies and require us to file annual financial and other reports, prepared under Statutory accounting principles, or SAP, relating to the financial condition of companies and other matters. These insurance departments conduct periodic examinations of the books and records, financial reporting, policy filings and market conduct of our insurance companies domiciled in their states, generally once every three to five years, although target financial, market conduct, and other examinations may take place at any time. These examinations are generally carried out in cooperation with the insurance departments of other states in which our insurance companies transact insurance business under guidelines promulgated by the NAIC. Our last financial examination was completed by the Ohio Department of Insurance, which coordinated the exam for Ohio, Pennsylvania and Hawaii, on October 19, 2006 for the period ending December 31, 2005. Any adverse findings by these insurance departments, or any others that conduct examinations, can result in significant fines and penalties, negatively affecting our profitability. We have not been notified by any regulatory agency that we are in material violation of any of the applicable laws and regulations referred to above nor are we aware of any such violation.
Generally, all material transactions among affiliated companies in our holding company system to which any of our insurance subsidiaries is a party, including sales, loans, reinsurance agreements, management agreements, and service agreements with the non-insurance companies within the companies or any other insurance subsidiary, must be fair and reasonable. In addition, if the transaction is material or of a specified category, prior notice and approval (or absence of disapproval within a specified time limit) by the insurance department where the subsidiary is domiciled is required.
SAP is a basis of accounting developed to assist insurance regulators in monitoring and regulating the solvency of insurance companies. One of the primary goals is to measure an insurers statutory surplus. Accordingly, statutory accounting focuses on valuing assets and liabilities of our insurance subsidiaries at financial reporting dates in accordance with appropriate insurance law and regulatory provisions applicable in each insurers domiciliary state. Insurance departments utilize SAP to help determine whether our insurance companies will have sufficient funds to timely pay all the claims of our policyholders and creditors. GAAP gives more consideration to matching of revenue and expenses than SAP. As a result, assets and liabilities will differ in financial statements prepared in accordance with GAAP as compared to SAP.
SAP established by the NAIC and adopted, for the most part, by the various state insurance regulators determine, among other things, the amount of statutory surplus and net income of our insurance subsidiaries and thus determine, in part, the amount of funds they have available to pay as dividends to us.
State insurance law restricts the ability of our insurance subsidiaries to declare shareholder dividends and requires our insurance companies to maintain specified levels of statutory capital and surplus. The amount of an insurers surplus following payment of any dividends must be reasonable in relation to the insurers outstanding liabilities and adequate to meet its financial needs. Limitations on dividends are generally based on net income or statutory capital and surplus.
The maximum amount of dividends that our insurance companies could pay to us in 2007 without seeking regulatory approval is $26.6 million. NIIC paid $3.0 million in dividends in 2006 without the need for regulatory approval and paid no dividends in 2005.
Virtually all states require insurers licensed to do business in their state to bear a portion of the loss suffered by insureds as a result of the insolvency of other insurers. Significant assessments could limit the ability of our insurance subsidiaries to recover such assessments through tax credits or other means. We paid assessments of $2.0 million, $1.2 million and $1.5 million in the years ended 2006, 2005 and 2004, respectively. Our estimated liability for anticipated assessments was $3.3 million as of December 31, 2006.
In order to enhance the regulation of insurer solvency, the NAIC has adopted formulas and model laws to determine minimum capital requirements and to raise the level of protection that statutory surplus provides for policyholder obligations. The model law provides for increasing levels of regulatory intervention as the ratio of an insurers total adjusted capital and surplus decreases relative to its risk based capital, 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, 2006, the capital and surplus of all of our insurance companies substantially exceeded the RBC requirements.
Many states in which we conduct business have laws and regulations that limit the ability of our insurance companies licensed in that state to exit a market, cancel policies, or not renew policies. Some states prohibit us from withdrawing one or more lines of business from the state, except pursuant to a plan approved by the state insurance regulator, which may disapprove a plan that may lead to market disruption.
The federal government generally does not directly regulate the insurance business. However, federal legislation and administrative policies in several areas, including age and sex discrimination, consumer privacy, terrorism and federal taxation, do affect our insurance business. There is legislation pending in the U.S. Congress and in various states designed to provide additional privacy protections to consumers of financial institutions, specifically in the area of information security and restrictions on the use of consumer credit information. These statutes and implementing regulations could affect our current business processes and our ability to market our products or otherwise limit the nature or scope of our insurance operations.
The Terrorism Risk Insurance Act of 2002, which established a federal backstop program for commercial/property casualty losses resulting from foreign acts of terrorism, was originally scheduled to expire on December 31, 2005, but was extended through December 31, 2007 by the Terrorism Risk Insurance Extension Act of 2005. The Act continues to require commercial insurers to make terrorism coverage available for commercial property/casualty losses, including workers compensation. Commercial auto, burglary/theft, surety, professional liability and farmowners multiple-peril are no longer included in the program. Industry deductible levels were increased and the event trigger under the Act now provides that in the case of a certified act of terrorism occurring after March 31, 2006, no federal compensation shall be paid by the Secretary of Treasury unless aggregate industry losses exceed $100 million in 2007. The federal government will pay 85% of covered terrorism losses in 2007.
We are continuing to take the steps necessary to comply with the Act, as well as the state regulations implementing its provisions, by providing required notices to commercial policyholders describing coverage provided for certified acts of terrorism (as defined by the Act). We do not anticipate terrorism losses to have a material impact on our results of operations.
To our knowledge and based on our internal review and control process for compliance, we believe that since 2002 we have been in compliance in all material respects with the laws, rules and regulations described above.
At December 31, 2006, we employed 309 people. None of our employees are covered by collective bargaining arrangements.
Please refer to Forward-Looking Statements following the Index in the front of this Form 10-K.
All material risks and uncertainties currently known regarding our business operations are included in this section. If any of the following risks, or other risks and uncertainties that we have not yet identified or that we currently consider not to be material, actually occur, our business, prospects, financial condition, results of operations and cash flows could be materially and adversely affected.
If we expand our operations too rapidly and do not manage that expansion effectively, our financial performance could be adversely affected.
We have experienced rapid growth since our incorporation in January of 1989. We intend to continue to grow by developing new products, expanding into new product lines, expanding our insurance distribution network, and possibly making strategic acquisitions. Continued growth will impose significant demands on our management, including the need to identify, recruit, maintain and integrate additional employees. We may experience higher than anticipated indemnity losses arising from new and expanded insurance products. In addition, our systems, procedures and internal controls may not be adequate to support our operations as they expand. Any failure by us to manage our growth effectively could have a material adverse effect on our business, financial condition or results of operations. In addition, our historical growth rates may not accurately reflect our future growth rates or our growth potential.
Because we are primarily a transportation insurer, conditions in that industry could adversely affect our business.
Approximately 73.6% of our gross written premiums for the year ended December 31, 2006 and 72.0% for the year ended December 31, 2005 were generated from transportation insurance policies, including captive programs for transportation companies. Adverse developments in the market for transportation insurance could cause our results of operations to suffer. The transportation insurance industry is cyclical. Historically, the industry has been characterized by periods of price competition and excess capacity followed by periods of high premium rates and shortages of underwriting capacity. We believe we are currently in the part of the cycle that can best be described as characterized by increased price competition, as compared to the peak of the hard market in 2002 and 2003. These fluctuations in the business cycle could negatively impact our revenues.
Additionally, our results may be affected by risks that impact the transportation industry related to severe weather conditions, such as rainstorms, snowstorms, hail and ice storms, floods, hurricanes, tornadoes and earthquakes, as well as explosions, terrorist attacks and riots. Our transportation insurance business also may be affected by cost trends that negatively impact profitability such as inflation in vehicle repair costs, vehicle replacement parts costs, used vehicle prices, fuel costs and medical care costs. Increased costs related to the handling and litigation of claims may also negatively impact our profitability.
We are continually evaluating new lines of business to add to our product mix. In some instances, we have limited experience with marketing and managing these new product lines and insuring the types of risks involved. Our failure to effectively analyze new underwriting risks, set adequate premium rates and establish reserves for these new products, or efficiently adjust claims arising from these new products, could have a material adverse effect on our business, financial condition or results of operations. During the start up period for new products, we generally set more conservative loss reserves. This could adversely affect our statutory capital, net income and ability to pay dividends.
We face competition from companies with greater financial resources, broader product lines, higher ratings and stronger financial performance than us, which may impair our ability to retain existing customers, attract new customers and maintain our profitability and financial strength.
The commercial transportation insurance business is highly competitive and, except for regulatory considerations, there are relatively few barriers to entry. Many of our competitors are substantially larger and may enjoy better name recognition, substantially greater financial resources, higher ratings by rating agencies, broader and more diversified product lines and more widespread agency relationships than we do. We compete with large national underwriters and smaller niche insurance companies. In particular, in the specialty insurance market we compete against, among others, Lancer Insurance Company, Lincoln General Insurance Company (a subsidiary of Kingsway Financial Services, Inc.), RLI Corporation, Progressive Corporation, Island Insurance Company, Great West Casualty Company (a subsidiary of Old Republic International Corporation), Northland Insurance Company (a subsidiary of St. Paul Travelers Corporation) and American Modern Home Insurance Company (a subsidiary of The Midland Company). Our underwriting profits could be adversely impacted if new entrants or existing competitors try to compete with our products, services and programs or offer similar or better products at or below our prices.
We have continued to develop alternative risk transfer (often known as captive insurance) programs, attracting new customers as well as transitioning existing traditional customers into these programs. Our alternative risk transfer component constituted approximately 44.3% of our gross premiums written as of December 31, 2006. We are subject to ongoing competition for both the individual customers and entire programs. The departure of an entire captive program due to competition could adversely affect our results.
If we are not able to attract and retain independent agents and brokers, our revenues could be negatively affected.
We compete with other insurance carriers to attract and retain business from independent agents and brokers. Some of our competitors offer a larger variety of products, lower prices for insurance coverage or higher commissions than we offer. Our top ten independent agents/brokers accounted for an aggregate of 44.1% of our direct premiums written during the year ended December 31, 2006, and our top two independent agents/brokers accounted for an aggregate of 14.3% of our direct premiums written during the year ended December 31, 2006. If we are unable to attract and retain independent agents/brokers to sell our products, our ability to compete and attract new customers and our revenues would suffer.
We are subject to comprehensive regulation, and our ability to earn profits may be restricted by these regulations.
We are subject to comprehensive regulation by government agencies in the states and foreign jurisdictions where our insurance company subsidiaries are domiciled (Ohio, Hawaii, Pennsylvania and the Cayman Islands) and, to a lesser degree, where these subsidiaries issue policies and handle claims. Failure by one of our insurance company subsidiaries to meet regulatory requirements could subject us to regulatory action. The regulations and associated examinations may have the effect of limiting our liquidity and may adversely affect results of operations. We must comply with statutes and regulations relating to, among other things:
In addition, state insurance department examiners perform periodic financial, market conduct and other examinations of insurance companies. Compliance with applicable laws and regulations is time consuming and personnel-intensive. The last financial examination of our insurance subsidiaries was completed by the Ohio Department of Insurance on October 19, 2006 for the period ending December 31, 2005. The Ohio Department of Insurance coordinated this examination, and the Departments of Insurance from Pennsylvania and Hawaii participated. No significant issues have surfaced to date. In addition to this financial examination, the California Department of Insurance conducted a market conduct examination of our claims handling practices in November 2006. We are awaiting the final results of this examination. The California Department of Insurance has also notified us of its intention to conduct a market conduct examination of our underwriting practices in 2007. Any adverse findings by these insurance departments, or any others that conduct examinations, can result in significant fines and penalties, negatively affecting our profitability.
In addition, insurance-related laws and regulations may become more restrictive in the future. New or more restrictive regulation, including changes in current tax or other regulatory interpretations affecting the alternative risk transfer insurance model, could make it more expensive for us to conduct our business, restrict the premiums we are able to charge, or otherwise change the way we do business. For a further discussion of the regulatory framework in which we operate, see the subsection of Business entitled Regulation.
As a holding company, we are dependent on the results of operations of our insurance company subsidiaries to meet our obligations and pay future dividends.
We are a holding company and a legal entity separate and distinct from our insurance company subsidiaries. As a holding company without significant operations of our own, one of our sources of funds are dividends and other distributions from our insurance company subsidiaries. As discussed under the subsection of Business entitled Regulation, statutory and regulatory restrictions limit the aggregate amount of dividends or other distributions that our insurance subsidiaries may declare or pay within any twelve-month period without advance regulatory approval, and require insurance companies to maintain specified levels of statutory capital and surplus. Insurance regulators have broad powers to prevent reduction of statutory capital and surplus to inadequate levels and could refuse to permit the payment of dividends calculated under any applicable formula. As a result, we may not be able to receive dividends from our insurance subsidiaries at times and in amounts necessary to meet our operating needs, to pay dividends to our shareholders, or to pay corporate expenses.
We are currently rated A (Excellent) by A.M. Best, their third highest rating out of 16 rating categories. A decline in our rating below A− could adversely affect our position in the insurance market, make it more difficult to market our insurance products and cause our premiums and earnings to decrease.
Financial ratings are an important factor influencing the competitive position of insurance companies. A.M. Best ratings, which are commonly used in the insurance industry, currently range from A++ (Superior) to F (In Liquidation), with a total of 16 separate ratings categories. A.M. Best currently assigns us a financial strength rating of A (Excellent). The objective of A.M. Bests rating system is to provide potential policyholders
and other interested parties an opinion of an insurers financial strength and ability to meet ongoing obligations, including paying claims. This rating reflects A.M. Bests analysis of our balance sheet, financial position, capitalization and management. It is not an evaluation of an investment in our common shares, nor is it directed to investors in our common shares and is not a recommendation to buy, sell or hold our common shares. This rating is subject to periodic review and may be revised downward, upward, or revoked at the sole discretion of A.M. Best.
If our rating is reduced by A.M. Best below an A−, we believe that our competitive position in the insurance industry could suffer, and it could be more difficult for us to market our insurance products. A downgrade could result in a significant reduction in the number of insurance contracts we write and in a substantial loss of business to other competitors with higher ratings, causing premiums and earnings to decrease.
New claim and coverage issues are continually emerging in the insurance industry, and these new issues could negatively impact our revenues, our business operations, or our reputation.
As insurance industry practices and regulatory, judicial, and industry conditions change, unexpected and unintended issues related to pricing, claims, coverage and business practices may emerge. Plaintiffs often target property and casualty insurers in purported class action litigation relating to claims handling and insurance sales practices. The resolution and implications of new underwriting, claims and coverage issues could have a negative effect on our insurance business by extending coverage beyond our underwriting intent, increasing the size of claims or otherwise requiring us to change our business practices. The effects of unforeseen emerging claim and coverage issues could negatively impact our revenues, results of operations and our reputation.
If our claims payments and related expenses exceed our reserves, our financial condition and results of operations could be adversely affected.
Our success depends upon our ability to accurately assess and price the risks covered by the insurance policies that we write. We establish reserves to cover our estimated liability for the payment of all losses and LAE incurred with respect to premiums earned on the insurance policies that we write. Reserves do not represent an exact calculation of liability. Rather, reserves are estimates of our expectations regarding the ultimate cost of resolution and administration of claims under the insurance policies that we write. These estimates are based upon actuarial and statistical projections, assessments of currently available data, historical claims information, as well as estimates and assumptions regarding future trends in claims severity and frequency, judicial theories of liability and other factors. We continually refine our reserve estimates in an ongoing process as experience develops and claims are reported and settled. Each year, our reserves are certified by an accredited actuary from Great American.
Establishing an appropriate level of reserves is an inherently uncertain process. The following factors may have a substantial impact on our future actual losses and LAE experience:
Unfavorable development in any of these factors could cause our level of reserves to be inadequate. To the extent that actual losses and LAE exceed expectations and the reserves reflected on our financial statements, we will be required to immediately reflect those changes by increasing reserves. When we increase reserves, the pre-tax income for the period in which we do so will decrease by a corresponding amount. In addition to having a negative effect on pre-tax income, increasing or strengthening reserves causes a reduction in our insurance companies surplus and could cause a downgrading of the rating of our insurance company subsidiaries. Such a downgrade could, in turn, adversely affect our ability to sell insurance policies.
Market fluctuations, changes in interest rates or a need to generate liquidity can have significant and negative effects on our investment portfolio.
Our results of operations depend in part on the performance of our invested assets. As of December 31, 2006, 85.2% of our investment portfolio (excluding cash and cash equivalents) was invested in fixed maturities and 8.9% was invested in equity securities. As of December 31, 2006, approximately 67.4% of our fixed maturity portfolio was invested in U.S. Government and government agency fixed income securities and approximately 95.1% was invested in fixed maturities rated AAA, AA and A by Standard & Poors Corporation.
Certain risks are inherent in investing in fixed maturities, including loss upon default and price volatility in reaction to changes in interest rates and general market factors. The fair value of our fixed maturities will fluctuate as interest rates change. The current environment of increasing interest rates may cause the market value of our fixed maturities to decrease. At December 31, 2006, we had pretax net unrealized losses of $5.1 million on fixed maturities. Changes in interest rates may result in fluctuations in the income from, and the valuation of, our fixed income investments. Large investment losses would significantly decrease our asset base, and affect our ability to underwrite new business.
Historically, and during the most recent extended low interest rate period, we have not had the need to sell our investments to generate liquidity. If we were forced to sell portfolio securities early for liquidity purposes rather than holding them to maturity, we would recognize gains or losses on those securities earlier than anticipated.
We may not be successful in reducing our risk and increasing our underwriting capacity through reinsurance arrangements, which could adversely affect our business, financial condition and results of operations.
In order to reduce our underwriting risk and increase our underwriting capacity, we transfer portions of our insurance risk to other insurers through reinsurance contracts. Ceded premiums written amounted to 20.8% and 21.8%, respectively, of our gross premiums written for the years ended December 31, 2006 and 2005. The availability, cost and structure of reinsurance protection are subject to prevailing market conditions that are outside of our control and which may affect our level of business and profitability. We continually assess and recently increased our participation in the risk retention for certain products in part because we believe the current price increases in the reinsurance market are excessive for the reinsurance exposure assumed. In order for these contracts to qualify for reinsurance accounting and to provide the additional underwriting capacity that we desire, the reinsurer generally must assume significant risk and have a reasonable possibility of a significant loss. Our reinsurance facilities are generally subject to annual renewal. We may be unable to maintain our current reinsurance facilities or obtain other reinsurance facilities in adequate amounts and at favorable rates. If we are unable to renew our expiring facilities or obtain new reinsurance facilities, either our net exposure to risk would increase or, if we are unwilling to bear an increase in net risk exposures, we would have to reduce the amount of risk we underwrite which could adversely impact our results of operations.
We are subject to credit risk with respect to the obligations of our reinsurers and certain of our insureds. The inability of our risk sharing partners to meet their obligations could adversely affect our profitability.
Although the reinsurer is liable to us to the extent of risk ceded by us, we remain ultimately liable to the policyholder on all risks, even those reinsured. As a result, ceded reinsurance arrangements do not limit our ultimate obligations to policyholders to pay claims. We are subject to credit risks with respect to the financial strength of our reinsurers. We are also subject to the risk that our reinsurers may dispute their obligations to pay our claims. As a result, we may not recover sufficient amounts for claims that we submit to our reinsurers in a timely manner, if at all. As of December 31, 2006, we had a total of $79.3 million of unsecured reinsurance recoverables and our largest unsecured recoverable from a single reinsurer, Platinum Underwriters Reinsurance, was $28.9 million. In addition, our reinsurance agreements are subject to specified limits and we would not have reinsurance coverage to the extent that we exceed those limits.
With respect to our insurance programs, we are subject to credit risk with respect to the payment of claims and on the portion of risk exposure either ceded to the captives or retained by our clients. The credit worthiness of prospective risk sharing partners is a factor we consider when entering into or renewing these alternative risk
transfer programs. We typically collateralize balances due through funds withheld or letters of credit. To date, we have not, in the aggregate, experienced material difficulties in collecting balances from our risk sharing partners. No assurance can be given, however, regarding the future ability of these entities to meet their obligations. The inability of our risk sharing partners to meet their obligations could adversely affect our profitability.
We may not be successful in executing our business plan for our US Virgin Islands servicing operations.
Hudson Management Group, Ltd. was formed on July 29, 2004 and received approval of its application to the US Virgin Islands Economic Development Commission for a grant of certain tax abatements and other benefits in June, 2005. We hired an initial staff of professionals in 2006, but in order to execute our business plan, we will need to continue to hire additional qualified professionals. We also need to continue to establish critical market relationships with our insurance customers and refine procedures and controls necessary to operate effectively and profitably. Finally, we have developed a business strategy for our US Virgin Islands servicing operations based on professional advice and available guidance from the Internal Revenue Service. Our failure to effectively implement our business plan could prevent us from realizing our US Virgin Islands operating efficiencies.
Our inability to retain our senior executives and other key personnel could adversely affect our business.
Our success depends, in part, upon the ability of our executive management and other key personnel to implement our business strategy and on our ability to attract and retain qualified employees. Although historically we have not entered into employment agreements with our executive management, we have recently entered into multi-year employment agreements with both our chief executive officer, Mr. Spachman, and our president and chief operating officer, Mr. Michelson. Mr. Michelson is also a party to an employee retention agreement with us. The employment agreements represent an important step in our succession planning process that began in 2005, and are designed to provide stability to our organization during this critical time. Since our formation in 1989, we have been highly dependent on Mr. Spachman, our founder and chief executive officer. We anticipate that Mr. Spachman will transition out of his role as chief executive during 2007, and that he will continue to work with Mr. Michelson, other members of senior management, and our Board of Directors to ensure an orderly transition of leadership over the two years following his retirement. A failure of these employment agreements to achieve their desired result, our inability to effectuate a successful transition, our loss of other senior executives, or our failure to attract and develop talented new executives and managers could adversely affect our business and the market price for our common shares.
Your interests as a holder of our common shares may be different than the interests of our majority shareholder, Great American Insurance Company.
As of December 31, 2006, American Financial Group, Inc., through its wholly-owned subsidiary Great American, owns 53.2% of our outstanding common shares. The interests of American Financial Group, Inc. may differ from the interests of our other shareholders. American Financial Group, Inc.s representatives hold four out of eight seats of our Board of Directors. As a result, American Financial Group, Inc. has the ability to exert significant influence over our policies and affairs including the power to affect the election of our Directors, appointment of our management and the approval of any action requiring a shareholder vote, such as amendments to our Articles of Incorporation or Code of Regulations, transactions with affiliates, mergers or asset sales.
Subject to the terms of our right of first refusal to purchase its shares in certain circumstances, American Financial Group, Inc. may be able to prevent or cause a change of control of the Company by either voting its shares against or for a change of control or selling its shares and causing a change of control. The ability of our majority shareholder to prevent or cause a change of control could delay or prevent a change of control, or cause a change of control to occur at a time when it is not favored by other shareholders. As a result, the trading price of our common shares could be adversely affected.
We may have conflicts of interest with our majority shareholder, Great American Insurance Company, that we are unable to resolve in our favor.
From time to time, Great American and its affiliated companies engage in underwriting activities and enter into transactions or agreements with us or in competition with us, which may give rise to conflicts of interest. We do not have any agreement or understanding with any of these parties regarding the resolution of potential conflicts of interest. In addition, we may not be in a position to influence any partys decision not to engage in activities that would give rise to a conflict of interest. These parties may take actions that are not in the best interests of our other shareholders.
We rely on Great American to provide certain services to us including actuarial and consultative services for legal, accounting and internal audit issues and other support services. If Great American no longer controlled a majority of our shares, it is possible that many of these services would cease or, alternatively, be provided at an increased cost to us. This could impact our personnel resources, require us to hire additional professional staff and generally increase our operating expenses.
Provisions in our organizational documents, Ohio corporate law and the insurance laws of Ohio, Pennsylvania and Hawaii could impede an attempt to replace or remove our management or Directors or prevent or delay a merger or sale, which could diminish the value of our common shares.
Our Amended and Restated Articles of Incorporation and Code of Regulations, the corporate laws of Ohio and the insurance laws of various states contain provisions that could impede an attempt to replace or remove our management or Directors or prevent the sale of our Company that shareholders might consider to be in their best interests. These provisions include, among others:
These provisions may prevent shareholders from receiving the benefit of any premium over the market price of our common shares offered by a bidder in a potential takeover. In addition, the existence of these provisions may adversely affect the prevailing market price of our common shares if they are viewed as discouraging takeover attempts.
The insurance laws of most states require prior notice or regulatory approval of changes in control of an insurance company or its holding company. The insurance laws of the States of Ohio, Hawaii and Pennsylvania, where our U.S. insurance companies are domiciled, provide that no corporation or other person may acquire control of a domestic insurance or reinsurance company unless it has given notice to such insurance or reinsurance company and obtained prior written approval of the relevant insurance regulatory authorities. Any purchaser of 10% or more of our aggregate outstanding voting power could become subject to these regulations and could be required to file notices and reports with the applicable regulatory authorities prior to such acquisition. In addition, the existence of these provisions may adversely affect the prevailing market price of our common shares if they are viewed as discouraging takeover attempts. See the subsection of Business entitled Regulation.
We cannot predict what effect, if any, future sales of our common shares, or the availability of common shares for future sale, will have on the trading price of our common shares. Sales of substantial amounts of our common shares in the public market by Great American or our other shareholders, or the possibility or perception that such sales could occur, could adversely affect prevailing market prices for our common shares. If such sales reduce the market price of our common shares, our ability to raise additional capital in the equity markets may be adversely affected.
In 2006, we registered all of the common shares of Great American and Mr. Spachman, our chairman and chief executive officer, pursuant to a registration statement on Form S-3. Great American and Mr. Spachman own 10,200,000 and 3,080,000, respectively, of our issued and outstanding shares. The registration statement became effective in 2006 and accordingly all shares covered by that registration statement could be sold into the public markets. In addition, in 2005, we filed a registration statement on Form S-8 under the Securities Act to register 1,338,800 of the common shares issued or reserved for issuance for awards granted under our Long Term Incentive Plan. Shares registered under the registration statement on Form S-8 also could be sold into the public markets, subject to applicable vesting provisions and any volume limitations and other restrictions applicable to our officers and Directors selling shares under Rule 144. The sale of the shares under these registration statements in the public market, or the possibility or perception that such sales could occur, could adversely affect prevailing market prices for our common shares.
We completed our initial public offering in February 2005, and we do not have a significant presence in the market. You may have difficulty selling your common shares because of the limited trading volume for such shares.
Our common shares began trading on the Nasdaq Global Market in January 2005. As a relatively new public company, there may be less coverage by security analysts, the trading price of our common shares may be lower, making it more difficult for our shareholders to dispose of their common shares. As noted above, we have a majority shareholder, Great American, which owns 53.2% of our common shares as of December 31, 2006 and another 19.1%, which is owned by management and our Board of Directors. This concentration of ownership could affect the number of shares available for purchase or sale on a daily basis. In addition, we do not have a regular practice of managing analysts or investors earnings expectations. One or more of these factors could result in price volatility and serve to depress the liquidity and market prices of our common shares.
We face ongoing challenges as a result of being a public company and our financial results could be adversely affected.
As a public company, we incur significant legal, accounting and other expenses that result from corporate governance requirements, including requirements under the Sarbanes-Oxley Act of 2002, as well as rules implemented by the Securities and Exchange Commission and the National Association of Securities Dealers. We expect these rules and regulations to increase our legal and finance compliance costs and to make some activities more time-consuming and costly. We continue to evaluate and monitor developments with respect to compliance with public company requirements, and we cannot predict or estimate the amount or timing of additional costs we may incur.
As of December 31, 2006, we became an accelerated filer, as defined by Securities and Exchange Commission rules and regulations, and are required to comply with Section 404 of the Sarbanes-Oxley Act relating to internal controls over financial reporting. We have committed, and will continue to expend, a significant amount of resources to monitor and address any internal control issues, which may occur, in our business. Any failure to do so could adversely impact our operating results.
We own two adjacent buildings that house our corporate headquarters and the surrounding real estate located in Richfield, Ohio. The buildings consist of approximately 177,000 square feet of office space on 17.5 acres. We occupy approximately 89,000 square feet and lease the remainder to unaffiliated tenants.
We lease office space in Duluth, Georgia; Honolulu, Hawaii; Mechanicsburg, Pennsylvania; and St. Thomas in the United States Virgin Islands. These leases account for approximately 17,100 square feet of office space. These leases expire within forty-eight months. The monthly rents, exclusive of operating expenses, to lease these facilities currently total approximately $20,000. We believe that these leases could be renewed or replaced at commercially reasonable rates without material disruption to our business.
Please refer to Forward-Looking Statements following the Index in front of this Form 10-K.
We are subject at times to various claims, lawsuits and legal proceedings arising in the ordinary course of business. All legal actions relating to claims made under insurance policies are considered in the establishment of our loss and LAE reserves. In addition, regulatory bodies, such as state insurance departments, the Securities and Exchange Commission, the Department of Labor and other regulatory bodies may make inquiries and conduct examinations or investigations concerning our compliance with insurance laws, securities laws, labor laws and the Employee Retirement Income Security Act of 1974, as amended.
Our insurance companies also have lawsuits pending in which the plaintiff seeks extra-contractual damages from us in addition to damages claimed, or in excess of the available limits under an insurance policy. These lawsuits, which are in various stages of development, generally mirror similar lawsuits filed against other carriers in the industry. Although we are vigorously defending these lawsuits, the outcomes of these cases cannot be determined at this time. We have established loss and LAE reserves for lawsuits as to which we have determined that a loss is both probable and estimable. In addition to these case reserves, we also establish reserves for claims incurred but not reported to cover unknown exposures and adverse development on known exposures. Based on currently available information, we believe that our reserves for these lawsuits are reasonable and that the amounts reserved did not have a material effect on our financial condition or results of operations. However, if any one or more of these cases results in a judgment against or settlement by us for an amount that is significantly greater than the amount so reserved, the resulting liability could have a material effect on our financial condition, cash flows and results of operations.
Please refer to Forward-Looking Statements following the Index in front of this Form 10-K.
Our common shares have been listed and traded on the Nasdaq Global Market under the symbol NATL, since January 28, 2005. Prior to such date, there was no established public trading market for our common shares. The information presented in the table below represents the high and low sales prices per share reported on the Nasdaq Global Market for the periods indicated.
There were approximately 54 shareholders of record of our common shares at March 1, 2007.
Our Board of Directors has instituted a policy authorizing us to pay quarterly dividends on our common shares in an amount to be determined at each quarterly Board of Directors meeting. The Board of Directors recently increased the quarterly dividend to $0.05 per share for the first quarter of 2007. The Board of Directors intends to continue to review our dividend policy annually during each regularly scheduled first quarter meeting, with the anticipation of considering annual dividend increases. We declared and paid dividends of $0.04 per share for all four quarters of 2006 and paid a $0.04 dividend for the third and fourth quarter of 2005.
The declaration and payment of dividends remains subject to the discretion of the Board of Directors, and will depend on, among other things, our financial condition, results of operations, capital and cash requirements, future prospects, regulatory and contractual restrictions on the payment of dividends by insurance company subsidiaries, and other factors deemed relevant by the Board. In addition, our ability to pay dividends would be restricted in the event of a default on our junior subordinated debentures, our failure to make payment obligations with respect to such debentures, or our election to defer interest payments on the debentures.
We are a holding company without significant operations of our own. Our principal sources of funds are dividends and other distributions from our subsidiaries including our insurance company subsidiaries. Our ability to receive dividends from our insurance company subsidiaries is also subject to limits under applicable state insurance laws.
The following graph shows the percentage change in cumulative total shareholder return on our common shares since the initial public offering measured by dividing (i) the sum of (A) the cumulative amount of dividends, assuming dividend reinvestment during the periods presented and (B) the difference between our share price at the end and the beginning of the periods presented by (ii) the share price at the beginning of the periods presented. The graph demonstrates our cumulative total returns compared to those of the Center for Research in Security Prices (CSRP) Total Return Index for Nasdaq Global Market and the CSRP Total Return Index for Nasdaq Insurance Stocks from the date of our initial public offering January 28, 2005, through December 31, 2006.
Cumulative Total Return as of December 31, 2006
(assumes a $100 investment at the close of trading on January 27, 2005)
The following table sets forth selected consolidated financial information for the periods ended and as of the dates indicated. These historical results are not necessarily indicative of the results to be expected from any future period. You should read this selected consolidated financial data together with our consolidated financial statements and the related notes and the section of the Form 10-K entitled Managements Discussion and Analysis of Financial Condition and Results of Operations.
Please refer to Forward-Looking Statements following the Index in front of this 10-K.
The following discussion and analysis of our historical consolidated financial statements should be read in conjunction with our audited consolidated financial statements and the related notes included elsewhere in this Form 10-K.
We are a holding company with operations being conducted by our subsidiaries.
Our specialty property and casualty insurance companies are licensed in all 50 states, the District of Columbia and the Cayman Islands. We generate underwriting profits by providing what we view as specialized insurance products, services and programs not generally available in the marketplace. While many companies write property and casualty insurance for transportation companies, we believe that few write passenger transportation coverage nationwide and very few write coverage for several of the classes of passenger transportation insurance written by us and our subsidiaries. We focus on niche insurance markets where we offer insurance products designed to meet the unique needs of targeted insurance buyers that we believe are underserved by the insurance industry. These niche markets typically possess what we view as barriers to entry, such as being too small, too remote or too difficult to attract or sustain most competitors. Examples of products that we write for these markets include property and casualty insurance for transportation companies (29.3% of 2006 gross written premiums), captive programs for transportation companies that we refer to as our alternative risk transfer operations (44.3%), specialty personal lines, primarily recreational vehicle coverage (17.0%) and transportation and general commercial insurance in Hawaii and Alaska (7.6%). We strive to become a market leader in the specialty markets that we choose and serve by offering what we believe are specialized products, excellent customer service and superior claims response.
We write insurance for various sizes of transportation fleets. Because of the amount of smaller fleets nationwide, we have more opportunities to write smaller risks than larger ones. When general economic conditions improve, entrepreneurs are encouraged to start new transportation companies, which typically commence operations as a smaller risk and a potential traditional insurance customer for us. During periods of economic downturn, such as immediately following September 11, 2001, smaller risks are more prone to failure due to a decrease in leisure travel and consolidation in the industry. An increase in the number of larger risks results in more prospective captive insurance customers. We do not believe that smaller fleets that generate annual premiums of less than $100,000 are large enough to retain the risks associated with participation in one of the captive programs we currently offer.
By offering insurance products to all sizes of risks, we believe we have hedged against the possibility that there will be a reduction in demand for the products we offer. We believe that we will continue to have opportunities to grow and profit with both traditional and alternative risk transfer customers based on our assumptions regarding future economic and competitive conditions. We generally incur low start-up costs for new businesses, typically less than $500,000 incurred over several quarters. We believe our flexible processes and scalable systems, along with controlled ramp up of businesses, allow us to manage costs and match them with the revenue flow.
The factors that impact our growth rate are consistent across all products. However, the trends impacting each of these factors may vary from time to time for individual products. Those factors are as follows:
The property and casualty insurance industry is cyclical. Historically, the industry has been characterized by periods of price competition and excess capacity (soft market) followed by periods of high premium rates and shortages of underwriting capacity (hard market). Since 2004, we believe that the commercial transportation market has been in the part of the cycle that can best be described as softening as compared to the peak of the hard market in 2002 and 2003. The cyclical nature of the industry impacts our business operations. Our business may be affected by the risks impacting the property and casualty insurance industry related to severe weather conditions, explosions, terrorist attacks and riots. For passenger transportation, distressed operators (whether distressed due to being insured by other insurance companies that have raised rates or exited the market, or due to having less than desirable risk characteristics) continue to be heavily marketed to us by brokers causing an increase in our new business declination rates. In addition, insurance rates for renewing policies for all transportation business remains relatively flat when compared to 2005 and lower than the increases attained from mid-2001 through 2004. Although the current condition of the market can be characterized as softening, the extent of the price competition we are currently experiencing is neither as significant nor as severe as we have previously experienced in other softening markets (e.g. 1999-2000).
Increased rate levels beyond those necessary to keep up with inflation and achieve our planned financial targets prior to 2004 and relatively flat pricing since 2004 have resulted in us attaining combined ratios better than our corporate objective of maintaining a combined ratio of 96.0% or lower. While our combined ratio may fluctuate from year to year, over the past five years we have exceeded our underwriting profit objective by achieving an average GAAP combined ratio of 84.2%. Our GAAP combined ratio was 83.5% in 2006, 82.6% in 2005, 83.5% in 2004, 80.3% in 2003 and 91.3% in 2002. We believe the following factors have contributed to this performance:
For weather-related events such as hurricanes, tornados and hailstorms, we conduct an analysis at least annually pursuant to which we input our in-force exposures (vehicle values in all states and property limits in Hawaii) into an independent catastrophe model that predicts our probable maximum loss at various statistical confidence levels. Our estimated probable maximum loss is impacted by changes in our in-force exposures as well as changes to the assumptions inherent in the catastrophe model. Hurricane and other weather-related events have not had a material negative impact on our past results. In 2006, we had no material impact on total losses incurred from hurricanes or other catastrophic events; however, severe hurricanes in the third and fourth quarter of 2005 resulted in approximately $3.4 million in total incurred losses.
Our transportation insurance business in particular also is affected by cost trends that negatively impact profitability such as inflation in vehicle repair costs, vehicle replacement parts costs, used vehicle prices, fuel costs and medical care costs. We routinely obtain independent data for vehicle repair inflation, vehicle replacement parts costs, used vehicle prices, fuel costs and medical care costs and adjust our pricing routines to attempt to more accurately project the future costs associated with insurance claims. Historically, these increased costs have not had a material adverse impact on our results. Of course, we would expect a negative impact on our future results if we fail to properly account for and project for these inflationary trends. Increased litigation of claims may also negatively impact our profitability.
As described below, the average revenue dollar per personal lines policy is significantly lower than typical commercial policies. Profitability in the specialty personal lines component is dependent on proper pricing and the efficiency of underwriting and policy administration. We continuously strive to improve our underwriting and policy issuance functions to keep this cost element as low as possible by utilizing current technology advances.
To succeed as a transportation underwriter and personal lines underwriter, we must understand and be able to quantify the different risk characteristics of the operations we consider quoting. Certain coverages are more stable and predictable than others and we must recognize the various components of the risks we assume when we write any specific class of insurance business. Examples of trends that can change and, therefore, impact our profitability are loss frequency, loss severity, geographic loss cost differentials, societal and legal factors impacting loss costs (such as tort reform, punitive damage inflation and increasing jury awards) and changes in regulation impacting the insurance relationship. Any changes in these factors that are not recognized and priced for accordingly will affect our future profitability. We believe our product management organization provides the focus on a specific risk class needed to stay current with the trends affecting each specific class of business we write.
We derive our revenues primarily from premiums from our insurance policies and income from our investment portfolio. Our underwriting approach is to price our products to achieve an underwriting profit even if it requires us to forego volume. As with all property and casualty companies, the impact of price increases is reflected in our financial results over time. Price increases on our in-force policies occur as they are renewed, which generally takes twelve months for our entire book of business and up to an additional twelve months to earn a full year of premium at the higher rate. Insurance rates charged on renewing policies have remained relatively flat in 2006 compared to 2005.
There are distinct differences in the timing of written premiums in traditional transportation insurance and our alternative risk transfer (captive) insurance components. We write traditional transportation insurance policies throughout all 12 months of the year and commence new annual policies at the expiration of the old policy. Under most captive programs, all members of the group share a common renewal date. These common renewal dates are scheduled throughout the calendar year. Any new captive program participant that joins after the common date will be written for other than a full annual term so its next renewal date coincides with the common expiration date of the captive program it has joined. Historically, most of our group captives had common renewal dates in the first six months of the year, but with the growth from new captive programs, we are now experiencing renewal dates
throughout the calendar year. The alternative risk transfer component of our business grew to 44.3% of total gross premium written during 2006 as compared to 38.4% in 2005.
The projected profitability from the traditional transportation and transportation captive businesses are substantially comparable. Increased investment income opportunities generally are available with traditional insurance but the lower acquisition expenses and persistence of the captive programs generally provide for lower operating expenses from these programs. The lower expenses associated with our captives generally offset the projected reductions in investment income potential. From a projected profitability perspective, we are ambivalent as to whether a transportation operator elects to purchase traditional insurance or one of our captive program options.
All of our transportation products, traditional or alternative risk transfer, are priced to achieve targeted underwriting margins. Because traditional insurance tends to have a higher operating expense structure, the portion of the premiums available to pay losses tends to be lower for a traditional insurance quote versus an alternative risk transfer insurance quote. We use a cost plus pricing approach that projects future losses based upon the insureds historic losses and other factors. Operating expenses, premium taxes, expenses and a profit margin are then added to the projected loss component to achieve the total premium to be quoted. The lower the projected losses, expenses and taxes, the lower the total quoted premiums regardless of whether it is a traditional or alternate risk transfer program quotation. Quoted premiums are computed in accordance with our approved insurance department filings in each state.
Our specialty personal lines products are also priced to achieve targeted underwriting margins. The average premium per policy for this business component is significantly less than transportation lines.
We employ what we consider to be a conservative approach to investment and capital management with the intention of supporting insurance operations by providing a stable source of income to offset underwriting risk and growing income to offset inflation. The priority of goals of our investment policy are to preserve principal, generate income, maintain required liquidity and achieve capital appreciation. Our Board of Directors has established investment guidelines and reviews the portfolio performance quarterly for compliance with its established guidelines.
Our expenses consist primarily of losses and LAE; commissions and other underwriting expenses; and other operating and general expenses. Losses and LAE are a function of the amount and type of insurance contracts we write and of the loss experience of the underlying risks. We record losses and LAE based on an actuarial analysis of the estimated losses we expect to be reported on contracts written. We seek to establish case reserves at the maximum probable exposure based on our historical claims experience. Our ability to estimate losses and LAE accurately at the time of pricing our contracts is a critical factor in determining our profitability. The amount reported under losses and LAE in any period includes payments in the period net of the change in the value of the reserves for unpaid losses and LAE between the beginning and the end of the period. Commissions and other underwriting expenses consist principally of brokerage and agent commissions that represent a percentage of the premiums on insurance policies and reinsurance contracts written, and vary depending upon the amount and types of contracts written, and to a lesser extent ceding commissions paid to ceding insurers and excise taxes. Other operating and general expenses consist primarily of personnel expenses (including salaries, benefits and certain costs associated with awards under our equity compensation plans, such as stock compensation expense associated with the adoption of Statement of Financial Accounting Standards (SFAS) No. 123(R) and other general operating expenses. Other than expenses relating to stock options and other equity grants, our personnel expenses are primarily fixed in nature and do not vary with the amount of premiums written. Interest expenses are disclosed separately from operating and general expenses.
Results of Operations
Our net earnings for 2006 were $35.7 million or $1.85 per share (diluted), compared to $30.3 million or $1.60 per share (diluted) recorded in 2005. Our earnings increased $5.4 million, or 17.9%, compared to the same period in 2005. There are several factors that contributed to the increase in net earnings, including continued growth in earned premium of $22.9 million, or 11.8%, primarily due to the addition of new captive programs and an increase in the number of participants in our existing captive programs. We also had favorable losses and LAE for 2006, which is evidenced by our 2006 loss and LAE ratio of 59.6%, a decrease from prior year of 0.8 percent. The current year losses and LAE include favorable development from prior years of $7.5 million. Also contributing to the increase in our net earnings in 2006 was an increase in investment income of $5.1 million, or 40.3%, due to higher interest rates available on our fixed income investments and growth in our cash flow from operations.
We operate our business as one segment property and casualty insurance. We manage this segment through a product management structure. The following table sets forth an analysis of gross premiums written by business component during the periods indicated:
The group captive programs, which focus on specialty or niche insurance businesses, provide various services and coverages tailored to meet specific requirements of defined client groups and their members. These services include risk management consulting, claims administration and handling, loss control and prevention, and reinsurance placement, along with providing various types of property and casualty insurance coverage. Insurance coverage is provided primarily to associations or similar groups of members and to specified classes of business of our agent partners.
Gross written premium includes both direct premium and assumed premium. During 2006, as a percent of total gross premiums written, the alternative risk transfer component of the business had the largest increase of $31.7 million or 5.9 percent compared to 2005. The growth in the alternative risk transfer component is primarily attributable to the addition in 2006 of seven new captive programs, which accounted for $14.4 million, or 45.4%, of the increase, as well as an increase in the number of participants in our existing captive programs. Additionally, to better offer an attractive group captive option to larger truck fleets, in 2006 one of our largest captive programs split into two captives. This new group captive opted to change their renewal date to October which resulted in an increase to gross written premium of $3.9 million.
As part of our captive programs, we have analyzed, on a quarterly basis, captive members loss performance on a policy year basis to determine if there would be a premium assessment to participants, or if there would be a return of premium to participants as a result of less than expected losses. Assessment premium and return of premium are recorded as adjustments to written premium (assessments increase written premium; returns of premium reduce written premium). Until 2006, this review has always generated net assessment premium. For the year ended December 31, 2006 and 2005, we recorded return of premium of $2.1 million and assessment of premium of $2.0 million, respectively, thus generating a $4.1 million year-over-year reduction in the alternative risk transfer
components written premium. Exclusive of this $4.1 million reduction to gross written premium, the captive business would have shown an increase in growth over 2005 of $35.9 million, or 35.4%.
Also contributing to the increase in the gross premiums written in 2006 was an increase in the specialty personal lines component of $6.1 million or 13.3% as compared to 2005. The increase is primarily related to a moderate rate increase as well as an increase in the number of policies in force associated with the recreational and companion auto vehicle programs.
The decrease in the transportation component of $1.4 million for the year ended December 31, 2006 compared to 2005, is the result of our continued application of our underwriting discipline even in a softening market with increased competition. Our underwriting approach is to price our products to achieve an underwriting profit even if we forgo volume as a result. Based on the number of accounts, our retention rates for traditional transportation are comparable between 2006 and 2005; however, we are experiencing a trend of competitive pricing on larger traditional accounts impacting premium to a greater degree than in prior periods. For 2006 we maintained flat rate levels on renewing commercial insurance business while our renewal hit ratios have been deteriorating to historic levels from the elevated levels we had in 2003 and 2004.
Due primarily to an increase in our Alaska business in 2006, our Hawaii and Alaska component increased $0.8 million for the year ended December 31, 2006 compared to 2005. Our Other component is primarily related to assigned risk policies that we receive from involuntary state insurance plans and over which we have no control. This component decreased $1.8 million from 2005.
2006 compared to 2005. The following table shows revenues for the years ended December 31, 2006 and 2005 summarized by the broader business component description, which were determined based primarily on similar economic characteristics, products and services:
Our premiums earned increased $22.9 million, or 11.8%, to $217.3 million during the year ended December 31, 2006 compared to $194.4 million for the year ended December 31, 2005. Our alternative risk transfer component increased 25.7% during 2006 compared to the same period in 2005, primarily due to new captive programs that were written in 2006 and the fourth quarter of 2005 and new participants in existing group captive programs. Our Alternative Risk Transfer business remains our fastest growing component. Due to moderate rate increases and an increase in the number of policies in force primarily from expanded distribution, our specialty personal lines component increased 20.4% in 2006 compared to 2005. The transportation component remained relatively constant in 2006 compared to 2005. In the transportation component, we are still feeling the effects from a $0.7 million decline in premium from a reinsurance arrangement involving primarily physical damage coverage on trucks and seeing a decline in renewal rate increases due to the current softening market. Our Other component, which is comprised primarily of premium from assigned risk plans from the states in which our insurance company subsidiaries operate, and over which we have no control, decreased $2.0 million, or 19.8%, to $8.2 million in 2006.
2005 compared to 2004. The following table shows revenues for the years ended December 31, 2005 and 2004 summarized by the broader business component description, which were determined based primarily on similar economic characteristics, products and services:
Our net premiums earned increased $37.5 million, or 23.9%, to $194.4 million during the year ended December 31, 2005 compared to $156.9 million for the year ended December 31, 2004. Our alternative risk transfer component increased 65.0% during 2005 compared to the same period in 2004, primarily due to new captive programs and new participants in existing captive programs. During 2005 and prior periods, our alternative risk transfer business was one of the fastest growing components of our business. A portion of the new customers in the alternative risk transfer component were larger premium customers that were previously in our transportation component. Due to an increase in the number of policies in force primarily from expanded distribution, our specialty personal lines component increased 35.9% in 2005 compared to 2004. The transportation component remained relatively constant in 2005 compared to 2004. The slight decrease in the transportation component is primarily due to (i) a decline in assumed premium from a reinsurance arrangement involving primarily physical damage coverage on trucks because the company with whom we had the agreement elected to exit the business and (ii) larger premium customers moving from the transportation component to our captive programs in the alternative risk transfer component. Our Other component, which is comprised primarily of premium from assigned risk plans from the states in which our insurance company subsidiaries operate, increased 70.5% or $4.2 million to $10.3 million in 2005. The increase in this component was primarily due to an increase in our assigned risk premiums.
Underwriting profitability, as opposed to overall profitability or net earnings, is measured by the combined ratio. The combined ratio is the sum of the loss and LAE ratio and the underwriting expense ratio. A combined ratio under 100% is indicative of an underwriting profit.
Our underwriting approach is to price our products to achieve an underwriting profit even if we forego volume as a result. From 2000 through 2005, our insurance subsidiaries increased their premium rates to offset rising losses and reinsurance costs. We have maintained flat rate levels on renewal business in 2006 as compared to the increase in rates in 2005,2004 and 2003.
The table below presents our premiums earned and combined ratios for the periods indicated:
2006 compared to 2005. Losses and LAE increased $12.0 million, or 10.3%, for 2006 compared to 2005. The loss and LAE ratio for the year ended December 31, 2006 was 59.6% compared to 60.4% for the year ended December 31, 2005. The decrease in the loss and LAE ratio in 2006 of 0.8 percent is primarily due to favorable development of $7.5 million from prior years loss reserves compared to favorable development in 2005 of $5.2 million. The increase in favorable development lowered the loss ratio by 0.8 percent. Consistent with prior years, we strive to be accurate, but tend to be conservative with our loss reserving methodology in areas where we are still experiencing double digit growth patterns. The favorable development for both years was primarily the settlements below the established case reserves and revisions to our estimated future settlements on an individual case by case basis. This savings represents just under 5% (4.9% and 4.7% for 2006 and 2005, respectively) of the prior year reserves.
Commissions and other underwriting expenses consist principally of brokerage and agent commissions that represent a percentage of the premiums on insurance policies and reinsurance contracts written, and vary depending upon the amount and types of contracts written, and ceding commissions paid to ceding insurers and excise taxes. The commissions and other underwriting expenses increased $6.9 million for 2006 compared to 2005. This increase in the commissions and other underwriting expenses is primarily due to an increase in commissions, premium taxes and other related expenses which are directly impacted by the growth in gross written premiums, and by two reclassifications that were made in 2005, which reduced the commissions and other underwriting expenses in that year, as noted below.
The underwriting expense ratio for the year ended December 31, 2006 increased 1.7 percent to 23.9% compared to 22.2% for the year ended December 31, 2005. The increase in the expense ratio is due to an increase in other operating and general expenses such as increased audit fees due to the audit of our insurance companies coordinated by the Ohio Department of Insurance ($0.2 million), the impact of stock based compensation expense recognized in 2006 ($0.8 million) and other costs associated with our growth and with being a publicly traded corporation. Also impacting the change in the expense ratio were two items that occurred in 2005 i) a reduction in estimated expenses for insolvencies and other state fees and ii) classifying business related to our assigned risks on a gross basis. These items reduced the 2005 expense ratio by 1.5 percent and are discussed in further detail below. When taking these items into consideration the expense ratio remained consistent from 2005 to 2006.
2005 compared to 2004. The loss and LAE ratio for the year ended December 31, 2005 was 60.4% compared to 58.6% for the year ended December 31, 2004. The increase in the loss and LAE ratio from 2004 to 2005 of 1.8 percent is primarily due to the fact that approximately 75% of the increase in premiums earned in 2005 was produced by the alternative risk transfer and other component. Historically, these components have higher loss and
LAE ratios than our traditional components; and as a result had the effect of raising the loss ratio in 2005. This increase is mostly offset by a $5.2 million favorable development of prior year loss reserves. We consider the variance in the loss and LAE ratio of 1.8 percent for the year ended December 31, 2005 compared to the year ended December 31, 2004 to be consistent with managements expectations that losses would deteriorate slightly based on our flat renewal rates and historical loss patterns.
The underwriting expense ratio for the year ended December 31, 2005 decreased 2.7 points to 22.2% compared to 24.9% for the year ended December 31, 2004. The decrease in the underwriting expense ratio is primarily a result of four factors: increased risk retention, continued leverage of our fixed expense, a reduction in our estimated expenses for insolvencies and other state fees and recording of assigned business. In November 2004, we increased our risk retention on public transportation products, which contributes to a decrease in our expense ratio as the additional retained written premium is earned. While expenses are higher in response to building our infrastructure and other related expenses of operating as a public entity, our overall increase in fixed expenses was lower than the revenue growth for the year ended December 31, 2005. Using data available from the National Conference of Insurance Guarantee Funds, we reduced our estimated expenses for insolvencies and other state fees during the third quarter of 2005. The reduction in estimated expenses reduced our underwriting expense ratio by 0.7 percent. We record our assigned risk premium quarterly based on reports from various states and agencies that manage the plans. The assignments are based on our written premium for specific coverages in certain states. We have written workers compensation insurance in several states beginning in 2004. Due to the lack of sufficient detail because the plans report to us on a lag, our estimated net share of the assigned risks were charged to commissions and other underwriting expenses, with a like amount recorded as assessments and fees payable in the correct periods. During the third and fourth quarter of 2005, sufficient information was obtained to enable us to classify the business on a gross basis, including premiums earned and losses and LAE. While this had no impact on net income, it reduced our underwriting expense ratio by 0.8 percent.
2006 compared to 2005. Net investment income increased $5.1 million, or 40.3%, to $17.6 million for the year ended December 31, 2006 compared to the same period in 2005. The increase is primarily related to a growth in average cash and invested assets over the same period and a higher yield on the fixed income portfolio. The growth in cash and invested assets is due to positive cash flow from operations and the reinvestment of earnings.
2005 compared to 2004. Net investment income increased $3.9 million, or 45.4% to $12.5 million in 2005 compared to 2004, due primarily to a growth in average cash and invested assets over the same period. The increase in cash and invested assets reflected the growth in premiums written and the proceeds, net of debt repayment, of $25.4 million from the IPO in February of 2005.
2006 compared to 2005. Net realized gains increased $0.9 million to $1.2 million for 2006 compared to net realized gains of $0.3 million for 2005. Realized gains are taken when opportunities arise. The realized gains in 2006 and 2005 were primarily generated from sales of equity holdings. When evaluating fixed maturity sales opportunities, we do not have any specific thresholds that would cause us to sell these securities prior to maturity. We consider multiple factors, such as reinvestment alternatives and specific circumstances of the investment currently held. Credit quality, portfolio allocation and other-than-temporary impairment are other factors that may encourage us to sell a fixed maturity security prior to maturity at a gain or loss. Historically, and during the most recent extended low interest rate period, we have not had the need to sell our investments to generate liquidity.
2005 compared to 2004. Net realized gains decreased $1.4 million to $0.3 million for 2005 compared to net realized gains of $1.7 million for 2004. The net realized gain in 2005 was partially offset by an other-than-temporary impairment adjustment of $0.3 million recognized in 2005. The decrease in net realized gains in 2005 was due to fewer sales opportunities in the fixed income market in 2005.
2006 compared to 2005. Other operating and general expenses increased $2.2 million, or 23.2% to $11.6 million during the year ended December 31, 2006 compared to $9.4 million for the same period in 2005. These increases reflect the continuing growth in our business, stock compensation expense recognized for SFAS No. 123(R) and additional costs incurred related to being a publicly traded company.
2005 compared to 2004. Other operating and general expenses increased $2.5 million, or 36.9% to $9.4 million during the year ended December 31, 2005 compared to $6.9 million for the same period in 2004. These increases reflect the continuing growth in our business and additional costs incurred related to being a publicly traded company.
The 2006 effective tax rate was 32.9%, remaining unchanged from 2005. While the low tax rate on profits generated by HMG reduced the effective tax rate by approximately 1.7%, that reduction was offset by an increase in income tax expense from the non-deductibility of certain expenses. See Note 8 to our audited consolidated financial statements for further analysis of items affecting our effective tax rate.
At December 31, 2006, our investment portfolio contained $327.4 million in fixed maturity securities and $34.1 million in equity securities, all carried at fair value with unrealized gains and losses reported as a separate component of shareholders equity on an after-tax basis. At December 31, 2006, we had pretax net unrealized losses of $5.1 million on fixed maturities and pretax unrealized gains of $0.6 million on equity securities.
At December 31, 2006, 99.1% of the fixed maturities in our portfolio were rated investment grade (credit rating of AAA to BBB) by Standard & Poors Corporation. Investment grade securities generally bear lower yields and lower degrees of risk than those that are unrated or non-investment grade.
Summary information for securities with unrealized gains or losses at December 31, 2006 follows:
The table below sets forth the scheduled maturities of fixed maturity securities at December 31, 2006 based on their fair values:
The table below summarizes the unrealized gains and losses on fixed maturities and equity securities by dollar amount:
When a decline in the value of a specific investment is considered to be other than temporary, a provision for impairment is charged to earnings (accounted for as a realized loss) and the cost basis of that investment is reduced. The determination of whether unrealized losses are other than temporary requires judgment based on subjective as well as objective factors. Factors considered and resources used by management include those discussed in Managements Discussion and Analysis of Financial Condition and Results of Operations Other-Than-Temporary Impairment.
Net realized gains on securities sold and charges for other-than-temporary impairment on securities held were as follows:
Liquidity and Capital Resources
Capital Ratios. The National Association of Insurance Commissioners model law for risk based capital (RBC) provides formulas to determine the amount of capital and surplus that an insurance company needs to ensure that it has an acceptable expectation of not becoming financially impaired. At December 31, 2006 and 2005, the capital and surplus of all our insurance companies substantially exceeded the RBC requirements.
Sources of Funds. The liquidity requirements of our insurance subsidiaries relate primarily to the liabilities associated with their products as well as operating costs and payments of dividends and taxes to us from insurance subsidiaries. Historically cash flows from premiums and investment income have provided more than sufficient funds to meet these requirements without requiring the sale of investments. If our cash flows change dramatically from historical patterns, for example as a result of a decrease in premiums or an increase in claims paid or operating expenses, we may be required to sell securities before their maturity and possibly at a loss. Our insurance subsidiaries generally hold a significant amount of highly liquid, short-term investments to meet their liquidity needs. Funds received in excess of cash requirements are generally invested in additional marketable securities. Our historic pattern of using receipts from current premium writings for the payment of liabilities incurred in prior periods has enabled us to extend slightly the maturities of our investment portfolio beyond the estimated settlement date of our loss reserves.
Our insurance subsidiaries generate liquidity primarily by collecting and investing premiums in advance of paying claims. We believe that our insurance subsidiaries maintain sufficient liquidity to pay claims and operating expenses, as well as meet commitments in the event of unforeseen events such as reserve deficiencies, inadequate premium rates or reinsurer insolvencies. Our principal sources of liquidity are our existing cash, cash equivalents, and short-term investments. Cash, cash equivalents and short-term investments were $44.9 million at December 31, 2006, a $29.5 million increase from December 31, 2005. For 2006, 2005 and 2004, we generated consolidated cash flow from operations of $83.3 million, $76.5 million, $56.9 million and $45.4 million, respectively. The increase of $6.8 million in 2006 is attributable to an increase in net income of $5.4 million, as well as various fluctuations within the operating activities associated with our growth.
Net cash used in investing activities was $65.8 million and $107.8 million for the years ended December 31, 2006 and 2005, respectively. The $42.0 million decrease in cash used in investing activities was primarily related to a $22.0 million decrease in the purchase of investments in 2006 and an $11.5 million increase in the proceeds from sales and maturities of investments as compared to 2005. Also impacting investing activities was the purchase, by NIIC, of an office building adjacent to our headquarters in Richfield, Ohio. The building was purchased for $7.0 million. An additional payment of $1.2 million was also made on January 3, 2006 for the remaining balance of the purchase price associated with the acquisition of TCC. As part of this acquisition, we acquired $5.6 million in cash and cash equivalents.
We utilized net cash from financing activities of $2.9 million and provided net cash of $22.9 million, respectively, for the years ended December 31, 2006 and 2005. The $25.8 million decrease in cash generated from financing activities primarily relates to the initial public offering completed in February 2005 whereby we sold 3,350,000 shares of common stock, generating approximately $40.4 million of net proceeds. We used the net proceeds for the repayment in full of a $15.0 million loan plus the accrued interest from Great American, our majority shareholder, and the remainder is currently being used as needed for general corporate purposes and potential growth opportunities.
We will have continuing cash needs for administrative expenses, the payment of principal and interest on borrowings, shareholder dividends and taxes. Funds to meet these obligations will come primarily from dividend and tax payments from our insurance company subsidiaries and from our line of credit. Under the state insurance laws, dividends and capital distributions from our insurance companies are subject to restrictions relating to statutory surplus and earnings. The maximum amount of dividends that our insurance companies could pay to us without seeking regulatory approval in 2006 is $26.6 million. Our insurance subsidiaries paid $3.0 million and $0 in dividends in 2006 and 2005, respectively, without the need for regulatory approval.
Under tax allocation and cost sharing agreements among NIC and its subsidiaries, taxes and expenses are allocated among the entities. The federal income tax provision of our individual subsidiaries is computed as if the subsidiary filed a separate tax return. The resulting provision (or credit) is currently payable to (or receivable from) us.
In May 2003, we purchased the outstanding common equity of a business trust that issued mandatorily redeemable preferred capital securities. The trust used the proceeds from the issuance of its capital securities and common equity to buy $15.5 million of debentures issued by us. These debentures are the trusts only assets and mature in 2033. The interest rate is equal to the three-month LIBOR (5.37% at December 31, 2006 and 4.41% at December 31, 2005) plus 420 basis points with interest payments due quarterly. Payments from the debentures finance the distributions paid on the capital securities. We have the right to redeem the debentures, in whole or in part, on or after May 23, 2008. We used the net proceeds from the debentures to fund our obligations to our subsidiaries and to increase the capitalization of our insurance company subsidiaries.
We also have a $2.0 million line of credit (unused at December 31, 2006) that bears interest at the lending institutions prime rate (8.25% at December 31, 2006 and 7.25% at December 31, 2005) less 50 basis points and requires an annual commitment fee of $1 thousand. In accordance with the terms of the line of credit agreement, interest payments are due monthly and the principal balance is due upon demand. The line of credit is available currently, and has been used in the past, for general corporate purposes, including the capitalization of our insurance company subsidiaries in order to support the growth of their written premiums. We may request an increase in this line of credit in the future based on liquidity and capital needs, although we have no immediate plans to do so.
In August 2006, our unsecured four-year term loan matured and the balance was paid off.
We believe that the cash and short term investments at December 31, 2006, funds generated from operations and funds available under our line of credit will provide sufficient resources to meet our liquidity requirements for at least the next 12 months. However, if these funds are insufficient to meet fixed charges in any period, we would be required to generate cash through additional borrowings, sale of assets, sale of portfolio securities or similar transactions. Historically, we have not had the need to sell our investments to generate liquidity. If we were forced to sell portfolio securities early for liquidity purposes rather than holding them to maturity, we could recognize gains or losses on those securities earlier than anticipated. If we were forced to borrow additional funds in order to meet liquidity needs, we would incur additional interest expense which would have a negative impact on our earnings. Since our ability to meet our obligations in the long term (beyond a 12-month period) is dependent upon factors such as market changes, insurance regulatory changes and economic conditions, no assurance can be given that the available net cash flow will be sufficient to meet our operating needs.
At December 31, 2005, we had $11.7 million held in an escrow account for the purchase of TCC from Triumphe Insurance Holdings LLC by NIIC. The $11.7 million that was held in an escrow account is shown on the December 31, 2005, Consolidated Balance Sheet in Other Assets. On January 3, 2006, the first business day after the January 1 effective date of the purchase, the funds were released from the escrow account. We made a second payment of $1.2 million for the remaining balance of the purchase price.
Off-Balance Sheet Items. We do not have any off-balance sheet arrangements (as such term is defined in applicable Securities and Exchange Commission rules) that are reasonably likely to have a current or future material effect on our financial condition, results of operations, liquidity, capital expenditures or capital resources.
Contractual Obligations. The following table summarizes our long-term contractual obligations as of December 31, 2006:
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect amounts reported in the financial statements. As more information becomes known, these estimates and assumptions could change and impact amounts reported in the future. Management believes that the establishment of loss and LAE reserves and the determination of other-than-temporary impairment on investments are two areas where by the degree of judgment required to determine amounts recorded in the financial statements make the accounting policies critical. We discuss these two policies below. Our other significant accounting policies are described in Note 2 to our consolidated financial statements.
Loss and Loss Adjustment Expenses Reserves
Significant periods of time can elapse between the occurrence of an insured loss, the reporting of that loss to us and our final payment of that loss, and its related LAE. To recognize liabilities for unpaid losses, we establish reserves as balance sheet liabilities. At December 31, 2006 and 2005, we had $266.0 million and $223.2 million, respectively, of gross losses and LAE reserves, representing managements best estimate of the ultimate loss. Management records on a monthly and quarterly basis its best estimate of loss reserves. For purposes of computing the recorded reserves, management utilizes various data inputs, including analysis that is derived from a review of prior quarter results performed by actuaries employed by Great American. In addition, on an annual basis, actuaries from Great American review the recorded reserves for NIIC, NIIC-HI and TCC utilizing current period data and provide a Statement of Actuarial Opinion, required annually in accordance with state insurance regulations, on the statutory reserves recorded by these U.S. insurance subsidiaries. The actuarial analysis of NIICs, NIIC-HIs and TCCs (for 2006, as we acquired TCC on January 1, 2006) net reserves as of December 31, 2006 and 2005 reflected point estimates that were within 1% of managements recorded net reserves as of such dates. Using this actuarial data along with its other data inputs, management concluded that the recorded reserves appropriately reflect managements best estimates of the liability as of each year end.
The quarterly reviews of unpaid loss and LAE reserves by Great American actuaries are prepared using standard actuarial techniques. These may include (but may not be limited to):
Supplementary statistical information is reviewed to determine which methods are most appropriate and whether adjustments are needed to particular methods. This information includes:
An important assumption underlying reserve estimates is that the cost trends implicitly built into development patterns will continue into the future. The sensitivity of recorded reserves to an unexpected change in the trends, is estimated by adding 1.0% to the trend that is embedded in the factors used to determine the reserves for ultimate liabilities. This unexpected change could arise from a variety of sources including a general increase in economic inflation, inflation from social programs, new medical technologies, or other factors such as those listed below in connection with our largest lines of business. The estimated cumulative unfavorable impact that this 1.0% change would have on our 2006 net income is shown below:
Commercial Auto Liability. In this line of business, we provide coverage protecting buses, limousines, other public transportation vehicles and trucking for accidents causing property damage or personal injury to others. Some of the important variables affecting our estimation of loss reserves for commercial auto liability include:
Workers Compensation. In this line of business, we provide coverage for employees who may be injured in the course of employment. Some of the important variables affecting our estimation of loss reserves for workers compensation include:
Within each line, Great American actuaries review the results of individual tests, supplementary statistical information and input from management to select their point estimate of the ultimate liability. This estimate may be one test, a weighted average of several tests, or a judgmental selection as the actuaries determine is appropriate. The actuarial review is performed each quarter as a test of the reasonableness of managements point estimate and to
provide management with a consulting opinion regarding the advisability of modifying its reserve setting assumptions for future periods. The Great American actuaries do not develop ranges of losses.
The level of detail at which data is analyzed varies among the different lines of business. We generally analyze data by major product or coverage, using countrywide data. We determine the appropriate segmentation of the data based on data volume, data credibility, mix of business and other actuarial considerations. Point estimates are selected based on test indications and judgment.
Claims we view as potentially significant are subject to a rigorous review process involving the adjuster, claims management and executive management. We seek to establish reserves at the maximum probable exposure based on our historic claims experience. Incurred but not yet reported, or IBNR reserves are determined separate from the case reserving process and include estimates for potential adverse development of the recorded case reserves. We monitor IBNR reserves monthly with financial management and quarterly with an actuary from Great American. IBNR reserves are adjusted monthly based on historic patterns and current trends and exposures. When a claim is reported, claims personnel establish a case reserve for the estimated amount of ultimate payment. The amount of the reserve is based upon an evaluation of the type of claim involved, the circumstances surrounding each claim and the policy provisions relating to the loss. The estimate reflects informed judgment of our claims personnel based on general insurance reserving practices and on the experience and knowledge of the claims personnel. During the loss adjustment period, these estimates are revised as deemed necessary by our claims department based on developments and periodic reviews of the cases. Individual case reserves are reviewed for adequacy at least quarterly by senior claims management.
When establishing and reviewing reserves, we analyze historic data and estimate the impact of various loss development factors, such as our historic loss experience and that of the industry, trends in claims frequency and severity, our mix of business, our claims processing procedures, legislative enactments, judicial decisions, legal developments in imposition of damages, and changes and trends in general economic conditions, including the effects of inflation. A change in any of these factors from the assumptions implicit in our estimate can cause our actual loss experience to be better or worse than our reserves, and the difference can be material. There is no precise method, however, for evaluating the impact of any specific factor on the adequacy of reserves. Currently established reserves may not prove adequate in light of subsequent actual occurrences. To the extent that reserves are inadequate and are increased or strengthened, the amount of such increase is treated as a charge to income in the period that the deficiency is recognized. To the extent that reserves are redundant and are released, the amount of the release is a benefit to income in the period that redundancy is recognized.
The changes we have recorded in our reserves in the past three years illustrate the potential for revisions inherent in estimating reserves. In 2006, we experienced favorable development of $7.5 million (4.9% of total net reserves) from claims incurred prior to 2006. In 2005, we experienced favorable development of $5.2 million (4.7% of total net reserves) from claims incurred prior to 2005. In 2004, we experienced favorable development of $2.3 million (2.6% of total net reserves) from claims incurred prior to 2004. We did not significantly change our reserving methodology or our claims settlement process in any of these years. The development reflected settlements that differed from the established case reserves, changes in the case reserves based on new information for that specific claim or the differences in the timing of actual settlements compared to the payout patterns assumed in our accident year IBNR reductions. The types of coverages we offer and risk levels we retain have a direct influence on the development of claims. Specifically, short duration claims and lower risk retention levels generally are more predictable and normally have less development. Future favorable or unfavorable development of reserves from this past development experience should not be assumed or estimated. The reserves reported in the financial statements are our best estimate.
The following table shows the breakdown of our reserves between case reserves (estimated amounts required to settle claims that have already been reported), IBNR reserves (estimated amounts that will be needed to settle claims that have already occurred but have not yet been reported to us, as well as reserves for possible development on known claims) and LAE reserves (estimated amounts required to adjust, record and settle claims, other than the claim payments themselves):
Gross Loss Reserves
Reinsurance Recoverables. We are also subject to credit risks with respect to our third party reinsurers. Although reinsurers are liable to us to the extent we cede risks to them, we are ultimately liable to our policyholders on all these risks. As a result, reinsurance does not limit our ultimate obligation to pay claims to policyholders and we may not be able to recover claims made to our reinsurers. We manage this credit risk by selecting what we believe to be quality reinsurers, closely monitoring their financial condition, timely billing and collecting amounts due and obtaining sufficient collateral when necessary.
Our investments are exposed to at least one of three primary sources of investment risk: credit, interest rate and market valuation risks. The financial statement risks are those associated with the recognition of impairments and income, as well as the determination of fair values. We evaluate whether impairments have occurred on a case-by-case basis. Management considers a wide range of factors about the security issuer and uses its best judgment in evaluating the cause and amount of decline in the estimated fair value of the security and in assessing the prospects for near-term recovery. Inherent in managements evaluation of the security are assumptions and estimates about the operations of the issuer and its future earnings potential. Considerations we use in the impairment evaluation process include, but are not limited to:
We closely monitor each investment that has a market value that is below its amortized cost and make a determination each quarter for other-than-temporary impairment for each of those investments. During the year ended December 31, 2006, we recorded no impairment adjustments. We recorded a $0.2 million impairment adjustment in 2005 and no impairment adjustments in 2004, respectively. None of the primarily fixed maturity securities that were in an unrealized loss position as of December 31, 2006, 2005 and 2004, were deemed to have any fundamental issues that would lead us to believe that they were other-than-temporarily impaired. Because total unrealized losses are a component of shareholders equity, any recognition of other-than-temporary impairment losses has no effect on our comprehensive income or book value. See Managements Discussions and Analysis of Financial Condition and Results of Operations Investments.
Market risk represents the potential economic loss arising from adverse changes in the fair value of financial instruments. Our exposures to market risk relate primarily to our investment portfolio, which is exposed to interest rate risk and, to a lesser extent, equity price risk. We have not entered, and do not plan to enter, into any derivative financial instruments for trading or speculative purposes.
Fixed Maturity Portfolio. The fair value of our fixed maturity portfolio is directly impacted by changes in interest rates, in addition to credit risk. Our fixed maturity portfolio is comprised of primarily fixed rate investments with primarily short-term and intermediate-term maturities. We believe this practice allows us to be flexible in reacting to fluctuations of interest rates. We manage the portfolios of our insurance companies to attempt to achieve an adequate risk-adjusted return while maintaining sufficient liquidity to meet policyholder obligations. We invest in an evolving mix of traditional fixed income and variable rate notes, including step-up rate and range notes, in our fixed maturity portfolio to capture what we believe are adequate risk-adjusted returns in an evolving investment environment.
The following table provides information about our available for sale fixed maturity investments that are sensitive to interest rate risk. The table shows expected principal cash flows and related weighted average interest rates by expected maturity date for each of the five subsequent years and collectively for all years thereafter. We include callable bonds and notes based on call date or maturity date depending upon which date produces the most conservative yield. Actual cash flows may differ from those expected.
Equity Risk. Equity risk is potential economic losses due to adverse changes in equity security prices. As of December 31, 2006, approximately 8.9% of the fair value of our investment portfolio (excluding cash and cash equivalents) was invested in equity securities. We manage equity price risk primarily through industry and issuer diversification and asset allocation techniques such as investing in exchange traded funds.
Selected Quarterly Financial Data has been included in Note 17 to the Consolidated Financial Statements.
We, as management of National Interstate Corporation, and its subsidiaries (the Company), are responsible for establishing and maintaining adequate internal control over financial reporting. Pursuant to the rules and regulations of the Securities and Exchange Commission, internal control over financial reporting is a process designed by, or under the supervision of, the Companys principal executive and principal financial officers, or persons performing similar functions, and effected by the Companys board of directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles and includes those policies and procedures that:
Management has evaluated the effectiveness of its internal control over financial reporting as of December 31, 2006, based on the control criteria established in a report entitled Internal Control Integrated Framework, issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on such evaluation, we have concluded that the Companys internal control over financial reporting is effective as of December 31, 2006.
The independent registered public accounting firm of Ernst & Young LLP, as auditors of the Companys consolidated financial statements, has issued an attestation report on managements assessment of the Companys internal control over financial reporting.
The Board of Directors and Shareholders
of National Interstate Corporation
We have audited the accompanying consolidated balance sheets of National Interstate Corporation and subsidiaries as of December 31, 2006 and 2005, and the related consolidated statements of income, shareholders equity, and cash flows for each of the three years in the period ended December 31, 2006. Our audits also included the financial statement schedules listed in the Index at Item 15(a). These financial statements and schedules are the responsibility of the Companys management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of National Interstate Corporation and subsidiaries at December 31, 2006 and 2005, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2006, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.
As discussed in Notes 2 and 9 to the consolidated financial statements, in 2006 the Company changed its method of accounting for stock-based compensation in accordance with the adoption of Statement of Financial Accounting Standards No. 123(R).
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of National Interstate Corporations internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 9, 2007, expressed an unqualified opinion thereon.
/s/ Ernst & Young LLP
March 9, 2007
ON INTERNAL CONTROL OVER FINANCIAL REPORTING
To the Board of Directors and Shareholders of
National Interstate Corporation
We have audited managements assessment, included in the accompanying Management Report on Internal Control over Financial Reporting, that National Interstate Corporation maintained effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). National Interstate Corporations management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on managements assessment and an opinion on the effectiveness of the companys internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating managements assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A companys internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A companys internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with U.S. generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the companys assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, managements assessment that National Interstate Corporation maintained effective internal control over financial reporting as of December 31, 2006, is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, National Interstate Corporation maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on the COSO criteria.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of National Interstate Corporation as of December 31, 2006 and 2005, and the related consolidated statements of income, shareholders equity, and cash flows for each of the three years in the period ended December 31, 2006 of National Interstate Corporation and our report dated March 9, 2007, expressed an unqualified opinion thereon.
/s/ Ernst & Young LLP
March 9, 2007
NATIONAL INTERSTATE CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
See notes to consolidated financial statements.
NATIONAL INTERSTATE CORPORATION AND SUBSIDIARIES
See notes to consolidated financial statements.
NATIONAL INTERSTATE CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS EQUITY
See notes to consolidated financial statements.
NATIONAL INTERSTATE CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS