Item 1 of Part I, “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources - Sources and Uses of Funds and - Capital Resources” in Item 7 of Part II, and the notes to the consolidated financial statements in Item 8 of Part II of this report.
Our common shareholders are not subject to taxes, including withholding provisions, under existing laws and regulations of the Cayman Islands.
Recent Sales of Unregistered Securities
None.
Item 6.
Selected Financial Data
The following information presented in this Item 6 Selected Financial Data includes historical financial data for United America Indemnity only, and excludes information relating to the business and operations of Penn-America Group and Penn Independent Group prior to our acquisition of them on January 24, 2005. Prior data relating to Penn-America Group, Inc. and Penn Independent Corporation can be found in our Current Report on Form 8-K/A, filed on April 7, 2005.
The following table sets forth selected consolidated historical financial data for United America Indemnity (“Successor”) and, for periods prior to September 5, 2003, Wind River Investment Corporation, which is considered United America Indemnity’s predecessor for accounting purposes (“Predecessor”). This selected financial data is derived from the consolidated financial statements and accompanying notes of United America Indemnity and Wind River Investment Corporation included elsewhere in this report. This selected historical financial data should be read together with the consolidated financial statements and accompanying notes of United America Indemnity and Wind River Investment Corporation and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included elsewhere in this report.
(1)
In 2002, we increased our net loss reserves relative to accident years 2001 and prior by $47.8 million primarily due to higher than anticipated losses in the multi-peril and other liability lines of business and by $23.6 million due to the conclusion of an arbitration proceeding. The net losses and loss adjustment expense ratio increased 43.9 points in 2002 due to this $71.4 million increase in net loss reserves.
(2)
Net losses and loss adjustment expenses for 2006 are net of a $7.0 million reserve release due to favorable development relative to construction defect losses as well as primary general liability, umbrella and excess, and asbestos and environmental losses and an $8.6 million reduction of our reinsurance reserve allowance. See “Results of Operations” in Item 7 of Part II of this report for a discussion of the impact of these items on the net losses and loss adjustment expenses and combined ratios.
(3)
We established an allowance for doubtful reinsurance receivables of $44.0 million in 2002, which resulted in a 27.0 percentage point increase in our 2002 underwriting expense ratio.
(4)
Our underwriting expense ratio for the period January 1, 2003 to September 5, 2003 includes a 4.7 percentage point increase attributable to a $4.2 million expense for stock appreciation rights and retention payments made to certain key executives upon completion of the acquisition and a $1.8 million allowance for doubtful reinsurance receivables.
(5)
Our discontinued operations consist of the net results of operations of our Agency Operations segment, including the gain on the sale of substantially all of the assets of our Agency Operations of $9.4 million.
(6)
The extraordinary gains of $1.4 million in 2005 and $1.2 million in 2004 represent the recognition of tax benefits derived from acquisition costs incurred in connection with the Acquisition, which are currently considered deductible for federal tax purposes. The $46.4 million excess of the estimated fair value of net assets over purchase price was recognized as an extraordinary gain in the consolidated statement of operations for the period September 6, 2003 to December 31, 2003.
(7)
Our insurance operating ratios are non-GAAP financial measures that are generally viewed as indicators of underwriting profitability. The net losses and loss adjustment expense ratio is the ratio of net losses and loss adjustment expenses to net premiums earned. The underwriting expense ratio is the ratio of acquisition costs and other underwriting expenses to net premiums earned. The combined ratio is the ratio of the sum of net losses, loss adjustment expenses, acquisition costs, and other underwriting expenses to net premiums earned.
(8)
Our net losses and loss adjustment expense ratios for 2005 and 2004 include $8.0 million and $1.7 million, respectively, of catastrophic losses related to hurricanes. See “Results of Operations” in Item 7 of Part II of this report for a discussion of the impact of these losses on the net losses and loss adjustment expense ratios for these years.
(9)
Our combined ratios for 2005 and 2004 include $8.0 million and $1.7 million, respectively, of catastrophic losses from named storms. See “Results of Operations” in Item 7 of Part II of this report for a discussion of the impact of these losses on the combined ratios. Our combined ratio for the period September 6, 2003 to December 31, 2003 includes $0.9 million of deferred compensation option expense. Our combined ratio for 2002 includes a 43.9 percentage point increase attributable to our $71.4 million reserve strengthening and a 27.0 percentage point increase attributable to establishment of a $44.0 million allowance for doubtful reinsurance receivables.
No cash dividends were declared on common stock in any year presented in the table.
Item 7.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the consolidated financial statements and accompanying notes of United America Indemnity included elsewhere in this report. Some of the information contained in this discussion and analysis or set forth elsewhere in this report, including information with respect to our plans and strategy, constitutes forward-looking statements that involve risks and uncertainties. Please see “Cautionary Note Regarding Forward-Looking Statements” at the end of this Item 7 and “Risk Factors” in Item 1A
Item 7A.
Quantitative and Qualitative Disclosures About Market Risk
Market Risk
Market risk is the risk of economic losses due to adverse changes in the estimated fair value of a financial instrument as the result of changes in interest rates, equity prices, credit risk, foreign exchange rates and commodity prices. Our consolidated balance sheet includes the estimated fair values of assets that are subject to market risk. Our primary market risks are interest rate risk and credit risks associated with investments in fixed maturities and equity price risk associated with investments in equity securities. Each of these risks is discussed in more detail below. We have no foreign exchange or commodity risk.
Interest Rate Risk
Our primary market risk exposure is to changes in interest rates. Our fixed income investments are exposed to interest rate risk. Fluctuations in interest rates have a direct impact on the market valuation of these securities. As interest rates rise, the market value of our fixed income investments fall, and the converse is also true. We expect to manage interest rate risk through an active portfolio management strategy that involves the selection, by our managers, of investments with appropriate characteristics, such as duration, yield, currency and liquidity, that are tailored to the anticipated cash outflow characteristics of our liabilities. Our strategy for managing interest rate risk also includes maintaining a high quality portfolio with a relatively short duration to reduce the effect of interest rate changes on book value. A significant portion of our investment portfolio matures each year, allowing for reinvestment at current market rates.
As of December 31, 2006, assuming identical shifts in interest rates for securities of all maturities, the table below illustrates the sensitivity of market value in United America Indemnity’s bonds to selected hypothetical changes in basis point increases and decreases:
Credit Risk
We have exposure to credit risk primarily as a holder of fixed income investments. Our investment policy requires that we invest in debt instruments of high credit quality issuers and limits the amount of credit exposure to any one issuer based upon the rating of the security.
In addition, we have credit risk exposure to our general agencies and reinsurers. We seek to mitigate and control our risks to producers by typically requiring our general agencies to render payments within no more than 45 days after the month in which a policy is effective and including provisions within our general agency contracts that allow us to terminate a general agency’s authority in the event of non-payment.
With respect to our credit exposure to reinsurers, we seek to mitigate and control our risk by ceding business to only those reinsurers having adequate financial strength and sufficient capital to fund their obligation. In addition, we seek to mitigate credit risk to reinsurers through the use of trusts and letters of credit for collateral. As of December 31, 2006, $642.9 million of collateral was held in trust to support the reinsurance receivables.
Equity Price Risk
The objective for our equity portfolio is to provide a total rate of return that exceeds the Russell 1000 Value index over the long run, with an overweighting towards dividend paying equities. Further, the equity portfolio will hold a high percentage of securities issued by companies with a significant historical record of having paid and increased their annual dividends. The equity portfolio will also be managed with a focus on tax-efficiency. Our equity strategy is based on the view that our core holdings should be a conservative, broadly diversified portfolio comprised of domestic large capitalization common stocks.
Seeking active returns, exclusively from stock selection means that we minimize all other portfolio risk for which we believe an investor is not adequately compensated, which includes market timing and sector, capitalization, and style biases. As part of our strategy, stocks are sold when their risk/return profile is no longer attractive.
We compare the results of our equity portfolio to the Russell 1000 Value Index, which is our benchmark index. To protect against equity price risk, the sector exposures within our equity portfolio closely correlate to the sector exposures within the Russell 1000 Value Index. In 2006, our common stock portfolio had a return of 21.67%, not including investment advisor fees, compared to the Russell 1000 Value Index which had a return of 22.24%.
The carrying values of investments subject to equity price risk are based on quoted market prices as of the balance sheet dates. Market prices are subject to fluctuation and thus the amount realized in the subsequent sale of an investment may differ from the reported market value. Fluctuation in the market price of a security results from perceived changes in the underlying economic makeup of a stock, the price of alternative investments and overall market conditions.
As of December 31, 2006, the table below summarizes our equity price risk and reflects the effect of a hypothetical 10%, and 20% increase or decrease in market prices. The selected hypothetical changes do not indicate what could be the potential best or worst scenarios.
Item 8.
Item 8. Financial Statements and Supplementary Data
UNITED AMERICA INDEMNITY, LTD.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and
Shareholders of United America Indemnity, Ltd.:
We have completed integrated audits of United America Indemnity, Ltd.’s consolidated financial statements and of its internal control over financial reporting as of December 31, 2006, in accordance with the standards of the Public Company Accounting Oversight Board (United States). Our opinions, based on our audits, are presented below.
Consolidated Financial Statements and Financial Statement Schedules
In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of United America Indemnity, Ltd. and its subsidiaries at December 31, 2006 and 2005, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2006 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedules listed in the accompanying index present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits of these statements 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 the financial statements are free of material misstatement. An audit of financial statements includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
Internal Control Over Financial Reporting
Also, in our opinion, management’s assessment, included in “Management’s Report on Internal Controls over Financial Reporting” appearing under Item 9A, that the Company 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 (COSO), is fairly stated, in all material respects, based on those criteria. Furthermore, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control - Integrated Framework issued by the COSO. The Company’s 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 opinions on management’s assessment and on the effectiveness of the Company’s internal control over financial reporting based on our audit. We conducted our audit of internal control over financial reporting 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. An audit of internal control over financial reporting includes obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we consider necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.
A company’s 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 company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable
assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with 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 (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s 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.
PricewaterhouseCoopers LLP
Philadelphia, Pennsylvania
March 16, 2007
UNITED AMERICA INDEMNITY, LTD.
Consolidated Balance Sheets
See accompanying notes to consolidated financial statements.
UNITED AMERICA INDEMNITY, LTD.
Consolidated Statements of Operations
See accompanying notes to consolidated financial statements.
UNITED AMERICA INDEMNITY, LTD.
Consolidated Statements of Comprehensive Income
See accompanying notes to consolidated financial statements.
UNITED AMERICA INDEMNITY, LTD.
Consolidated Statements of Changes in Shareholders’ Equity
See accompanying notes to consolidated financial statements.
UNITED AMERICA INDEMNITY, LTD.
Consolidated Statements of Cash Flows
See accompanying notes to consolidated financial statements.
UNITED AMERICA INDEMNITY, LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1.
Principles of Consolidation and Basis of Presentation
United America Indemnity, Ltd. (“United America Indemnity” or the “Company”), was incorporated on August 26, 2003, and is domiciled in the Cayman Islands. On January 24, 2005, the Company changed its name from United National Group, Ltd. to United America Indemnity, Ltd. The Company’s Class A common stock is publicly traded on the NASDAQ Global Market. On March 14, 2005, the Company changed its trading symbol on the NASDAQ Global Market from “UNGL” to “INDM.”
The Company offers three general classes of insurance products in the excess and surplus lines marketplace: Small Business, which markets to small commercial businesses through a select network of general agents having specific binding authority; Program, which markets insurance products for targeted insured segments, including specialty products, such as professional lines through program administrators having specific binding authority; and Specialty Wholesale, which markets property, casualty, and professional brokerage products, which are developed by the Company’s underwriting department by individuals with expertise in those lines of business, through wholesale brokers. Collectively, the Company’s U.S. insurance subsidiaries are licensed in all 50 states and the District of Columbia.
The consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America (“GAAP”), which differ in certain respects from those followed in reports to insurance regulatory authorities. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
The consolidated financial statements include the accounts of United America Indemnity and its wholly owned subsidiaries. All intercompany balances and transactions have been eliminated in consolidation.
The Company’s wholly-owned business trust subsidiaries, United National Group Capital Trust I (“UNG Trust I”), United National Group Capital Statutory Trust II (“UNG Trust II”), Penn-America Statutory Trust I (“Penn Trust I”) and Penn-America Statutory Trust II (“Penn Trust II”), are not consolidated pursuant to Financial Accounting Standards Board (“FASB”) Interpretation No. 46(R), “Consolidation of Variable Interest Entities” (“FIN 46R”). The Company’s business trust subsidiaries have issued $60.0 million in floating rate capital securities (“Trust Preferred Securities”) and $1.9 million of floating rate common securities. The sole assets of the Company’s business trust subsidiaries are $61.9 million of junior subordinated debentures issued by the Company, which have the same terms with respect to maturity, payments and distributions as the Trust Preferred Securities and the floating rate common securities.
In July 2005, Wind River Barbados, through a series of tax-exempt transactions, contributed the Company’s U.S. Subsidiaries to U.A.I. (Luxembourg) Investment S.à r.l.
Certain prior period amounts have been reclassified to conform to the current period presentation.
2.
Acquisition of Penn Independent Corporation and Merger with Penn-America Group, Inc.
Through a series of transactions on January 24, 2005, the Company acquired 100% of the voting equity interest of Penn-America Group, Inc. (together with its subsidiaries, “Penn-America Group”). The Company acquired 67.3% through the merger with Penn-America Group, Inc., 30.5% through the purchase of Penn Independent Corporation, which held common shares of Penn-America Group, Inc., and 2.2% in two separate transactions with individual shareholders.
Acquisition of Penn Independent Corporation
As stated in Note 4, the Company sold substantially all of the assets of its Agency Operations on September 30, 2006. This Note reflects the disclosures related to the purchase of Penn Independent and its subsidiaries.
UNITED AMERICA INDEMNITY, LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
On January 24, 2005, the Company acquired 100% of the voting equity interest of Penn Independent Corporation (together with its subsidiaries, “Penn Independent Group”), a wholesale insurance broker and underwriting manager for all types of commercial and industrial accounts, from Penn Independent Group’s shareholders for $98.5 million in cash. Penn Independent Group also owns, through its wholly owned subsidiary PIC Holdings, Inc., 30.5% of the voting equity interest of Penn-America Group, Inc. Upon the acquisition of Penn Independent Group, the Company also indirectly acquired Penn Independent Group’s shares of Penn-America Group, Inc. common stock. In accordance with the terms of the acquisition, $6.0 million of the purchase price was placed in escrow on January 24, 2005 to secure potential indemnification for pre-closing taxes and damages resulting from breach of warranties, representations or covenants due to the Company under the terms of the stock purchase agreement between the Company, Penn Independent Corporation, its former principal shareholders and Irvin Saltzman. All escrowed funds due to Irvin Saltzman have been released. The Company has filed no claims under the escrow agreement to date.
The $98.6 million purchase price, which includes transaction related expenses, was allocated to the acquired assets and liabilities which were adjusted to their estimated fair value. The transaction was accounted for using the purchase method of accounting. The $17.1 million excess of cash and acquisition costs over the estimated fair value of assets acquired was recognized as goodwill.
Acquired intangible assets of $7.1 million were as follows:
Purchases of Penn-America Group, Inc. Common Shares from Individual Shareholders
On January 24, 2005, in a series of related transactions, the Company acquired all shares of Penn-America Group, Inc. common stock owned by members of the Saltzman family, including all shares of common stock issued upon the exercise of vested options to acquire shares of Penn-America Group, Inc. common stock, for $13.53 a share in cash. The Saltzman family and trusts controlled by them constituted 100% of the Penn Independent Corporation shareholders prior to the acquisition by United America Indemnity.
Merger with Penn-America Group, Inc.
On January 24, 2005, the Company acquired 67.3% of the voting equity interest of the Penn-America Group, Inc., a specialty property and casualty insurance holding company, for $15.3 million in cash and approximately 7.9 million Class A common shares of United America Indemnity in a transaction classified as a merger. Under the terms of the merger agreement, Penn-America Group, Inc. shareholders received $15.375 of value for each share of Penn-America Group, Inc. common stock as follows: 1) 0.7756 of a Class A common share of United America Indemnity, based on $13.875 divided by the volume weighted average sales price of United America Indemnity’s Class A common shares for the 20 consecutive trading days ending January 21, 2005, which was $17.89, and 2) $1.50 per share in cash. Penn-America Group’s results of operations are included in the Company’s results of operations subsequent to the date of the merger.
UNITED AMERICA INDEMNITY, LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The Company’s primary reasons for the merger were to: 1) strengthen its position in the highly competitive specialty property and casualty insurance industry; 2) achieve enhanced growth opportunities arising from a balanced business model, improved financial flexibility, and strong cash flow; and 3) achieve a financial base and scale capable of delivering enhanced value to customers.
In connection with the merger with Penn-America Group, Inc., the acquisition of Penn Independent Corporation, and the transactions with individual shareholders on January 24, 2005, the $249.4 million purchase price, which includes transaction related expenses, was allocated to the estimated fair values of the acquired assets and liabilities as follows (dollars in thousands):
The transaction was accounted for using the purchase method of accounting. The $84.9 million excess of cash, fair value of United America Indemnity’s Class A common shares exchanged, other consideration, and acquisition costs over the estimated fair value of the net assets acquired was recognized as goodwill.
UNITED AMERICA INDEMNITY, LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
In connection with the merger of Penn-America Group, Inc., the assets and liabilities acquired by the Company were adjusted to fair value. Accordingly, the fair values of the reserve for unpaid losses and loss adjustment expenses and reinsurance receivables were estimated by (1) discounting the gross reserve for unpaid losses and loss adjustment expenses and reinsurance receivables, (2) applying a risk margin to the gross reserves and reinsurance receivables and (3) reducing gross reinsurance receivables by an amount equal to an estimate of potentially uncollectible reinsurance receivables as of the acquisition date. The factor (3) did not affect net reinsurance receivables materially because Penn-America Group, Inc. had recorded an allowance for uncollectible reinsurance, which was considered a reasonable estimate of the credit risk inherent in the reinsurance receivables as of the acquisition date.
Penn-America Group, Inc. discounted the reserve for unpaid losses and loss adjustment expenses and reinsurance receivables based on the present value of the expected underlying cash flows using a risk-free interest rate of 3%, which approximated the U.S. Treasury rate on the acquisition date. The discounting pattern was developed by Penn-America Group, Inc.’s actuarial department based on historical loss data.
The risk margin applied to the discounted reserve for unpaid losses and loss adjustment expenses and reinsurance receivables was approximately 9% and intended to reflect management’s estimate of the cost Penn-America Group, Inc. would incur to reinsure the full amount of its unpaid losses and loss adjustment expenses with a third-party reinsurer. This risk margin was based upon management’s assessment of the uncertainty inherent in the reserve for unpaid losses and loss adjustment expenses and their knowledge of the reinsurance marketplace.
As a result of these two adjustments, the fair value of the reserve for losses and loss adjustment expenses and reinsurance receivables was reduced by $19.5 million as of the acquisition date.
As of the acquisition date, Penn-America Group, Inc. adjusted its gross and net unearned premium reserves to fair value by (1) discounting the unearned premium reserves and (2) applying a risk margin to the unearned premium reserves. The risk margin utilized to record the gross unearned premium reserves at fair value was 25%. A slightly lower 20% risk margin was utilized to calculate the net unearned premium reserves because of the shorter period of the underlying exposures, which produces a lower degree of variability in the embedded future profits. Penn-America Group, Inc. discounted the unearned premium reserves based on the present value of the expected underlying cash flows using a risk-free interest rate of 3%, which approximated the U.S. Treasury rate on the acquisition date. The discounting pattern was developed by Penn-America Group, Inc.’s actuarial department based on historical loss data.
As a result of these adjustments, the fair value of the gross unearned premium reserves was reduced by $26.3 million as of January 24, 2005, with a $5.2 million decrease in prepaid reinsurance premiums, thereby resulting in an $21.1 million decrease in the net unearned premium reserves. The adjustments to the gross and net unearned premium reserves had a directly proportional impact to gross and net premiums earned.
Acquired intangible assets of $25.4 million were as follows:
UNITED AMERICA INDEMNITY, LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Penn-America Group, Inc. leased its home office facility in Hatboro, Pennsylvania from Irvin Saltzman through October 18, 2005, and the lease was accounted for as a capital lease. On October 19, 2005, AIS, an indirect wholly owned subsidiary of the Company, purchased the Hatboro facility from Irvin Saltzman for $5.5 million in cash, and incurred $0.1 million in expenses related to the acquisition.
3.
Summary of Significant Accounting Policies
Investments
The Company’s investments in bonds, preferred stock, and common stock are classified as available for sale and are carried at their fair value. The difference between amortized cost and fair value of these investments, excluding the derivative components of the Company’s convertible bond and preferred stock portfolios, net of the effect of deferred income taxes, is reflected in accumulated other comprehensive income in shareholders’ equity and, accordingly, has no effect on net income other than for impairments deemed to be other than temporary. The difference between amortized cost and fair value of the derivative components of the bonds is included in income.
At December 31, 2006, the Company held $22.1 million of convertible bonds and $4.4 million of convertible preferred stock. The convertible bonds include convertible options with a market value of $5.5 million and the convertible preferred stocks include convertible options with market value of $0.9 million. The change in the difference between the amortized cost and the market value of the options is included in income as a component of net realized investments gains/(losses). The Company realized a $1.6 million gain, a $1.2 million loss, and a $0.3 million gain for the years ended December 31, 2006, 2005, and 2004, respectively, due to market value changes related to options. See “New Accounting Pronouncements” below for a discussion of the impact of adopting SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments an amendment of FASB Statements No. 133 and 140” on accounting for the change in the difference between the amortized cost and the market value of the options.
The Company’s investments in other invested assets are comprised primarily of limited liability partnership interests. Partnership interests of 3% ownership or greater are accounted for using the equity method. The change in the difference between amortized cost and fair value of partnership interests of 3% ownership or greater, net of the effect of deferred income taxes, is reflected in income. Partnership interests of less than 3% ownership are carried at their fair value. The change in the difference between amortized cost and fair value of partnership interests of less than 3% ownership, net of the effect of deferred income taxes, is reflected in accumulated other comprehensive income in shareholders’ equity and, accordingly, has no effect on net income other than for impairments deemed to be other than temporary. Several of the limited partnerships invest solely in securities that are publicly traded and are valued at the net asset value as reported by the investment manager. For the partnerships that do not invest solely in publicly traded securities, the fair value of such securities is determined by the general partner of each limited partnership based on comparisons to transactions involving similar investments. Material assumptions and factors utilized in pricing these securities include future cash flows, constant default rates, recovery rates and any market clearing activity that may have occurred since the prior month-end pricing period. The Company’s investments in other invested assets, including investments in several limited partnerships, were valued at $60.9 million and $52.4 million as of December 31, 2006 and 2005, respectively.
As of December 31, 2006 and 2005, respectively, the Company’s other invested assets portfolio included $14.6 million and $13.1 million in securities for which there is no readily available independent market price.
Net realized gains and losses on investments are reported as a component of income from investments. Such gains or losses are determined based on the specific identification method.
The Company regularly performs various analytical valuation procedures with respect to its investments, including identifying any security where the fair value is below its cost. Upon identification of such securities, a detailed review is performed to determine whether the decline is considered other than temporary. This review
UNITED AMERICA INDEMNITY, LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
includes an analysis of several factors, including but not limited to, the credit ratings and cash flows of the securities, and the magnitude and length of time that the fair value of such securities is below cost.
For bonds, the factors considered in reaching the conclusion that a decline below cost is other than temporary include, among others, whether (1) the issuer is in financial distress, (2) the investment is secured, (3) a significant credit rating action occurred, (4) scheduled interest payments were delayed or missed and (5) changes in laws or regulations have affected an issuer or industry.
The amount of any write-down, including those that are deemed to be other than temporary, is included in earnings as a realized loss in the period in which the impairment arose.
For equity securities, a decline in value is considered to be other than temporary if an unrealized loss has either (1) persisted for more than 12 consecutive months or, (2) the value of the investment has been 20% or more below cost for six continuous months or more. For securities with significant declines in value for periods shorter than six continuous months, the security is evaluated to determine whether the cost basis of the security should be written down to its fair value.
The Company recorded the following other than temporary losses on its investment portfolio for the years ended December 31, 2006, 2005, and 2004:
Fair value is defined as the amount at which the instrument could be exchanged in a current arms-length transaction with willing parties. The fair values of the Company’s investments in bonds and stocks are determined on the basis of quoted market prices. The fair values of the Company’s investments in limited partnerships are determined by the general partner of each limited partnership based on comparisons to transactions involving similar investments. Several of these partnerships invest solely in securities that are publicly traded and are valued at the net asset value as reported by the investment manager. Material assumptions and factors utilized in pricing these securities include future cash flows, constant default rates, recovery rates and any market clearing activity that may have occurred since the prior month-end pricing period.
Derivative Instruments
The Company accounts for derivative instruments under Statement of Financial Accounting Standards (“SFAS”) No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”), as amended, which established accounting reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities. All derivatives, whether designated in hedging relationships or not, are required to be recorded on the balance sheet at fair value.
Other than its convertible bond and convertible preferred stock investments, the Company holds a single derivative instrument as of December 31, 2006, an interest rate swap, which is included in “Other assets” on the balance sheet. In accordance with SFAS 133, the interest rate swap is designated as a cash flow hedge, and is recorded on the balance sheet at fair value. Change in fair value is recorded in other comprehensive income and is reclassified to earnings in the same period during which the hedged item affects earnings.
The primary objective of the Company’s interest rate swap was to hedge risk arising from interest rate volatility related to $15.0 million of Trust Preferred Securities issued by Penn Trust I. The Company has designated the
UNITED AMERICA INDEMNITY, LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
$15.0 million of junior subordinated debentures issued by Penn-America Group, Inc. to Penn Trust I as the hedged item. The junior subordinated debentures have the same terms with respect to maturity, payment, and distributions as the Trust Preferred Securities issued by Penn Trust I. The Company’s strategy is to convert distributions based on a floating rate on its junior subordinated debentures with Penn Trust I to a fixed-rate basis.
In accordance with SFAS 133, the Company formally documents the cash flow hedging relationship between the hedging instrument and the hedged item, the risk management objective and strategy for undertaking the hedge, and how the effectiveness of hedging the exposure to variability in interest rates will be assessed. At inception, the Company determined its cash flow hedge to be highly effective in achieving offsetting cash flows attributable to the hedge risk during the term of the hedge, as it meets the criteria for assuming “no ineffectiveness”, pursuant to SFAS 133.
By using derivative instruments, the Company is exposed to credit risk based on current market conditions and potential payment obligations between the Company and its counterparty. The Company has entered into the interest rate swap with a high credit quality counterparty, which is rated “A1” by Moody’s Investors Service Inc. (“Moody’s”). The Company’s interest rate swap contract is governed by an International Swaps and Derivatives Association Master Agreement, and includes provisions that require collateral to be pledged by the Company or its counterparty if the current value of the interest rate swap exceeds certain thresholds. As of December 31, 2006, no collateral was held by the Company’s counterparty.
Cash and Cash Equivalents
For the purpose of the statements of cash flows, the Company considers all liquid instruments with an original maturity of three months or less to be cash equivalents. The Company has a cash management program that provides for the investment of excess cash balances primarily in short-term money market instruments. Generally, bank balances exceed federally insured limits. The carrying amount of cash and cash equivalents approximates fair value.
In 2006, the Company included uncashed checks in the Cash and cash equivalents line on the balance sheet, instead of the Other liabilities line where they had been included previously. As a result, the prior year balances of Cash and cash equivalents have been adjusted to conform to the current period presentation. The balances as of December 31, 2005 and 2004 have been reduced by $4.6 million and $3.3 million, respectively.
Valuation of Agents’ Balances and Accounts Receivable
The Company evaluates the collectibility of agents’ balances and accounts receivable based on a combination of factors. In circumstances in which the Company is aware of a specific agent’s inability to meet its financial obligations to the Company, a specific allowance for bad debts against amounts due is recorded to reduce the net receivable to the amount reasonably believed by the Company’s management to be collectible. No such instances occurred in 2006. For all remaining balances, allowances are recognized for bad debts based on historical statistics of the length of time the receivables are past due. The allowance for bad debts was $1.0 million and $0.6 million as of December 31, 2006 and 2005, respectively. For each of 2006 and 2005, there were net bad debts written off of $0.07 million.
Goodwill and Intangible Assets
Effective July 1, 2001, the Company’s predecessor adopted the provisions of SFAS No. 141, “Business Combinations” and SFAS No. 142, “Goodwill and Other Intangible Assets” (“SFAS 142”). On January 24, 2005, the Company recorded $102.0 million and $32.5 million of goodwill and intangible assets, respectively, as a result of the acquisition of Penn Independent Corporation and the merger with Penn-America Group, Inc. Goodwill of $17.0 million and intangible assets of $5.8 million of the Company’s Agency Operations were netted against the gain on the sale of substantially all of the assets of the Company’s Agency Operations on September 30, 2006. These
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
amounts represented the net book values of goodwill and intangible assets of Agency Operations as of the date of the sale. See Note 4 for details about this sale.
In accordance with SFAS 142, the Company tests for impairment of goodwill and other indefinite lived assets at least annually and more frequently as circumstances warrant and concluded that there was no impairment as of December 31, 2006.
Other intangible assets that are not deemed to have an indefinite useful life are amortized over their estimated useful lives. The carrying amount of intangible assets that are not deemed to have an indefinite useful life is regularly reviewed for indicators of impairments in value in accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” Impairment is recognized only if the carrying amount of the intangible asset is considered not to be recoverable from its undiscounted cash flows and is measured as the difference between the carrying amount and the estimated fair value of the asset. No impairments of intangible assets that are not deemed to have indefinite life were recognized in the year ended December 31, 2006.
As of December 31, 2006, intangible assets are as follows:
Amortization expense related to the Penn-America Group, Inc. merger for the years ended December 31, 2006 and 2005 was $1.0 million and $1.1 million, respectively. Amortization expense related to the Penn Independent Corporation acquisition for the years ended December 31, 2006 and 2005 was $0.5 million and $0.8 million, respectively.
Reinsurance
In the normal course of business, the Company seeks to reduce the loss that may arise from events that cause unfavorable underwriting results by reinsuring certain levels of risk in various areas of exposure with reinsurers. Amounts receivable from reinsurers are estimated in a manner consistent with the reinsured policy. The Company analyzes its reinsurance contracts to ensure they meet the risk transfer requirements of SFAS No. 113, “Accounting for Reinsurance of Short Duration and Long Duration Contracts” (“SFAS 113”) and regularly reviews the collectibility of reinsurance receivables. Any allowances resulting from this review are included in income during the period in which the determination is made.
During 2005, a provision for doubtful reinsurance receivables of $0.2 million was established by the Penn-America Insurance Companies. The need for an allowance for uncollectible reinsurance is based on the results of the Company’s regular review of collectibility of recorded reinsurance receivables due from its external reinsurers. During 2006, the Company decreased its uncollectible reinsurance reserve by $8.6 million due to (i) an A.M. Best rating upgrade of one of the reinsurers included in the Company’s reserve and (ii) continued collections and reductions of receivables from other reinsurers included in the reserve.
SFAS 113 requires that the reinsurer must assume significant insurance risk under the reinsured portions of the underlying insurance contracts and that there must be a reasonably possible chance that the reinsurer may realize a significant loss from the transaction. The Company has evaluated its reinsurance contracts and concluded that each contract qualifies for reinsurance accounting treatment pursuant to SFAS 113.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Income Taxes
Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.
A valuation allowance is provided when it is more likely than not that some portion of the deferred tax assets will not be realized. Management believes that it is more likely than not that the results of future operations will generate sufficient taxable income to realize the remaining deferred income tax assets, and accordingly, the Company has not established any valuation allowances.
Deferred Acquisition Costs
The costs of acquiring new and renewal insurance and reinsurance contracts include commissions, premium taxes and certain other costs that vary with and are primarily related to the acquisition of new and renewal insurance and reinsurance contracts. The excess of the Company’s costs of acquiring new and renewal insurance and reinsurance contracts over the related ceding commissions earned from reinsurers is capitalized as deferred acquisition costs and amortized over the period in which the related premiums are earned. In accordance with SFAS No. 60, “Accounting and Reporting by Insurance Enterprises,” the method followed in computing such amounts limits them to their estimated realizable value that gives effect to the premium to be earned, related investment income, losses and loss adjustment expenses, and certain other costs expected to be incurred as the premium is earned. The amortization of deferred acquisition costs for the years ended December 31, 2006, 2005, and 2004 was $145.7 million, $107.4 million, and $53.2 million, respectively.
Notes and Loans Payable
The carrying amounts reported in the balance sheet represent the outstanding balances and approximate fair value.
Insurance Premium Payables
The carrying amounts reported in the balance sheet approximate fair value.
Junior Subordinated Debentures
In accordance with SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity,” which establishes standards for classifying and measuring certain financial instruments with characteristics of both liabilities and equity, the Company’s junior subordinated debentures are classified as a liability on the balance sheets and the related distributions are recorded as interest expense in the Statements of Operations.
Pursuant to FIN 46R, the Company does not consolidate its business trust subsidiaries, which in the aggregate issued $60.0 million of Trust Preferred Securities and $1.9 million of floating rate common securities. The sole assets of the Company’s business trust subsidiaries are $61.9 million of junior subordinated debentures issued by the Company, which have the same terms with respect to maturity, payments and distributions as the Trust Preferred Securities and the floating rate common securities. Therefore, the Company’s junior subordinated debentures are presented as a liability in the balance sheet at December 31, 2006.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Guaranty Fund Assessments
The U.S. Insurance Subsidiaries are subject to various state guaranty fund assessments, which enable states to provide for the payment of covered claims or meet other insurance obligations from insurance company insolvencies. Each state has enacted legislation establishing guaranty funds and other insurance activity related assessments resulting in a variety of assessment methodologies. Expenses for guaranty fund and insurance-related assessments are recognized when it is probable that an assessment will be imposed, the obligatory event has occurred and the amount of the assessment is reasonably estimable. As of December 31, 2006 and 2005, included in other liabilities in the consolidated balance sheets were $1.3 million and $1.6 million, respectively, of liabilities for state guaranty funds and other assessments. As of December 31, 2006 and 2005, included in other assets in the consolidated balance sheets were $0.5 million and $0.3 million, respectively, of related assets for premium tax offsets or policy surcharges. The related asset is limited to the amount that is determined based upon future premium collections or policy surcharges from policies in force at the balance sheet date.
Unpaid Losses and Loss Adjustment Expenses
The liability for unpaid losses and loss adjustment expenses represents the Company’s best estimate of future amounts needed to pay losses and related settlement expenses with respect to events insured by the Company. This liability is based upon the accumulation of individual case estimates for losses reported prior to the close of the accounting period with respect to direct business, estimates received from ceding companies with respect to assumed reinsurance and estimates of unreported losses.
The process of establishing the liability for unpaid losses and loss adjustment expenses of a property and casualty insurance company is complex, requiring the use of informed actuarially based estimates and judgments. In some cases, significant periods of time, up to several years or more, may elapse between the occurrence of an insured loss and the reporting of that loss to the Company. To establish this liability, the Company regularly reviews and updates the methods of making such estimates and establishing the resulting liabilities. Any resulting adjustments are recorded in income during the period in which the determination is made.
Premiums
Premiums are recognized as revenue ratably over the term of the respective policies. Unearned premiums are computed on a pro rata basis to the day of expiration.
Contingent Commissions
Certain professional general agencies of the U.S. Insurance Operations are paid special incentives when loss results of business produced by these agencies are more favorable than predetermined thresholds. These costs are charged to other underwriting expenses when incurred.
Stock Based Compensation
The Company accounts for stock options and other equity based compensation using the modified prospective application of the fair value-based method permitted by SFAS No. 123R, “Share-Based Payment” (“SFAS 123R”), which revised SFAS 123 “Accounting for Share-Based Compensation.” The Company adopted SFAS 123R effective January 1, 2006. See Note 14 for details.
Extraordinary Gain
The extraordinary gains of $1.4 million and $1.2 million for 2005 and 2004, respectively, represent the recognition of tax benefits derived from acquisition costs incurred in connection with the Company’s acquisition of Wind River Investment Corporation, which are currently considered to be deductible for federal tax purposes.
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Earnings Per Share
Basic earnings per share has been calculated by dividing net income available to common shareholders by the weighted-average common shares outstanding. Diluted earnings per share has been calculated by dividing net income available to common shareholders by the sum of the weighted-average common shares outstanding and the weighted-average common share equivalents outstanding, which include options and warrants and other equity awards.
New Accounting Pronouncements
In February 2006, the FASB issued SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments an amendment of FASB Statements No. 133 and 140” (“SFAS 155”), which amends SFAS 133, and SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities” (“SFAS 140”). SFAS 155 (1) permits fair value remeasurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation; (2) clarifies which interest-only strips and principal-only strips are not subject to the requirements of SFAS 133; (3) establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation; (4) clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives; and (5) amends SFAS 140 to eliminate the prohibition on a qualifying special-purpose entity from holding a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument. The provisions of SFAS 155 are effective for all financial instruments acquired or issued after the beginning of an entity’s first fiscal year that begins after September 15, 2006. The Company adopted SFAS 155 on January 1, 2007. The impact of adopting this statement will be to decrease accumulated other comprehensive income by $0.3 million and increase retained earnings by $0.3 million.
In June 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109” (“FIN 48”), which prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. The provisions of FIN 48 will be effective on January 1, 2007. The Company is currently evaluating the impact that this interpretation will have on its financial results and position.
In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS 157”), which defines fair value, establishes a framework for measuring fair value in GAAP, and expands disclosures about fair value measurements. SFAS 157 applies under other accounting pronouncements that require or permit fair value measurements, and accordingly, it does not require any new fair value measurements. However, for some entities, the application of SFAS 157 will change current practice. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. The Company is in the process of determining the impact, if any, that the implementation of SFAS 157 will have on its consolidated financial condition or results of operations.
In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities - Including an amendment of FASB Statement No. 115” (“SFAS 159”). SFAS 159 permits entities to choose to measure many financial instruments and certain other items at fair value. The objective is to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. SFAS 159 is expected to expand the use of fair value measurement, which is consistent with the FASB’s long-term measurement objectives for accounting for financial instruments. Most of the provisions of SFAS 159 apply only to entities that elect the fair value option. However, the amendment to FASB Statement No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” applies to all entities with available-for-sale and trading
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
securities. The provisions of SFAS 159 will be effective for the Company on January 1, 2008. The Company is currently evaluating the impact that this statement will have on its financial results and position.
4.
Sale of Agency Assets
On September 30, 2006, the Company sold to Brown & Brown, Inc., an unrelated third party, substantially all of the assets of its Agency Operations. The gain on the sale was $9.4 million, net of applicable taxes of $4.5 million. As part of the sale agreement, 10% of the cash payment is being held in escrow for a period of up to two years to cover indemnification obligations under the asset purchase agreement. As a result of this sale, the Company has terminated its Agency Operations segment and has classified the results of this segment, including the gain on the sale, as discontinued operations for 2006 and 2005. There were no Agency Operations prior to the Company’s acquisition of Penn Independent Corporation in 2005.
Aggregate revenues and pretax income (loss), before and after intercompany eliminations, of discontinued operations were as follows:
The following table sets forth the composition of income (loss) from discontinued operations:
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
5.
Investments
The amortized cost and estimated fair value of investments classified as available for sale were as follows as of December 31, 2006 and 2005:
The Company did not hold any debt or equity investments in a single issuer that was in excess of 10% of shareholders’ equity at December 31, 2006 or 2005.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The Company holds several investments in limited partnerships where it owns less than 3% of the limited partnerships. Changes in the value of these partnerships are included in accumulated other comprehensive income as a component of shareholders’ equity. The estimated fair value and cost of these investments are as follows:
The Company is a limited partner in a high yield fund where it owns more than a 3% interest. Changes in the value of this investment are included in equity in earnings of partnerships on the income statement. The market value and amortized cost of that partnership are as follows:
Accumulated comprehensive income of $22.6 million as of December 31, 2006 is comprised of $27.1 million of net unrealized gains from partnerships where the Company owns less than a 3.0% interest, $7.7 million of net unrealized gains from the Company’s available-for-sale portfolio, $0.2 million of net unrealized gains from the Company’s interest rate swap, and $12.4 million of deferred taxes related to the unrealized gains and losses.
Accumulated comprehensive income of $9.5 million as of December 31, 2005 is comprised of $18.9 million of net unrealized gains from partnerships where the Company owns less than a 3.0% interest, $3.7 million of net unrealized losses from the Company’s available-for-sale portfolio, $0.2 million of net unrealized gains from the Company’s interest rate swap, and $5.9 million of deferred taxes related to the unrealized gains and losses.
The following table contains an analysis of the Company’s securities with gross unrealized losses, categorized by the period that the securities were in a continuous loss position as of December 31, 2006:
(1)
At December 31, 2006, the Company had 299 bonds that were in an unrealized loss position for greater than one year. The estimated fair value and amortized cost of these securities was $436.7 million and $447.8 million, respectively. The Company has analyzed these securities and has determined that they are not impaired. The Company has the ability to hold these investments until maturity or until recovery. 99.8% of these securities are investment grade.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The following table contains an analysis of the Company’s securities with gross unrealized losses, categorized by the period that the securities were in a continuous loss position as of December 31, 2005:
Subject to the risks and uncertainties in evaluating the potential impairment of a security’s value, the impairment evaluation conducted by the Company as of December 31, 2006, concluded the unrealized losses discussed above are not other than temporary impairments. The impairment evaluation process is discussed in the “Investment” section of Note 4 (“Summary of Significant Accounting Policies”).
The Company recorded the following other than temporary losses on its investment portfolio for the years ended December 31, 2006, 2005, and 2004:
The amortized cost and estimated fair value of bonds classified as available for sale at December 31, 2006, by contractual maturity, are shown below. Actual maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The components of net realized investment gains (losses) on the sale of investments for the years ended December 31, 2006, 2005, and 2004 were as follows:
Proceeds from the sales of bonds classified as available-for-sale resulting in net realized investment gains (losses) for the years ended December 31, 2006, 2005, and 2004 were $340.1 million, $371.7 million, and $298.4 million, respectively.
Proceeds from the sales of equity securities classified as available-for-sale resulting in net realized investment gains (losses) for the years ended December 31, 2006, 2005 and 2004 were $36.9 million, $76.1 million, and $31.6 million, respectively.
The sources of net investment income for the years ended December 31, 2006, 2005, and 2004 were as follows:
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
There was one non-income producing bond with an estimated fair value of $0.5 million as of December 31, 2006, 2005, and 2004. The Company has evaluated the investment and believes the value will be recouped.
Certain cash balances, cash equivalents and bonds available for sale were deposited with various governmental authorities in accordance with statutory requirements or were held in trust pursuant to intercompany reinsurance agreements. The estimated fair value of bonds available for sale and on deposit or held in trust were as follows as of December 31, 2006 and December 31, 2005:
6.
Reinsurance
The Company cedes insurance to unrelated insurers on a pro rata (“quota share”) and excess of loss basis in the ordinary course of business to limit its net loss exposure on insurance contracts. Reinsurance ceded arrangements do not discharge the Company of primary liability as the originating insurer. Moreover, reinsurers may fail to pay us due to a lack of reinsurer liquidity, perceived improper underwriting, losses for risks that are excluded from reinsurance coverage, and other similar factors, all of which could adversely affect the Company’s financial results.
At December 31, 2006 and 2005, the Company carried reinsurance receivables of $982.5 million and $1,278.1 million, respectively. These amounts are net of two purchase accounting adjustments. The first purchase accounting adjustment is due to discounting the loss reserves to their present value and applying a risk margin to the discounted reserves. This adjustment was $18.5 million and $21.2 million at December 31, 2006 and 2005, respectively. The second purchase accounting adjustment netted uncollectible reinsurance reserves against the reinsurance receivables to properly reflect the reinsurance receivables at their fair value on the date the Company acquired all of the outstanding common stock of Wind River Investment Corporation and its subsidiaries (“Wind River Acquisition date”). This purchase accounting adjustment was $20.5 million and $28.7 million at December 31, 2006 and 2005, respectively. The change includes a reduction of the Company’s reinsurance reserve allowance of $8.6 million, which was recognized as a reduction of net losses and loss adjustment expenses, and recoveries of $0.4 million that were previously charged against the purchase accounting adjustment.
During 2006 and 2005, the Company’s unpaid losses and loss adjustment expenses and related reinsurance receivables were decreased by $295.7 million and $253.7 million, respectively. Of these amounts, $107.1 million and $142.3 million, respectively, were due to the Company’s review of unpaid loss and loss adjustment expenses and related reinsurance receivables, and the remainder was due to the payment of losses in the ordinary course of business. At the Wind River Acquisition date, discounts and risk margins were applied to reinsurance receivables related to ceded loss reserves. During 2006 and 2005, the Company decreased its discount and risk margin purchase adjustment by $2.7 million and $28.2 million, respectively, due to (1) reductions in ceded loss reserves that existed as of the Wind River Acquisition date and (2) decreases to the amount of discount due to the passage of time. This adjustment equally affected reinsurance receivables and loss reserves and had no impact on the net income of the Company during 2006 and 2005.
At December 31, 2006 and 2005, the Company held collateral securing its reinsurance receivables of $642.9 million and $691.7 million, respectively. Prepaid reinsurance premiums were $38.3 million and
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
$41.7 million at December 31, 2006 and 2005, respectively. Reinsurance receivables, net of collateral held, were $339.6 million and $586.4 million at December 31, 2006 and 2005, respectively.
During the years ended December 31, 2006, 2005, and 2004, the Company recorded the following ceded amounts:
(1)
As a result of the Company’s quarterly reviews of unpaid losses and loss adjustment expenses, the Company reduced gross unpaid loss and loss adjustment expenses related to prior periods by $114.1 million and ceded unpaid loss and loss adjustment expenses related to prior periods by $107.1 million, in 2006.
(2)
As a result of the Company’s quarterly reviews of unpaid losses and loss adjustment expenses, the Company reduced both gross and ceded unpaid loss and loss adjustment expenses related to prior periods by $142.3 million in 2005.
Since the Wind River Acquisition date, an allowance for uncollectible reinsurance of $0.2 million has been established as a result of the Company’s regular review of the collectibility of recorded reinsurance receivables due from its external non-affiliated reinsurers.
The Company’s current property writings create exposure to catastrophic events, and its casualty writings create exposure to casualty clash events. Casualty clash exposure arises when two or more insureds are involved in the same loss occurrence. To protect against these exposures, the Company has purchased $70.0 million in excess of $5.0 million of property catastrophe coverage for events occurring in 2006 and $10.0 million in excess of $3.0 million of casualty clash coverage for events occurring in 2006, both of which are on a per occurrence basis. To the extent that there may be increased catastrophe or casualty clash exposure in the future, the Company may increase its reinsurance protection for these exposures commensurately. The Company did not cede any losses under the property catastrophe and casualty clash contracts during 2006.
As a result of the 2005 hurricane season and the related losses in the insurance industry, the reinsurance market conditions have changed dramatically. In addition to a reduction of capacity for certain geographical zones, carriers saw significant increases in their 2006 reinsurance renewal costs. Prior to the storms of 2005, the Company was able to buy $25.0 million of property catastrophe reinsurance in excess of a $5.0 million retention at a cost of $1.6 million. The post-2005 costs of the same amount of reinsurance capacity with a similar amount and concentration of catastrophe exposed business would have cost $4.3 million. As a result of such dramatic price increases, the Company chose to co-participate in the lower layers of its catastrophe facilities which effectively reduced the ceded premium burden, but did increase the retention for a single catastrophe occurrence from $5.0 million to $7.1 million. Additionally, as a reflection of an increase in risks underwritten, in 2006, the Company purchased an additional $45.0 million of property catastrophe reinsurance capacity above the $30.0 million bought the prior year. In 2007, the Company may look to buy additional property catastrophe reinsurance capacity provided the market bears acceptable rates for such capacity. If the acceptable rates for such capacity are unavailable, the Company will look to either take a larger net risk position or reduce its underwriting risk.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
As of December 31, 2006, the Company had aggregate unsecured reinsurance receivables that exceeded 3% of shareholders’ equity from the following groups of reinsurers. Unsecured reinsurance receivables include amounts receivable for paid and unpaid losses and loss adjustment expenses and prepaid reinsurance premiums, less amounts secured by collateral.
The effect of reinsurance on premiums written and earned is as follows:
7.
Income Taxes
Under current Cayman Islands law, the Company is not required to pay any taxes in the Cayman Islands on its income or capital gains. The Company has received an undertaking that, in the event of any taxes being imposed, the Company will be exempted from taxation in the Cayman Islands until the year 2023. Under current Bermuda law, the Company and its Bermuda subsidiaries are not required to pay any taxes in Bermuda on its income or capital gains. The Company has received an undertaking from the Minister of Finance in Bermuda that, in the event of any taxes being imposed, the Company will be exempt from taxation in Bermuda until March 2016.
U.A.I. (Ireland) Limited is a tax resident in Ireland, and therefore, is subject to taxation in Ireland on its income and gains, if any.
United America Indemnity Group and its respective subsidiaries are subject to income taxes imposed by U.S. authorities and file U.S. tax returns.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The Luxembourg subsidiaries of the Company are subject to income taxes imposed by the Grand Duchy of Luxembourg and file Luxembourg tax returns.
The Company is not subject to taxation other than as stated above. There can be no assurance that there will not be changes in applicable laws, regulations or treaties, which might require the Company to change the way it operates or become subject to taxation.
The weighted average expected tax provision has been calculated using income (loss) before income taxes in each jurisdiction multiplied by that jurisdiction’s applicable statutory tax rate. The Company’s income before income taxes in 2006 of $106.5 million represents $42.8 million from its foreign operations and $63.7 million from its United States operations. The Company’s income before income taxes in 2005 of $66.6 million represents $44.1 million from its foreign operations and $22.5 million from its United States operations. The Company’s income before income taxes in 2004 of $32.3 million represents $26.0 million from its foreign operations and $6.3 million from its United States operations. The following table summarizes the differences between the tax provision for financial statement purposes and the expected tax provision at the weighted average tax rate:
The Company recognized tax expense (benefit) on discontinued operations of $ 4.9 million and $(0.4) million for the years ended December 31, 2006 and 2005, respectively.
In 2005 and 2004, the Company recognized extraordinary gains of $1.4 million and $1.2 million, respectively, for tax benefits derived from acquisition costs included as a reduction in equity as a result of the Wind River Acquisition, that have been or will be deducted in the future from income for federal tax purposes.
The following table summarizes the components of income tax expense (benefit):
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The tax effects of temporary differences that give rise to significant portions of the net deferred tax assets at December 31, 2006 and 2005 are presented below:
(1)
As of the dates of the Wind River Acquisition, the acquisition of Penn Independent Corporation, and the merger with Penn-America Group, Inc., the market values of the respective investment portfolios at those dates became the new cost basis. The amounts included here represent the deferred tax associated with the market tax difference for securities that were owned at those dates that are still held.
Management believes it is more likely than not that the deferred tax assets will be completely utilized in future years. As a result, there is no valuation allowance at December 31, 2006 and 2005.
As of December 31, 2006, the Company has an alternative minimum tax credit carryover of $2.8 million, which, subject to statutory limitations, can be carried forward indefinitely. As of December 31, 2005, the carryover was $13.0 million. The Company was able to utilize a sizable amount of this carryover during 2006 as a result of the sale of substantially all of the assets of its Agency Operations, the release of prior year loss reserves, and the shift of $194.0 million of its tax-free investments to taxable investments.
The Company’s U.S. operations are open to audit by the IRS. The IRS is currently performing audits of the Company’s federal tax returns for the short period from September 6, 2003 through December 31, 2003 and the year 2004. Management believes that adequate provisions have been made in the financial statements to cover these and any other potential audits and tax related matters for all years for which the statute of limitation has not expired. In
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addition to the previously mentioned periods that are currently being audited, the statute of limitations has not yet expired for the short period March 1, 2003 through September 5, 2003 and the years 2005 and 2006.
8.
Liability for Unpaid Losses and Loss Adjustment Expenses
Activity in the liability for unpaid losses and loss adjustment expenses is summarized as follows:
(1)
Unpaid loss and loss adjustment expenses and gross reinsurance receivable on unpaid losses acquired on January 24, 2005, as a result of the merger with Penn-America Group, Inc.
(2)
Included in 2005 is $5.8 million of negative development for the Penn-America Group that is related to prior years. This amount is not included in the “Prior years” line due to the fact that the Company did not own the Penn-America Group during the prior year periods to which the losses and loss adjustment expenses are related.
(3)
In 2006, the Company decreased its net loss reserve relative to accident years 2005 and prior by $7.0 million due to favorable development relative to construction defect losses as well as primary general liability, umbrella and excess, and asbestos and environmental, and by $8.6 million as a reduction of its reinsurance reserve allowance. In 2005, the Company decreased its net loss reserve relative to accident years 2004 and prior by $1.3 million due to lower than anticipated frequency in its animal mortality program. In 2004, the Company decreased its net loss reserve relative to accident years 2003 and prior by $0.8 million.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
During 2006, the Penn-America Insurance Companies increased incurred losses related to insured events of years 2004 and prior by $4.3 million. This increase in incurred losses related primarily to the Company’s casualty lines of business relating to accident years 1997 through 2003.
Prior to 2001, the Company underwrote multi-peril business insuring general contractors, developers, and sub-contractors primarily involved in residential construction that has resulted in significant exposure to construction defect (“CD”) claims. Management believes its reserves for CD claims ($47.3 million and $41.6 million as of December 31, 2006 and 2005, net of reinsurance, respectively) are appropriately established based upon known facts, existing case law and generally accepted actuarial methodologies. However, due to the inherent uncertainty concerning this type of business, the ultimate exposure for these claims may vary significantly from the amounts currently recorded.
The Company has exposure to asbestos and environmental (“A&E”) claims. The asbestos exposure primarily arises from the sale of product liability insurance, and the environmental exposure arises from the sale of general liability and commercial multi-peril insurance. In establishing the liability for unpaid losses and loss adjustment expenses related to A&E exposures, management considers facts currently known and the current state of the law and coverage litigation. Liabilities are recognized for known claims (including the cost of related litigation) when sufficient information has been developed to indicate the involvement of a specific insurance policy, and management can reasonably estimate its liability. In addition, liabilities have been established to cover additional exposures on both known and unasserted claims. Estimates of the liabilities are reviewed and updated continually. Developed case law and claim history do not exist for such claims, especially because significant uncertainty exists about the outcome of coverage litigation and whether past claim experience will be representative of future claim experience. Included in net unpaid losses and loss adjustment expenses as of December 31, 2006 and 2005 were IBNR reserves of $6.7 million and $7.5 million, respectively, and case reserves of approximately $4.5 million and $4.0 million, respectively, for known A&E-related claims.
The following table shows the Company’s gross reserves for A&E losses:
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The following table shows the Company’s net reserves for A&E losses:
As of December 31, 2006, 2005, and 2004, the survival ratio on a gross basis for the Company’s open A&E claims was 7.4 years, 7.1 years, and 9.4 years, respectively. As of December 31, 2006, 2005, and 2004, the survival ratio on a net basis for the Company’s open A&E claims was 10.6 years, 9.6 years, and 17.3 years, respectively. The survival ratio, which is the ratio of gross or net reserves to the 3-year average of annual paid claims, is a non-GAAP financial measure that indicates how long the current amount of gross or net reserves are expected to last based on the current rate of paid claims.
9.
Debt
Junior Subordinated Debentures
In 2003, trusts formed and owned by the Company issued a total of $30.0 million of trust preferred securities. In 2002 and 2003, trusts formed and owned by Penn-America Group, Inc. issued a total of $30.0 million of trust preferred securities. The funds were used to support growth in operations and general corporate purposes. A summary of the terms related to these trust preferred securities is as follows:
(1)
To protect against increases in interest rates, the Company has a fixed rate interest rate swap on these securities that locks the interest at an annual rate of 7.4%. The swap agreement expires on December 4, 2007.
The proceeds from the above offerings were used to purchase junior subordinated interest notes and were used to support the business growth in the insurance subsidiaries and general business needs.
Distributions on the above securities can be deferred up to five years, but in the event of such deferral, the Company may not declare or pay cash dividends on the common stock of the applicable subsidiary.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The Company’s wholly owned business trust subsidiaries, UNG Trust I, UNG Trust II, Penn Trust I, and Penn Trust II, are not consolidated pursuant to FIN 46R. These business trust subsidiaries have issued $60.0 million in floating rate capital securities and $1.9 million of floating rate common securities. The sole assets of the business trust subsidiaries are $61.9 million of the Company’s junior subordinated debentures, which have the same terms with respect to maturity, payments and distributions as the floating rate capital securities and the floating rate common securities.
Guaranteed Senior Notes
On July 20, 2005, United America Indemnity Group sold $90.0 million of guaranteed senior notes, due July 20, 2015. These senior notes have an interest rate of 6.22%, payable semi-annually. On July 20, 2011 and on each anniversary thereafter to and including July 20, 2014, United America Indemnity Group is required to prepay $18.0 million of the principal amount. On July 20, 2015, United America Indemnity Group is required to pay any remaining outstanding principal amount on the notes. The notes are guaranteed by United America Indemnity, Ltd.
In conjunction with the issuance of these senior notes, Wind River Investment Corporation (“Wind River”) reached agreement with the trustee of the Ball family trusts for the prepayment of the $72.8 million principal and related interest due as of July 20, 2005 on senior notes issued by Wind River. The terms of the prepayment agreement required the Ball family trusts to pay Wind River for $0.3 million of the issuance costs of the new senior notes plus $1.0 million of the incremental interest costs that United America Indemnity Group is estimated to incur under the new senior notes. The total amount of these payments of $1.3 million by the Ball family trusts was recorded as a gain on the early extinguishment of debt in 2005.
Revolving Credit Facility
During 2002, the Company established a $25.0 million Revolving Credit Facility with Citizens Bank of Pennsylvania. Interest is payable monthly at LIBOR plus 65 basis points or the Prime Rate. The Revolving Credit Facility was converted to a Demand Discretionary Facility in February 2003. As of December 31, 2006, there was no balance due in connection with this credit facility.
10.
Notes and Loans Payable
Notes Payable
Notes payable and term loans assumed through the acquisition of Penn Independent Corporation is comprised of a $2.5 million revolving line of credit which expires on November 30, 2007, bearing interest at the bank’s prime rate less 1.25% payable monthly. The outstanding amounts due on the line of credit as of December 31, 2006 and 2005 were $1.5 million and $2.9 million, respectively. The Company has agreed to a security agreement granting the bank a first priority perfected lien on finance receivables of Penn Independent Financial Services, Inc. (“PIFSI”). On December 29, 2005, AIS entered into a guaranty and suretyship agreement with the bank whereby AIS will unconditionally jointly and severally guarantee the timely payment of any and all indebtedness owed to the bank by PIFSI. Interest expense resulting from the line of credit was $0.2 million and $0.1 million for 2006 and 2005, respectively.
Loans Payable
Loans payable of $2.8 million and $3.6 million as of December 31, 2006 and 2005 were comprised of three and five loans payable, respectively, to vendors, a minority shareholder, and former minority shareholders. There were no minority shareholders at December 31, 2006. The current portion of these loans that will be payable in 2007 is $0.5 million. Interest expense related to loans payable was $0.1 million for 2006 and 2005.
UNITED AMERICA INDEMNITY, LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
11.
Related Party Transactions
As of December 31, 2006, Fox Paine & Company beneficially owns shares having approximately 84.9% of the Company’s total share voting authority. Two of the Company’s directors, including its Chairman and Chief Executive Officer, are employees of Fox Paine & Company. The Company relies on Fox Paine & Company to provide management services and other services related to the operations of the Company.
At December 31, 2006 and 2005, Wind River Reinsurance was a limited partner in investment funds managed by Fox Paine & Company. The Company’s investment in these limited partnerships was valued at $5.9 million and $6.1 million at December 31, 2006 and 2005, respectively. At December 31, 2006, the Company had an additional capital commitment of $4.1 million to these limited partnerships.
In November 2006, management fees of $1.5 million in the aggregate were paid to Fox Paine & Company. The management fees cover the period from September 5, 2006 through September 4, 2007 and will be recognized ratably over that period. In November 2005, management fees of $1.5 million in the aggregate were paid to Fox Paine & Company and The AMC Group, L.P. (“The AMC Group”), both of which were affiliates. The management fees covered the period from September 5, 2005 through September 4, 2006 and were recognized ratably over that period. In November 2004, management fees of $1.5 million in the aggregate were made to Fox Paine & Company and The AMC Group, covering the period from September 5, 2004 through September 4, 2005 and were recognized ratably over that period.
In October 2006, the Company paid Fox Paine & Company a fee of $0.5 million for investment banking services provided in connection with the sale of substantially all of the assets of the Company’s Agency Operations.
On June 30, 2006, DVUA Massachusetts, Inc. repurchased twenty shares of common stock that it issued to a minority shareholder. As a result, DVUA Massachusetts, Inc. is a wholly owned subsidiary of the Company.
On May 25, 2006, the Company, Fox Paine & Company, and Wind River Holdings, L.P, formerly The AMC Group, L.P. (“Wind River Holdings”), entered into Amendment No. 1 (the “Amendment”) to the Management Agreement (the “Agreement”). The Amendment terminated Wind River Holdings’ services as of May 25, 2006, and provided that Wind River Holdings refund $0.04 million to the Company as a net repayment of the Annual Service Fee paid by the Company to Wind River Holdings on November 2, 2005. Furthermore, the Amendment modified the Agreement to reflect the Company’s new 6.22% guaranteed senior notes, which were issued in 2005, as opposed to the 5% senior notes, which were repaid by the Company in 2005 upon the issuance of the guaranteed senior notes. Per terms of the Amendment, the next management fee payment of $1.5 million was payable to Fox Paine & Company and was paid on November 8, 2006.
On April 20, 2006, the Company announced that it had entered into Amendment No. 1 (the “Amendment”) of the Amended and Restated Shareholders Agreement. The Amendment reduced the requirement that the Board of Directors be comprised of no fewer than eleven directors to no fewer than seven directors. Furthermore, the Amendment (i) reduced the number of directors that Fox Paine & Company can nominate for election from six directors to five directors; and (ii) terminated the right of the Ball family trust to nominate one director for election.
In 2006 and 2005, the Company directly reimbursed Fox Paine & Company $0.1 million and $0.2 million, respectively, for expenses incurred in providing management services.
In 2006 and 2005, the Company paid $0.2 million and $0.08 million, respectively, to Cozen O’Connor for legal services rendered. Stephen A. Cozen, the chairman of Cozen O’Connor, is a member of the Company’s Board of Directors.
In 2006, the Company paid $0.5 million in premium to Validus Reinsurance Ltd. (“Validus”), a current participant on the Company’s $25.0 million in excess of $5.0 million and $30.0 million in excess of $30.0 million catastrophe reinsurance treaties. No losses have yet been ceded by the Company under these treaties. The Company expects to pay $0.7 million of premium to Validus in connection with its participation in these reinsurance
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
agreements during the current treaty periods. There were no payments made to Validus in 2005. Edward J. Noonan, the Chairman and Chief Executive Officer of Validus is a member of the Company’s Board of Directors.
In connection with the merger with Penn-America Group, Inc. and the acquisition of Penn Independent Corporation on January 24, 2005, the Company paid a $6.0 million transaction fee to Fox Paine & Company.
12.
Commitments and Contingencies
Lease Commitments
Total rental expense under operating leases for the years ended December 31, 2006, 2005, and 2004 were $3.5 million, $4.0 million, and $2.6 million, respectively. At December 31, 2006, future minimum payments under non-cancelable operating leases were as follows:
Legal Proceedings
The Company is, from time to time, involved in various legal proceedings in the ordinary course of business. The Company purchases insurance and reinsurance policies covering such risks in amounts that it considers adequate. However, there can be no assurance that the insurance and reinsurance coverage that the Company maintains is sufficient or will be available in adequate amounts or at a reasonable cost. The Company does not believe that the resolution of any currently pending legal proceedings, either individually or taken as a whole, will have a material adverse effect on the Company’s business, results of operations, cash flows, or financial condition.
There is a greater potential for disputes with reinsurers who are in a runoff of their reinsurance operations. Some of the Company’s reinsurers’ reinsurance operations are in runoff, and therefore, the Company closely monitors those relationships. The Company anticipates that, similar to the rest of the insurance and reinsurance industry, it will continue to be subject to litigation and arbitration proceedings in the ordinary course of business.
Other Commitments
The Company has committed to investing into several limited liability partnership funds. As of December 31, 2006, $41.0 million has been invested. The Company has a remaining commitment of $4.1 million. The timing and funding of this remaining commitment has not been determined. As investment opportunities are identified by the partnerships, capital calls will be made.
The Company is party to a Management Agreement, as amended, with Fox Paine & Company, whereby in connection with certain management services provided to it by Fox Paine & Company, the Company agreed to pay an annual management fee of $1.5 million to Fox Paine & Company. The most recent annual management fee of $1.5 million was paid to Fox Paine & Company on November 8, 2006. The next annual management fee payment of $1.5 million is payable on November 1, 2007.
13.
Shareholders’ Equity
Shareholders’ equity as of December 31, 2006 and 2005 was $763.3 million and $639.9 million, respectively. The increase of $123.3 million during 2006 was primarily due to net income for the year of $99.4 million,
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
accumulated other comprehensive income of $13.1 million from net unrealized gains on investments, and an increase in additional paid-in-capital of $10.8 million. The increase in additional paid-in-capital was attributable to restricted stock and stock option compensation accruals of $4.9 million related to awards under the Share Incentive Plan (see Note 14 for further information regarding this plan), stock option exercises of $4.6 million, the purchase of stock by a Company officer of $1.0 million, and non-employee director share payments of $0.3 million.
14.
Share-Based Compensation Plans
The fair value method of accounting recognizes share-based compensation in the statements of operation using the grant-date fair value of the stock options and other equity-based compensation expensed over the requisite service and vesting period.
On January 1, 2006, the Company adopted the provisions of SFAS 123R, which revised SFAS 123, using the modified prospective application method. SFAS 123R sets accounting requirements for share-based compensation to employees and non-employee directors, and requires companies to recognize in the statement of operations the grant-date fair value of stock options and other equity based compensation. For the purpose of determining the fair value of stock option awards, the Company uses the Black-Scholes option-pricing model. SFAS 123R requires the estimation of forfeitures when recognizing compensation expense and that this estimate be adjusted over the requisite service period should actual forfeitures differ from such estimates. Changes in estimated forfeitures are recognized through a cumulative adjustment to compensation in the period of change.
Prior to the adoption of SFAS 123R, cash retained as a result of tax deductions relating to share-based compensation was presented in operating cash flows, along with other tax cash flows. SFAS 123R requires tax benefits relating to excess stock-based compensation deductions to be prospectively presented in the statement of cash flows as financing cash inflows. Tax benefits resulting from stock-based compensation deductions in excess of amounts reported for financial reporting purposes were $0.4 million and $0.5 million for the years ended December 31, 2006 and 2005, respectively. There were no such benefits for the year ended December 31, 2004.
The adoption of SFAS 123R resulted in a cumulative benefit to equity of $0.4 million in 2006.
UNITED AMERICA INDEMNITY, LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Share Incentive Plan
The Company maintains the United America Indemnity, Ltd. Share Incentive Plan (as so amended, the “Plan”). The purpose of the Plan is to give the Company a competitive advantage in attracting and retaining officers, employees, consultants and non-employee directors by offering stock options, restricted stock and other stock-based awards. As amended in May 2005, the Company may issue up to 5.0 million Class A common shares for issuance pursuant to awards granted under the Plan. Award activity for stock options granted under the Plan is summarized as follows:
NOTE:
The above table excludes 55,000 warrants that were issued, at an exercise price of $10.00 per share, on September 5, 2003 and which expire on September 11, 2008. In addition, the Tranche A options were granted outside of the Plan.
On September 5, 2003, the Company granted options to purchase 256,074 Class A common shares to two officers of the Company (“Option-A Tranche”). The Option-A Tranche options have an exercise price of $6.50 per share, expire on September 5, 2013 and were fully vested at the time of the grant. The Company recorded $0.9 million of compensation expense during the period from September 5, 2003 to December 31, 2003, which represents the fair value of the Option-A Tranche on the date of the grant since they were fully vested on that date. During 2005, 93,825 of the Option-A Tranche options were forfeited and 78,000 options were exercised. During 2006, 28,175 Tranche-A options were exercised.
During the period from September 5, 2003 to December 31, 2003, the Company granted 566,661 Time-Based Options and 895,989 Performance-Based Options under the Plan. The Time-Based Options were originally scheduled to vest in 20% increments over a five-year period, with any unvested options forfeitable upon termination of employment for any reason, and expire 10 years after the grant date. The first vesting period ended on December 31, 2004. The Performance-Based Options were originally scheduled to vest in 25% increments and were conditioned upon the Company achieving various operating targets or Fox Paine & Company’s holdings in United America Indemnity achieving an agreed upon rate of return, and expire 10 years after the grant date. On December 31, 2005, the Company modified the 2003 grant of 566,661 Time-Based Options and the 2003 grant of 895,989 Performance-Based Options. Of the 2003 stock option grants, a total of 369,540 and 15,552 were forfeited and exercised, respectively, before the change. The Time Based Options were amended so as to modify the vesting schedule for the remaining unvested options to reflect vesting at the rate of 12% on December 31, 2006, 12% on December 31, 2007, and 36% on December 31, 2008. Also, the performance hurdle with respect to accelerated option vesting upon a change of control was eliminated. The Performance-Based Options were amended to eliminate the performance vesting criteria relating to the annual option vesting and catch-up vesting. Also, the performance hurdle with respect to accelerated option vesting upon a change of control was eliminated. The
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
remaining unvested options become exercisable at the rate of 10% on December 31, 2006, 10% on December 31, 2007, and 30% on December 31, 2008. As a result of these changes, the Company incurred an additional $2.5 million in stock option expense in 2005.
During 2004, the Company granted 10,000 Time-Based Options under the Plan. The Time Based Options vest in 20% increments over a five-year period, with any unvested options forfeited upon termination of employment for any reasons, and expire 10 years after grant date. The first vesting period ended on August 3, 2005.
In accordance with the Penn-America Group, Inc. Stock Incentive Plan, the merger with United America Indemnity on January 24, 2005 caused immediate vesting of all Penn-America Group, Inc.’s unvested stock options. As of January 24, 2005, Penn-America Group, Inc. had 203,635 stock options outstanding, all of which were exercisable. Each holder of the Penn-America Group, Inc. stock options received converted stock options of United America Indemnity. In exchange for outstanding options to purchase Penn-America Group, Inc.’s Class A common shares, the Company granted 175,008 stock options at the acquisition date. The modification of converting the options to purchase Penn-America Group, Inc.’s Class A common shares to options to purchase United America Indemnity’s Class A common shares had no impact on earnings.
During 2005, the Company granted 438,993 Time-Based Options and 133,415 Performance-Based Options under the Plan. The Time-Based Options vest in 20% increments over a five-year period, with any unvested options forfeited upon termination of employment for any reason, and expire 10 years after grant date. The Performance-Based Options vest in 25% increments and are conditional upon the Company achieving various operating targets and expire 10 years after the grant date.
In 2006, the Company recorded $2.0 million of compensation expense for the 1,334,568 outstanding options granted under the Plan. In 2005, the Company recorded $3.3 million of compensation expense for the 1,460,806 options granted under the Plan. In 2004, the Company recorded $0.5 million of compensation expense for the 1,464,090 options granted under the Plan. The Company received $4.6 million and $2.6 million of proceeds from the exercise of options during 2006 and 2005, respectively. There were no proceeds from the exercise of options during 2004.
Option intrinsic values, which are the differences between the fair market value of $25.33 at December 31, 2006 and the strike price of the option, are as follows:
UNITED AMERICA INDEMNITY, LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Option activity for the years ended December 31, 2005 and 2006 is as follows:
The options exercisable at December 31, 2006 include the following:
The weighted average fair value of options granted under the Plan was $8.31 and $4.69 in 2006 and 2005, respectively, using a Black-Scholes option-pricing model and the following weighted average assumptions:
UNITED AMERICA INDEMNITY, LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The following tables summarize the range of exercise prices of options outstanding at December 31, 2006 and 2005:
In addition to stock option awards, the Plan also provides for the issuance of Restricted Shares to employees and non-employee Directors. The following table summarizes the restricted stock awards since inception.
During 2005, the Company granted an aggregate of 62,046 Class A common shares, subject to certain restrictions, to key employees of the Company under the Plan (“Restricted Shares”) which vest in 20% increments over a five-year period . In addition, an aggregate of 15,686 Class A common shares with a weighted average grant date value of $17.59 per share were granted, subject to certain restrictions, to the non-employee directors of the Company under the Plan (“Director Restricted Shares”). Due to an amendment to the Directors’ Compensation Plan, effective June 30, 2005, all of these Director Restricted Shares have vested. As a result of this amendment, 17,331 units were converted into 14,977 Director Restricted Shares, which vested immediately, subject to certain holding requirements, and 10,590 Director Restricted Shares granted in 2004 and prior to June 2005 vested immediately, subject to certain holding requirements. Prior to January 1, 2006, the Company granted an aggregate of 331,964 Restricted Shares to key employees of the Company and an aggregate of 38,084 fully vested Director Restricted Shares to non-employee directors of the Company under the Plan.
During 2006, the Company granted an aggregate of 216,201 Restricted Shares to key employees of the Company and an aggregate of 20,720 fully vested Director Restricted Shares, at a weighted average fair value of $20.77 per share, to non-employee directors of the Company under the Plan. Included in the 216,201 shares, as a result of the Compensation Committee approval of an award of an Annual Integration Bonus as described below under the heading “Annual Incentive Plans”, the Company granted 173,701 Restricted Shares to Plan Participants employed as of February 15, 2006. Of the 173,701 shares, 61,436 shares vested immediately, 67,546 shares
UNITED AMERICA INDEMNITY, LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(including 20,000 shares, subject to certain restrictions, which were awarded to several key employees) vest over five years, and 44,719 shares vest over a three-year period.
The Company recognized compensation expense for restricted stock of $2.5 million and $0.6 million for 2006 and 2005, respectively. The total unrecognized compensation expense for the non-vested restricted stock was $2.4 million at December 31, 2006, which will be recognized over a weighted average life of 1.9 years. The fair value of the 92,852 Restricted Shares that vested during the year ended December 31, 2006 was $21.14 per share.
The following table summarizes the non-vested restricted stock activity for the year ended December 31, 2006:
Based on the terms of the Restricted Stock awards, all forfeited shares revert back to the Company.
During the third quarter of 2006, the Board of Directors authorized a restricted stock incentive award to officers of the Company if the Company achieves a minimum 10% return on equity based on 2006’s operating results. 54,484 common shares were awarded during the first quarter of 2007, based on the December 31, 2006 market value of the Company’s common shares, and will vest 331/3% on each January 1 of years 2008 through 2010. The Board of Directors also authorized an incentive award of restricted stock to these individuals if the Company earns no less than 85% of planned 2006 operating income. The results of calendar year 2006 will be examined three years hence by an independent actuary. If operating income, adjusted to reflect the results of the actuarial study, is greater than or equal to operating income as originally reported, restricted stock may be awarded based on the December 31, 2006 market value of the Company’s common shares. The awards are being expensed over the intrinsic service period, which includes the performance period and the employee service period. The employee must be continually employed through the vesting date to be eligible to receive the award. The Company recognized $0.3 million of expense in 2006 related to these awards.
During the fourth quarter of 2006, the Board of Directors authorized restricted stock incentive awards to key executives of the Company in exchange for signed employment and/or non-compete agreements. The related 42,500 shares of restricted stock vest 331/3% on each subsequent anniversary date of the award for a period of three years.
Annual Incentive Plans
In May 2005, shareholders approved the Amended and Restated United America Indemnity, Ltd. Annual Incentive Awards Program (the “Awards Program”). The purpose of the Awards Program is to encourage increased efficiency and profitability and reward employees’ contributions to corporate success. All employees of the Company and its subsidiaries are eligible to participate in the Awards Program, and Awards Program participants are selected by the Compensation Committee of the Board of Directors (the “Committee”). Incentive awards under the Awards Program are determined and paid in cash and/or restricted stock based upon objective performance-based criteria as determined by the Committee. The criteria relate to certain performance goals, such as net income, combined ratio, return on equity, and individual performance expectations as established by the Committee, except that certain specific performance targets will be approved by the Section 162(m) Committee of the Board of
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Directors with respect to the executives covered by Section 162(m) of the Internal Revenue Code (“Section 162(m)”). It is the Company’s intent that any compensation paid pursuant to the Awards Program comply with Section 162(m).
In connection with the business combinations of the Company with Penn-America Group and Penn Independent Group, along with their respective subsidiaries, certain executives of Penn-America Group and Penn Independent Group entered into employment agreements which provided for the establishment of an integration bonus payable in Class A common shares of the Company in 2006 and 2007, if specified integrated company performance goals for 2005 and 2006, respectively, were achieved (“Integration Plan”).
On February 15, 2006, the Compensation Committee of the Company modified certain aspects of the Integration Plan (the “Plan”).
First, the Compensation Committee revised the definition of the “Merger Price” from $15.375 per share to $17.89 per share. This change corrected a typographical error contained within the Plan.
Second, the Compensation Committee approved an award of an Annual Integration Bonus relating to the 2006 fiscal year to the Plan Participants who were employed by Penn-America Group, Inc. as of February 15, 2006 (the “Current Plan Participants”). Such awards would have otherwise been determined and paid in full following the 2006 fiscal year. The decision by the Compensation Committee to modify the determination and award of the 2006 Annual Integration Bonus was based on: (i) the Compensation Committee’s recognition of the earlier-than-anticipated consolidation of the Company’s U.S. insurance operations, (ii) the Compensation Committee’s determination that the Penn-America Group, Inc. performance targets contained in the Integration Plan for the 2006 Bonus Determination Year were no longer appropriate performance targets on which to base plan awards given the earlier - than-anticipated consolidation, and the fact that the 2006 targets were exceeded in 2005, and (iii) the Compensation Committee’s desire to achieve parity among the Current Plan Participants and other executives of the Company entitled to receive awards of stock based on time versus performance-based vesting. Therefore, the Compensation Committee eliminated the performance criteria relating to the 2006 Bonus Determination Year, and instead granted restricted stock to the Current Plan Participants, which will vest at the rate 20% on each of February 15, 2007 and February 15, 2008 and 60% on February 15, 2009, subject to certain employment-related requirements. Although the Current Plan Participants were granted restricted stock earlier than they otherwise would have, the restricted stock vests over time as set forth above. Under the original terms of the Integration Plan, the granted stock would have vested immediately.
New Chief Executive Officer
Effective November 27, 2006, Robert M. Fishman was hired as the Company’s Chief Executive Officer. Mr. Fishman’s four-year employment agreement includes several equity components including (a) the granting of $10.0 million of stock options, or 404,858 shares split evenly between time-based and performance-based options at the grant date market value of $24.70 per share; (b) an annual bonus program under which the first $0.5 million is paid in restricted stock based on the market value at December 31 of the subject Bonus Year; (c) the purchase of $1.0 million of the Company’s Class A common shares by Mr. Fishman; and (d) the requirement that, effective January 1, 2009, Mr. Fishman hold Class A common shares of the Company with a value of the lesser of two times his Annual Compensation or the sum of owned, granted, and vested Class A common shares. The time-based options vest at 25% on each December 31 of years 2007 through 2010. The performance-based options generally vest at the same rate based on the achievement of various Company financial performance goals. The restricted stock portion of the 2007, 2008, and 2009 bonuses vest at 25% per year each year after the bonus year, and awards for the 2010 bonus year and thereafter will vest at 33.3% per year each year after the bonus year.
As mentioned in Note 20, Mr. Fishman was recently appointed President and Chief Executive Officer of United America Insurance Group and was replaced by Saul A. Fox as the Company’s Chief Executive Officer. Mr. Fishman’s current employment contract will be amended.
UNITED AMERICA INDEMNITY, LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
401(k) Plans
Through December 31, 2006, the Company maintained two 401(k) defined contribution plans covering all U.S employees.
Through December 31, 2006, for employees, exclusive of employees of Penn Independent Corporation, Penn-America Group, Inc. and their respective subsidiaries, the Company matched 75% of the first 6% contributed by an eligible employee. Additionally, the Company contributed 1% of the employee’s salary regardless of whether an employee contributed to the plan. Eligible employees vested in the Company’s contribution and relative investment income after three years of service. Total expenses related to this plan for the years ended December 31, 2006, 2005, and 2004 were $0.8 million, $0.7 million, and $0.9 million, respectively.
Through December 31, 2006, for employees of Penn Independent Corporation, Penn-America Group Inc. and their respective subsidiaries, the Company matched 50% of the first 6% contributed by an eligible employee. Vesting in the Company’s contribution was immediate for eligible employees. Total expenses for this plan for the years ended December 31, 2006 and 2005 were $0.4 million and $0.5 million, respectively.
Effective January 1, 2007, all eligible U.S. employees will be covered by a single 401(k) defined contribution plan. Under this plan, the Company will match 100% of the first 6% contributed by an employee. Vesting on contributions made by the Company for new employees will occur pro-rata over a three year period. Contributions made by the Company prior to the January 1, 2007 effective date will continue to vest at the rate set forth in the eligible employees’ previous plan.
15.
Earnings Per Share
Earnings per share have been computed using the weighted average number of common shares and common share equivalents outstanding during the period.
The following table sets forth the computation of basic and diluted earnings per share.
UNITED AMERICA INDEMNITY, LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
A reconciliation of weighted average shares for basic earnings per share to weighted average shares for diluted earnings per share is as follows:
16.
Statutory Financial Information
GAAP differs in certain respects from Statutory Accounting Principles (“SAP”) as prescribed or permitted by the various U.S. State Insurance Departments. The principal differences between SAP and GAAP are as follows:
•
Under SAP, investments in debt securities are primarily carried at amortized cost, while under GAAP the Company records its debt securities at estimated fair value.
•
Under SAP, policy acquisition costs, such as commissions, premium taxes, fees and other costs of underwriting policies are charged to current operations as incurred, while under GAAP such costs are deferred and amortized on a pro rata basis over the period covered by the policy.
•
Under SAP, certain assets designated as “Non-admitted Assets” (such as prepaid expenses) are charged against surplus.
•
Under SAP, net deferred income tax assets are admitted following the application of specified criteria, with the resulting admitted deferred tax amount being credited directly to surplus.
•
Under SAP, certain premium receivables are non-admitted and are charged against surplus based upon aging criteria.
•
Under SAP, the costs and related receivables for guaranty funds and other assessments are recorded based on management’s estimate of the ultimate liability and related receivable settlement, while under GAAP such costs are accrued when the liability is probable and reasonably estimable and the related receivable amount is based on future premium collections or policy surcharges from in-force policies.
•
Under SAP, unpaid losses and loss adjustment expenses and unearned premiums are reported net of the effects of reinsurance transactions, whereas under GAAP, unpaid losses and loss adjustment expenses and unearned premiums are reported gross of reinsurance.
•
Under SAP, a provision for reinsurance is charged to surplus based on the authorized status of reinsurers, available collateral, and certain aging criteria, whereas under GAAP, an allowance for uncollectible
UNITED AMERICA INDEMNITY, LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
reinsurance is established based on management’s best estimate of the collectibility of reinsurance receivables.
The National Association of Insurance Commissioners (“NAIC”) issues model laws and regulations, many of which have been adopted by state insurance regulators, relating to: (a) risk-based capital (“RBC”) standards; (b) codification of insurance accounting principles; (c) investment restrictions; and (d) restrictions on the ability of insurance companies to pay dividends.
The Company’s U.S. insurance subsidiaries are required by law to maintain certain minimum surplus on a statutory basis, and are subject to regulations under which payment of a dividend from statutory surplus is restricted and may require prior approval of regulatory authorities. Applying the current regulatory restrictions as of December 31, 2006, the maximum amount of distributions that could be paid by the United National Insurance Companies and the Penn-America Insurance Companies as dividends under applicable laws and regulations without regulatory approval is approximately $65.3 million and $19.6 million, respectively. The Penn-America Insurance Companies limitation includes $6.4 million that would be distributed to United National Insurance Company or its subsidiary Penn Independent Corporation based on the December 31, 2006 ownership percentages. For 2006, United National Insurance Companies and Penn-America Insurance Companies declared and paid dividends of $31.0 million and $11.0 million, respectively.
The NAIC’s RBC model provides a tool for insurance regulators to determine the levels of statutory capital and surplus an insurer must maintain in relation to its insurance and investment risks, as well as its reinsurance exposures, to assess the potential need for regulatory attention. The model provides four levels of regulatory attention, varying with the ratio of an insurance company’s total adjusted capital to its authorized control level RBC (“ACLRBC”). If a company’s total adjusted capital is:
(a) less than or equal to 200%, but greater than 150% of its ACLRBC (the “Company Action Level”), the company must submit a comprehensive plan to the regulatory authority proposing corrective actions aimed at improving its capital position;
(b) less than or equal to 150%, but greater than 100% of its ACLRBC (the “Regulatory Action Level”), the regulatory authority will perform a special examination of the company and issue an order specifying the corrective actions that must be followed;
(c) less than or equal to 100%, but greater than 70% of its ACLRBC (the “Authorized Control Level”), the regulatory authority may take any action it deems necessary, including placing the company under regulatory control; and
(d) less than or equal to 70% of its ACLRBC (the “Mandatory Control Level”), the regulatory authority must place the company under its control.
Based on the standards currently adopted, the capital and surplus of the United National Insurance Companies and the Penn-America Insurance Companies are above the prescribed Company Action Level RBC requirements of $195.0 million and $88.0 million, respectively, as of December 31, 2006.
The following is selected information for the Company’s U.S. Insurance Subsidiaries, net of intercompany eliminations, where applicable, as determined in accordance with SAP:
17.
Segment Information
As noted in Note 5, substantially all of the assets of the Agency Operations were sold. The Company continues to manage its business through its Insurance Operations segment. The results of the Agency Operations are now
UNITED AMERICA INDEMNITY, LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
classified as discontinued operations. The Insurance Operations segment includes the operations of the United America Insurance Group. The Insurance Operations segment and the discontinued Agency Operations segment follow the same accounting policies used for the Company’s consolidated financial statements.
As a result of the amalgamation of the Non-U.S. Insurance Operations into a single Bermuda based entity on September 30, 2006, the Company has a new financial reporting segment, Reinsurance Operations, that offers third party reinsurance products. Reinsurance Operations began offering third party reinsurance in the third quarter of 2006; however, the coverage inception dates for this reinsurance was subsequent to December 31, 2006. As such, the Reinsurance Operations segment is not yet material enough for separate disclosure.
Gross premiums written by business classification are as follows:
Following is a tabulation of business segment information. Corporate information is included to reconcile segment data to the consolidated financial statements.
UNITED AMERICA INDEMNITY, LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
UNITED AMERICA INDEMNITY, LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
18.
Supplemental Cash Flow Information
Taxes and Interest Paid
UNITED AMERICA INDEMNITY, LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Non-Cash Activities
On January 24, 2005, the Company purchased 100% of the common shares of Penn Independent Corporation and 100% of the common shares of Penn-America Group, Inc. In conjunction with the acquisition, liabilities were assumed as follows:
19.
Restructuring
On January 23, 2006, the Company announced that it was combining the operations of United National and Penn-America under a single United America Insurance Group management structure. As a result of this restructuring, the Company recognized severance costs of approximately $0.3 million in the first quarter of 2006.
20.
Subsequent Events
The Company agreed to commute its reinsurance agreement with Lumbermens Mutual Casualty Company. As part of the commutation, the Company received $3.5 million in cash during the first quarter of 2007. The impact of the commutation was reserved in prior years, and the transaction should not have a material effect on the Company’s 2007 results.
Effective January 1, 2007, Wind River Reinsurance entered into two limited liability quota share reinsurance agreements with unrelated third parties. To reduce its exposure on these agreements, Wind River Reinsurance has entered into separate quota share retrocession agreements with Validus, which is a related party, and an unrelated third party.
Effective January 1, 2007, each of the quota share agreements between Wind River Reinsurance and the U.S. Insurance Operations expired and was consolidated into a single quota share reinsurance agreement. Under this new agreement, the U.S. Insurance Operations have agreed to cede 50% of their net unearned premiums as of December 31, 2006, plus 50% of the net retained insurance liability of all new and renewal business bound on or after January 1, 2007 to Wind River Reinsurance.
Effective February 5, 2007, William F. Schmidt, President and Chief Executive Officer of United America Insurance Group, Jonathan P. Ritz, Senior Vice President and Chief Operating Officer of United America Insurance Group, and Gerould J. Goetz, Senior Vice President of United America Insurance Group, resigned. In response to these departures, on February 9, 2007, the Board of Directors appointed Saul A. Fox as Chief Executive Officer of the Company, which was the role previously held by Robert M. Fishman, and Mr. Fishman as President and Chief Executive Officer of United America Insurance Group. Mr. Fishman is performing the duties previously performed by Messrs. Schmidt and Ritz. In addition, Mr. Fishman has appointed William Devlin, who previously reported to Mr. Goetz, to manage the claims department. Additional senior level positions may be recruited by Mr. Fishman to position the Company for the future.
On February 12, 2007, the Company filed a lawsuit in state court in Montgomery County, Pennsylvania to enforce non-competition, non-solicitation, confidentiality, and certain other restrictive covenants in the employment agreements signed by Messrs. Schmidt, Ritz, and Goetz. The Company sought and the court issued a stipulated temporary restraining order that requires the former executives to comply with the non-competition, non-solicitation, confidentiality, and certain other restrictive covenants. For more information regarding this lawsuit, see Item 3 in Part I of this report.
UNITED AMERICA INDEMNITY, LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
In February 2007, the Company contracted Cozen O’Connor for legal services related to the above mentioned lawsuit. Stephen A. Cozen, the chairman of Cozen O’Connor, is a member of the Company’s Board of Directors.
21.
Summary of Quarterly Financial Information (Unaudited)
An unaudited summary of the Company’s 2006 and 2005 quarterly performance is as follows:
Item 9.
Item 9.
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None.
Item 9A.
Item 9A.
Controls and Procedures
Evaluation of Disclosure Controls and Procedures
Based on their evaluation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)), our principal executive officer and principal financial officer have concluded that as of December 31, 2006, our disclosure controls and procedures were designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms and are operating in an effective manner.
Management’s Report on Internal Control Over Financial Reporting
Our management is responsible for establishing and maintaining adequate internal control over financial reporting (as defined in Rule 13a-15(f) under the Securities Exchange Act of 1934, as amended). Our management assessed the effectiveness of our internal control over financial reporting as of December 31, 2006. In making this assessment, our management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) in Internal Control-Integrated Framework. Our management has concluded that, as of December 31, 2006, our internal control over financial reporting was effective based on these criteria. Our independent registered public accounting firm, PricewaterhouseCoopers LLP, has audited our assessment of the effectiveness of our internal control over financial reporting, as stated in their report, which is included in Item 8 of this report on Form 10-K.
Changes in Internal Control over Financial Reporting
As a result of combining the operations of the United National Insurance Companies and the Penn-America Insurance Companies under a single United America Insurance Group management structure, we have added, deleted, or modified certain of our internal controls over financial reporting. However, there were no changes in our internal controls over financial reporting during 2006 that have materially affected, or are reasonably likely to materially affect our internal controls over financial reporting.
During the fourth quarter of 2006, we successfully transitioned to a new financial reporting general ledger system. While we do not believe that there were any significant deficiencies or material weaknesses associated with the system previously used, the new system provides greater efficiency in our accounting process.
Item 9B.
Item 9B.
Other Information
None.
PART III
Item 10.
Item 10.
Directors, Executive Officers of the Registrant, and Corporate Governance
The information concerning our directors and executive officers required by this Item is incorporated by reference to, and will be contained in, our definitive proxy statement.
Item 11.
Item 11.
Executive Compensation
The information required by this Item is incorporated by reference to, and will be contained in, our definitive proxy statement.
Item 12.
Item 12.
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
The information required by this Item is incorporated by reference to, and will be contained in, our definitive proxy statement.
Item 13.
Item 13.
Certain Relationships and Related Transactions, and Director Independence
The information required by this Item is incorporated by reference to, and will be contained in, our definitive proxy statement.
Item 14.
Item 14.
Principal Accounting Fees and Services
The information required by this Item is incorporated by reference to, and will be contained in, our definitive proxy statement.
PART IV
Item 15.
Item 15.
Exhibits and Financial Statement Schedules
(a) The following documents are filed as part of this report:
(1) The Financial Statements listed in the accompanying index on page 72 are filed as part of this report.
(2) The Financial Statement Schedules listed in the accompanying index on page 72 are filed as part of this report.
(3) The Exhibits listed below are filed as part of, or incorporated by reference into, this report.
+ Filed herewith.
* Management contract or compensatory plan or arrangement required to be filed as an exhibit to this Form 10-K.
SIGNATURES
Pursuant to the requirements of the Section 13 or 15 (d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
United America Indemnity, Ltd.
By:
/s/ Saul A. Fox
Name: Saul A. Fox
Title: Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the registrant and in the capacities indicated below on March 16, 2007.
UNITED AMERICA INDEMNITY, LTD.
SCHEDULE I - SUMMARY OF INVESTMENTS - OTHER THAN INVESTMENTS
IN RELATED PARTIES
*
Original cost of equity securities; original cost of fixed maturities adjusted for amortization of premiums and accretion of discounts. All amounts are shown net of impairment losses.
S-1
UNITED AMERICA INDEMNITY, LTD.
SCHEDULE II - CONDENSED FINANCIAL INFORMATION OF REGISTRANT
(Parent Only)
Balance Sheets
(1)
This item has been eliminated in the Company’s Consolidated Financial Statements.
See Notes to Consolidated Financial Statements included in Item 8.
S-2
UNITED AMERICA INDEMNITY, LTD.
SCHEDULE II - CONDENSED FINANCIAL INFORMATION OF REGISTRANT - (Continued)
(Parent Only)
Statement of Operations and Comprehensive Income
(1)
This item has been eliminated in the Company’s Consolidated Financial Statements.
See Notes to Consolidated Financial Statements included in Item 8.
S-3
UNITED AMERICA INDEMNITY, LTD.
SCHEDULE II - CONDENSED FINANCIAL INFORMATION OF REGISTRANT - (Continued)
(Parent Only)
Statement of Cash Flows
(1)
This item has been eliminated in the Company’s Consolidated Financial Statements.
Non-cash transactions:
In connection with the merger with Penn-America Group, Inc. on January 24, 2005, the Company issued 7.9 million Class A common shares valued at $141.9 million and issued options to purchase 0.2 million shares with a fair value of $1.6 million during 2005.
See Notes to Consolidated Financial Statements included in Item 8.
S-4
UNITED AMERICA INDEMNITY, LTD.
SCHEDULE III - SUPPLEMENTARY INSURANCE INFORMATION
S-5
UNITED AMERICA INDEMNITY, LTD.
SCHEDULE IV - REINSURANCE EARNED PREMIUMS
S-6
UNITED AMERICAN INDEMNITY, LTD.
SCHEDULE V - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES
S-7
UNITED AMERICA INDEMNITY, LTD.
SCHEDULE VI - SUPPLEMENTARY INFORMATION FOR PROPERTY CASUALTY UNDERWRITERS
Note: All of the Company’s insurance subsidiaries are 100% owned and consolidated.
S-8