e424b4
Filed
Pursuant to Rule 424(b)(4)
File No. 333-143306
PROSPECTUS
3,301,260 Shares
First Mercury
Financial Corporation
Common Stock
$19.25 per share
We are selling 200,000 shares of our common stock. The selling
stockholders identified in this prospectus are selling an
additional 3,101,260 shares. We will not receive any of the
proceeds from the sale of the shares being sold in this offering
by the selling stockholders. We have granted the underwriters an
option to purchase up to 495,189 additional shares of common
stock from us to cover over-allotments.
Our common stock is listed on the New York Stock Exchange under
the symbol FMR. The last reported sale price of our
common stock on June 14, 2007 was $19.36 per share.
Investing in our common stock involves risks. See Risk
Factors beginning on page 10.
Neither the Securities and Exchange Commission nor any state
securities commission has approved or disapproved of these
securities or determined if this prospectus is truthful or
complete. Any representation to the contrary is a criminal
offense.
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Per Share
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Total
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Public Offering Price
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$
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19.25
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$
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63,549,255
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Underwriting Discount
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$
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1.06
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$
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3,499,336
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Proceeds to the Company (before
expenses)
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$
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18.19
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$
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3,638,000
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Proceeds to the selling
stockholders (before expenses)
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$
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18.19
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$
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56,411,919
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The underwriters expect to deliver the shares to purchasers on
or about June 20, 2007.
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JPMorgan |
Keefe,
Bruyette & Woods |
Prospectus dated June 14, 2007
You should rely only on the information contained in this
prospectus. We have not authorized anyone to provide you with
different information. Neither we nor the selling stockholders
are making an offer of these securities in any state where the
offer is not permitted. You should not assume that the
information contained in this prospectus is accurate as of any
date other than the date on the front of this prospectus.
TABLE OF
CONTENTS
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G-1
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SUMMARY
This summary highlights information about this offering and
our company, which includes First Mercury Financial Corporation,
which we refer to as FMFC, its subsidiaries and First Mercury
Holdings, Inc., formerly our sole stockholder, which we refer to
as Holdings. Holdings was formed in connection with the notes
offering and repurchase of shares of minority stockholders that
occurred in August 2005 as described in The Company,
which we refer to as the Holdings Transaction. Holdings was
merged with and into FMFC on October 16, 2006, immediately
prior to the completion of our initial public offering. In this
prospectus, unless the context otherwise indicates,
we, us, and our refer to
FMFC and its subsidiaries and, subsequent to the Holdings
Transaction but prior to such merger, Holdings and its
subsidiaries. Because this is a summary, it may not contain all
the information you should consider before investing in our
common stock. You should carefully read this entire prospectus.
Certain insurance terms used in this prospectus are defined in
the Glossary of Selected Insurance Terms included
herein.
Overview
We are a provider of insurance products and services to the
specialty commercial insurance markets, primarily focusing on
niche and underserved segments where we believe that we have
underwriting expertise and other competitive advantages. During
our 34 years of underwriting security risks, we have
established
CoverX®
as a recognized brand among insurance agents and brokers and
developed significant underwriting expertise and a
cost-efficient infrastructure. Over the last seven years, we
have leveraged our brand, expertise and infrastructure to expand
into other specialty classes of business, particularly focusing
on smaller accounts that receive less attention from
competitors. As part of this extension of our business, we have
increased our underwriting staff and opened offices in Chicago,
Dallas, Naples, Florida, Boston and Irvine, California.
As primarily an excess and surplus, or E&S, lines
underwriter, our business philosophy is to generate an
underwriting profit by identifying, evaluating and appropriately
pricing and accepting risk using customized forms tailored for
each risk. Our combined ratio, a customary measure of
underwriting profitability, has averaged 67.1% over the past
three years. A combined ratio is the sum of the loss ratio and
the expense ratio. A combined ratio under 100% generally
indicates an underwriting profit. A combined ratio over 100%
generally indicates an underwriting loss. As an E&S lines
underwriter, we have more flexibility than standard property and
casualty insurance companies to set and adjust premium rates and
customize policy forms to reflect the risks being insured. We
believe this flexibility has a beneficial impact on our
underwriting profitability and our combined ratio.
In addition, through our insurance services business, which
provides underwriting, claims and other insurance services to
third parties, we are able to generate significant fee income
that is not dependent upon our underwriting results. For our
entire business, we generated an average annual return on
stockholders equity of 25.8% over the past three calendar
years.
Our CoverX subsidiary is a licensed wholesale insurance broker
that produces and underwrites all of the insurance policies for
which we retain risk and receive premiums. As a wholesale
insurance broker, CoverX markets our insurance policies through
a nationwide network of wholesale and retail insurance brokers
who then distribute these policies through retail insurance
brokers. CoverX also provides underwriting services with respect
to the insurance policies it markets in that it reviews the
applications submitted for insurance coverage, decides whether
to accept all or part of the coverage requested and determines
applicable premiums. We participate in the risk on insurance
policies sold through CoverX, which we refer to as policies
produced by CoverX, generally by directly writing the policies
through our insurance subsidiaries and then retaining all or a
portion of the risk. The portion of the risk that we decide not
to retain is ceded to, or assumed by, reinsurers in exchange for
paying the reinsurers a proportionate amount of the premium
received by us for issuing the policy. This cession is commonly
referred to as reinsurance. Depending on market conditions, we
can retain a higher or lower amount of premiums produced by
CoverX.
Prior to June 2004, when the rating of our insurance subsidiary,
First Mercury Insurance Company, or FMIC, was upgraded by
A.M. Best Company, Inc., or A.M. Best, to
A−, we did not directly write a significant
amount of insurance policies produced by CoverX, but instead
utilized fronting arrangements under
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which we contracted with third party insurers, or fronting
insurers, to directly write the policies produced by CoverX.
Under these fronting arrangements, we then controlled the
cession of the insurance from the fronting insurer and either
assumed most of the risk under these policies as a reinsurer or
arranged for it to be ceded directly to other reinsurers. In
connection with our insurance subsidiarys rating upgrade,
we were able to eliminate most of our fronting relationships by
May 2005 and become the direct writer of substantially all of
the policies produced by CoverX.
Effective January 1, 2007, FMIC and our other insurance
subsidiary, All Nation Insurance Company, or ANIC, entered into
an intercompany pooling reinsurance agreement wherein all
premiums, losses and expenses of FMIC and ANIC are combined and
apportioned between FMIC and ANIC in accordance with fixed
percentages. On May 4, 2007, A.M. Best assigned the
financial strength rating A− to the First
Mercury Group pool and its members, FMIC and ANIC. ANICs
A.M. Best rating was upgraded to A− as a
result.
Our direct and assumed written premiums grew from
$92.1 million in 2004 to $218.2 million in 2006. These
amounts do not include $54.8 million and $11.9 million
of premiums in 2004 and 2006, respectively, that were produced
and underwritten by CoverX and directly written by our fronting
insurers. A discussion of how the shift from relying on fronting
relationships to directly writing insurance has impacted our
financial presentation and our direct and assumed written
premiums is set forth in Managements Discussion and
Analysis of Financial Condition and Results of
Operations Overview.
We have written general liability insurance for the security
industry, which includes security guards and detectives, alarm
installation and service businesses, and safety equipment
installation and service businesses, for 34 years. We focus
on small and mid-size accounts that are often underserved by
other insurance companies. For 2006 and the three months ended
March 31, 2007, our direct and assumed written premiums
from security classes represented 31.2% and 26.8%, respectively,
of our total direct and assumed written premiums. Our loss and
allocated loss adjustment expense ratio on a weighted average
basis for security classes has been 61.2% over the past 20
accident years and 39.8% over the past three accident years. A
loss and allocated loss adjustment expense ratio consists of the
total net incurred losses and allocated loss adjustment expenses
related to a specified class or classes of business divided by
the total net earned premium related to a specified class or
classes of business over the same time period. We believe that
this calculation is useful in providing information on the
historical long term underwriting performance of our business
from security classes and is an indicator of how an insurance
company has managed its risk exposure.
We have leveraged our nationally recognized CoverX brand, our
broad distribution channels through CoverX, and our underwriting
and claims expertise to expand our business into other specialty
classes. For example, we have leveraged our experience in
insuring the security risks of the contractors that install
safety and fire suppression equipment, which often involves
significant plumbing work and exposure, into the underwriting of
other classes of risks for plumbing contractors. We write
general liability insurance for other specialty classes
primarily consisting of contractor classes of business,
including roofing contractors, plumbing contractors, electrical
contractors, energy contractors, and other artisan and service
contractors, legal professional liability, and, most recently,
hospitality and employer general liability coverage. As part of
this extension of our business, we have increased our
underwriting staff and opened regional offices in Chicago,
Dallas, Naples, Florida, Boston and Irvine, California. For 2006
and the three months ended March 31, 2007, our direct and
assumed written premiums from other specialty classes
represented 68.8% and 73.2%, respectively, of our total direct
and assumed written premiums. Our loss and allocated loss
adjustment expense ratio on a weighted average basis for other
specialty classes has been 42.7% over the past three accident
years and 47.2% over the past seven accident years, which
represents the period in which we have expanded our business in
other specialty classes. We believe this calculation is useful
in providing information on the underwriting performance of
business from other specialty classes for the seven-year period.
Because we have limited experience in these classes compared to
security classes, loss and allocated loss adjustment expense
ratio may not be indicative of the long term underwriting
performance of our business from other specialty classes.
Our insurance services business provides underwriting, claims
and other insurance services to third parties, including
insurance carriers and customers, and generated
$10.9 million in commission and fee income in 2006. Most of
this revenue is generated by American Risk Pooling Consultants,
Inc. and its subsidiaries,
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which we refer to as ARPCO, through which we provide third party
administration services for risk sharing pools of governmental
entity risks, including underwriting, claims, loss control and
reinsurance services.
For the year ended December 31, 2006, our operating income
was $50.2 million, a 24% increase over the prior year, and
our net income was $21.9 million, a 4% decrease over the
prior year. For the three months ended March 31, 2007, our
operating income was $16.3 million, a 53% increase over the
three months ended March 31, 2006, and our net income was
$10.0 million, an 85% increase from the same period in
2006. As of March 31, 2007, we had total assets of
$566.7 million and stockholders equity of
$182.8 million. The changes in net income from 2005 to 2006
and from the three months ended March 31, 2006 compared to
the corresponding period in 2007 were not comparable to the
respective changes in operating income due to interest expense
incurred after August 17, 2005 on the $65.0 million in
senior notes issued in August 2005 and repaid in October 2006.
Competitive
Strengths
The following competitive strengths drive our ability to execute
our business plan and growth strategy:
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Recognized Brand and Nationwide Distribution
Platform. Our CoverX brand has been
well-known among insurance brokers and agents for over
30 years. Brokers and agents have depended upon us to
provide a consistent insurance market since 1973 for security
guards and detectives, alarm installation and service businesses
and safety equipment installation and service businesses. We
have developed relationships with numerous brokers nationwide,
and produced business from approximately 1,000 different brokers
in 2006. Throughout our history, we have successfully leveraged
our brand and broker distribution network to enter into other
specialty classes of business.
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Proprietary Data and Underwriting
Expertise. Recognizing the importance of the
collection of claims and loss information, we have developed and
maintained an extensive database of underwriting and claims
information that we believe is unmatched by our competitors and
which includes over 20 years of loss information. We
believe our database and underwriting expertise allow us to
price the risks that we insure more appropriately than our
competitors. We also enhance our historical risk database by
using our knowledge to draft extensively customized forms which
precisely define the exposures that we insure.
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Opportunistic Business Model. Because
CoverX controls a broad policy distribution network through its
relationships with brokers and possesses significant
underwriting expertise, we have the ability to selectively
increase or decrease the underwriting exposure we retain based
upon the pricing environment and how the exposure fits with our
underwriting and capital management criteria. We have the
ability to offset lower net written premiums by generating
higher fee income by either underwriting through CoverX on
behalf of third party insurance carriers or ceding more risk to
reinsurers.
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Cost-Efficient Operating Structure. We
believe that our cost-efficient operating structure allows us to
focus on underserved, small accounts more profitably than our
competitors. We streamlined our underwriting and claims
processes to create a paperless interactive process that
requires significantly less administration. While the premiums
generated from insurance policies produced by CoverX increased
from $28.1 million in 2000 to $230.1 million in 2006,
our total employees over that same period only increased from
110 to 142.
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Significant Commission and Fee Income
Earnings. We have demonstrated the ability to
generate non-risk bearing commissions and fees that provide a
significant recurring source of income, and as a result, our
revenue and net income are not solely dependent upon our
underwriting results.
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Proven Leadership and Highly Experienced
Employees. Our management team, led by our
Chairman, President and Chief Executive Officer, Richard H.
Smith, has an average of over 25 years of insurance
experience. Additionally, both our underwriters and our senior
claims personnel average over 20 years of experience in the
insurance industry.
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3
Business
Challenges
We face the following challenges in conducting our business:
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Our Continued Success is Dependent Upon Our Ability to
Maintain Our Third Party Ratings to Continue to Engage in Direct
Insurance Writing. Any downgrade in the
rating that FMIC receives from A.M. Best could prevent us from
engaging in direct insurance writing or being able to obtain
adequate reinsurance on competitive terms, which could lead to
decreased revenue and earnings.
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We Need to Maintain Adequate
Reserves. Our actual incurred losses may
exceed the loss and loss adjustment expense reserves we
maintain, which could have a material adverse effect on our
results of operations and financial condition.
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We Bear Credit Risk With Respect to Our
Reinsurers. We continue to have primary
liability on risks we cede to reinsurers. If any of these
reinsurers fails to pay us on a timely basis or at all, we could
experience losses.
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Our Continued Success is Dependent Upon Our Ability to
Obtain Reinsurance on Favorable Terms. We use
significant amounts of reinsurance to manage our exposure to
market and insurance risks and to enable us to write policies in
excess of the level that our capital supports. Without adequate
levels of appropriately priced reinsurance, the level of
premiums we can underwrite could be materially reduced.
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A Substantial Portion of Our Business is Concentrated in
the Security Industry. Our direct and assumed
written premiums from security classes represented 31.2% and
26.8% of our total premiums produced in 2006 and the three
months ended March 31, 2007, respectively. As a result, any
adverse changes in the security insurance market could reduce
our underwriting profitability.
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We Operate in a Highly Competitive
Market. It is difficult to attract and retain
business in the highly competitive market in which we operate.
As a result of this intense competition, prevailing conditions
relating to price, coverage and capacity can change very rapidly
and we might not be able to effectively compete.
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Strategy
We intend to grow our business while enhancing underwriting
profitability and maximizing capital efficiency by executing the
following strategies:
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Profitably Underwrite. We will continue
to focus on generating an underwriting profit in each of our
classes, regardless of market conditions. Our average combined
ratio for the last three years was 67.1%, comprised of an
average loss ratio of 50.3% and an average expense ratio of
16.8%. Our ability to achieve similar underwriting results in
the future depends on numerous factors discussed in the
Risk Factors section and elsewhere in this
prospectus, many of which are outside of our control.
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Opportunistically Grow. We plan to
opportunistically grow our business in markets where we can use
our expertise to generate consistent profits. Our ability to
opportunistically grow our business may be impeded by factors
such as our vulnerability to adverse events affecting our
existing lines, the ability to acquire and retain additional
underwriting expertise, and the ability to attract and retain
business in the competitive environment in which we operate. Our
growth strategy includes the following:
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Selectively Retain More of the Premiums Generated from
Insurance Policies Produced by CoverX. In
2006, our insurance subsidiaries retained 62.1% of the premiums
generated from insurance policies produced by CoverX, either by
directly writing these premiums or by assuming these premiums
under our fronting arrangements. The remaining portion, or
37.9%, of these premiums were ceded to reinsurers through quota
share and excess of loss reinsurance or retained by the issuing
fronting carriers. We intend to continue to selectively retain
more of these premiums and to use quota share and other
reinsurance arrangements.
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Selectively Expand Geographically and into Complementary
Classes of General Liability Insurance. We
provide general liability insurance to certain targeted niche
market segments where we believe
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our experience and infrastructure give us a competitive
advantage. We believe there are numerous opportunities to expand
our existing general liability product offerings both
geographically and into complementary classes of specialty
insurance. We intend to identify additional classes of risks
that are related to our existing insurance products where we can
leverage our experience and data to profitably expand.
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Enter into Additional Niche Markets and Other Specialty
Commercial Lines of Business. We plan to
leverage our brand recognition, extensive distribution network,
and underwriting expertise to enter into new E&S lines or
admitted markets in which we believe we can capitalize on our
underwriting and claims platform. We intend to expand into these
markets and other lines through internal growth, as well as by
making acquisitions and hiring teams of experienced underwriters.
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Actively Pursue Opportunities for Commission and Fee
Income Growth. To the extent we have more
market opportunities than we choose to underwrite on our own
balance sheet, we plan to pursue and leverage these
opportunities to generate commission and fee income by providing
our distribution, underwriting and claims services to third
party carriers or insureds.
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Continue to Focus on Opportunistic Business
Model. We intend to selectively increase or
decrease the underwriting exposure we retain based upon the
pricing environment and how the exposure fits with our
underwriting and capital management criteria. The efficient
deployment of our capital, in part, requires that we
appropriately anticipate the amount of premiums that we will
write and retain. Changes in the amount of premiums that we
write or retain may cause our financial results to be less
comparable from period to period.
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Efficiently Deploy Capital. To the
extent the pursuit of the growth opportunities listed above
require capital that is in excess of our internally generated
capital, we may raise additional capital in the form of debt or
equity in order to pursue these opportunities. We have no
current specific plans to raise additional capital and do not
intend to raise or retain more capital than we believe we can
profitably deploy in a reasonable time frame. Maintaining at
least an A− rating from A.M. Best is critical
to us, and will be a principal consideration in our decisions
regarding capital as well as our underwriting, reinsurance and
investment practices.
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Corporate
History
CoverX was founded in 1973 as an underwriter and broker of
specialty commercial insurance products with a specific
concentration on the security market. In 1985, our founding
shareholder formed the predecessor of First Mercury Insurance
Company, which we refer to as FMIC, to become the reinsurer of
business produced by CoverX and fronted by other insurance
companies. In June 2004, we raised $40.0 million from the
issuance of convertible preferred stock to an entity controlled
by Glencoe Capital, LLC, which we refer to as Glencoe. Glencoe
is controlled by David S. Evans, its Chairman. The convertible
preferred stock issuance enabled FMIC to obtain an
A− rating from A.M. Best and reduce its
reliance on fronting carriers. In August 2005, we completed a
transaction after which Glencoe became our controlling
shareholder. This transaction was financed by the issuance of
$65.0 million aggregate principal amount of Senior Floating
Rate Notes due 2012, which we refer to as the senior notes. We
repurchased these senior notes with a portion of the net
proceeds from our initial public offering. In connection with
our initial public offering, the convertible preferred stock was
converted into common stock and cash, we repurchased
4,705,882 shares of common stock held by Glencoe and
Glencoes stock ownership was reduced to 10.9% of our
outstanding common stock.
Our principal executive offices are located at 29110 Inkster
Road, Suite 100, Southfield, Michigan 48034 and our
telephone number at that address is
(800) 762-6837.
Our website is located at
www.firstmercury.com. The information on our
website is not part of this prospectus.
5
THE
OFFERING
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Common stock offered by us |
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200,000 shares |
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Common stock offered by the selling stockholders |
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3,101,260 shares |
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Common stock outstanding after this offering |
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17,540,979 shares |
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Over-allotment option |
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We have granted the underwriters an option to purchase up to
495,189 shares of common stock from us to cover
over-allotments. |
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NYSE symbol |
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FMR |
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Use of proceeds |
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We estimate that our net proceeds from this offering will be
approximately $3.2 million. We intend to use the net
proceeds from this offering for general corporate purposes,
including working capital. We will not receive any proceeds from
the sale of shares in this offering by the selling stockholders. |
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Dividend policy |
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Our board of directors does not intend to declare cash dividends
for the foreseeable future on our common stock. |
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Risk factors |
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See Risk Factors beginning on page 10 and other
information included in this prospectus for a discussion of
factors you should carefully consider before deciding to invest
in shares of our common stock. |
Unless we specifically state otherwise, the information in this
prospectus:
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assumes that the underwriters will not exercise their
over-allotment option to purchase up to an additional
495,189 shares from us; and
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excludes, in the number of shares of common stock to be
outstanding after this offering, options to purchase
927,775 shares of common stock issuable upon the exercise
of outstanding stock options under our 1998 Stock Compensation
Plan (the 1998 Plan) and 476,188 shares of
common stock issuable upon exercise of outstanding stock options
under our Omnibus Incentive Plan of 2006 (the Omnibus
Plan). An additional 1,013,664 shares are available
for issuance under the Omnibus Plan.
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6
SUMMARY
HISTORICAL AND UNAUDITED PRO FORMA
CONSOLIDATED FINANCIAL AND OTHER DATA
The table shown below presents our summary historical and
unaudited pro forma consolidated financial and other data for
the years ended December 31, 2006, 2005 and 2004 and the
three months ended March 31, 2007 and 2006. The summary
historical and unaudited pro forma consolidated financial and
other data presented below should be read in conjunction with
Managements Discussion and Analysis of Financial
Condition and Results of Operations, Selected
Historical Consolidated Financial and Other Data,
Capitalization and the consolidated annual and
interim financial statements and accompanying notes included
elsewhere in or incorporated by reference in this prospectus.
The summary historical and unaudited pro forma consolidated
financial and other data included below and elsewhere in or
incorporated by reference in this prospectus are not necessarily
indicative of future performance.
On August 17, 2005, we completed a transaction in which we
formed Holdings to purchase shares of FMFC common stock from
certain FMFC stockholders and to exchange shares and options
with the remaining stockholders of FMFC. As a result of this
transaction, which we refer to as the Holdings Transaction,
Glencoe became the majority stockholder of Holdings and Holdings
became the controlling stockholder of FMFC. The purchase and
exchange of shares was financed by the issuance of
$65.0 million aggregate principal amount of senior notes by
Holdings. As a result of this acquisition and resulting purchase
accounting adjustments the results of operations for periods
prior to August 17, 2005 are not comparable to periods
subsequent to that date. Holdings was merged into FMFC on
October 16, 2006 and the senior notes were repaid in full
with a portion of the net proceeds from our initial public
offering.
The summary historical and consolidated financial and other data
presented below for the year ended December 31, 2004
(Predecessor) have been derived from the audited consolidated
financial statements of our predecessor incorporated by
reference in this prospectus. The information presented for the
year ended December 31, 2005 reflects the pro forma
combined results of the predecessor and the successor companies
as it relates to the Holdings Transaction. The pro forma
information presented below for the years ended
December 31, 2006 and 2005 and the three months ended
March 31, 2006 reflect certain pro forma adjustments to
exclude the impact of interest expense, the amortization of debt
issuance costs, write-off of remaining debt issuance costs in
the fourth quarter of 2006, prepayment penalty in the fourth
quarter of 2006, and federal tax benefits arising from the
senior notes that were repaid in full with the proceeds from our
initial public offering. See Unaudited Pro Forma
Consolidated Statements of Income.
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Three Months Ended March 31,
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Year Ended December 31,
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2007
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2006
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2006
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2005
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2004(1)
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Pro Forma
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Pro Forma
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Pro Forma
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Successor
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Successor
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Successor
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Combined
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Predecessor
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(Dollars in thousands, except share and per share data)
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Income Statement
Data:
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|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Direct and assumed written premiums
|
|
$
|
60,600
|
|
|
$
|
56,876
|
|
|
$
|
218,181
|
|
|
$
|
175,896
|
|
|
$
|
92,066
|
|
Net written premiums
|
|
|
34,460
|
|
|
|
27,108
|
|
|
|
142,926
|
|
|
|
105,701
|
|
|
|
72,895
|
|
Net earned premiums
|
|
|
44,929
|
|
|
|
28,529
|
|
|
|
110,570
|
|
|
|
97,722
|
|
|
|
61,291
|
|
Commissions and fees
|
|
|
4,657
|
|
|
|
4,444
|
|
|
|
16,692
|
|
|
|
26,076
|
|
|
|
33,730
|
|
Net investment income
|
|
|
3,294
|
|
|
|
2,129
|
|
|
|
9,676
|
|
|
|
6,718
|
|
|
|
4,619
|
|
Net realized gains (losses) on
investments
|
|
|
135
|
|
|
|
(153
|
)
|
|
|
517
|
|
|
|
220
|
|
|
|
(120
|
)
|
Total operating revenues
|
|
|
53,015
|
|
|
|
34,949
|
|
|
|
137,455
|
|
|
|
130,736
|
|
|
|
99,520
|
|
Losses and loss adjustment
expenses, net
|
|
|
23,954
|
|
|
|
14,907
|
|
|
|
56,208
|
|
|
|
55,094
|
|
|
|
26,854
|
|
Amortization of deferred
acquisition expenses
|
|
|
8,739
|
|
|
|
4,894
|
|
|
|
16,358
|
|
|
|
20,630
|
|
|
|
15,713
|
|
Underwriting, agency and other
operating expenses
|
|
|
3,730
|
|
|
|
4,210
|
|
|
|
13,458
|
|
|
|
13,470
|
|
|
|
26,953
|
|
Amortization of intangible assets
|
|
|
307
|
|
|
|
292
|
|
|
|
1,270
|
|
|
|
1,166
|
|
|
|
632
|
|
Total operating expenses
|
|
|
36,730
|
|
|
|
24,303
|
|
|
|
87,294
|
|
|
|
90,360
|
|
|
|
70,152
|
|
Operating income
|
|
|
16,285
|
|
|
|
10,646
|
|
|
|
50,161
|
|
|
|
40,376
|
|
|
|
29,368
|
|
Interest expense
|
|
|
982
|
|
|
|
438
|
|
|
|
1,920
|
|
|
|
2,279
|
|
|
|
1,697
|
|
Income taxes
|
|
|
5,229
|
|
|
|
3,635
|
|
|
|
16,884
|
|
|
|
13,754
|
|
|
|
10,006
|
|
Net income
|
|
$
|
9,967
|
|
|
$
|
6,802
|
|
|
$
|
31,397
|
|
|
$
|
24,908
|
|
|
$
|
17,735
|
|
Net Income Per Share
Data:(2)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Basic historical
|
|
$
|
0.58
|
|
|
$
|
1.41
|
|
|
$
|
4.12
|
|
|
$
|
5.17
|
|
|
$
|
1.32
|
|
Diluted historical
|
|
|
0.55
|
|
|
|
0.55
|
|
|
|
2.27
|
|
|
|
2.07
|
|
|
|
1.05
|
|
Weighted-average shares
outstanding basic historical
|
|
|
17,331,901
|
|
|
|
4,183,479
|
|
|
|
6,907,905
|
|
|
|
4,146,045
|
|
|
|
12,041,334
|
|
Weighted-average shares
outstanding diluted historical
|
|
|
18,183,841
|
|
|
|
12,291,514
|
|
|
|
13,831,649
|
|
|
|
12,044,004
|
|
|
|
16,872,247
|
|
GAAP Underwriting
Ratios:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Loss ratio(3)
|
|
|
53.3
|
%
|
|
|
52.3
|
%
|
|
|
50.8
|
%
|
|
|
56.4
|
%
|
|
|
43.8
|
%
|
Expense ratio(4)
|
|
|
20.4
|
%
|
|
|
22.5
|
%
|
|
|
16.9
|
%
|
|
|
14.3
|
%
|
|
|
18.9
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Combined ratio(5)
|
|
|
73.7
|
%
|
|
|
74.8
|
%
|
|
|
67.7
|
%
|
|
|
70.7
|
%
|
|
|
62.7
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
8
|
|
|
|
|
|
|
|
|
|
|
As of March 31, 2007
|
|
|
|
Actual
|
|
|
As Adjusted(6)
|
|
|
|
(Dollars in thousands)
|
|
|
Balance Sheet Data:
|
|
|
|
|
|
|
|
|
Total investments
|
|
$
|
359,982
|
|
|
$
|
363,160
|
|
Total assets
|
|
|
566,665
|
|
|
|
569,843
|
|
Loss and loss adjustment expense
reserves
|
|
|
211,271
|
|
|
|
211,271
|
|
Unearned premium reserves(7)
|
|
|
97,943
|
|
|
|
97,943
|
|
Long-term debt
|
|
|
46,394
|
|
|
|
46,394
|
|
Total stockholders equity
|
|
|
182,848
|
|
|
|
186,026
|
|
|
|
|
(1) |
|
Includes the operations of ARPCO from the date of acquisition of
ARPCO in June 2004. |
|
(2) |
|
Net income per share and weighted average shares outstanding
reflect a
925-for-1
stock split of our common stock which occurred prior to the
completion of our initial public offering. The only significant
difference between basic and diluted net income per share is the
treatment of options. |
|
(3) |
|
Loss ratio is defined as the ratio of incurred losses and loss
adjustment expenses to net earned premiums. |
|
(4) |
|
Expense ratio is defined as the ratio of (i) the
amortization of deferred acquisition expenses plus other
operating expenses, less expenses related to insurance services
operations, less commissions and fee income related to
underwriting operations to (ii) net earned premiums. |
|
(5) |
|
A combined ratio is the sum of the loss ratio and the expense
ratio. A combined ratio under 100% generally indicates an
underwriting profit. A combined ratio over 100% generally
indicates an underwriting loss. |
|
(6) |
|
As adjusted for the sale of 200,000 shares of our common
stock in this offering at the offering price to the public of
$19.25 per share, after deducting underwriting discounts
and estimated offering expenses payable by us. |
|
(7) |
|
Unearned premium reserves are reserves established for the
portion of premiums that is allocable to the unexpired portion
of the policy term. |
9
RISK
FACTORS
An investment in our common stock involves a number of risks.
Before making an investment in our common stock, you should
carefully consider the following risks, as well as the other
information contained in or incorporated by reference in this
prospectus, including our consolidated financial statements and
the related notes and Managements Discussion and
Analysis of Financial Condition and Results of Operations.
Additional risks and uncertainties not currently known to us, or
risks that we currently deem immaterial, may also impair our
business operations. Any of the risks described below could
result in a significant or material adverse effect on our
financial condition or our results of operations. As a result,
the trading price of our common stock could decline and you may
lose all or part of your investment.
Risks
Relating to Our Business
Any
downgrade in the A.M. Best rating of FMIC would prevent us
from successfully engaging in direct insurance writing or
obtaining adequate reinsurance on competitive terms, which would
lead to a decrease in revenue and net income.
Third party rating agencies periodically assess and rate the
claims-paying ability of insurers based on criteria established
by the rating agencies. In June 2004, FMIC received an
A− rating (the fourth highest of fifteen
ratings) with a stable outlook from A.M. Best Company,
Inc., or A.M. Best, a rating agency and publisher for the
insurance industry. This rating is not a recommendation to buy,
sell or hold our securities but is viewed by insurance consumers
and intermediaries as a key indicator of the financial strength
and quality of an insurer. FMIC currently has the lowest rating
necessary to compete in our targeted markets as a direct
insurance writer because an A− rating or
higher is required by many insurance brokers, agents and
policyholders when obtaining insurance and by many insurance
companies that reinsure portions of our policies.
Our A.M. Best rating is based on a variety of factors, many
of which are outside of our control. These factors include our
business profile and the statutory surplus of our insurance
subsidiaries, which is adversely affected by underwriting losses
and dividends paid by them to us. Other factors include balance
sheet strength (including capital adequacy and loss and loss
adjustment expense reserve adequacy) and operating performance.
Any downgrade of our ratings could cause our current and future
brokers and agents, retail brokers and insureds to choose other,
more highly rated, competitors and increase the cost or reduce
the availability of reinsurance to us. Without at least an
A− A.M. Best rating for FMIC, we could
not competitively engage in direct insurance writing, but
instead would be heavily dependent on fronting carriers to
underwrite premiums. These fronting arrangements would require
us to pay significant fees, which could then cause our earnings
to decline. Moreover, we may not be able to enter into fronting
arrangements on acceptable terms, which would impair our ability
to operate our business.
Effective January 1, 2007, FMIC and ANIC entered into an
intercompany pooling reinsurance agreement wherein all premiums,
losses and expenses of FMIC and ANIC are combined and
apportioned between FMIC and ANIC in accordance with fixed
percentages. On May 4, 2007, A.M. Best assigned the
financial strength rating A− to the First
Mercury Group pool and its members, FMIC and ANIC, affirming
FMICs A− rating and upgrading
ANICs rating to A−.
Our
actual incurred losses may be greater than our loss and loss
adjustment expense reserves, which could have a material adverse
effect on our financial condition or our results of
operations.
We are liable for losses and loss adjustment expenses under the
terms of the insurance policies issued directly by us and under
those for which we assume reinsurance obligations. As a result,
if we fail to accurately assess the risk associated with the
business that we insure, our loss reserves may be inadequate to
cover our actual losses. In many cases, several years may elapse
between the occurrence of an insured loss, the reporting of the
loss to us and our payment of the loss. In addition, our
policies generally do not provide limits on defense costs, which
could increase our liability exposure under our policies.
10
We establish loss and loss adjustment expense reserves with
respect to reported and unreported claims incurred as of the end
of each period. Our loss and loss adjustment expense reserves
were $191.0 million, $113.9 million, and
$68.7 million at December 31, 2006, 2005 and 2004,
respectively, and $211.3 million at March 31, 2007,
all of which are gross of ceded loss and loss adjustment expense
reserves. These reserves do not represent an exact measurement
of liability, but are our estimates based upon various factors,
including:
|
|
|
|
|
actuarial projections of what we, at a given time, expect to be
the cost of the ultimate settlement and administration of claims
reflecting facts and circumstances then known;
|
|
|
|
estimates of future trends in claims severity and frequency;
|
|
|
|
assessment of asserted theories of liability; and
|
|
|
|
analysis of other factors, such as variables in claims handling
procedures, economic factors and judicial and legislative trends
and actions.
|
Most or all of these factors are not directly or precisely
quantifiable, particularly on a prospective basis, and are
subject to a significant degree of variability over time. For
example, insurers have been held liable for large awards of
punitive damages, which generally are not reserved for. In many
cases, estimates are made more difficult by significant
reporting lags between the occurrence of the insured event and
the time it is actually reported to the insurer and additional
lags between the time of reporting and final settlement of
claims. Accordingly, the ultimate liability may be more or less
than the current estimate. While we set our reserves based on
our assessment of the insurance risk assumed, as we have
expanded into new specialty classes of business, we do not have
extensive proprietary loss data for other specialty classes to
use to develop reserves. Instead, we must rely on industry loss
information, which may not reflect our actual claims results. As
a result, our continued expansion into new specialty classes may
make it more difficult to ensure that our actual losses are
within our loss reserves.
If any of our reserves should prove to be inadequate, we will be
required to increase reserves, resulting in a reduction in our
net income and stockholders equity in the period in which
the deficiency is identified. In addition, future loss
experience substantially in excess of established reserves could
also have a material adverse effect on future earnings and
liquidity as well as our financial strength rating.
Under generally accepted accounting principles, or GAAP, we are
only permitted to establish loss and loss adjustment expense
reserves for losses that have occurred on or before the
financial statement date. Case reserves and incurred but not
reported, or IBNR, reserves contemplate these obligations. No
contingency reserve allowances are established to account for
future loss occurrences. Losses arising from future events will
be estimated and recognized at the time the losses are incurred
and could be substantial.
We
bear credit risk with respect to our reinsurers, and if any
reinsurer fails to pay us, or fails to pay us on a timely basis,
we could experience losses.
Reinsurance is a practice whereby one insurer, called the
reinsurer, agrees to indemnify another insurer, called the
ceding insurer, for all or part of the potential liability
arising from one or more insurance policies issued by the ceding
insurer. Although reinsurance makes the reinsurer liable to us
to the extent of the risk transferred or ceded to the reinsurer,
this arrangement does not relieve us of our primary liability to
our policyholders. Moreover, our primary liability for losses
and loss adjustment expenses under the insurance policies that
we underwrite will increase as our business shifts from relying
on fronting arrangements to our direct writing of insurance. At
March 31, 2007, we had $98.8 million of reinsurance
recoverables. We expect our recoverables from reinsurers to
increase as we increase the insurance that we directly write
instead of using a fronting relationship. Under fronting
arrangements, policies produced by our CoverX subsidiary were
directly written by third party insurers, and a portion of the
risk under these policies was assumed by us or other reinsurers
for a portion of the related premium. With the elimination of
most of our fronting relationships in May 2005, we became the
direct writer of substantially all of the policies produced by
us, and as a result, our premiums ceded to reinsurers has
increased from 2004 to 2006. Most of our reinsurance
recoverables are from four reinsurers, consisting of
subsidiaries of ACE Limited, Swiss Reinsurance America
Corporation, Platinum Underwriters Reinsurance, Inc. and W.R.
Berkley Corp. At March 31, 2007, the balances from ACE
11
Limited, Swiss Reinsurance America Corporation, Platinum
Underwriters Reinsurance, Inc. and W.R. Berkley Corp. were
$62.4 million, $25.9 million, $4.3 million and
$1.1 million, respectively. Although we believe that we
have high internal standards for reinsurers with whom we place
reinsurance, we cannot assure you that our reinsurers will pay
reinsurance claims on a timely basis or at all. If reinsurers
are unwilling or unable to pay us amounts due under reinsurance
contracts, we will incur unexpected losses and our cash flow
will be adversely affected, which would have a material adverse
effect on our financial condition and operating results.
We may
not be able to obtain adequate reinsurance coverage or
reinsurance on acceptable terms.
We use significant amounts of reinsurance to manage our exposure
to market and insurance risks and to enable us to write policies
in excess of the level that our capital supports. The
availability and cost of reinsurance are subject to prevailing
market conditions, both in terms of price and available
capacity, which can affect our business volume and
profitability. Without adequate levels of appropriately priced
reinsurance, the level of premiums we can underwrite could be
materially reduced. The reinsurance market has changed
dramatically over the past few years as a result of a number of
factors, including inadequate pricing, poor underwriting and the
significant losses incurred as a consequence of the terrorist
attacks on September 11, 2001. As a result, reinsurers have
exited some lines of business, reduced available capacity and
implemented provisions in their contracts designed to reduce
their exposure to loss. In addition, the historical results of
reinsurance programs and the availability of capital also affect
the availability of reinsurance. Our reinsurance facilities
generally are subject to annual renewal and are from four
reinsurers. We cannot provide any assurance that we will be able
to maintain our current reinsurance facilities or that we will
be able to obtain other reinsurance facilities in adequate
amounts and at favorable rates.
The
failure of any of the loss limitations or exclusions we employ
or changes in other claim or coverage issues could have a
material adverse effect on our financial condition or our
results of operations.
Various provisions of our policies, such as loss limitations,
exclusions from coverage or choice of forum, which have been
negotiated to limit our risks, may not be enforceable in the
manner we intend. At the present time, we employ a variety of
endorsements to our policies in an attempt to limit exposure to
known risks. As industry practices and legal, social and other
conditions change, unexpected and unintended issues related to
claims and coverage may emerge. These issues may adversely
affect our business by either extending coverage beyond our
underwriting intent or by increasing the size or number of
claims. Recent examples of emerging claims and coverage issues
include increases in the number and size of claims relating to
construction defects, which often present complex coverage and
damage valuation questions. The effects of these and other
unforeseen emerging claim and coverage issues are difficult to
predict and could harm our business.
In addition, we craft our insurance policy language to limit our
exposure to expanding theories of legal liability such as those
which have given rise to claims for lead paint, asbestos, mold
and construction defects. Many of the policies we issue also
include conditions requiring the prompt reporting of claims to
us and our right to decline coverage in the event of a violation
of that condition, as well as limitations restricting the period
during which a policyholder may bring a breach of contract or
other claim against our company, which in many cases is shorter
than the statutory limitations for such claims in the states in
which we write business. It is possible that a court or
regulatory authority could nullify or void an exclusion or that
legislation could be enacted which modifies or bars the use of
such endorsements and limitations in a way that would adversely
affect our loss experience, which could have a material adverse
effect on our financial condition or results of operations. In
some instances, these changes may not become apparent until some
time after we have issued insurance policies that are affected
by the changes. As a result, we may not know the full extent of
liability under our insurance contracts for many years after a
contract is issued.
The
lack of long-term operating history and proprietary data on
claims results for relatively new specialty classes may cause
our future results to be less predictable.
Since 2000, we have expanded our focus on new classes of the
specialty insurance market, which we refer to as other specialty
classes, in addition to our long-standing business for security
classes. Other specialty
12
classes represented 24.2% of our premiums produced in 2000 and
68.8% of our premiums produced in 2006. As a result of this
expansion, we have a more limited operating and financial
history available for other specialty classes when compared to
our data for security classes. This may adversely impact our
ability to adequately price the insurance we write to reflect
the risk assumed and to exclude risks that generate large or
frequent claims and to establish appropriate loss reserves. For
example, in 2005, we increased our reserves applicable to other
specialty classes by approximately $6.2 million,
principally as a result of using updated industry loss
development factors in the calculations of ultimate expected
losses and reserves on those classes that we believed were more
closely aligned with our classifications and coverage limits and
actual emerging experience. Because we rely more heavily on
industry data in calculating reserves for other specialty
classes than we do for security classes, we may need to further
adjust our reserve estimates for other specialty classes in the
future, which could materially adversely affect our operating
results.
Our
growth may be dependent upon our successful acquisition and
retention of additional underwriting expertise.
Our operating results and future growth depend, in part, on the
acquisition and successful retention of underwriting expertise.
We rely on a small number of underwriters in the other specialty
classes for which we write policies. For example, we
significantly expanded our business into other specialty classes
in 2000 by hiring three senior underwriters and we introduced
legal professional liability coverage by contracting with one
underwriter who operates in Boston. In 2007, we introduced
employers general liability and hospitality general liability by
contracting with two new underwriters. In addition, we intend to
continue to expand into other specialty classes through the
acquisition of key underwriting personnel. While we intend to
continue to search for suitable candidates to augment and
supplement our underwriting expertise in existing and additional
classes of specialty insurance, we may not be successful in
identifying, hiring and retaining candidates. If we are
successful in identifying candidates, there can be no assurance
that we will be able to hire and retain them or, if they are
hired and retained, that they will be successful in enhancing
our business or generating an underwriting profit.
We may
require additional capital in the future, which may not be
available or may be available only on unfavorable
terms.
Our future capital requirements, especially those of our
insurance subsidiaries, depend on many factors, including our
ability to write new business successfully and to establish
premium rates and reserves at levels sufficient to cover losses
and loss adjustment expenses. We may need to raise additional
funds to the extent that our cash flows are insufficient to fund
future operating requirements, support growth and maintain our
A.M. Best rating. Many factors will affect our capital
needs, including our growth and profitability, our claims
experience, and the availability of reinsurance, as well as
possible acquisition opportunities, market disruptions and other
unforeseeable developments. If we have to raise additional
capital, equity or debt financing may not be available or may be
available only on terms, amounts or time periods that are not
favorable to us. Equity financings could be dilutive to our
existing stockholders and debt financings could subject us to
covenants that restrict our ability to operate our business
freely. If we cannot obtain adequate capital on favorable terms
or at all, our business, financial condition or results of
operations could be materially adversely affected.
Our
business could be adversely affected by the loss of one or more
key employees.
We are substantially dependent on a small number of key
employees at our operating companies, in particular Richard H.
Smith, our Chairman, President and Chief Executive Officer, and
our key underwriting employees. We believe that the experience
and reputation in the insurance industry of Mr. Smith and
our key underwriting employees are important factors in our
ability to attract new business. Our success has been, and will
continue to be, dependent on our ability to retain the services
of our existing key employees and to attract and retain
additional qualified personnel in the future. As we continue to
grow, we will need to recruit and retain additional qualified
management personnel, but we may be unsuccessful in doing so.
The loss of the services of Mr. Smith or any other key
employee, or the inability to identify, hire and retain other
highly qualified personnel in the future, could adversely affect
the quality and profitability of our operations.
13
Our
insurance business is concentrated in relatively few specialty
classes.
Premiums produced for security classes represented 31.2% and
26.8% of our total direct and assumed written premiums in 2006
and for the three months ended March 31, 2007,
respectively. As a result, any changes in the security insurance
market, such as changes in business, economic or regulatory
conditions or changes in federal or state law or legal
precedents, could adversely impact our ability to write
insurance for this market. For example, any legal outcome or
other incident could have the effect of increasing insurance
claims in the security insurance market which could adversely
impact our operating results.
The
loss of one or more of our top wholesale brokers could have a
material adverse effect on our financial condition or our
results of operations.
For security classes, we generate business from traditional
E&S lines insurance wholesalers and specialists that focus
on security guards and detectives, alarm installation and
service businesses and safety equipment installation and service
businesses. These wholesalers and specialists are not under any
contractual obligation to provide us business. Our top five
wholesale brokers represented 29.2% of the premiums produced
from security classes in 2006. For other specialty classes, we
generate business from traditional E&S lines insurance
wholesalers who have a presence in the other specialty classes
we underwrite. Our top five wholesale brokers represented 37.3%
of the premiums produced from other specialty classes in 2006.
In certain other specialty classes, we rely on a small number of
agents to generate the insurance that we underwrite. For
example, substantially all of our legal professional liability
coverage is generated by one agent. The loss of one or more of
our top wholesale brokers for security classes or other
specialty classes could have a material adverse effect on our
financial condition or our results of operations.
We
operate in a highly competitive environment, which makes it more
difficult for us to attract and
retain business.
The insurance industry in general and the markets in which we
compete are highly competitive and we believe that they will
remain so for the foreseeable future. We face competition from
several companies, which include insurance companies,
reinsurance companies, underwriting agencies, program managers
and captive insurance companies. As a result of this intense
competition, prevailing conditions relating to price, coverage
and capacity can change very rapidly. Many of our competitors
are larger and have greater financial, marketing and management
resources than we do and may be perceived as providing greater
security to policyholders. There are low barriers to entry in
the E&S lines insurance market, which is the primary market
in which we operate, and competition in this market is
fragmented and not dominated by one or more competitors.
Competition in the E&S lines insurance industry is based on
many factors, including price, policy terms and conditions,
ratings by insurance agencies, overall financial strength of the
insurer, services offered, reputation, agent and broker
compensation and experience. We may face increased competition
in the future in the insurance markets in which we operate, and
any such increased competition could have a material adverse
effect on us.
Several E&S lines insurers and industry groups and
associations currently offer alternative forms of risk
protection in addition to traditional insurance products. These
alternative products, including large deductible programs and
various forms of self-insurance that use captive insurance
companies and risk retention groups, have been instituted to
allow for better control of risk management and costs. We cannot
predict how continued growth in alternative forms of risk
protection will affect our future operations.
Results
in the insurance industry, and specifically the E&S lines
insurance market, are subject to fluctuations and uncertainty
which may adversely affect our ability to write
policies.
Historically, the financial performance of the property and
casualty insurance industry has fluctuated in cyclical periods
of price competition and excess underwriting capacity (known as
a soft market) followed by periods of high premium rates and
shortages of underwriting capacity (known as a hard market).
Although an individual insurance companys financial
performance is dependent on its own specific business
characteristics, the profitability of most property and casualty
insurance companies tends to follow this cyclical market
14
pattern. Further, this cyclical market pattern can be more
pronounced in the E&S lines market than in the standard
insurance market due to greater flexibility in the E&S
lines market to adjust rates to match market conditions. When
the standard insurance market hardens, the E&S lines market
hardens even more than the standard insurance market. During
these hard market conditions, the standard insurance market
writes less insurance and more customers must resort to the
E&S lines market for insurance. As a result, the E&S
lines market can grow more rapidly than the standard insurance
market. Similarly, when conditions begin to soften, many
customers that were previously driven into the E&S lines
market may return to the standard insurance market, exacerbating
the effects of rate decreases in the E&S lines market.
Beginning in 2000 and accelerating in 2001, the property and
casualty insurance industry experienced a hard market reflecting
increasing rates, more restrictive coverage terms and more
conservative risk selection. We believe that this trend
continued through 2003. We believe that these trends slowed
beginning in 2004 and that the current insurance market has
become more competitive in terms of pricing and policy terms and
conditions. We are currently experiencing some downward pricing
pressure. Because this cyclicality is due in large part to the
actions of our competitors and general economic factors, we
cannot predict the timing or duration of changes in the market
cycle. These cyclical patterns have caused our revenues and net
income to fluctuate and are expected to do so in the future.
We are
subject to extensive regulation, which may adversely affect our
ability to achieve our business objectives. In addition, if we
fail to comply with these regulations, we may be subject to
penalties, including fines and suspensions, which may adversely
affect our financial condition and results of
operations.
Our insurance subsidiaries are subject to extensive regulation,
primarily by insurance regulators in Illinois and Minnesota, the
states in which our two insurance company subsidiaries are
domiciled and, to a lesser degree, the other jurisdictions in
which we operate. Most insurance regulations are designed to
protect the interests of insurance policyholders, as opposed to
the interests of the insurance companies or their shareholders.
These insurance regulations generally are administered by a
department of insurance in each state and relate to, among other
things, licensing, authorizations to write E&S lines of
business, capital and surplus requirements, rate and form
approvals, investment and underwriting limitations, affiliate
transactions (which includes the review of services, tax sharing
and other agreements with affiliates that can be a source of
cash flow to us, other than dividends which are specifically
regulated by law), dividend limitations, changes in control,
solvency and a variety of other financial and non-financial
aspects of our business. Significant changes in these laws and
regulations could further limit our discretion to operate our
business as we deem appropriate or make it more expensive to
conduct our business. State insurance departments also conduct
periodic examinations of the affairs of insurance companies and
require the filing of annual and other reports relating to
financial condition, holding company issues and other matters.
These regulatory requirements may adversely affect our ability
to achieve some or all of our business objectives.
In addition, regulatory authorities have broad discretion to
deny or revoke licenses or approvals for various reasons,
including the violation of regulations. In instances where there
is uncertainty as to the applicability of regulations, we follow
practices based on our interpretations of regulations or
practices that we believe generally to be followed by the
insurance industry. These practices may turn out to be different
from the interpretations of regulatory authorities. If we do not
have the requisite licenses and approvals or do not comply with
applicable regulatory requirements, insurance regulatory
authorities could preclude or temporarily suspend us from
carrying on some or all of our activities or otherwise penalize
us. These actions could adversely affect our ability to operate
our business. Further, changes in the level of regulation of the
insurance industry and changes in laws or regulations themselves
or their interpretations by regulatory authorities could
adversely affect our ability to operate our business.
If we
have insufficient risk-based capital, our ability to conduct our
business could be adversely affected.
The National Association of Insurance Commissioners, or NAIC,
has adopted a system to test the adequacy of statutory capital,
known as risk-based capital. This system establishes
the minimum amount of risk-based capital necessary for a company
to support its overall business operations. It identifies
property and
15
casualty insurers that may be inadequately capitalized by
looking at certain inherent risks of each insurers assets
and liabilities and its mix of net written premiums. Insurers
falling below a calculated threshold may be subject to varying
degrees of regulatory action, including supervision,
rehabilitation or liquidation. Failure to maintain our
risk-based capital at the required levels could adversely affect
the ability of our insurance subsidiaries to maintain regulatory
authority to conduct our business.
If our
IRIS ratios are outside the usual range, our business could be
adversely affected.
Insurance Regulatory Information System, or IRIS, ratios are
part of a collection of analytical tools designed to provide
state insurance regulators with an integrated approach to
screening and analyzing the financial condition of insurance
companies operating in their respective states. As of
December 31, 2006, FMIC had IRIS ratios outside the usual
range in three of the IRIS tests and ANIC had IRIS ratios
outside the usual range in one of the IRIS tests. An insurance
company may become subject to increased scrutiny when four or
more of its IRIS ratios fall outside the range deemed usual by
the NAIC. The nature of increased regulatory scrutiny resulting
from IRIS ratios that are outside the usual range is subject to
the judgment of the applicable state insurance department, but
generally will result in accelerated review of annual and
quarterly filings. Depending on the nature and severity of the
underlying cause of the IRIS ratios being outside the usual
range, increased regulatory scrutiny could range from increased
but informal regulatory oversight to placing a company under
regulatory control. FMIC has, in the past, had more than four
ratios outside the usual range. If, in the future, FMIC has four
or more ratios outside the usual range, we could become subject
to greater scrutiny and oversight by regulatory authorities. See
Insurance and Other Regulatory Matters.
If we
are unable to realize our investment objectives, our financial
condition may be adversely affected.
Our operating results depend in part on the performance of our
investment portfolio. The primary goals of our investment
portfolio are to:
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accumulate and preserve capital;
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assure proper levels of liquidity;
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optimize total after tax return subject to acceptable risk
levels;
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provide an acceptable and stable level of current income; and
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approximate duration match between our investments and our
liabilities.
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The ability to achieve our investment objectives is affected by
general economic conditions that are beyond our control. General
economic conditions can adversely affect the markets for
interest rate-sensitive securities, including the extent and
timing of investor participation in such markets, the level and
volatility of interest rates and, consequently, the value of
fixed income securities. Interest rates are highly sensitive to
many factors, including governmental monetary policies, domestic
and international economic and political conditions and other
factors beyond our control. General economic conditions, stock
market conditions and many other factors can also adversely
affect the equities markets and, consequently, the value of the
equity securities we own. We may not be able to realize our
investment objectives, which could reduce our net income
significantly.
Our
directors and executive officers own a large percentage of our
common stock, which allows them to effectively control matters
requiring stockholder approval.
Our directors and executive officers will beneficially own 22.3%
of our outstanding common stock (including options exercisable
within 60 days) immediately following completion of this
offering, including 14.4% owned by Jerome Shaw, our founder and
former Chief Executive Officer. Accordingly, these directors and
executive officers will have substantial influence, if they act
as a group, over the election of directors and the outcome of
other corporate actions requiring stockholder approval and could
seek to arrange a sale of our company at a time or under
conditions that are not favorable to our other stockholders.
These stockholders may also delay or prevent a change of
control, even if such a change of control would benefit our
other
16
stockholders, if they act as a group. This significant
concentration of stock ownership may adversely affect the
trading price of our common stock due to investors
perception that conflicts of interest may exist or arise.
We
rely on our information technology and telecommunication
systems, and the failure of these systems could adversely affect
our business.
Our business is highly dependent on the successful and
uninterrupted functioning of our information technology and
telecommunications systems. We rely on these systems to process
new and renewal business, provide customer service, make claims
payments, facilitate collections and cancellations and to share
data across our organization. These systems also enable us to
perform actuarial and other modeling functions necessary for
underwriting and rate development. The failure of these systems,
or the termination of a third party software license on which
any of these systems is based, could interrupt our operations or
materially impact our ability to evaluate and write new
business. Because our information technology and
telecommunications systems interface with and depend on third
party systems, we could experience service denials if demand for
such services exceeds capacity or such third party systems fail
or experience interruptions. If sustained or repeated, a system
failure or service denial could result in a deterioration of our
ability to write and process new and renewal business and
provide customer service or compromise our ability to pay claims
in a timely manner.
Our
third party governmental entities risk-sharing pooling
administration business is concentrated among a limited number
of pools and the termination of any single contract for this
business could significantly reduce the profitability of this
business.
Since June 2004, we have owned and managed a third party
governmental entities risk-sharing pooling administration
business through ARPCO. Each pool is composed of public entity
members (such as cities, townships, counties, etc.) that have
joined together by means of an intergovernmental contract to
pool their insurance risk and provide related insurance services
to its members. The pooling is authorized by state statute or as
noted in the enabling legislation. Pooling provides a risk
sharing alternative to the traditional purchase of commercial
insurance. The governmental risk-sharing pools that we provide
services for are located in the Midwest. ARPCO currently has
multi-year contracts with five risk-sharing pools and the
termination or non-renewal of any single contract for this
business would significantly reduce the profitability of this
business.
Risks
Related to this Offering and the Common Stock
The
price of our shares of common stock may be
volatile.
The trading price of shares of our common stock following this
offering may fluctuate substantially. The price of the shares of
our common stock that will prevail in the market after this
offering may be higher or lower than the price you pay,
depending on many factors, some of which are beyond our control
and may not be related to our operating performance. These
fluctuations could cause you to lose part or all of your
investment in shares of our common stock. Factors that could
cause fluctuations include, but are not limited to, the
following:
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price and volume fluctuations in the overall stock market from
time to time;
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significant volatility in the market price and trading volume of
insurers securities;
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actual or anticipated changes in our earnings or fluctuations in
our operating results or in the expectations of securities
analysts;
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general economic conditions and trends;
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losses in our insured portfolio;
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sales of large blocks of shares of our common stock; or
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departures of key personnel.
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Our
results of operations and revenues may fluctuate as a result of
many factors, including cyclical changes in the insurance
industry, which may cause the price of our shares to
decline.
The results of operations of companies in the insurance industry
historically have been subject to significant fluctuations and
uncertainties. Our profitability can be affected significantly
by:
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the differences between actual and expected losses that we
cannot reasonably anticipate using historical loss data and
other identifiable factors at the time we price our products;
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volatile and unpredictable developments, including man-made,
weather-related and other natural catastrophes or terrorist
attacks, or court grants of large awards for particular damages;
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changes in the amount of loss reserves resulting from new types
of claims and new or changing judicial interpretations relating
to the scope of insurers liabilities; and
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fluctuations in equity markets, interest rates, credit risk and
foreign currency exposure, inflationary pressures and other
changes in the investment environment, which affect returns on
invested assets and may impact the ultimate payout of losses.
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In addition, the demand for the types of insurance we will offer
can vary significantly, rising as the overall level of economic
activity increases and falling as that activity decreases,
causing our revenues to fluctuate. These fluctuations in results
of operations and revenues may cause the price of our securities
to be volatile.
If a
substantial number of our shares of common stock become
available for sale and are sold in a short period of time, the
market price of our shares of common stock could
decline.
If our existing stockholders sell substantial amounts of our
shares of common stock in the public market following this
offering, the market price of our shares of common stock could
decrease significantly. The perception in the public market that
our existing stockholders might sell our shares of common stock
could also depress our market price. Upon completion of this
offering we will have 17,540,979 shares of our common stock
outstanding.
Certain of our stockholders will be subject to agreements with
the underwriters that restrict their ability to transfer their
shares for a period of 90 days from the date of this
prospectus, subject to a few exceptions. However, the
underwriters may waive these restrictions and allow these
stockholders to sell their shares at any time. After all of
these agreements expire, an aggregate of 4,069,330 shares
(including options exercisable within 60 days of the date
hereof) subject to such
lock-ups
will be eligible for sale. The market price of our shares of
common stock may drop significantly when the restrictions on
resale by our existing stockholders lapse. A decline in the
price of shares of our common stock might impede our ability to
raise capital through the issuance of additional shares of our
common stock or other equity securities.
We do
not currently intend to pay cash dividends on our common stock
to our stockholders and any determination to pay cash dividends
in the future will be at the discretion of our board of
directors.
We currently intend to retain any profits to provide capacity to
write insurance and to accumulate reserves and surplus for the
payment of claims. Our board of directors does not intend to
declare cash dividends in the foreseeable future. Any
determination to pay dividends to our stockholders in the future
will be at the discretion of our board of directors and will
depend on our results of operations, financial condition and
other factors deemed relevant by our board of directors.
Consequently, it is uncertain when, if ever, we will declare
dividends to our stockholders. If we do not pay dividends,
investors will only obtain a return on their investment if the
market value of our shares of common stock appreciates.
We conduct substantially all of our operations through our
subsidiaries. Our status as a holding company and a legal entity
separate and distinct from our subsidiaries affects our ability
to pay dividends and make other payments. Our principal source
of funds is dividends and other payments from our subsidiaries.
Therefore, our ability to pay dividends depends largely on our
subsidiaries earnings and operating capital requirements
and is subject to the regulatory, contractual, rating agency and
other constraints of our
18
subsidiaries, including the effect of any such dividends or
distributions on the A.M. Best rating or other ratings of
our insurance subsidiaries. Our two insurance subsidiaries are
limited by regulation in their ability to pay dividends. For
example, during 2007, FMIC and ANIC may pay in the aggregate
dividends to FMFC of up to $15.7 million without regulatory
approval. In addition, the terms of our borrowing arrangements
may limit our ability to pay cash dividends to our stockholders.
Provisions
in our certificate of incorporation and bylaws and under
Delaware law could prevent or delay transactions that
stockholders may favor and entrench current
management.
We are incorporated in Delaware. Our certificate of
incorporation and bylaws, as well as Delaware corporate law,
contain provisions that could delay or prevent a change of
control or changes in our management that a stockholder might
consider favorable, including a provision that authorizes our
board of directors to issue preferred stock with such voting
rights, dividend rates, liquidation, redemption, conversion and
other rights as our board of directors may fix and without
further stockholder action. The issuance of preferred stock with
voting rights could make it more difficult for a third party to
acquire a majority of our outstanding voting stock. This could
frustrate a change in the composition of our board of directors,
which could result in entrenchment of current management.
Takeover attempts generally include offering stockholders a
premium for their stock. Therefore, preventing a takeover
attempt may cause you to lose an opportunity to sell your shares
at a premium. If a change of control or change in management is
delayed or prevented, the market price of our common stock could
decline.
Delaware law also prohibits a corporation from engaging in a
business combination with any holder of 15% or more of its
capital stock until the holder has held the stock for three
years unless, among other possibilities, the board of directors
approves the transaction. This provision may prevent changes in
our management or corporate structure. Also, under applicable
Delaware law, our board of directors is permitted to and may
adopt additional anti-takeover measures in the future.
Our bylaws provide for the division of our board of directors
into three classes with staggered three year terms. The
classification of our board of directors could have the effect
of making it more difficult for a third party to acquire, or
discourage a third party from attempting to acquire, control of
us.
Our
ability to implement, for the fiscal year ending
December 31, 2007, the requirements of Section 404 of
the Sarbanes-Oxley Act of 2002 in a timely and satisfactory
manner could subject us to regulatory scrutiny and cause the
price of our common stock to decline.
Section 404 of the Sarbanes-Oxley Act of 2002, or
Sarbanes-Oxley, requires management of a reporting company to
annually review, assess and disclose the effectiveness of a
companys internal control over financial reporting and to
provide an attestation by independent auditors on its assessment
of and the effectiveness of internal control over financial
reporting. We are first subject to the requirements of
Section 404 for the fiscal year ending December 31,
2007. Investor perception that our internal controls are
inadequate or that we are unable to produce accurate financial
statements on a timely, consistent basis may adversely affect
our stock price. Ensuring that we have adequate internal
financial and accounting controls and procedures in place to
help ensure that we can produce accurate financial statements on
a timely basis is a costly and time-consuming effort that needs
to be re-evaluated frequently.
We and our independent auditors may in the future discover areas
of our internal controls that need further attention and
improvement, particularly with respect to businesses that we may
acquire in the future. We cannot be certain that any remedial
measures we take will ensure that we implement and maintain
adequate internal controls over our financial processes and
reporting in the future. Implementing any appropriate changes to
our internal controls may require specific compliance training
of our directors, officers and employees, entail substantial
costs in order to modify our existing accounting systems and
take a significant period of time to complete. Such changes may
not, however, be effective in maintaining the adequacy of our
internal controls, and any failure to maintain that adequacy, or
consequent inability to produce accurate financial statements on
a timely basis, could increase our operating costs and could
harm our ability to operate our business. Any failure to
implement required new or improved controls, or difficulties
19
encountered in their implementation could harm our operating
results or cause us to fail to meet our reporting obligations.
If we are unable to conclude that we have effective internal
controls over financial reporting, or if our independent
auditors are unable to provide us with an unqualified report
regarding the effectiveness of our internal controls over
financial reporting as of December 31, 2007 and in future
periods as required by Section 404, investors could lose
confidence in the reliability of our financial statements, which
could result in a decrease in the value of our common stock.
Failure to comply with Section 404 could potentially
subject us to sanctions or investigations by the Securities and
Exchange Commission, or SEC, the New York Stock Exchange or
other regulatory authorities.
We are
exposed to increased regulatory oversight and incur increased
costs as a result of being a public company.
As a public company, we are required to satisfy corporate
governance requirements of the New York Stock Exchange and incur
significant legal, accounting and other expenses that we did not
incur as a private company. Currently, our audit and
compensation committees are each comprised of two independent
directors and one non-independent director, based upon the rules
of the New York Stock Exchange. These committees must be
composed of all independent members on October 17, 2007. If
we fail to find and elect an additional independent board member
to serve on these committees, we would not be in compliance with
the New York Stock Exchange rules. We also incur costs
associated with our public company reporting requirements and
corporate governance requirements, including requirements under
Sarbanes-Oxley, as well as rules implemented by the SEC and the
New York Stock Exchange. These rules and regulations have
increased our legal and financial compliance costs and have made
certain activities more time-consuming and costly. Being a
public company has also made it more expensive for us to hire
directors and to obtain director and officer liability
insurance. Further, we have incurred costs in connection with
hiring additional accounting, financial and compliance staff
with appropriate public company experience and technical
accounting knowledge. We cannot predict or estimate the amount
of additional costs we may incur or the timing of such costs.
Any of these expenses could harm our business, operating results
and financial condition.
20
CAUTIONARY
STATEMENT REGARDING FORWARD LOOKING STATEMENTS
This prospectus contains forward-looking statements that relate
to future periods and includes statements regarding our
anticipated performance. Generally, the words
anticipates, believes,
expects, intends, estimates,
projects, plans and similar expressions
identify forward-looking statements. These forward-looking
statements involve known and unknown risks, uncertainties and
other important factors that could cause our actual results,
performance or achievements or industry results to differ
materially from any future results, performance or achievements
expressed or implied by these forward-looking statements. These
risks, uncertainties and other important factors include, among
others:
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our ability to maintain, and the effects of any lowering or loss
of any one of, our financial or claims-paying ratings;
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our actual incurred losses exceeding our loss and loss
adjustment expense reserves;
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the failure of reinsurers to meet their obligations to us;
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our inability to obtain reinsurance coverage at reasonable
prices;
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the failure of any of the loss limitations or exclusions we
employ or changes in other claim or coverage issues;
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our lack of long-term operating history in certain classes of
our specialty general liability business;
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our ability to acquire and retain additional underwriting
expertise and capacity;
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our ability to obtain additional capital on terms favorable to
us;
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the loss of one or more key employees;
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the concentration of our insurance business in relatively few
specialty classes;
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the loss of one or more of our top wholesale brokers;
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the highly competitive environment in which we operate our
business;
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fluctuations and uncertainty of results within the excess and
surplus lines insurance industry;
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the extensive regulations to which our business is subject and
our failure to comply with these regulations resulting in
penalties, fines and suspensions;
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our ability to maintain our risk-based capital at levels
required by regulatory authorities;
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our compliance with Insurance Regulatory Information System, or
IRIS, ratios;
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our inability to realize our investment objectives;
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the control our directors and executive officers have over our
corporate actions as a result of their ownership of a
significant percentage of our common stock;
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the business disruption caused by any failure of our information
technology or telecommunications systems; and
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the concentration of our third party governmental entities
risk-sharing pooling administration business among a limited
number of pools.
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Although we believe that these statements are based upon
reasonable assumptions, we can give no assurance that our goals
will be achieved. Given these uncertainties, prospective
investors are cautioned not to place undue reliance on these
forward-looking statements. These forward-looking statements are
made as of the date of this prospectus. Except as required by
law, we assume no obligation to update or revise them or provide
reasons why actual results may differ.
21
THE
COMPANY
The following chart sets forth our corporate structure:
Description
CoverX is our licensed wholesale insurance broker which
produces and underwrites all of the insurance policies for which
we retain risk and receive premiums. CoverX also provides
marketing, underwriting and policy administration services on
business insured by a limited number of third party insurance
carriers in exchange for commissions and fee revenue. CoverX
also receives commissions on business insured by FMIC and ceded
via quota share reinsurance arrangements to third party
reinsurers. CoverX has a recognized brand name among the
wholesale insurance industry and works with approximately 1,000
brokers and agents to produce business for FMIC.
FMIC is our insurance company that provides insurance, or
writes policies, directly for CoverX customers. FMIC also
provides claims handling and adjustment services generally on
all business produced by CoverX, for both itself and other
insurance companies issuing CoverX underwritten business.
ANIC is our insurance company that provides reinsurance
for business generated by CoverX. Although ANIC is licensed as
an admitted carrier in 15 states, it currently does not
write its own insurance. We refer to FMIC and ANIC as our
insurance subsidiaries.
ARPCO was acquired by us in June 2004 from an affiliate.
ARPCO provides third party administration services for risk
sharing pools of governmental entity risks, including
underwriting, claims, loss control and reinsurance services.
ARPCO is solely a fee-based business and receives fees for these
services and also receives commissions on excess per occurrence
insurance placed in the commercial market with third party
companies on behalf of the pools.
History
CoverX was founded in 1973 as an underwriter and broker of
specialty commercial insurance business, including a specific
concentration on the security market, and has continuously
operated in this capacity since that time. The premiums
underwritten by CoverX were originally placed with various third
party insurance carriers. In 1985, recognizing a developing hard
market in the P&C insurance industry, in which premium
rates were increasing and underwriting capacity was decreasing,
our founding shareholder led a group of investors in the
formation of First Mercury Syndicate, Inc., or FMS, as a
syndicate on the Illinois Insurance Exchange, which we refer to
as the Exchange. Through FMS, we had access to broad state
E&S lines authorizations and were able to retain the
majority of the underwriting risk on the business produced by
CoverX.
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In 1986, in an additional reaction to the hard market, our
founding shareholder formed a separately owned business
providing underwriting, claims, reinsurance placement and other
third party administration services to public entity risk pools
through ARPCO.
In 1996, seeking other risk bearing alternatives to the
Exchange, FMIC was formed and FMS subsequently withdrew from the
Exchange and merged into FMIC in June 1996. Due to the fact that
FMIC did not have broad E&S lines authorizations and
initially received an A.M. Best rating of B++,
we began to underwrite the business through the use of fronting
carriers, which provided access to broad E&S lines
authorizations and an A.M. Best rating of
A− or above in exchange for a fee. FMIC
retained the majority of the underwriting risk by serving as the
primary reinsurer for the business produced by CoverX and
written through the fronting carriers.
Anticipating another hardening P&C insurance market, in
2000 we began offering general liability insurance for other
specialty classes besides security classes, which involved
opening regional underwriting offices and hiring experienced
underwriters. Each of these underwriters had in excess of
20 years of insurance industry experience and contacts that
allowed them to quickly write a significant amount of profitable
premium. As this premium for other specialty classes and our
premium for security classes began to grow at a pace that
exceeded our growth in capital, we began purchasing quota share
reinsurance from third party reinsurers that assumed premium
directly from our fronting carriers. Quota share reinsurance was
also provided by our affiliate, ANIC, which had overlapping
controlling shareholders with FMFC. ANIC had no operations of
its own and, in December 2003, became a direct subsidiary of
FMFC.
We continued to rely primarily on third party fronting
arrangements with respect to business we underwrote through
2004. Under these fronting arrangements, policies produced by us
were directly written by third party insurers, and a portion of
the risk under these policies was assumed by us or other
reinsurers for a portion of the related premium under the
policy. The fronting insurer received from us or other
reinsurers fees for providing fronting services and ceding
commissions related to the premiums assumed by us and other
reinsurers. In June 2004, an entity controlled by Glencoe
invested $40.0 million in us with its purchase of
$40.0 million of our convertible preferred stock. A portion
of the proceeds from this investment were contributed to the
statutory surplus of FMIC which led to an upgrade of FMICs
A.M. Best rating to A− and also enabled
FMIC to more easily expand its state E&S lines
authorizations. This upgrade allowed us to directly write the
business produced by CoverX and allowed us to reduce our
reliance on fronting arrangements. Following a transition
period, our existing fronting arrangements and related assumed
reinsurance contracts were terminated effective May 1,
2005, and we currently only utilize fronting arrangements when
they serve our business goals. As a result of these changes in
our consolidated business model, our results of operations
commencing in July 2004 and thereafter, while based principally
upon the same premiums produced, will differ from earlier
periods in the areas of earned premium, commissions, assumed and
ceded reinsurance, loss, loss adjustment and underwriting
expenses, and net income. Additionally, in connection with the
Glencoe investment, a portion of the proceeds were also used to
acquire ARPCO in June 2004 from an affiliate, which provides us
with a consistent source of fee income that is not dependent on
our underwriting results.
Effective January 1, 2007, FMIC and ANIC entered into an
intercompany pooling reinsurance agreement wherein all premiums,
losses and expenses of FMIC and ANIC are combined and
apportioned between FMIC and ANIC in accordance with fixed
percentages. On May 4, 2007, A.M. Best assigned the
financial strength rating A− to the First
Mercury Group pool and its members, FMIC and ANIC. ANICs
A.M. Best rating was upgraded to A− as a
result.
Holdings
Transaction and Initial Public Offering
On August 17, 2005, we completed a transaction in which we
formed Holdings to purchase shares of FMFC common stock from
certain FMFC stockholders, and to exchange shares and options
with other stockholders of FMFC. As a result of that
transaction, Glencoe became the majority stockholder of Holdings
and Holdings owned approximately 96% of FMFC. On
December 29, 2005, Holdings became the sole stockholder of
FMFC. The purchase and exchange of shares was financed by the
issuance of $65.0 million
23
aggregate principal amount of senior notes by Holdings. Holdings
was merged into FMFC on October 16, 2006 and the senior
notes were repaid in full with a portion of the net proceeds
from our initial public offering. The initial public offering of
our common stock occurred on October 17, 2006 and our
common stock began trading on the New York Stock Exchange on
October 18, 2006. In connection with our initial public
offering, the preferred stock held by Glencoe was converted into
common stock and cash, we repurchased 4,705,882 shares of
common stock held by Glencoe and Glencoes stock ownership
was reduced to 10.9% of our outstanding common stock.
24
USE OF
PROCEEDS
The net proceeds to us from the sale of 200,000 shares of
common stock that we are offering will be approximately
$3.2 million, after deducting underwriting discounts and
commissions and estimated offering expenses payable by us. If
the over-allotment option is exercised in full, we will receive
additional net proceeds of approximately $9.0 million. We
intend to use the net proceeds from this offering for general
corporate purposes, including working capital. Pending
application of the net proceeds, we plan to invest the net
proceeds in marketable securities. We will not receive any of
the proceeds from the sale of shares of common stock offered by
the selling stockholders.
25
DIVIDEND
POLICY
Our board of directors does not intend to declare cash dividends
on our common stock in the foreseeable future. We currently
intend to retain any profits to provide capacity to write
insurance and to accumulate reserves and surplus for the payment
of claims. Our board of directors does not intend to declare
cash dividends in the foreseeable future. Any determination to
pay dividends to our stockholders in the future will be at the
discretion of our board of directors and will depend on our
results of operations, financial condition and other factors
deemed relevant by our board of directors. Consequently, it is
uncertain when, if ever, we will declare dividends to our
stockholders. If we do not pay dividends, investors will only
obtain a return on their investment if the value of our shares
of common stock appreciates.
We conduct substantially all of our operations through our
subsidiaries. Our status as a holding company and a legal entity
separate and distinct from our subsidiaries affects our ability
to pay dividends and make other payments. Our principal source
of funds is dividends and other payments from our subsidiaries.
Therefore, our ability to pay dividends depends largely on our
subsidiaries earnings and operating capital requirements
and is subject to the regulatory, contractual, rating agency and
other constraints of our subsidiaries, including the effect of
any such dividends or distributions on the A.M. Best rating
or other ratings of our insurance subsidiaries. Our two
insurance subsidiaries are limited by regulation in their
ability to pay dividends. For example, during 2007, FMIC and
ANIC may pay in the aggregate dividends to FMFC of up to
$15.7 million without regulatory approval. There are
generally no restrictions on the payment of dividends by our
non-insurance subsidiaries. In addition, the terms of our
borrowing arrangements may limit our ability to pay cash
dividends to our stockholders. Prior to the completion of our
initial public offering, FMFC was a wholly owned subsidiary of
Holdings. Holdings was a holding company with no operations or
assets other than its interest in FMFC and the issuance of the
senior notes. Holdings was merged into the Company immediately
prior to our initial public offering. Holdings did not pay any
cash dividends during its existence. FMFC paid a dividend of
$7.0 million to Holdings in May 2006.
26
CAPITALIZATION
The following table sets forth our capitalization as of
March 31, 2007 on an actual basis and as adjusted to give
effect to the issue and sale by us of 200,000 shares of common
stock in this offering, after deducting estimated underwriting
discounts and commissions and estimated offering expenses
payable by us in this offering. This table should be read in
conjunction with our consolidated financial statements and the
accompanying notes incorporated by reference in this prospectus.
|
|
|
|
|
|
|
|
|
|
|
As of March 31, 2007
|
|
|
|
Actual
|
|
|
As Adjusted(1)
|
|
|
|
(Dollars in thousands)
|
|
|
Total long-term debt
|
|
$
|
46,394
|
|
|
$
|
46,394
|
|
Stockholders equity:
|
|
|
|
|
|
|
|
|
Common stock, $0.01 par value
per share: 100,000,000 shares authorized and
17,335,019 shares issued and outstanding, actual, and
100,000,000 shares authorized and 17,535,019 shares
issued and outstanding, as adjusted
|
|
|
174
|
|
|
|
176
|
|
Additional paid-in capital
|
|
|
153,630
|
|
|
|
156,806
|
|
Accumulated other comprehensive
loss
|
|
|
(781
|
)
|
|
|
(781
|
)
|
Retained earnings
|
|
|
30,423
|
|
|
|
30,423
|
|
Treasury Stock; 92,500 shares
|
|
|
(598
|
)
|
|
|
(598
|
)
|
|
|
|
|
|
|
|
|
|
Total stockholders equity
|
|
|
182,848
|
|
|
|
186,026
|
|
|
|
|
|
|
|
|
|
|
Total capitalization
|
|
$
|
229,242
|
|
|
$
|
232,420
|
|
|
|
|
|
|
|
|
|
|
|
|
|
(1) |
|
If the over-allotment option is exercised in full: |
|
|
|
|
|
an additional 495,189 shares would be issued and we would
receive $9.0 million in additional net proceeds;
|
|
|
|
total stockholders equity would increase to $195,034 and
|
|
|
|
our total capitalization would increase to $241,428.
|
27
MARKET
PRICE OF COMMON STOCK
Our common stock has been listed on the New York Stock Exchange
under the trading symbol FMR since October 18, 2006. Prior
to that time, there was no public market for our common stock.
The following table sets forth for the periods indicated the
high and low sales prices of our common stock, as reported by
the New York Stock Exchange.
|
|
|
|
|
|
|
|
|
|
|
2006
|
|
Quarter Ended
|
|
High
|
|
|
Low
|
|
|
December 31, 2006 (commencing
October 18, 2006)
|
|
$
|
24.01
|
|
|
$
|
18.75
|
|
|
|
|
|
|
|
|
|
|
|
|
2007
|
|
Quarter Ended
|
|
High
|
|
|
Low
|
|
|
March 31, 2007
|
|
$
|
23.58
|
|
|
$
|
19.46
|
|
June 30, 2007 (through
June 14, 2007)
|
|
$
|
21.95
|
|
|
$
|
18.55
|
|
On June 14, 2007, the last reported sales price of our
common stock was $19.36 per share.
As of June 13, 2007, there were 17,340,979 shares of
issued and outstanding common stock. As of May 25, 2007, we
had approximately 1,100 holders of record.
28
UNAUDITED
PRO FORMA CONSOLIDATED STATEMENTS OF INCOME
The unaudited pro forma consolidated statement of income set
forth below should be read in conjunction with the information
contained in Summary Historical and Unaudited Pro Forma
Consolidated Financial and Other Data, Selected
Historical Consolidated Financial and Other Data,
Capitalization, Managements Discussion
and Analysis of Financial Condition and Results of
Operations and our consolidated financial statements and
the related notes thereto appearing elsewhere in or incorporated
by reference in this prospectus.
On August 17, 2005, we completed a transaction in which we
formed Holdings to purchase shares of FMFC common stock from
certain FMFC stockholders, and to exchange shares and options
with the remaining stockholders of FMFC. As a result of this
transaction, which we refer to as the Holdings Transaction,
Glencoe became the majority stockholder of Holdings and Holdings
became the controlling stockholder of FMFC. The purchase and
exchange of shares was financed by the issuance of
$65.0 million aggregate principal amount of senior notes by
Holdings. As a result of this acquisition and resulting purchase
accounting adjustments, the results of operations for periods
prior to August 17, 2005 are not comparable to periods
subsequent to that date. Holdings was merged into FMFC on
October 16, 2006 and the senior notes were repaid in full
with a portion of the net proceeds from our initial public
offering.
Reconciliation
year ended December 31, 2006 and three months ended
March 31, 2006
actual to unaudited pro forma consolidated financial and
operating data
The following table sets forth the reconciliation of the
unaudited pro forma adjusted information presented for the year
ended December 31, 2006 and for the three months ended
March 31, 2006 in the Summary Historical And
Unaudited Pro Forma Consolidated Financial and Other Data
with our actual historical consolidated financial and other data
for that period. The unaudited pro forma adjusted information
assumes the application of the net proceeds from our initial
public offering were used to repay the senior notes on the first
day of the period presented. The pro forma adjusted information
excludes the impact of interest expense, the amortization of
debt issuance costs, the prepayment penalty on early redemption,
the write-off of unamortized debt issuance costs upon repayment,
and related income tax effects arising from the issuance of the
notes.
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Successor
|
|
|
Pro Forma
|
|
|
Pro Forma
|
|
|
|
Year Ended
|
|
|
Adjustments for
|
|
|
Year Ended
|
|
|
|
December 31,
|
|
|
Repayment of the
|
|
|
December 31,
|
|
|
|
2006
|
|
|
Senior Notes
|
|
|
2006
|
|
|
|
(Dollars in thousands)
|
|
|
Income Statement
Data:
|
|
|
|
|
|
|
|
|
|
|
|
|
Direct and assumed written premiums
|
|
$
|
218,181
|
|
|
$
|
|
|
|
$
|
218,181
|
|
Net written premiums
|
|
|
142,926
|
|
|
|
|
|
|
|
142,926
|
|
Net earned premiums
|
|
|
110,570
|
|
|
|
|
|
|
|
110,570
|
|
Commissions and fees
|
|
|
16,692
|
|
|
|
|
|
|
|
16,692
|
|
Net investment income
|
|
|
9,713
|
|
|
|
(37
|
)(1a)
|
|
|
9,676
|
|
Net realized gains (losses) on
investments
|
|
|
517
|
|
|
|
|
|
|
|
517
|
|
Total operating revenues
|
|
|
137,492
|
|
|
|
(37
|
)
|
|
|
137,455
|
|
Losses and loss adjustment
expenses, net
|
|
|
56,208
|
|
|
|
|
|
|
|
56,208
|
|
Amortization of deferred
acquisition expenses
|
|
|
16,358
|
|
|
|
|
|
|
|
16,358
|
|
Underwriting, agency, and other
expenses
|
|
|
13,458
|
|
|
|
|
|
|
|
13,458
|
|
Amortization of intangible assets
|
|
|
1,270
|
|
|
|
|
|
|
|
1,270
|
|
Total operating expenses
|
|
|
87,294
|
|
|
|
|
|
|
|
87,294
|
|
Operating income
|
|
|
50,198
|
|
|
|
(37
|
)
|
|
|
50,161
|
|
Interest expense
|
|
|
16,615
|
|
|
|
(14,695
|
)(1b)
|
|
|
1,920
|
|
Income taxes
|
|
|
11,754
|
|
|
|
5,130
|
(1c)
|
|
|
16,884
|
|
Net income
|
|
|
21,869
|
|
|
|
9,528
|
|
|
|
31,397
|
|
29
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Successor
|
|
|
Pro Forma
|
|
|
Pro Forma
|
|
|
|
Year Ended
|
|
|
Adjustments for
|
|
|
Year Ended
|
|
|
|
December 31,
|
|
|
Repayment of the
|
|
|
December 31,
|
|
|
|
2006
|
|
|
Senior Notes
|
|
|
2006
|
|
|
|
(Dollars in thousands)
|
|
|
Net Income Per Share:
|
|
|
|
|
|
|
|
|
|
|
|
|
Basic
|
|
|
2.74
|
|
|
|
N/A
|
|
|
|
4.12
|
|
Diluted
|
|
|
1.58
|
|
|
|
N/A
|
|
|
|
2.27
|
|
Weighted Average
Shares Outstanding:
|
|
|
|
|
|
|
|
|
|
|
|
|
Basic
|
|
|
6,907,905
|
|
|
|
N/A
|
|
|
|
6,907,905
|
|
Diluted
|
|
|
13,831,649
|
|
|
|
N/A
|
|
|
|
13,831,649
|
|
|
|
|
(1) |
|
Represents the adjustment as of January 1, 2006 for the use
of a portion of the net proceeds from the Companys initial
public offering to repurchase the $65.0 million aggregate
principal amount of senior notes: |
|
|
|
(a) |
|
Represents an adjustment to eliminate historical interest earned
on the proceeds that remained after issuance of the senior notes
and purchase of shares from certain FMFC stockholders. |
|
(b) |
|
Represents an adjustment to eliminate historical interest
expense that was incurred at LIBOR plus 8% (13.36% for the
period), the historical amortization of $4.8 million in
debt issuance costs that were being amortized over the seven
year term of the senior notes, the prepayment penalty on the
senior notes, and the write-off of unamortized debt issuance
costs related to the senior notes. The pro forma adjustment is
as follows: |
|
|
|
|
|
Interest expense:
|
|
|
|
|
Eliminate historical interest
expense
|
|
$
|
(6,909
|
)
|
Eliminate historical amortization
of debt issuance costs
|
|
|
(571
|
)
|
Eliminate historical prepayment
penalty on early redemption
|
|
|
(3,250
|
)
|
Eliminate historical write-off of
unamortized debt issuance costs
|
|
|
(3,965
|
)
|
|
|
|
|
|
Pro Forma adjustment
|
|
$
|
(14,695
|
)
|
|
|
|
|
|
|
|
|
(c) |
|
Represents the tax effect based on the statutory rate of 35% on
pro forma adjustments (1)(a) and (1)(b). |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Successor
|
|
|
|
|
|
Pro Forma
|
|
|
|
Three Months
|
|
|
Pro Forma
|
|
|
Three Months
|
|
|
|
Ended
|
|
|
Adjustments for
|
|
|
Ended
|
|
|
|
March 31,
|
|
|
Repayment of the
|
|
|
March 31,
|
|
Income Statement Data:
|
|
2006
|
|
|
Senior Notes
|
|
|
2006
|
|
|
|
(Dollars in thousands)
|
|
|
Direct and assumed written premiums
|
|
$
|
56,876
|
|
|
$
|
|
|
|
$
|
56,876
|
|
Net written premiums
|
|
|
27,108
|
|
|
|
|
|
|
|
27,108
|
|
Net earned premiums
|
|
|
28,529
|
|
|
|
|
|
|
|
28,529
|
|
Commissions and fees
|
|
|
4,444
|
|
|
|
|
|
|
|
4,444
|
|
Net investment income
|
|
|
2,150
|
|
|
|
(21
|
)(2a)
|
|
|
2,129
|
|
Net realized gains (losses) on
investments
|
|
|
(153
|
)
|
|
|
|
|
|
|
(153
|
)
|
Total operating revenues
|
|
|
34,970
|
|
|
|
(21
|
)
|
|
|
34,949
|
|
Losses and loss adjustment
expenses, net
|
|
|
14,907
|
|
|
|
|
|
|
|
14,907
|
|
Amortization of deferred
acquisition expenses
|
|
|
4,894
|
|
|
|
|
|
|
|
4,894
|
|
Underwriting, agency, and other
expenses
|
|
|
4,210
|
|
|
|
|
|
|
|
4,210
|
|
Amortization of intangible assets
|
|
|
292
|
|
|
|
|
|
|
|
292
|
|
Total operating expenses
|
|
|
24,303
|
|
|
|
|
|
|
|
24,303
|
|
30
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Successor
|
|
|
|
|
|
Pro Forma
|
|
|
|
Three Months
|
|
|
Pro Forma
|
|
|
Three Months
|
|
|
|
Ended
|
|
|
Adjustments for
|
|
|
Ended
|
|
|
|
March 31,
|
|
|
Repayment of the
|
|
|
March 31,
|
|
Income Statement Data:
|
|
2006
|
|
|
Senior Notes
|
|
|
2006
|
|
|
|
(Dollars in thousands)
|
|
|
Operating income
|
|
|
10,667
|
|
|
|
(21
|
)
|
|
|
10,646
|
|
Interest expense
|
|
|
2,648
|
|
|
|
(2,210
|
)(2b)
|
|
|
438
|
|
Income taxes
|
|
|
2,869
|
|
|
|
766
|
(2c)
|
|
|
3,635
|
|
Net income
|
|
|
5,379
|
|
|
|
1,423
|
|
|
|
6,802
|
|
Net Income Per Share:
|
|
|
|
|
|
|
|
|
|
|
|
|
Basic
|
|
|
1.07
|
|
|
|
N/A
|
|
|
|
1.41
|
|
Diluted
|
|
|
0.44
|
|
|
|
N/A
|
|
|
|
0.55
|
|
Weighted Average
Shares Outstanding:
|
|
|
|
|
|
|
|
|
|
|
|
|
Basic
|
|
|
4,183,479
|
|
|
|
N/A
|
|
|
|
4,183,479
|
|
Diluted
|
|
|
12,291,514
|
|
|
|
N/A
|
|
|
|
12,291,514
|
|
|
|
|
(2) |
|
Represents the adjustment as of January 1, 2006 for the use
of a portion of the net proceeds from the Companys initial
public offering to repurchase the $65.0 million aggregate
principal amount of senior notes: |
|
|
|
(a) |
|
Represents an adjustment to eliminate historical interest earned
on the proceeds that remained after issuance of the senior notes
and purchase of shares from certain FMFC stockholders. |
|
(b) |
|
Represents an adjustment to eliminate historical interest
expense that was incurred at LIBOR plus 8% (12.55% for the
period) and the historical amortization of $4.8 million in
debt issuance costs that were being amortized over the seven
year term of the senior notes. The pro forma adjustment is as
follows: |
|
|
|
|
|
Interest expense:
|
|
|
|
|
Eliminate historical interest
expense
|
|
$
|
(2,039
|
)
|
Eliminate historical amortization
of debt issuance costs
|
|
|
(171
|
)
|
|
|
|
|
|
Pro Forma adjustment
|
|
$
|
(2,210
|
)
|
|
|
|
|
|
|
|
|
(c) |
|
Represents the tax effect based on the statutory rate of 35% on
pro forma adjustments (2)(a) and (2)(b). |
31
Reconciliation
unaudited pro forma consolidated financial
and operating data for the year ended December 31,
2005
The following unaudited pro forma consolidated income statement
has been prepared to combine the historical results of the
predecessor and successor periods, and to give effect to, as of
the beginning of 2005, (i) the acquisition including the
issuance of the senior notes and (ii) the application of a
portion of the net proceeds from our initial public offering to
repay all of the senior notes. The unaudited pro forma
consolidated income statement includes (excludes) the impact of
interest expense and the amortization of debt issuance costs
arising from the issuance (repayment) of the senior notes. The
pro forma adjustments also include the income tax effect of the
unaudited pro forma adjustments. The
Sub-Total
column represents the combination of the predecessor and
successor periods and the pro forma adjustments for the Holdings
Transaction including the issuance of the senior notes. The
Pro Forma Year Ended December 31, 2005 column
represents the combination of the
Sub-Total
column and the unaudited pro forma adjustments for the
application of a portion of the proceeds from our initial public
offering, as if they were used to repay all of the senior notes
on the first day of the period presented.
The unaudited pro forma consolidated statement of income is
presented for illustrative purposes only and is not necessarily
indicative of the results of operations that would have actually
been reported had the Holdings Transaction and the repayment of
the senior notes occurred on the dates specified above, nor are
they necessarily indicative of the results of operations.
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Predecessor
|
|
|
Successor
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
January 1,
|
|
|
August 17,
|
|
|
Pro Forma
|
|
|
|
|
|
Pro Forma
|
|
|
Pro Forma
|
|
|
|
2005 to
|
|
|
2005 to
|
|
|
Adjustments
|
|
|
|
|
|
Adjustments for
|
|
|
Year Ended
|
|
|
|
August 16,
|
|
|
December 31,
|
|
|
for Holdings
|
|
|
|
|
|
Repayment of
|
|
|
December 31,
|
|
|
|
2005
|
|
|
2005
|
|
|
Transactions
|
|
|
Sub-Total
|
|
|
the Senior Notes
|
|
|
2005
|
|
|
|
(Dollars in thousands)
|
|
|
Income Statement Data:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Direct and assumed written premiums
|
|
$
|
104,856
|
|
|
$
|
71,040
|
|
|
$
|
|
|
|
$
|
175,896
|
|
|
$
|
|
|
|
$
|
175,896
|
|
Net written premiums
|
|
|
68,473
|
|
|
|
37,228
|
|
|
|
|
|
|
|
105,701
|
|
|
|
|
|
|
|
105,701
|
|
Net earned premiums
|
|
|
57,576
|
|
|
|
40,146
|
|
|
|
|
|
|
|
97,722
|
|
|
|
|
|
|
|
97,722
|
|
Commissions and fees
|
|
|
13,649
|
|
|
|
12,427
|
|
|
|
|
|
|
|
26,076
|
|
|
|
|
|
|
|
26,076
|
|
Net investment income
|
|
|
4,119
|
|
|
|
2,629
|
|
|
|
|
|
|
|
6,748
|
|
|
|
(30
|
)(4a)
|
|
|
6,718
|
|
Net realized gains (losses) on
investments
|
|
|
(58
|
)
|
|
|
278
|
|
|
|
|
|
|
|
220
|
|
|
|
|
|
|
|
220
|
|
Total operating revenues
|
|
|
75,286
|
|
|
|
55,480
|
|
|
|
|
|
|
|
130,766
|
|
|
|
(30
|
)
|
|
|
130,736
|
|
Losses and loss adjustment
expenses, net
|
|
|
28,072
|
|
|
|
27,022
|
|
|
|
|
|
|
|
55,094
|
|
|
|
|
|
|
|
55,094
|
|
Amortization of deferred
acquisition expenses
|
|
|
12,676
|
|
|
|
7,954
|
|
|
|
|
|
|
|
20,630
|
|
|
|
|
|
|
|
20,630
|
|
Underwriting, agency, and other
expenses
|
|
|
7,758
|
|
|
|
5,712
|
|
|
|
|
|
|
|
13,470
|
|
|
|
|
|
|
|
13,470
|
|
Amortization of intangible assets
|
|
|
732
|
|
|
|
434
|
|
|
|
|
|
|
|
1,166
|
|
|
|
|
|
|
|
1,166
|
|
Total operating expenses
|
|
|
49,238
|
|
|
|
41,122
|
|
|
|
|
|
|
|
90,360
|
|
|
|
|
|
|
|
90,360
|
|
Operating income
|
|
|
26,048
|
|
|
|
14,358
|
|
|
|
|
|
|
|
40,406
|
|
|
|
(30
|
)
|
|
|
40,376
|
|
Interest expense
|
|
|
1,519
|
|
|
|
3,980
|
|
|
|
5,302
|
(3a)
|
|
|
10,801
|
|
|
|
(8,522
|
)(4b)
|
|
|
2,279
|
|
Income taxes
|
|
|
8,636
|
|
|
|
4,001
|
|
|
|
(1,855
|
)(3b)
|
|
|
10,782
|
|
|
|
2,972
|
(4c)
|
|
|
13,754
|
|
Net income
|
|
|
16,123
|
|
|
|
6,712
|
|
|
|
(3,447
|
)
|
|
|
19,388
|
|
|
|
5,520
|
|
|
|
24,908
|
|
32
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Predecessor
|
|
|
Successor
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
January 1,
|
|
|
August 17,
|
|
|
Pro Forma
|
|
|
|
|
|
Pro Forma
|
|
|
Pro Forma
|
|
|
|
2005 to
|
|
|
2005 to
|
|
|
Adjustments
|
|
|
|
|
|
Adjustments for
|
|
|
Year Ended
|
|
|
|
August 16,
|
|
|
December 31,
|
|
|
for Holdings
|
|
|
|
|
|
Repayment of
|
|
|
December 31,
|
|
|
|
2005
|
|
|
2005
|
|
|
Transactions
|
|
|
Sub-Total
|
|
|
the Senior Notes
|
|
|
2005
|
|
|
|
(Dollars in thousands)
|
|
|
Net Income Per Share:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Basic
|
|
|
1.12
|
|
|
|
1.30
|
|
|
|
N/A
|
|
|
|
3.84
|
|
|
|
N/A
|
|
|
|
5.17
|
|
Diluted
|
|
|
0.80
|
|
|
|
0.56
|
|
|
|
N/A
|
|
|
|
1.61
|
|
|
|
N/A
|
|
|
|
2.07
|
|
Weighted Average
Shares Outstanding:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Basic
|
|
|
12,536,224
|
|
|
|
4,146,045
|
|
|
|
N/A
|
|
|
|
4,146,045
|
|
|
|
N/A
|
|
|
|
4,146,045
|
|
Diluted
|
|
|
20,093,596
|
|
|
|
12,044,004
|
|
|
|
N/A
|
|
|
|
12,044,004
|
|
|
|
N/A
|
|
|
|
12,044,004
|
|
|
|
|
(3) |
|
Represents adjustment of the following as if the Holdings
Transaction and issuance of the $65.0 million of senior
notes occurred as of January 1, 2005: |
|
|
|
(a) |
|
Represents an adjustment for additional interest expense during
the predecessor period at three month LIBOR plus 8% (12% for the
period) and additional amortization on the $4.8 million in
debt issuance costs that are being amortized over the seven year
term of the loans. The pro forma adjustment is as follows: |
|
|
|
|
|
Interest expense:
|
|
|
|
|
Additional interest expense to
reflect a full-year of expense
|
|
$
|
4,872
|
|
Additional amortization of debt
issuance costs to reflect a full-year of expense
|
|
|
430
|
|
|
|
|
|
|
Pro forma adjustment
|
|
$
|
5,302
|
|
|
|
|
|
|
|
|
|
(b) |
|
Represents the tax effect based on the statutory rate of 35% on
pro forma adjustment (3)(a). |
|
|
|
(4) |
|
Represents the adjustment as of January 1, 2005 for the use
of proceeds from our initial public offering to repay the
$65.0 million aggregate principal amount of senior notes: |
|
|
|
(a) |
|
Represents an adjustment to eliminate historical interest earned
on the proceeds that remained after issuance of senior notes. |
|
(b) |
|
Represents an adjustment to eliminate historical interest
expense that was incurred during the successor period at three
month LIBOR plus 8% (12.16% for the period), eliminate the
historical amortization recorded during the successor period on
the $4.8 million in debt issuance costs that are being
amortized over the seven year term of the senior notes, and
eliminate pro forma adjustment (3)(a). The pro forma adjustment
is as follows: |
|
|
|
|
|
Interest expense:
|
|
|
|
|
Eliminate pro forma
adjustment(3)(a)
|
|
$
|
(5,302
|
)
|
Eliminate historical interest
expense
|
|
|
(2,963
|
)
|
Eliminate historical amortization
of debt issuance costs
|
|
|
(257
|
)
|
|
|
|
|
|
Pro forma adjustment
|
|
$
|
(8,522
|
)
|
|
|
|
|
|
|
|
|
(c) |
|
Represents the tax effect based on the statutory rate of 35% on
pro forma adjustments (4)(a) and (4)(b). |
33
SELECTED
HISTORICAL CONSOLIDATED FINANCIAL AND OTHER DATA
The table shown below presents our selected historical
consolidated financial and other data for the five years ended
December 31, 2006 and the three months ended March 31,
2007 and 2006, which have been derived from our audited
consolidated financial statements and unaudited condensed
interim consolidated financial statements which are incorporated
by reference in this prospectus. The summary historical
consolidated financial data presented below should be read in
conjunction with Managements Discussion and Analysis
of Financial Condition and Results of Operations,
Capitalization and the Summary Historical and
Unaudited Pro Forma Consolidated Financial and Other Data
and the consolidated annual and interim financial statements and
accompanying notes included elsewhere in or incorporated by
reference in this prospectus.
On August 17, 2005, we completed a transaction in which we
formed Holdings to purchase shares of FMFC common stock from
certain FMFC stockholders, and to exchange shares and options
with the remaining stockholders of FMFC. As a result of this
transaction, Glencoe became the majority stockholder of Holdings
and Holdings became the controlling stockholder of FMFC. The
purchase and exchange of shares was financed by the issuance of
$65.0 million aggregate principal amount of senior rate
notes by Holdings. As a result of this acquisition and resulting
purchase accounting adjustments, the results of operations for
periods prior to August 17, 2005 are not comparable to
periods subsequent to that date. Holdings was merged into FMFC
on October 16, 2006 and the senior notes were repaid in
full with a portion of the net proceeds from our initial public
offering.
The selected historical consolidated financial and other data
presented below for each of the years in the three-year period
ended December 31, 2004 (Predecessor), for the periods from
January 1, 2005 through August 16, 2005 (Predecessor)
and from August 17, 2005 through December 31, 2005
(Successor), and for the year ended December 31, 2006 have
been derived from our audited consolidated financial statements
incorporated by reference in this prospectus. The summary
historical consolidated financial and other data for each of the
three month periods ended March 31, 2007 and 2006
(Successor) have been derived from our unaudited condensed
consolidated financial statements incorporated by reference in
this prospectus. The operating results for the three months
ended March 31, 2007 are not necessarily indicative of the
results of our operations for the full year 2007 or any future
periods.
34
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Successor
|
|
|
Predecessor
|
|
|
|
Three Months
|
|
|
Three Months
|
|
|
|
|
|
August 17,
|
|
|
January 1,
|
|
|
|
|
|
|
|
|
|
|
|
|
Ended
|
|
|
Ended
|
|
|
Year Ended
|
|
|
2005 to
|
|
|
2005 to
|
|
|
Year Ended
|
|
|
Year Ended
|
|
|
Year Ended
|
|
|
|
March 31,
|
|
|
March 31,
|
|
|
December 31,
|
|
|
December 31,
|
|
|
August 16,
|
|
|
December 31,
|
|
|
December 31,
|
|
|
December 31,
|
|
|
|
2007
|
|
|
2006
|
|
|
2006
|
|
|
2005
|
|
|
2005
|
|
|
2004(1)
|
|
|
2003
|
|
|
2002
|
|
|
|
(Dollars in thousands, except for share and per share
data)
|
|
|
Income Statement Data:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Direct and assumed written premiums
|
|
$
|
60,600
|
|
|
$
|
56,876
|
|
|
$
|
218,181
|
|
|
$
|
71,040
|
|
|
$
|
104,856
|
|
|
$
|
92,066
|
|
|
$
|
48,735
|
|
|
$
|
49,255
|
|
Net written premiums
|
|
|
34,460
|
|
|
|
27,108
|
|
|
|
142,926
|
|
|
|
37,228
|
|
|
|
68,473
|
|
|
|
72,895
|
|
|
|
48,469
|
|
|
|
41,968
|
|
Net earned premiums
|
|
|
44,929
|
|
|
|
28,529
|
|
|
|
110,570
|
|
|
|
40,146
|
|
|
|
57,576
|
|
|
|
61,291
|
|
|
|
40,338
|
|
|
|
39,981
|
|
Commissions and fees
|
|
|
4,657
|
|
|
|
4,444
|
|
|
|
16,692
|
|
|
|
12,428
|
|
|
|
13,649
|
|
|
|
33,730
|
|
|
|
33,489
|
|
|
|
20,793
|
|
Net investment income
|
|
|
3,294
|
|
|
|
2,150
|
|
|
|
9,713
|
|
|
|
2,629
|
|
|
|
4,119
|
|
|
|
4,619
|
|
|
|
3,983
|
|
|
|
4,426
|
|
Net realized gains (losses) on
investments
|
|
|
135
|
|
|
|
(153
|
)
|
|
|
517
|
|
|
|
278
|
|
|
|
(58
|
)
|
|
|
(120
|
)
|
|
|
813
|
|
|
|
435
|
|
Total operating revenues
|
|
|
53,015
|
|
|
|
34,970
|
|
|
|
137,492
|
|
|
|
55,481
|
|
|
|
75,286
|
|
|
|
99,520
|
|
|
|
78,623
|
|
|
|
65,634
|
|
Losses and loss adjustment
expenses, net
|
|
|
23,954
|
|
|
|
14,907
|
|
|
|
56,208
|
|
|
|
27,022
|
|
|
|
28,072
|
|
|
|
26,854
|
|
|
|
21,732
|
|
|
|
23,832
|
|
Amortization of deferred
acquisition expenses
|
|
|
8,739
|
|
|
|
4,894
|
|
|
|
16,358
|
|
|
|
7,954
|
|
|
|
12,676
|
|
|
|
15,713
|
|
|
|
11,995
|
|
|
|
13,350
|
|
Underwriting, agency, and other
expenses
|
|
|
3,730
|
|
|
|
4,210
|
|
|
|
13,458
|
|
|
|
5,712
|
|
|
|
7,758
|
|
|
|
26,953
|
|
|
|
29,923
|
|
|
|
22,134
|
|
Amortization of intangible assets
|
|
|
307
|
|
|
|
292
|
|
|
|
1,270
|
|
|
|
434
|
|
|
|
732
|
|
|
|
632
|
|
|
|
|
|
|
|
|
|
Total operating expenses
|
|
|
36,730
|
|
|
|
24,303
|
|
|
|
87,294
|
|
|
|
41,122
|
|
|
|
49,238
|
|
|
|
70,152
|
|
|
|
63,650
|
|
|
|
59,316
|
|
Operating income
|
|
|
16,285
|
|
|
|
10,667
|
|
|
|
50,198
|
|
|
|
14,359
|
|
|
|
26,048
|
|
|
|
29,368
|
|
|
|
14,973
|
|
|
|
6,318
|
|
Interest expense
|
|
|
982
|
|
|
|
2,648
|
|
|
|
16,615
|
|
|
|
3,980
|
|
|
|
1,519
|
|
|
|
1,697
|
|
|
|
965
|
|
|
|
821
|
|
Income taxes
|
|
|
5,229
|
|
|
|
2,869
|
|
|
|
11,754
|
|
|
|
4,001
|
|
|
|
8,636
|
|
|
|
10,006
|
|
|
|
3,288
|
|
|
|
761
|
|
Net income
|
|
|
9,967
|
|
|
|
5,379
|
|
|
|
21,869
|
|
|
|
6,712
|
|
|
|
16,123
|
|
|
|
17,735
|
|
|
|
10,977
|
|
|
|
4,702
|
|
Balance Sheet Data:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total investments
|
|
|
359,982
|
|
|
|
228,873
|
|
|
|
297,841
|
|
|
|
211,025
|
|
|
|
202,013
|
|
|
|
171,659
|
|
|
|
114,901
|
|
|
|
91,125
|
|
Total assets
|
|
|
566,665
|
|
|
|
404,202
|
|
|
|
512,933
|
|
|
|
365,597
|
|
|
|
321,863
|
|
|
|
253,965
|
|
|
|
159,011
|
|
|
|
128,515
|
|
Loss and loss adjustment expense
reserve
|
|
|
211,271
|
|
|
|
132,949
|
|
|
|
191,013
|
|
|
|
113,864
|
|
|
|
92,153
|
|
|
|
68,699
|
|
|
|
61,727
|
|
|
|
59,449
|
|
Unearned premium reserves(2)
|
|
|
97,943
|
|
|
|
91,924
|
|
|
|
91,803
|
|
|
|
84,476
|
|
|
|
77,778
|
|
|
|
52,484
|
|
|
|
24,423
|
|
|
|
15,624
|
|
Long-term debt
|
|
|
46,394
|
|
|
|
85,620
|
|
|
|
46,394
|
|
|
|
85,620
|
|
|
|
27,535
|
|
|
|
29,535
|
|
|
|
17,754
|
|
|
|
13,000
|
|
Total stockholders equity
|
|
|
182,848
|
|
|
|
69,227
|
|
|
|
172,738
|
|
|
|
64,327
|
|
|
|
106,908
|
|
|
|
91,630
|
|
|
|
36,340
|
|
|
|
27,411
|
|
Net Income Per Share
Data(3):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Basic
|
|
$
|
0.58
|
|
|
$
|
1.07
|
|
|
$
|
2.74
|
|
|
$
|
1.30
|
|
|
$
|
1.12
|
|
|
$
|
1.32
|
|
|
$
|
0.95
|
|
|
$
|
0.40
|
|
Diluted
|
|
$
|
0.55
|
|
|
$
|
0.44
|
|
|
$
|
1.58
|
|
|
$
|
0.56
|
|
|
$
|
0.80
|
|
|
$
|
1.05
|
|
|
$
|
0.91
|
|
|
$
|
0.40
|
|
Weighted average shares
outstanding, basic
|
|
|
17,331,901
|
|
|
|
4,183,479
|
|
|
|
6,907,905
|
|
|
|
4,146,045
|
|
|
|
12,536,224
|
|
|
|
12,041,334
|
|
|
|
11,610,068
|
|
|
|
11,610,068
|
|
Weighted average shares
outstanding, diluted
|
|
|
18,183,841
|
|
|
|
12,291,514
|
|
|
|
13,831,649
|
|
|
|
12,044,004
|
|
|
|
20,093,596
|
|
|
|
16,872,247
|
|
|
|
12,031,433
|
|
|
|
11,646,589
|
|
GAAP Underwriting
Ratios:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Loss ratio(4)
|
|
|
53.3
|
%
|
|
|
52.3
|
%
|
|
|
50.8
|
%
|
|
|
67.3
|
%
|
|
|
48.8
|
%
|
|
|
43.8
|
%
|
|
|
53.9
|
%
|
|
|
59.6
|
%
|
Expense ratio(5)
|
|
|
20.4
|
%
|
|
|
22.5
|
%
|
|
|
16.9
|
%
|
|
|
8.7
|
%
|
|
|
18.3
|
%
|
|
|
18.9
|
%
|
|
|
20.9
|
%
|
|
|
36.7
|
%
|
Combined ratio(6)
|
|
|
73.7
|
%
|
|
|
74.8
|
%
|
|
|
67.7
|
%
|
|
|
76.0
|
%
|
|
|
67.1
|
%
|
|
|
62.7
|
%
|
|
|
74.8
|
%
|
|
|
96.3
|
%
|
Other Data:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Annual return on average
stockholders equity
|
|
|
22.4
|
%
|
|
|
32.2
|
%
|
|
|
23.6
|
%
|
|
|
29.0
|
%
|
|
|
26.0
|
%
|
|
|
27.7
|
%
|
|
|
34.4
|
%
|
|
|
19.0
|
%
|
Debt to total capitalization ratio
|
|
|
20.2
|
%
|
|
|
55.3
|
%
|
|
|
21.2
|
%
|
|
|
57.1
|
%
|
|
|
20.5
|
%
|
|
|
24.4
|
%
|
|
|
32.8
|
%
|
|
|
32.2
|
%
|
|
|
|
(1) |
|
Includes ARPCOs operations from the date of acquisition of
ARPCO in June 2004. |
35
|
|
|
(2) |
|
Unearned premium reserves are established for the portion of
premiums that is allocable to the unexpired portion of the
policy term. |
|
(3) |
|
Net income per share and weighted average shares outstanding
reflect a
925-for-1
stock split of our common stock which occurred prior to the
completion of our initial public offering in October 2006. |
|
(4) |
|
Loss ratio is defined as the ratio of incurred losses and loss
adjustment expenses to net earned premiums. |
|
(5) |
|
Expense ratio is defined as the ratio of (i) the
amortization of deferred acquisition expenses plus other
operating expenses, less expenses related to insurance services
operations, less commissions and fee income related to
underwriting operations to (ii) net earned premiums. |
|
(6) |
|
Combined ratio is the sum of the loss ratio and the expense
ratio. |
36
The following discussion and analysis of our financial
condition and results of operations should be read in
conjunction with the consolidated financial statements and the
related notes incorporated by reference in this prospectus. The
discussion and analysis below includes certain forward-looking
statements that are subject to risks, uncertainties and other
factors described in Cautionary Statement Regarding
Forward-Looking Information and Risk Factors
and elsewhere in this prospectus that could cause actual results
to differ materially from those expressed in, or implied by,
those forward-looking statements.
Overview
We are a provider of insurance products and services to the
specialty commercial insurance markets, primarily focusing on
niche and underserved segments where we believe that we have
underwriting expertise and other competitive advantages. During
our 34 years of underwriting security risks, we have
established
CoverX®
as a recognized brand among insurance agents and brokers and
developed the underwriting expertise and cost-efficient
infrastructure which have enabled us to underwrite such risks
profitably. Over the last seven years, we have leveraged our
brand, expertise and infrastructure to expand into other
specialty classes of business, particularly focusing on smaller
accounts that receive less attention from competitors. As part
of this extension of our business, we have increased our
underwriting staff and opened offices in Chicago, Dallas,
Naples, Florida, Boston and Irvine, California.
As primarily an excess and surplus, or E&S, lines
underwriter, our business philosophy is to generate an
underwriting profit by identifying, evaluating and appropriately
pricing and accepting risk using customized forms tailored for
each risk. Our combined ratio, a customary measure of
underwriting profitability, has averaged 67.1% over the past
three years. A combined ratio is the sum of the loss ratio and
the expense ratio. A combined ratio under 100% generally
indicates an underwriting profit. A combined ratio over 100%
generally indicates an underwriting loss. As an E&S lines
underwriter, we have more flexibility than standard property and
casualty insurance companies to set and adjust premium rates and
customize policy forms to reflect the risks being insured. We
believe this flexibility has a beneficial impact on our
underwriting profitability and our combined ratio.
In addition, through our insurance services business, which
provides underwriting, claims and other insurance services to
third parties, we are able to generate significant fee income
that is not dependent upon our underwriting results. For our
entire business, we generated an average annual return on
stockholders equity of 25.8% over the past three calendar
years.
FMFC is a holding company for our operating subsidiaries. Our
operations are conducted with the goal of producing overall
profits by strategically balancing underwriting profits from our
insurance subsidiaries with the commissions and fee income
generated by our non-insurance subsidiaries. FMFCs
principal operating subsidiaries are CoverX, FMIC, ANIC and
ARPCO.
CoverX is a licensed wholesale broker that produces and
underwrites all of the insurance policies for which we retain
risk and receive premiums. As a wholesale insurance broker,
CoverX markets our insurance policies through a nationwide
network of wholesale and retail insurance brokers who then
distribute these policies through retail insurance brokers.
CoverX also provides underwriting services with respect to the
insurance policies it markets in that it reviews the
applications submitted for insurance coverage, decides whether
to accept all or part of the coverage requested and determines
applicable premiums. CoverX receives commissions from affiliated
insurance companies, reinsurers, and non-affiliated insurers as
well as policy fees from wholesale and retail insurance brokers.
The commission and fee income earned by CoverX is less dependent
on the underwriting results of our insurance subsidiaries and
thus provides diversification to our revenue stream. Over the
past three years, the premiums generated from insurance policies
sold through CoverX, which we refer to as premiums produced, has
increased from $146.9 million to $230.1 million.
FMIC and ANIC are our two insurance subsidiaries. FMIC writes
substantially all the policies produced by CoverX. ANIC provides
reinsurance to FMIC. Effective January 1, 2007, FMIC and
ANIC entered into an
37
intercompany pooling reinsurance agreement wherein all premiums,
losses and expenses of FMIC and ANIC, including all past
liabilities, are combined and apportioned between FMIC and ANIC
in accordance with fixed percentages. Prior to the change in
business model discussed below, FMIC and ANIC primarily provided
quota share reinsurance to third party insurance companies that
issued policies to CoverX customers under fronting arrangements.
FMIC also provides claims handling and adjustment services for
policies produced by CoverX and directly written by third
parties.
ARPCO, which we acquired from an affiliate in June 2004,
provides third party administrative services for risk sharing
pools of governmental entity risks, including underwriting,
claims, loss control and reinsurance services. ARPCO is solely a
fee-based business and receives fees for these services and
commissions on excess per occurrence insurance placed in the
commercial market with third party companies on behalf of the
pools.
Holdings
Transaction and Initial Public Offering
On August 17, 2005, we completed a transaction in which we
formed Holdings to purchase shares of FMFC common stock from
certain FMFC stockholders, and to exchange shares and options
with other stockholders of FMFC. As a result of that
transaction, Glencoe became the majority stockholder of Holdings
and Holdings became the controlling stockholder of FMFC. The
purchase and exchange of shares was financed by the issuance of
$65.0 million aggregate principal amount of senior notes by
Holdings. Holdings was merged into FMFC on October 16, 2006
and the senior notes were repaid in full with a portion of the
net proceeds from our initial public offering. The initial
public offering of our common stock occurred on October 17,
2006 and our common stock began trading on the New York Stock
Exchange on October 18, 2006. In connection with our
initial public offering, the preferred stock held by Glencoe was
converted into common stock and cash, we repurchased
4,705,882 shares of common stock held by Glencoe and
Glencoes stock ownership was reduced to 10.9% of our
outstanding common stock.
As a result of the acquisition and resulting purchase accounting
adjustments, the results of operations for periods prior to
August 17, 2005 are not comparable to periods subsequent to
that date. Our fiscal 2005 results discussed below represent the
mathematical addition of the historical results for (i) the
predecessor period from January 1, 2005 through
August 16, 2005, and (ii) the successor period from
August 17, 2005 through December 31, 2005. This
approach is not consistent with generally accepted accounting
principles and yields results that are not comparable on a
period-to-period
basis. However, we believe it is the most meaningful way to
discuss our operating results for 2005 when comparing them to
our operating results for 2004 and 2006 because it would not be
meaningful to discuss the partial period from January 1,
2005 through August 16, 2005 (Predecessor) separately from
the period from August 17, 2005 to December 31, 2005
(Successor) when comparing 2005 operating results to 2004 and
2006 operating results.
Change in
Business Model
In June 2004, an investment by Glencoe along with additional
cash from FMFC increased FMICs statutory surplus by
$26.0 million. As a result of this capital infusion,
A.M. Best raised FMICs financial strength rating to
A−, and beginning in July 2004, FMIC began
directly writing the majority of new and renewal policies
produced by CoverX.
Prior to June 2004 and our insurance subsidiarys rating
upgrade with A.M. Best to A−, we did not
directly write a significant amount of insurance produced by
CoverX through our insurance subsidiaries, but instead utilized
fronting arrangements under which we contracted with third party
insurers, or fronting insurers, to directly write the policies
underwritten and produced by CoverX. Under these fronting
arrangements, policies produced by CoverX were directly written
by third party insurers, which are commonly referred to as
fronting insurers. Under these fronting arrangements, we
controlled the cession of the insurance from the fronting
insurer and either assumed most of the risk under these policies
as a reinsurer or arranged for it to be ceded to other
reinsurers. We paid the fronting insurers a fee for this
arrangement and were required to maintain collateral grantor
trusts to cover losses and loss adjustment expenses and unearned
premiums. We entered into fronting arrangements because our
customers require an A.M. Best rating of
A− or greater and
38
FMICs A.M. Best rating was B+ prior to
the $26.0 million increase in its statutory surplus. By
utilizing fronting arrangements, we were able to use the
availability, capacity and rating status of the fronting
insurers to market insurance. With our insurance
subsidiarys rating upgrade, we were able to eliminate most
of our fronting relationships by May 2005 and become the direct
writer of substantially all of the policies produced by CoverX.
We currently only use fronting arrangements when they serve our
business purpose and CoverX has continued to provide broker and
general agent services to third party insurers although we do
not expect revenues generated from such services to be
significant.
As a result of our shift from the fronting model to the direct
writing model, fees we paid to fronting insurers and a portion
of our administrative expenses related to interacting with
fronting insurers were eliminated, which has reduced our
expenses. As a result of the decrease in fronting and
administrative expenses, the shift to the direct writing model
has increased our profitability. We are no longer subject to the
underwriting and claims oversight of fronting insurers nor are
we required to fund collateral grantor trust accounts. In
addition, we are not dependent on the availability, capacity or
rating status of fronting insurers.
This change in our business model impacted our operating results
and the comparability of 2006 to 2005 and 2005 to 2004 operating
results in several ways, including the following:
|
|
|
|
|
Direct, Assumed and Ceded Written
Premiums: The elimination of fronting
arrangements resulted in an increase in our direct written
premiums because we no longer relied on fronting insurers to
directly write insurance that we then reinsured or placed with
other reinsurers. The increase in our direct written premiums
resulted in a corresponding decrease in our assumed written
premiums, and an increase in our ceded written premiums from
2004 to 2006.
|
|
|
|
Net Written and Earned
Premiums: The change in business model
did not have a significant impact on our net written or earned
premiums.
|
|
|
|
Insurance Underwriting
Commissions: Under the fronting model, we
received fixed rate commission income on all premiums produced
by CoverX for fronting insurers, as well as profit sharing
commission income on all premiums produced that were retained by
fronting insurers or ceded to third party insurers. Under the
direct writing model, we do not report commission income on
premiums written by our insurance subsidiaries because they are
eliminated for consolidated financial statement purposes. The
change in our business model therefore resulted in a decrease of
our insurance underwriting commission income from 2004 to 2006.
|
|
|
|
Assumed Reinsurance Commission
Expense: Under the fronting model, other
operating expenses included fixed commissions incurred under
assumed reinsurance agreements with the fronting insurers, and,
in some cases, profit sharing expense incurred related to
assumed reinsurance agreements. The fronting fees charged to us
by the fronting insurers were added to the commission expenses
incurred or were deducted from the fixed commissions earned by
CoverX. The change in our business model therefore resulted in a
decrease of our assumed reinsurance commission expense from 2004
to 2006.
|
|
|
|
Ceded Reinsurance
Commissions: Under the direct writing
model, we earn ceding commissions on insurance risks ceded from
FMIC to third party insurers under reinsurance treaties and earn
ceded profit sharing commissions on ceded reinsurance. Under the
fronting model, these ceding commissions were paid to the
fronting insurer by the reinsurers who received the
corresponding premiums. Both of these items are reported as an
offset to our other operating expenses. The change in our
business model resulted in an increase in our ceded reinsurance
commissions from 2004 to 2006.
|
Our discussion and analysis of financial condition and results
of operations should be read with an understanding of this
change in our business model.
Premiums
Produced
We use the operational measure premiums produced to
identify premiums generated from insurance policies sold through
CoverX on insurance policies that it produces and underwrites on
behalf of FMIC and under fronting relationships. Premiums
produced includes both our direct written premiums and premiums
39
directly written by our fronting insurers, all of which are
produced and underwritten by CoverX. Although the premiums
billed by CoverX under fronting relationships are directly
written by the fronting insurer, we control the ultimate
placement of those premiums, by either assuming the premiums by
our insurance subsidiaries or arranging for the premiums to be
ceded to third party reinsurers. The operational measure
premiums produced is used by our management,
reinsurers, creditors and rating agencies as a meaningful
measure of the dollar growth of our underwriting operations
because it represents the premiums that we control by directly
writing insurance and by our fronting relationships. It is also
a key indicator of our insurance underwriting operations
revenues, and is the basis for broker commission expense
calculations in our consolidated income statement. We generate
direct and net earned premium income from premiums directly
written by our insurance subsidiaries, and generate commission
income, profit sharing commission income and assumed written and
earned premiums from premiums directly written by third party
insurance companies. We believe that premiums produced is an
important operational measure of our insurance underwriting
operations, and refer to it in the following discussion and
analysis of financial condition and results of our operations.
Critical
Accounting Policies
Use of
Estimates
In preparing our consolidated financial statements, management
is required to make estimates and assumptions that affect the
reported amounts of assets and liabilities and the disclosures
of contingent assets and liabilities as of the date of the
consolidated financial statements, and revenues and expenses
reported for the periods then ended. Actual results may differ
from those estimates. Material estimates that are susceptible to
significant change in the near term relate primarily to the
determination of the reserves for losses and loss adjustment
expenses and the recoverability of deferred tax assets.
Loss
and Loss Adjustment Expense Reserves
The reserves for losses and loss adjustment expenses represent
our estimated ultimate costs of all reported and unreported
losses and loss adjustment expenses incurred and unpaid at the
balance sheet date. Our reserves reflect our estimates at a
given time of amounts that we expect to pay for losses that have
been reported, which are referred to as case reserves, and
losses that have been incurred but not reported and the expected
development of losses and allocated loss adjustment expenses on
open reported cases, which are referred to as IBNR reserves. We
do not discount the reserves for losses and loss adjustment
expenses.
We allocate the applicable portion of our estimated loss and
loss adjustment expense reserves to amounts recoverable from
reinsurers under ceded reinsurance contracts and report those
amounts separately from our loss and loss adjustment expense
reserves as an asset on our balance sheet.
The estimation of ultimate liability for losses and loss
adjustment expenses is an inherently uncertain process. Our loss
and loss adjustment expense reserves do not represent an exact
measurement of liability, but are our estimates based upon
various factors, including:
|
|
|
|
|
actuarial projections of what we, at a given time, expect to be
the cost of the ultimate settlement and administration of claims
reflecting facts and circumstances then known;
|
|
|
|
estimates of future trends in claims severity and frequency;
|
|
|
|
assessment of asserted theories of liability; and
|
|
|
|
analysis of other factors, such as variables in claims handling
procedures, economic factors, and judicial and legislative
trends and actions.
|
Most or all of these factors are not directly or precisely
quantifiable, particularly on a prospective basis, and are
subject to a significant degree of variability over time. In
addition, the establishment of loss and loss adjustment expense
reserves makes no provision for the broadening of coverage by
legislative action or judicial interpretation or for the
extraordinary future emergence of new types of losses not
sufficiently represented in our historical experience or which
cannot yet be quantified. Accordingly, the ultimate liability
40
may be more or less than the current estimate. The effects of
changes in the estimated reserves are included in the results of
operations in the period in which the estimate is revised.
Our reserves consist entirely of reserves for liability losses,
consistent with the coverages provided for in the insurance
policies directly written or assumed by the Company under
reinsurance contracts. In many cases, several years may elapse
between the occurrence of an insured loss, the reporting of the
loss to us and our payment of the loss. The estimation of
ultimate liability for losses and loss adjustment expenses is an
inherently uncertain process, requiring the use of informed
estimates and judgments. Our loss and loss adjustment expense
reserves do not represent an exact measurement of liability, but
are estimates. Although we believe that our reserve estimates
are reasonable, it is possible that our actual loss experience
may not conform to our assumptions and may, in fact, vary
significantly from our assumptions. Accordingly, the ultimate
settlement of losses and the related loss adjustment expenses
may vary significantly from the estimates included in our
financial statements. We continually review our estimates and
adjust them as we believe appropriate as our experience develops
or new information becomes known to us. Such adjustments are
included in current operations.
When a claim is reported to us, our claims department completes
a case-basis valuation and establishes a case reserve for the
estimated amount of the ultimate payment as soon as practicable
after receiving notice of a claim and after it has sufficient
information to form a judgment about the probable ultimate
losses and loss adjustment expenses associated with that claim.
We take into consideration the facts and circumstances for each
claim filed as then known by our claims department, as well as
actuarial estimates of aggregate unpaid losses and loss
adjustment expenses based on our experience and industry data,
and expected future trends in loss costs. The amount of unpaid
losses and loss adjustment expenses for reported claims, which
we refer to as case reserves, is based primarily upon a claim by
claim evaluation of coverage, including an evaluation of the
following factors:
|
|
|
|
|
the type of loss;
|
|
|
|
the severity of injury or damage;
|
|
|
|
our knowledge of the circumstances surrounding the claim;
|
|
|
|
jurisdiction of the occurrence;
|
|
|
|
policy provisions related to the claim;
|
|
|
|
expenses intended to cover the ultimate cost of settling claims,
including investigation and defense of lawsuits resulting from
such claims, costs of outside adjusters and experts, and all
other expenses which are identified to the case; and
|
|
|
|
any other information considered pertinent to estimating the
indemnity and expense exposure presented by the claim.
|
Our claims department updates their case-basis valuations
continuously to incorporate new information. We also use
actuarial analyses to estimate both the costs of losses and
allocated loss adjustment expenses that have been incurred but
not reported to us and the expected development of costs of
losses and loss adjustment expenses on open reported cases.
We determine IBNR reserve estimates separately for our security
classes and for our other specialty classes, since we have
extensive historical experience data on the security classes and
limited historical experience data for our other specialty
classes. For security classes, our IBNR reserve estimates are
determined using our actual historical loss and loss adjustment
expense experience and reporting patterns from our loss and loss
adjustment expense database which covers the last 22 years.
For other specialty classes, for which we have seven years or
less of historical data, our estimates give significant weight
to industry loss and loss adjustment expense costs and industry
reporting patterns applicable to our classes, from industry
sources including actuarial circulars published by Insurance
Services Offices (ISO) in combination with our
actual paid and incurred loss and loss adjustment expenses and
reporting patterns. Our estimates also include
41
estimates of future trends that may affect the frequency of
claims and changes in the average cost of potential future
claims.
We also estimate bulk reserves for our unallocated loss
adjustment expenses not specifically identified to a particular
claim, namely our internal claims department salaries and
associated general overhead and administrative expenses
associated with the adjustment and processing of claims. These
estimates, which are referred to as ULAE reserves, are based on
internal cost studies and analyses reflecting the relationship
of unallocated loss adjustment expenses paid to actual paid and
incurred losses. We select factors that are applied to case
reserves and to IBNR reserve estimates in order to estimate the
amount of unallocated loss reserves applicable to estimated loss
reserves at the balance sheet date.
Our reserves for losses and loss adjustment expenses at
March 31, 2007 and at December 31, 2006, 2005 and
2004, gross and net of ceded reinsurance were as follows:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
March 31,
|
|
|
December 31,
|
|
|
|
2007
|
|
|
2006
|
|
|
2005
|
|
|
2004
|
|
|
|
(Dollars in thousands)
|
|
|
Gross
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Case reserves
|
|
$
|
49,615
|
|
|
$
|
47,004
|
|
|
$
|
36,200
|
|
|
$
|
27,929
|
|
IBNR and ULAE reserves
|
|
|
161,656
|
|
|
|
144,009
|
|
|
|
77,664
|
|
|
|
40,770
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total reserves
|
|
$
|
211,271
|
|
|
$
|
191,013
|
|
|
$
|
113,864
|
|
|
$
|
68,699
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net of
reinsurance
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Case reserves
|
|
$
|
38,359
|
|
|
$
|
37,376
|
|
|
$
|
32,874
|
|
|
$
|
26,544
|
|
IBNR and ULAE reserves
|
|
|
103,787
|
|
|
|
86,711
|
|
|
|
59,121
|
|
|
|
36,502
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total
|
|
$
|
142,146
|
|
|
$
|
124,087
|
|
|
$
|
91,995
|
|
|
$
|
63,046
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
We utilize accepted actuarial methods to arrive at our loss and
loss adjustment expense IBNR reserve estimates. The
determination of our best estimate of ultimate loss and loss
adjustment expenses and IBNR reserves requires significant
actuarial analysis and judgment, both in application of these
methods and in the use of the results of these methods. The
principal methods we use include:
|
|
|
|
|
The Loss Development Method - based on paid and reported
losses and loss adjustment expenses and loss and loss adjustment
expense reporting and payment and reporting patterns;
|
|
|
|
The Bornhuetter-Ferguson Method - based on paid and
reported losses and loss adjustment expenses, expected loss and
loss adjustment expense ratios, and loss and loss adjustment
expense reporting and payment and reporting patterns; and
|
|
|
|
The Expected Loss Ratio Method - based on historical or
industry experience, adjusted for changes in premium rates,
coverage restrictions and estimated loss cost trends.
|
Our estimates for security classes and other specialty classes
give different weight to each of these methods based upon the
amount of historical experience data we have and our judgments
as to what method we believe will result in the most accurate
estimate. The application of each method for security classes
and other specialty classes may change in the future if we
determine a different emphasis for each method would result in
more accurate estimates.
We apply these methods to net paid and incurred loss and loss
adjustment expense and net earned premium information after
ceding reinsurance to determine ultimate net loss and loss
adjustment expense and net IBNR reserves. Since our ceded
reinsurance is principally on a quota share basis, we determine
our ceded IBNR reserves based on the ultimate net loss and loss
adjustment expense ratios determined in the estimation of our
net IBNR reserves. Ceded case reserves are allocated based on
monthly or quarterly reinsurance settlement reports prepared in
accordance with the reporting and settlement terms of the ceded
reinsurance contracts.
42
For security classes where we have many years of historical
experience data, we perform semi-annual analyses of the payment
and reporting patterns of losses and loss adjustment expenses as
well as reported and closed claims by accident year for security
guard, alarm, and safety equipment
sub-classes.
We have generally relied primarily on the Loss Development
Method in calculating ultimate losses and loss adjustment
expenses for the more mature accident years, applying our
historical loss and loss adjustment expense reporting patterns
to paid and incurred losses and loss adjustment expenses
reported to date by accident year to estimate ultimate loss and
loss adjustment expense and IBNR reserves. In determining our
reserve estimates for the more recent, less mature accident
years, we have relied more on the Bornhuetter-Ferguson Method to
calculate expected loss and loss adjustment expense ratios.
Although we have calculated the results from the Expected Loss
Ratio Method for the less mature years, we have not relied
significantly on this method due to the more meaningful results
of the other methods we have used for security classes.
During 2006, the Company experienced approximately
$1.1 million in net prior year reserve development
primarily in the 2000 accident year, offset somewhat by
favorable development on prior years unallocated loss
adjustment expense reserves. The development on accident year
2000 reserves was concentrated primarily in the safety equipment
class as a result of obtaining new information on several high
severity cases. See Year Ended
December 31, 2006 Compared to Year Ended December 31,
2005, Losses and Loss Adjustment
Expenses.
During 2005 the Company experienced approximately
$12.8 million in net prior accident year development in its
security classes, primarily in accident years 2000 to 2002,
principally in the safety equipment
sub-class.
The prior year reserve development occurred due to new
information which emerged during 2005 on a small number of high
severity cases, causing increased net case reserve valuations or
loss and loss adjustment expense payments of $7.4 million
that were not anticipated in our prior years IBNR reserve
estimates. This development was inconsistent with our historical
loss and loss and loss adjustment expense reporting patterns. As
a result, we also increased net IBNR reserves by
$5.4 million in the affected accident years, and
sub-classes,
and we increased the expected loss and loss adjustment expense
ratios and the reporting patterns used in our reserve estimates
for subsequent accident years in those
sub-classes.
The impact of these increases on our more recent accident
years IBNR reserves are mitigated somewhat by the purchase
of excess reinsurance coverage for high severity cases beginning
in June 2004, which was not in place during most of the accident
year periods experiencing development on prior year reserves. In
addition, our security classes were completely re-underwritten
during 2001 and 2002, and large rate increases and extensive use
of restrictive and exclusionary coverage policy forms were
subsequently implemented, resulting in significant reductions in
claims frequency and in reported incurred loss and loss
adjustment expense ratios for subsequent accident years. See
Year Ended December 31, 2005 Compared to
Year Ended December 31, 2004,
Losses and Loss Adjustment Expenses.
For other specialty classes, we have relied more on the
Bornhuetter-Ferguson Method in calculating our semi-annual
reserve estimates. Although we use the Loss Development Method,
we have not relied significantly on it as we are still building
our experience database for other specialty classes. We have
also used the Expected Loss Ratio Method, which we have
developed from industry loss cost information, adjusted for
changes in premium rates, coverage restrictions, and estimated
loss cost trends. We have seven years or less of historical
experience of losses and loss adjustment expenses for other
specialty classes, so we have relied on industry reporting
patterns included in actuarial circulars published by ISO by
sub-class
groupings that are consistent with our class profiles within our
other specialty classes, in combination with our own historical
experience.
From 2000 through 2004, our reserve estimates for other
specialty classes utilized industry loss and loss adjustment
expense reporting pattern information that was included in
actuarial circulars available from ISO in 2000. New, updated ISO
industry loss and loss adjustment expense reporting pattern
information became available during 2005 which was more detailed
for each of the
sub-class
groupings within other specialty classes. The new industry
information reflected higher and slower loss reporting patterns
than the industry information that was previously available.
This was due to a number of factors, including more recent data,
additional data from different sources and more detailed
segmentation of the data. During 2005, we compared the new
industry reporting pattern information to our actual loss
experience and determined that the new
43
information more closely aligned with our emerging experience,
coverage class groupings and limits profiles for other specialty
classes. As a result, in the fourth quarter of 2005, we adopted
usage of the new industry loss reporting pattern information in
our reserve estimates for all accident years, resulting in
increases in prior years reserves, and in higher 2005 and
later accident year reserve estimates. This change in loss
reporting pattern assumptions resulted in the majority of the
$6.2 million in prior accident year development that
occurred in specialty classes during 2005. See
Year Ended December 31, 2005 Compared to
Year Ended December 31, 2004,
Losses and Loss Adjustment Expenses.
Our reserve analysis determines an actuarial point estimate
rather than a range of reserve estimates. We do not compute
estimated ranges of loss reserves. Because of the inherent
variability in liability losses, point estimates using
appropriate actuarial methods and reasonable assumptions provide
the best estimate of reserves.
We review loss and loss adjustment expense reserves on a regular
basis. We supplement this internal review by engaging an
independent actuary. The same independent actuary has conducted
semi-annual external analyses for us for the past 14 years.
The independent actuary also provides the annual reserve
certification in accordance with insurance regulatory
requirements. The carried reserves reflect managements
best estimate of the outstanding losses and loss adjustment
expense liabilities. Management arrived at this estimate after
reviewing both the internal and external analyses.
During the first six months of an accident year, for both
security classes and other specialty classes, we have used the
Expected Loss Ratio Method based on the previous year end
estimates for the previous accident year, adjusted for estimated
changes in premium rates, coverage restrictions and estimated
loss cost trends. We monitor emerging loss experience monthly
and make adjustments to the current accident year expected loss
ratio as we believe appropriate. Throughout the year we also
compare actual emerging loss development on prior accident years
to expected loss development included in our prior accident
years loss reserve estimates and make quarterly interim
adjustments to prior years reserve estimates during
interim reporting periods as we believe appropriate.
Our loss and loss adjustment expense reserves do not represent
an exact measurement of liability, but are estimates. Although
we believe that our reserve estimates are reasonable, it is
possible that our actual loss experience may not conform to our
assumptions. The most significant assumptions affecting our IBNR
reserve estimates are expected loss and loss adjustment expense
ratios, and expected loss and loss adjustment expense reporting
patterns. These vary by underwriting class,
sub-classes,
and accident years, and are subject to uncertainty and
variability with respect to any individual accident year and
sub-class.
Generally, the reserves for the most recent accident years
depend heavily on both assumptions. The most recent accident
years are characterized by more unreported losses and less
information available for settling claims, and have more
inherent uncertainty than the reserve estimates for more mature
accident years. The more mature accident years depend more on
expected loss and loss expense reporting patterns.
The following sensitivity analysis represents reasonably likely
levels of variability in these assumptions in the aggregate.
Individual classes and
sub-classes
and accident years have different degrees of variability in both
assumptions and it is not reasonably likely that each assumption
for each
sub-class
and accident year would vary in the same direction and to the
same extent in the same reporting period. We believe the most
meaningful approach to the sensitivity analysis is to vary the
ultimate loss and loss adjustment expense estimates that result
from application of the assumptions. We apply this approach on
an accident year basis, reflecting the reasonably likely
differences in variability by level of maturity of the
underlying loss experience for each accident year, using
variability factors of plus or minus 10% for the most recent
accident year, 5% for the preceding accident year, and 2.5% for
the second preceding accident year. There is minimal expected
variability for accident years at four or more years
maturity.
44
The following table includes net ultimate loss and loss
adjustment expense amounts by accident year from our statutory
filing for our insurance subsidiaries for the year ended
December 31, 2006, which are equal to the net ultimate loss
and loss adjustment expense amounts by accident year included in
our loss and loss adjustment expense reserve estimates in the
consolidated financial statements at December 31, 2006. The
use of net of ceded reinsurance amounts is most meaningful since
the vast majority of our ceded reinsurance is on a quota share
basis. We have applied the sensitivity factors to each accident
year amount and have calculated the amount of potential net
reserve change and the impact on 2006 reported pre-tax income
and on net income and stockholders equity at
December 31, 2006. We do not believe it is appropriate to
sum the illustrated amounts as it is not reasonably likely that
each accident years reserve estimate assumptions will vary
simultaneously in the same direction to the full extent of the
sensitivity factor.
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Potential
|
|
|
|
Ultimate Loss
|
|
|
December 31, 2006
|
|
|
Potential
|
|
|
Impact on 2006
|
|
|
|
and LAE
|
|
|
Ultimate Losses
|
|
|
Impact on 2006
|
|
|
Net Income and
|
|
|
|
Sensitivity
|
|
|
and LAE Net of
|
|
|
Pre-Tax
|
|
|
December 31, 2006
|
|
|
|
Factor
|
|
|
Ceded Reinsurance
|
|
|
Income
|
|
|
Stockholders Equity
|
|
|
|
(Dollars in thousands)
|
|
|
Increased Ultimate
Losses & LAE
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Accident Year 2006
|
|
|
10.00
|
%
|
|
$
|
55,090
|
|
|
$
|
(5,509
|
)
|
|
$
|
(3,581
|
)
|
Accident Year 2005
|
|
|
5.00
|
|
|
|
35,466
|
|
|
|
(1,773
|
)
|
|
|
(1,153
|
)
|
Accident Year 2004
|
|
|
2.50
|
|
|
|
23,983
|
|
|
|
(600
|
)
|
|
|
(390
|
)
|
Decreased Ultimate
Losses & LAE
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Accident Year 2006
|
|
|
(10.00
|
)%
|
|
$
|
55,090
|
|
|
$
|
5,509
|
|
|
$
|
3,581
|
|
Accident Year 2005
|
|
|
(5.00
|
)
|
|
|
35,466
|
|
|
|
1,773
|
|
|
|
1,153
|
|
Accident Year 2004
|
|
|
(2.50
|
)
|
|
|
23,983
|
|
|
|
600
|
|
|
|
390
|
|
Revenue
Recognition
Premiums. Premiums are
recognized as earned using the daily pro rata method over the
terms of the policies. When premium rates increase, the effect
of those increases will not immediately affect earned premium.
Rather, those increases will be recognized ratably over the
period of coverage. Unearned premiums represent the portion of
premiums written that relate to the unexpired terms of
policies-in-force.
As policies expire, we audit those policies comparing the
estimated premium rating units that were used to set the initial
premium to the actual premiums rating units for the period and
adjust the premiums accordingly. Premium adjustments identified
as a result of these audits are recognized as earned when
identified.
Commissions and Fees. Wholesale
agency commissions and fee income from unaffiliated companies
are earned at the effective date of the related insurance
policies produced or as services are provided under the terms of
the administrative and service provider contracts. Related
commissions to retail agencies are concurrently expensed at the
effective date of the related insurance policies produced.
Profit sharing commissions due from certain insurance companies,
based on losses and loss adjustment expense experience, are
earned when determined and communicated by the applicable
insurance company.
Investments
Our marketable investment securities, including money market
accounts held in our investment portfolio, are classified as
available-for-sale
and, as a result, are reported at market value. A decline in the
market value of any security below cost that is deemed other
than temporary is charged to earnings and results in the
establishment of a new cost basis for the security. In most
cases, declines in market value that are deemed temporary are
excluded from earnings and reported as a separate component of
stockholders equity, net of the related taxes, until
realized. The exception of this rule relates to investments in
convertible securities with embedded derivatives. These
convertible securities were accounted for under
SFAS No. 155 Accounting for Certain Hybrid
Financial Instruments (SFAS 155) for
the three months ended March 31, 2007 and under
SFAS No. 133 Accounting for Derivative
Instruments and Hedging Activities
(SFAS 133) for the three months ended
March 31, 2006 and for the years ended December 31,
2006, 2005, and 2004.
45
Premiums and discounts are amortized or accreted over the life
of the related debt security as an adjustment to yield using the
effective-interest method. Dividend and interest income are
recognized when earned. Realized gains and losses are included
in earnings and are derived using the specific identification
method for determining the cost of securities sold.
Deferred
Policy Acquisition Costs
Policy acquisition costs related to direct and assumed premiums
consist of commissions, underwriting, policy issuance, and other
costs that vary with and are primarily related to the production
of new and renewal business, and are deferred, subject to
ultimate recoverability, and expensed over the period in which
the related premiums are earned. Investment income is included
in the calculation of ultimate recoverability.
Intangible
Assets
In accordance with SFAS No. 142, Goodwill and
Other Intangible Assets, intangible assets that are
not subject to amortization shall be tested for impairment
annually, or more frequently if events or changes in
circumstances indicate that the asset might be impaired. The
impairment test shall consist of a comparison of the fair value
of an intangible asset with its carrying amount. If the carrying
amount of an intangible asset exceeds its fair value, an
impairment loss shall be recognized in an amount equal to that
excess.
In accordance with SFAS No. 144, Accounting
for the Impairment or Disposal of Long-lived Assets,
the carrying value of long-lived assets, including
amortizable intangibles and property and equipment, are
evaluated whenever events or changes in circumstances indicate
that a potential impairment has occurred relative to a given
asset or assets. Impairment is deemed to have occurred if
projected undiscounted cash flows associated with an asset are
less than the carrying value of the asset. The estimated cash
flows include managements assumptions of cash inflows and
outflows directly resulting from the use of that asset in
operations. The amount of the impairment loss recognized is
equal to the excess of the carrying value of the asset over its
then estimated fair value.
46
Results
of Operations
Three
Months Ended March 31, 2007 Compared to Three Months Ended
March 31, 2006
The following table summarizes our results for the three months
ended March 31, 2007 and 2006:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended
|
|
|
|
|
|
|
March 31,
|
|
|
|
|
|
|
2007
|
|
|
2006
|
|
|
Change
|
|
|
|
(Dollars in thousands)
|
|
|
|
|
|
Operating revenue
|
|
|
|
|
|
|
|
|
|
|
|
|
Net earned premiums
|
|
$
|
44,929
|
|
|
$
|
28,529
|
|
|
|
57
|
%
|
Commissions and fees
|
|
|
4,657
|
|
|
|
4,444
|
|
|
|
5
|
|
Net investment income
|
|
|
3,294
|
|
|
|
2,150
|
|
|
|
53
|
|
Net realized gains (losses) on
investments
|
|
|
135
|
|
|
|
(153
|
)
|
|
|
(188
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total operating
revenues
|
|
|
53,015
|
|
|
|
34,970
|
|
|
|
52
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Operating expenses
|
|
|
|
|
|
|
|
|
|
|
|
|
Losses and loss adjustment
expenses, net
|
|
|
23,954
|
|
|
|
14,907
|
|
|
|
61
|
|
Amortization of intangible assets
|
|
|
307
|
|
|
|
292
|
|
|
|
5
|
|
Other operating expenses
|
|
|
12,469
|
|
|
|
9,104
|
|
|
|
37
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total operating
expenses
|
|
|
36,730
|
|
|
|
24,303
|
|
|
|
51
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Operating income
|
|
|
16,285
|
|
|
|
10,667
|
|
|
|
53
|
|
Interest expense
|
|
|
1,089
|
|
|
|
2,419
|
|
|
|
(55
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Income before income
taxes
|
|
|
15,196
|
|
|
|
8,248
|
|
|
|
84
|
|
Income taxes
|
|
|
5,229
|
|
|
|
2,869
|
|
|
|
82
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net income
|
|
$
|
9,967
|
|
|
$
|
5,379
|
|
|
|
85
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Loss ratio
|
|
|
53.3
|
%
|
|
|
52.3
|
%
|
|
|
1.0 point
|
|
Underwriting expense
ratio
|
|
|
20.4
|
%
|
|
|
22.5
|
%
|
|
|
(2.1 points
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Combined ratio
|
|
|
73.7
|
%
|
|
|
74.8
|
%
|
|
|
(1.1 points
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Premiums
Produced
Premiums produced, which consists of all of the premiums billed
by CoverX, for the three months ended March 31, 2007 were
$64.3 million, a $4.3 million, or 7%, increase over
$59.9 million in premiums produced during the three months
ended March 31, 2006. This growth was primarily due to
$1.9 million from the opening of the Companys
California underwriting office during the fourth quarter of 2006
and continuing growth from our existing underwriting offices,
offset somewhat by a modest decline in premium rates.
47
Operating
Revenue
Net
Earned Premiums
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended
|
|
|
|
|
|
|
March 31,
|
|
|
|
|
|
|
2007
|
|
|
2006
|
|
|
Change
|
|
|
|
(Dollars in thousands)
|
|
|
|
|
|
Written premiums
|
|
|
|
|
|
|
|
|
|
|
|
|
Direct
|
|
$
|
59,334
|
|
|
$
|
55,537
|
|
|
|
7
|
%
|
Assumed
|
|
|
1,266
|
|
|
|
1,339
|
|
|
|
(5
|
)
|
Ceded
|
|
|
(26,140
|
)
|
|
|
(29,768
|
)
|
|
|
(12
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net written premiums
|
|
$
|
34,460
|
|
|
$
|
27,108
|
|
|
|
27
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Earned premiums
|
|
|
|
|
|
|
|
|
|
|
|
|
Direct
|
|
$
|
53,374
|
|
|
$
|
48,861
|
|
|
|
9
|
%
|
Assumed
|
|
|
1,086
|
|
|
|
765
|
|
|
|
42
|
|
Ceded
|
|
|
(11,064
|
)
|
|
|
(21,278
|
)
|
|
|
(48
|
)
|
Earned but unbilled premiums
|
|
|
1,533
|
|
|
|
181
|
|
|
|
747
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net earned premiums
|
|
$
|
44,929
|
|
|
$
|
28,529
|
|
|
|
57
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Direct written premiums increased $3.8 million, or 7%,
primarily due to the opening of the Companys California
underwriting office in December 2006 and the growth in premiums
produced by existing underwriting offices during the three
months ended March 31, 2007. Direct earned premiums
increased $4.5 million in the three months ended
March 31, 2007, or 9%, compared to the three months ended
March 31, 2006.
Assumed written premiums decreased $0.1 million, or 5%, and
assumed earned premiums increased $0.3 million or 42%. The
slight decrease in assumed written premiums is due to the growth
in the admitted legal liability
sub-class
written through a fronting insurer, offset by the elimination of
2006 assumed premium audits related to expirations of policies
written under prior fronting relationships. The 42% growth in
assumed earned premiums is primarily related to the increase in
legal liability
sub-class
premiums written through a fronting insurer during 2006.
Ceded written premiums decreased $3.6 million, or 12%, and
ceded earned premiums decreased $10.2 million, or 48%, in
the three months ended March 31, 2007 compared to the three
months ended March 31, 2006. Ceded written premiums
decreased principally due to purchasing 35% quota share
reinsurance effective January 1, 2007, while the Company
purchased 50% quota share reinsurance during the first quarter
of 2006, offset somewhat by the increase in direct written
premiums subject to the quota share arrangement. Ceded earned
premiums decreased primarily due to the termination of the
Companys 2006 50% quota share reinsurance treaties on
December 31, 2006 on a cut-off basis, resulting
in the previously ceded unearned premiums being returned to the
Company on that date, so that there were no ceded earned
premiums related to the 50% reinsurance treaties during the
three months ended March 31, 2007. The three months ended
March 31, 2006 included ceded earned premiums related to
the 2005 quota share reinsurance treaties which continued into
2006. The effect of the December 31, 2006 50% quota share
cut-off reinsurance termination was to reduce ceded earned
premiums for the three months ended March 31, 2007 by
approximately $17.6 million, and to increase net earned
premiums by the same amount.
Earned but unbilled premiums increased $1.4 million, or
747%, primarily due to the growth in the rate of audit premiums
to original premiums written during 2006, recognition of
increased audit premium collection experience, and growth in net
retained earned premiums subject to premium audits.
48
Commissions
and Fees
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended
|
|
|
|
|
|
|
March 31,
|
|
|
|
|
|
|
2007
|
|
|
2006
|
|
|
Change
|
|
|
|
(Dollars in thousands)
|
|
|
|
|
|
Insurance underwriting commissions
and fees
|
|
$
|
1,872
|
|
|
$
|
1,431
|
|
|
|
31
|
%
|
Insurance services commissions and
fees
|
|
|
2,785
|
|
|
|
3,013
|
|
|
|
(8
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total commissions and fees
|
|
$
|
4,657
|
|
|
$
|
4,444
|
|
|
|
5
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Insurance underwriting commissions and fees increased
$0.4 million, or 31%, from the three months ended
March 31, 2006 to the three months ended March 31,
2007, principally due to increases in commissions on fronted
premiums. Insurance services commissions and fees, which were
principally ARPCO income and not related to premiums produced,
decreased $0.2 million, or 8%, principally as the result of
increased ARPCO fees of $0.2 million offset by decreased
brokerage fees income of $0.4 million.
Net Investment Income and Realized Gains on
Investments. During the three months
ended March 31, 2007, net investment income was
$3.3 million, a $1.1 million, or 53%, increase from
$2.2 million reported for the three months ended
March 31, 2006 primarily due to the increase in invested
assets over the period. At March 31, 2007, invested assets
were $360.0 million, a $131.1 million, or 57%,
increase over $228.9 million of invested assets at
March 31, 2006. This increase was due to increases in net
written premiums, the reinsurer payment of the unearned premiums
related to the 2006 50% quota share reinsurance terminated on a
cut-off basis on December 31, 2006 during the
three months ended March 31, 2007, retaining cash received
for net written premiums under the 2007 35% quota share
reinsurance contracts on a funds withheld basis
during the three months ended March 31, 2007, and proceeds
from the initial public offering and the issuance of junior
subordinated debentures related to trust preferred securities
during the fourth quarter of 2006. Net investment income earned
continued to benefit from higher reinvestment rates as proceeds
from maturing bonds were reinvested at currently higher interest
rates. The annualized investment yield (net of investment
expenses) was 4.0% and 3.9% at March 31, 2007 and
March 31, 2006, respectively. The increase was the result
of the general increase in market interest rates offset by
increased allocation to municipal securities. The annualized tax
equivalent yield on total investments was 4.8% and 4.2% for the
three months ended March 31, 2007 and 2006, respectively.
During the three months ended March 31, 2007, net realized
capital gains were $0.1 million, a $0.3 million
increase over the net realized capital loss of $0.2 million
during the three months ended March 31, 2006. The three
months ended March 31, 2007 net realized capital gains
were principally due to sales of investment securities at gains
of approximately $0.6 million, offset by mark to market
declines in convertible bonds carried at market in accordance
with the Companys adoption of SFAS 155 during the
three months ended March 31, 2007 of approximately
$0.3 million, and due to other than temporary impairments
on debt securities of $0.2 million.
Operating
Expenses
Losses and Loss Adjustment
Expenses. Losses and loss adjustment
expenses incurred increased $9.0 million, or 61%, in the
three months ended March 31, 2007 compared to the three
months ended March 31, 2006 principally due to the increase
in net earned exposures reflected in the 57% growth in net
earned premiums, and due to an increase in the accident year
loss and loss adjustment expense ratio. This growth was offset
somewhat by approximately $0.1 million in favorable
development of December 31, 2006 and prior years
unallocated loss adjustment expense reserves in the three months
ended March 31, 2007, as compared to the $0.5 million
in unfavorable loss and loss adjustment expense reserves
development of December 31, 2005 and prior reserves
reported during the three months ended March 31, 2006.
49
Other
Operating Expenses
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended
|
|
|
|
|
|
|
March 31,
|
|
|
|
|
|
|
2007
|
|
|
2006
|
|
|
Change
|
|
|
|
(Dollars in thousands)
|
|
|
|
|
|
Amortization of deferred
acquisition expenses
|
|
$
|
8,739
|
|
|
$
|
4,894
|
|
|
|
79
|
%
|
Ceded reinsurance commissions
|
|
|
(8,258
|
)
|
|
|
(9,063
|
)
|
|
|
(9
|
)
|
Other underwriting and operating
expenses
|
|
|
11,988
|
|
|
|
13,273
|
|
|
|
(10
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Other operating expenses
|
|
$
|
12,469
|
|
|
$
|
9,104
|
|
|
|
37
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
During the three months ended March 31, 2007, other
operating expenses increased $3.4 million, or 37%, from the
three months ended March 31, 2006. Amortization of deferred
acquisition expenses increased by $3.8 million, or 79%,
including a $5.7 million increase related to the
approximately $17.6 million in net premiums earned due to
the termination on a cut-off basis of the 2006 50%
quota share reinsurance treaties on December 31, 2006
offset by a decrease of $1.9 million related to remaining
net earned premiums during the three months ended March 31,
2007. Ceded reinsurance commissions decreased $0.8 million,
or 9%, principally due to the effect of purchasing 35% quota
share reinsurance during the first quarter of 2007 compared to
purchasing 50% quota share reinsurance during the first quarter
of 2006, offset somewhat by changes in ceding commission rates.
Other underwriting and operating expenses, which consist of
commissions, other acquisition costs, and general and
underwriting expenses, net of acquisition cost deferrals,
decreased by $1.3 million, or 10%, principally due to
increased net deferrals of acquisition costs of
$0.8 million, and a decrease of $0.5 million in
general and underwriting expenses primarily due to certain
non-recurring expenses during the three months ended
March 31, 2006.
Interest
Expense
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended
|
|
|
|
|
|
|
March 31,
|
|
|
|
|
|
|
2007
|
|
|
2006
|
|
|
Change
|
|
|
|
(Dollars in thousands)
|
|
|
|
|
|
Senior notes
|
|
$
|
|
|
|
$
|
2,210
|
|
|
|
(100
|
)%
|
Junior subordinated debentures
|
|
|
1,089
|
|
|
|
206
|
|
|
|
429
|
|
Other
|
|
|
|
|
|
|
3
|
|
|
|
(100
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total interest expense
|
|
$
|
1,089
|
|
|
$
|
2,419
|
|
|
|
(55
|
)%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Interest expense decreased $1.3 million, or 55%, from the
three months ended March 31, 2006 to the three months ended
March 31, 2007. This decrease was principally attributable
to a $2.2 million decrease in interest expense related to
the $65.0 million senior notes issued in August 2005 and
repaid in October 2006. This decrease was offset by a
$0.9 million increase in interest expense related to junior
subordinated debentures of $46.4 million and
$20.6 million at March 31, 2007 and 2006,
respectively, which included the change in fair value of
interest rate swap on junior subordinated debentures as
discussed in Liquidity and Capital
Resources.
Income Taxes. Our effective tax
rates were approximately 34.4% for the three months ended
March 31, 2007 and 34.8% for the three months ended
March 31, 2006.
Year
Ended December 31, 2006 Compared to Year Ended
December 31, 2005
On August 17, 2005, we formed a parent holding company,
Holdings, to purchase shares of FMFC common stock from certain
FMFC stockholders and to exchange shares and options with the
remaining stockholders of FMFC. The purchase of shares was
financed by the issuance of $65.0 million aggregate
principal amount of senior notes by Holdings. Holdings was
merged into FMFC on October 16, 2006 and the senior notes
were repaid in full with a portion of the net proceeds from our
initial public offering.
50
As a result of the acquisition and resulting purchase accounting
adjustments, the results of operations for periods prior to
August 17, 2005 are not comparable to periods subsequent to
that date. Our fiscal 2005 results discussed below represent the
mathematical addition of the historical results for (i) the
predecessor period from January 1, 2005 through
August 16, 2005, and (ii) the successor period from
August 17, 2005 through December 31, 2005. This
approach is not consistent with generally accepted accounting
principles and yields results that are not comparable on a
period-to-period
basis. However, we believe it is the most meaningful way to
discuss our operating results for 2006 when comparing them to
our operating results for 2005 because it would not be
meaningful to discuss the partial period from January 1,
2005 through August 16, 2005 (Predecessor) separately from
the period from August 17, 2005 to December 31, 2005
(Successor) when comparing 2006 operating results to 2005
operating results.
The following table summarizes our results for the years ended
December 31, 2006 and 2005:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Year Ended
|
|
|
|
|
|
|
December 31,
|
|
|
|
|
|
|
2006
|
|
|
2005
|
|
|
Change
|
|
|
|
(Dollars in thousands)
|
|
|
|
|
|
Operating revenue
|
|
|
|
|
|
|
|
|
|
|
|
|
Net earned premiums
|
|
$
|
110,570
|
|
|
$
|
97,722
|
|
|
|
13
|
%
|
Commissions and fees
|
|
|
16,692
|
|
|
|
26,077
|
|
|
|
(36
|
)
|
Net investment income
|
|
|
9,713
|
|
|
|
6,748
|
|
|
|
44
|
|
Net realized gains on investments
|
|
|
517
|
|
|
|
220
|
|
|
|
135
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total operating
revenues
|
|
|
137,492
|
|
|
|
130,767
|
|
|
|
5
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Operating expenses
|
|
|
|
|
|
|
|
|
|
|
|
|
Losses and loss adjustment
expenses, net
|
|
|
56,208
|
|
|
|
55,094
|
|
|
|
2
|
|
Amortization of intangible assets
|
|
|
1,270
|
|
|
|
1,166
|
|
|
|
9
|
|
Other operating expenses
|
|
|
29,816
|
|
|
|
34,100
|
|
|
|
(13
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total operating
expenses
|
|
|
87,294
|
|
|
|
90,360
|
|
|
|
(3
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Operating income
|
|
|
50,198
|
|
|
|
40,407
|
|
|
|
24
|
|
Interest expense
|
|
|
16,575
|
|
|
|
4,935
|
|
|
|
236
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Income before income
taxes
|
|
|
33,623
|
|
|
|
35,472
|
|
|
|
(5
|
)
|
Income taxes
|
|
|
11,754
|
|
|
|
12,637
|
|
|
|
(7
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net income
|
|
$
|
21,869
|
|
|
$
|
22,835
|
|
|
|
(4
|
)%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Loss ratio
|
|
|
50.8
|
%
|
|
|
56.4
|
%
|
|
|
(5.8 points
|
)
|
Underwriting expense
ratio
|
|
|
16.9
|
%
|
|
|
14.3
|
%
|
|
|
1.8 points
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Combined ratio
|
|
|
67.7
|
%
|
|
|
70.7
|
%
|
|
|
(4.0 points
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Premiums
Produced
Premiums produced, which consists of all of the premiums billed
by CoverX, for the year ended December 31, 2006, were
$230.1 million, a $41.6 million, or 22%, increase over
$188.5 million in premiums produced during the year ended
December 31, 2005. This growth was primarily attributable
to:
|
|
|
|
|
Approximately $32.6 million in net new business, including
a full year of operations in the Northeast and the legal
professional liability program, and continued growth in existing
markets; and
|
|
|
|
$9.0 million increase in premiums on the audit of expiring
policies.
|
51
Operating
Revenue
Net
Earned Premiums
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Year Ended
|
|
|
|
|
|
|
December 31,
|
|
|
|
|
|
|
2006
|
|
|
2005
|
|
|
Change
|
|
|
|
(Dollars in thousands)
|
|
|
|
|
|
Written premiums
|
|
|
|
|
|
|
|
|
|
|
|
|
Direct
|
|
$
|
213,842
|
|
|
$
|
168,223
|
|
|
|
27
|
%
|
Assumed
|
|
|
4,339
|
|
|
|
7,673
|
|
|
|
(43
|
)
|
Ceded
|
|
|
(75,255
|
)
|
|
|
(70,195
|
)
|
|
|
7
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net written premiums
|
|
$
|
142,926
|
|
|
$
|
105,701
|
|
|
|
35
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Earned premiums
|
|
|
|
|
|
|
|
|
|
|
|
|
Direct
|
|
$
|
206,768
|
|
|
$
|
126,525
|
|
|
|
63
|
%
|
Assumed
|
|
|
3,736
|
|
|
|
17,742
|
|
|
|
(79
|
)
|
Ceded
|
|
|
(101,408
|
)
|
|
|
(48,571
|
)
|
|
|
109
|
|
Earned but unbilled premiums
|
|
|
1,474
|
|
|
|
2,026
|
|
|
|
(27
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net earned premiums
|
|
$
|
110,570
|
|
|
$
|
97,722
|
|
|
|
13
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Direct written premiums increased $45.6 million, or 27%,
while direct earned premiums increased $80.2 million, or
63%, in the year ended December 31, 2006 compared to the
year ended December 31, 2005. The increases in direct
written premiums and direct earned premiums were due primarily
to the change in our business model as a result of which we
ceased relying on fronting arrangements under which we assumed
insurance from fronting insurers and instead began to write
substantially all of the new and renewal policies produced by
CoverX. As of December 31, 2006, we had the benefit of a
full year of direct written premiums with minimal fronting,
which resulted in direct earned premiums increasing at a higher
rate than direct written premiums. For the year ended
December 31, 2005, while the change in business model had
been in effect for a full year, the first six months after the
change was more of a gradual shift away from fronting towards
directly writing policies and as such, there were lower volumes
of policies to be earned for the year ended December 31,
2005.
Assumed written premiums decreased $3.3 million, or 43%,
and assumed earned premiums decreased $14.0 million, or
79%, for the year ended December 31, 2006 compared to the
year ended December 31, 2005. These decreases were
consistent with the change in our business model as a result of
which we ceased relying on fronting arrangements under which we
assumed insurance from fronting insurers and instead began to
directly write substantially all of our premiums produced.
Ceded written premiums increased $5.0 million, or 7%, and
ceded earned premiums increased $52.8 million, or 109%, for
the year ended December 31, 2006 compared to the year ended
December 31, 2005. This increase was due to the increase in
premiums produced as well as elections to increase premiums
ceded under our current quota share arrangement by 10% to 50% in
January 2006. This increase was offset by the return to the
Company of $39.6 million in ceded written premiums on
December 31, 2006 as a result of the Companys
exercise of its election to terminate expiring quota share
reinsurance contracts on a cut-off basis, in accordance with the
terms of the reinsurance contracts. The $39.6 million in
returned premiums will be earned by the Company and reported as
net earned premiums during 2007. The time lag between ceded
premiums being written and ceded premiums being earned resulted
in a more substantial increase in the ceded earned premiums.
52
Commissions
and Fees
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Year Ended
|
|
|
|
|
|
|
December 31,
|
|
|
|
|
|
|
2006
|
|
|
2005
|
|
|
Change
|
|
|
|
(Dollars in thousands)
|
|
|
|
|
|
Insurance underwriting commissions
and fees
|
|
$
|
5,789
|
|
|
$
|
15,578
|
|
|
|
(63
|
)%
|
Insurance services commissions and
fees
|
|
|
10,903
|
|
|
|
10,499
|
|
|
|
4
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total commissions and fees
|
|
$
|
16,692
|
|
|
$
|
26,077
|
|
|
|
(36
|
)%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Insurance underwriting commissions and fees decreased
$9.8 million, or 63%, from the year ended December 31,
2005 to the year ended December 31, 2006. This was
primarily the result of the change in our business model, which
resulted in an increase in direct written premiums as a
percentage of premiums produced, and insurance underwriting
commissions and fees decreased. This decline was offset by the
impact of the increase in premiums produced. Insurance services
commissions and fees, which were principally ARPCO income and
not related to premiums produced, increased $0.4 million,
or 4%.
Net
Investment Income and Realized Gains on
Investments
During the year ended December 31, 2006, net investment
income earned was $9.7 million, a $3.0 million, or
44%, increase from $6.7 million reported in the year ended
December 31, 2005 primarily due to the increase in invested
assets over the period. At December 31, 2006, invested
assets were $297.8 million, a $86.8 million, or 41%,
increase over $211.0 million of invested assets at
December 31, 2005 due to increases in net written premiums
and proceeds from the issuance of trust preferred securities.
Net investment income earned continued to benefit from higher
reinvestment rates as proceeds from maturing bonds were
reinvested at currently higher interest rates. The investment
yield (net of investment expenses) was 3.9% and 3.5% at
December 31, 2006 and December 31, 2005, respectively.
The tax equivalent investment yield was 4.66% and 4.08% at
December 31, 2006 and December 31, 2005, respectively.
The increase was the result of the general increase in market
interest rates offset by increased allocation to municipal
securities.
During the year ended December 31, 2006 realized capital
gains were $0.5 million, a $0.3 million increase over
the net realized capital gains of $0.2 million during the
year ended December 31, 2005.
Operating
Expenses
Losses
and Loss Adjustment Expenses
Losses and loss adjustment expenses incurred during the year
ended December 31, 2006 increased by approximately
$1.1 million, or 2%, over the year ended December 31,
2005. This increase reflects the growth in net exposures
applicable to the approximately 13% increase in net earned
premiums, and an increase in the accident year loss and loss
adjustment expense ratio, both of which were substantially
offset by a $17.9 million decline in prior years reserve
development from the level experienced in 2005.
During 2006, the Company experienced approximately
$1.1 million in net prior year reserve development
primarily in the 2000 accident year, offset somewhat by
favorable development on prior years unallocated loss adjustment
expense reserves. The development on accident year 2000 reserves
was concentrated primarily in the safety equipment class as a
result of obtaining new information on several high severity
cases.
The increase in the accident year loss and loss adjustment
expense ratio was primarily related to the adoption of unpaid
industry loss development pattern assumptions in our reserve
estimates for other specialty classes during the fourth quarter
of 2005, changes in the mix of classes of earned exposures,
increased loss and loss adjustment expense cost trends, and
increased premium rate competition.
53
Other
Operating Expenses
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Year Ended
|
|
|
|
|
|
|
December 31,
|
|
|
|
|
|
|
2006
|
|
|
2005
|
|
|
Change
|
|
|
|
(Dollars in thousands)
|
|
|
|
|
|
Amortization of deferred
acquisition expenses
|
|
$
|
16,358
|
|
|
$
|
20,630
|
|
|
|
(21
|
)%
|
Ceded reinsurance commissions
|
|
|
(23,507
|
)
|
|
|
(18,551
|
)
|
|
|
27
|
|
Other underwriting and operating
expenses
|
|
|
36,965
|
|
|
|
32,021
|
|
|
|
15
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Other operating expenses
|
|
$
|
29,816
|
|
|
$
|
34,100
|
|
|
|
(13
|
)%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
During the year ended December 31, 2006, other operating
expenses decreased $4.3 million, or 13%, from the year
ended December 31, 2005. Amortization of deferred
acquisition expenses decreased by $4.3 million, or 21%, as
a result of the growth in net earned premiums, more than offset
by a decline in the rate of acquisition expenses on premiums.
Ceded reinsurance commissions increased $5.0 million, or
27%. This was due to the increase in direct written premiums and
ceded premiums, as well as our election to increase premiums
ceded under our quota share arrangement by 10% (to 50%) in
January 2006. Other underwriting and operating expenses, which
consist of commissions, other acquisition costs, and general and
underwriting expenses, net of acquisition cost deferrals,
increased by $4.9 million. Insurance underwriting
commissions increased by $5.3 million, and other
acquisition costs and general and underwriting expenses
increased by $3.4 million. In addition, the aforementioned
increase in ceding commissions caused deferrals of acquisition
costs to decline by $3.8 million.
Interest
Expense
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Year Ended
|
|
|
|
|
|
|
December 31,
|
|
|
|
|
|
|
2006
|
|
|
2005
|
|
|
Change
|
|
|
|
(Dollars in thousands)
|
|
|
|
|
|
Senior notes
|
|
$
|
14,695
|
|
|
$
|
3,220
|
|
|
|
356
|
%
|
Junior subordinated debentures
|
|
|
1,880
|
|
|
|
942
|
|
|
|
100
|
|
Other
|
|
|
|
|
|
|
773
|
|
|
|
(100
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total interest expense
|
|
$
|
16,575
|
|
|
$
|
4,935
|
|
|
|
236
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Interest expense increased $11.6 million, or 236%, from
2005 to 2006. This increase was principally attributable to a
$3.9 million increase in interest expense, a $0.4 million
increase in amortization of debt issuance costs, a
$3.3 million prepayment penalty, and $4.0 million in
write-off of debt issuance costs related to the
$65.0 million senior notes issued in August 2005 and repaid
in October 2006. This increase was offset by our redemption of a
$5.0 million promissory note, $1.9 million of
subordinated notes and the cancellation of our bank credit
facility that eliminated other interest expense. Interest
expense on the junior subordinated debentures included the
change in fair value of the interest rate swap on the junior
subordinated debentures as discussed in
Liquidity and Capital Resources.
Income
Taxes
Our effective tax rates were approximately 35.0% and 35.6% for
the years ended December 31, 2006 and 2005, respectively.
Year
Ended December 31, 2005 Compared to Year Ended
December 31, 2004
As a result of the acquisition and resulting purchase accounting
adjustments, the results of operations for periods prior to
August 17, 2005 are not comparable to periods subsequent to
that date. Our fiscal 2005 results discussed below represent the
mathematical addition of the historical results for (i) the
predecessor period from January 1, 2005 through
August 16, 2005, and (ii) the successor period from
August 17, 2005 through December 31, 2005. This
approach is not consistent with generally accepted accounting
principles and yields
54
results that are not comparable on a
period-to-period
basis. However, we believe it is the most meaningful way to
discuss our operating results for 2005 when comparing them to
our operating results of 2004 because it would not be meaningful
to discuss the partial period from January 1, 2005 through
August 16, 2005 (Predecessor) separately from the period
from August 17, 2005 to December 31, 2005 (Successor)
when comparing 2005 operating results to 2004 operating results.
The following table summarizes our results for the year ended
December 31, 2005 and 2004:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Year Ended
|
|
|
|
|
|
|
December 31,
|
|
|
|
|
|
|
2005
|
|
|
2004
|
|
|
Change
|
|
|
|
(Dollars in thousands)
|
|
|
|
|
|
Operating revenues
|
|
|
|
|
|
|
|
|
|
|
|
|
Net earned premiums
|
|
$
|
97,722
|
|
|
$
|
61,291
|
|
|
|
59
|
%
|
Commissions and fees
|
|
|
26,077
|
|
|
|
33,730
|
|
|
|
(23
|
)
|
Net investment income
|
|
|
6,748
|
|
|
|
4,619
|
|
|
|
46
|
|
Net realized gains (losses) on
investments
|
|
|
220
|
|
|
|
(120
|
)
|
|
|
(283
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total operating
revenues
|
|
|
130,767
|
|
|
|
99,520
|
|
|
|
31
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Operating expenses
|
|
|
|
|
|
|
|
|
|
|
|
|
Losses and loss adjustment
expenses, net
|
|
|
55,094
|
|
|
|
26,854
|
|
|
|
105
|
|
Amortization of intangible assets
|
|
|
1,166
|
|
|
|
632
|
|
|
|
84
|
|
Other operating expenses
|
|
|
34,100
|
|
|
|
42,666
|
|
|
|
(20
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total operating
expenses
|
|
|
90,360
|
|
|
|
70,152
|
|
|
|
29
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Operating income
|
|
|
40,407
|
|
|
|
29,368
|
|
|
|
38
|
|
Interest expense
|
|
|
4,935
|
|
|
|
1,627
|
|
|
|
203
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Income before income
taxes
|
|
|
35,472
|
|
|
|
27,741
|
|
|
|
28
|
|
Income taxes
|
|
|
12,637
|
|
|
|
10,006
|
|
|
|
26
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net income
|
|
$
|
22,835
|
|
|
$
|
17,735
|
|
|
|
29
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Loss ratio
|
|
|
56.4
|
%
|
|
|
43.8
|
%
|
|
|
12.6 points
|
|
Underwriting expense
ratio
|
|
|
14.3
|
%
|
|
|
18.9
|
%
|
|
|
(4.6) points
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Combined ratio
|
|
|
70.7
|
%
|
|
|
62.7
|
%
|
|
|
8.0 points
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Premiums
Produced
Premiums produced for 2005 were $188.5 million, a
$41.6 million, or 28%, increase over the
$146.9 million in premiums produced in 2004. This growth
was primarily attributable to:
|
|
|
|
|
Approximately $24.5 million increase in premiums produced
from other specialty classes underwriting operations in the
Northeast that began in the period ended June 30, 2005;
|
|
|
|
$11.2 million increase from premiums produced for other
specialty classes in established markets, primarily from growth
in renewals and audit premiums on expiring policies; and
|
|
|
|
$5.9 million increase from premiums produced for security
classes, both new business and renewals and audit premiums on
expiring policies.
|
55
Operating
Revenue
Net
Earned Premiums
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Year Ended
|
|
|
|
|
|
|
December 31,
|
|
|
|
|
|
|
2005
|
|
|
2004
|
|
|
Change
|
|
|
|
(Dollars in thousands)
|
|
|
|
|
|
Written premiums
|
|
|
|
|
|
|
|
|
|
|
|
|
Direct
|
|
$
|
168,223
|
|
|
$
|
53,121
|
|
|
|
217
|
%
|
Assumed
|
|
|
7,673
|
|
|
|
38,945
|
|
|
|
(80
|
)
|
Ceded
|
|
|
(70,195
|
)
|
|
|
(19,171
|
)
|
|
|
266
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net written premiums
|
|
$
|
105,701
|
|
|
$
|
72,895
|
|
|
|
45
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Earned premiums
|
|
|
|
|
|
|
|
|
|
|
|
|
Direct
|
|
$
|
126,525
|
|
|
$
|
12,510
|
|
|
|
911
|
%
|
Assumed
|
|
|
17,742
|
|
|
|
51,496
|
|
|
|
(66
|
)
|
Ceded
|
|
|
(48,571
|
)
|
|
|
(4,279
|
)
|
|
|
1,035
|
|
Earned but unbilled premiums
|
|
|
2,026
|
|
|
|
1,564
|
|
|
|
30
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net earned premiums
|
|
$
|
97,722
|
|
|
$
|
61,291
|
|
|
|
59
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Direct written premiums increased $115.1 million, or 217%,
and direct earned premiums increased $114.0 million, or
911%, in 2005 over 2004 primarily due to the change in our
business model in June 2004 as a result of which we ceased
relying on fronting arrangements under which we assumed
insurance from fronting insurers and instead began to directly
write substantially all of our premiums produced.
Assumed written premiums decreased $31.3 million, or 80%,
and assumed earned premiums decreased $33.8 million, or
66%. These decreases were consistent with the change in our
business model as a result of which we ceased relying on
fronting arrangements under which we assumed insurance from
fronting insurers and instead began to directly write
substantially all of our premiums produced.
Ceded written premiums increased $51.0 million, or 266%,
and ceded earned premiums increased $44.3 million, or
1,035%, in 2005 over 2004. This was due to the increase in
direct written premiums and a decision to increase premiums
ceded under the current quota share arrangement from 30% to 40%
in July 2005. The time lag between ceded premium being written
and ceded premium being earned resulted in a more substantial
increase in the ceded earned premium.
Commissions
and Fees
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Year Ended
|
|
|
|
|
|
|
December 31,
|
|
|
|
|
|
|
2005
|
|
|
2004
|
|
|
Change
|
|
|
|
(Dollars in thousands)
|
|
|
|
|
|
Insurance underwriting commissions
and fees
|
|
$
|
15,578
|
|
|
$
|
28,831
|
|
|
|
(46
|
)%
|
Insurance services commissions and
fees
|
|
|
10,499
|
|
|
|
4,899
|
|
|
|
114
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total commissions and fees
|
|
$
|
26,077
|
|
|
$
|
33,730
|
|
|
|
(23
|
)%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Insurance underwriting commissions and fees decreased
$13.3 million, or 46%, from 2004 to 2005, primarily as a
result of the change in business model, which resulted in an
increase in direct written premiums as a percentage of premiums
produced and a decrease in third party commissions and fees.
This decline was offset by the impact of the increase in
premiums produced. Insurance services commissions and fees,
which was principally ARPCO income and not related to premiums
produced, increased $5.6 million, or 114%, in 2005 over
2004. Due to the acquisition of ARPCO in June 2004, only a half
year of ARPCO income was included in the 2004 results.
56
Net Investment Income and Realized Gains (Losses) on
Investments. For 2005, net investment
income earned increased $2.1 million, or 46%, from 2004
primarily due to the increase in invested assets over the
period. As of December 31, 2005, invested assets were
$211.0 million, a $39.3 million, or 23%, increase over
$171.7 million of invested assets as of December 31,
2004 primarily due to increases in net written premiums. The
increase in interest rates of approximately 1% in the
intermediate part of the yield curve also contributed to the
increased level of investment income. The annualized investment
yield (net of investment expenses) on average total investments
was 3.5% and 3.2% for the 2005 and 2004, respectively. The tax
equivalent investment yield was 4.08% and 3.65% at
December 31, 2005 and December 31, 2004, respectively.
The increase was the result of the general increase in market
rates offset by increased allocation to municipal securities.
For 2005, realized capital gains were $0.2 million versus
realized capital losses of $0.1 million for 2004. These
portfolio gains were driven by the sale of several convertible
securities which occurred in an effort to manage the overall
risk of the convertible exposure. In addition, throughout the
year, we continued to reduce treasury and corporate bond
exposure in favor of what we believe to be a more compelling
value in the municipal and asset backed sectors.
Operating
Expenses
Losses and Loss Adjustment
Expenses. Losses and loss adjustment
expenses incurred during 2005 increased by approximately
$28.2 million, or 105%, over 2004. This increase was due
both to the growth in net earned exposures, which was reflected
in the approximately 59% increase in net earned premiums and due
to the 12.6 percentage point higher loss ratio during 2005
compared to 2004. The increase in loss ratio was due principally
to a $19.0 million increase in losses and loss adjustment
expenses related to prior accident years. Approximately
$12.8 million of the prior accident year development
occurred in the security classes, especially in the safety
equipment class for the 2000 to 2002 accident years, because we
experienced unusually large increases in severity on a small
number of reported claims, and also increased our incurred but
not reported loss reserve estimates as a result of increasing
our assumptions for expected severity of losses.
Approximately $6.2 million of the prior accident year
development occurred in other specialty classes primarily due to
the adoption of new industry loss development pattern
assumptions that became available during 2005. From 2000 through
2004 our reserve estimates for other specialty classes utilized
industry development pattern information that was available in
2000. New industry development pattern information became
available during 2005. This new industry information reflected
higher and more slowly developing loss patterns than the
previously available industry information. This was due to a
number of factors, including more recent data and more detailed
segmentation in the data. We compared the new industry
information to our actual loss experience and determined that
the updated information aligned more closely with our emerging
loss experience, coverage class groupings and limits profiles
for other specialty classes. As a result, we adopted usage of
the new industry loss development pattern assumptions in our
reserve estimates for all accident years during the fourth
quarter of 2005, resulting in increases in prior years
reserves, and in higher 2005 accident year reserve estimates
than had been estimated in 2004 for the 2004 accident year.
Other
Operating Expenses
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Year Ended
|
|
|
|
|
|
|
December 31,
|
|
|
|
|
|
|
2005
|
|
|
2004
|
|
|
Change
|
|
|
|
(Dollars in thousands)
|
|
|
|
|
|
Amortization of deferred
acquisition expenses
|
|
$
|
20,630
|
|
|
$
|
15,713
|
|
|
|
31
|
%
|
Ceded reinsurance commissions
|
|
|
(18,551
|
)
|
|
|
(4,643
|
)
|
|
|
300
|
|
Other underwriting and operating
expenses
|
|
|
32,021
|
|
|
|
31,596
|
|
|
|
1
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Other operating expenses
|
|
$
|
34,100
|
|
|
$
|
42,666
|
|
|
|
(20
|
)%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
During 2005, other operating expenses declined by
$8.6 million, or 20%, from 2004. Amortization of
acquisition expenses increased by $4.9 million, or 31%, as
a result of the growth in net earned premiums
57
slightly offset by a decline in the rate of acquisition expenses
on premiums as a result of reduced fronting insurer fees. Ceded
reinsurance commissions increased $13.9 million, or 300%,
in 2005 over 2004. This was due to the increase in direct
written premiums and ceded premiums under our change in business
model, as well as our decision in July 2005 to increase premiums
ceded under our quota share arrangement by 10% (to 40%). Other
underwriting and operating expenses remained relatively constant
on a net basis year over year. Included in other underwriting
and operating expenses was:
|
|
|
|
|
Increased CoverX commissions paid to brokers of
$6.2 million;
|
|
|
|
Decreased assumed reinsurance commissions of $10.1 million
and an increase in the deferral portion of acquisition expenses
of $3.2 million, which were consistent with the change in
our business model;
|
|
|
|
Increased insurance services expenses of $1.5 million due
to the inclusion of a full year of results after the June 2004
acquisition of ARPCO; and
|
|
|
|
Increased general underwriting and operating expenses of
$6.0 million due primarily to increased compensation
expenses.
|
Interest
Expense
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Year Ended
|
|
|
|
|
|
|
December 31,
|
|
|
|
|
|
|
2005
|
|
|
2004
|
|
|
Change
|
|
|
|
(Dollars in thousands)
|
|
|
|
|
|
Senior notes
|
|
$
|
3,220
|
|
|
$
|
|
|
|
|
N/M
|
|
Junior subordinated debentures
|
|
|
942
|
|
|
|
660
|
|
|
|
43
|
%
|
Other
|
|
|
773
|
|
|
|
967
|
|
|
|
(20
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total interest expense
|
|
$
|
4,935
|
|
|
$
|
1,627
|
|
|
|
203
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Interest expense increased $3.3 million, or 203%, from 2004
to 2005. The increase was principally attributable to interest
on the senior notes issued in August 2005 and a full year of
interest on the $20.6 million junior subordinated
debentures offset by a reduction in other debt. Interest expense
on the junior subordinated debentures included the change in
fair value of the interest rate swap on the junior subordinated
debentures as discussed in Liquidity and Capital
Resources.
Income Taxes. Our effective tax
rates were approximately 35.6% and 36.1% for the years ended
December 31, 2005 and 2004, respectively.
Liquidity
and Capital Resources
Sources
and Uses of Funds
FMFC. FMFC is a holding company
with all of its operations being conducted by its subsidiaries.
Accordingly, FMFC has continuing cash needs for primarily
administrative expenses, debt service and taxes. Funds to meet
these obligations come primarily from management and
administrative fees from all of our subsidiaries, and dividends
from our non-insurance subsidiaries.
Insurance Subsidiaries. The
primary sources of our insurance subsidiaries cash are net
written premiums, claims handling fees, amounts earned from
investments and the sale or maturity of invested assets.
Additionally, FMFC has in the past and may in the future
contribute capital to its insurance subsidiaries.
The primary uses of our insurance subsidiaries cash
include the payment of claims and related adjustment expenses,
underwriting fees and commissions and taxes and making
investments. Because the payment of individual claims cannot be
predicted with certainty, our insurance subsidiaries rely on our
paid claims history and industry data in determining the
expected payout of claims and estimated loss reserves. To the
extent that FMIC and ANIC have an unanticipated shortfall in
cash, they may either liquidate securities held in their
investment portfolios or obtain capital from FMFC. However,
given the cash generated by our
58
insurance subsidiaries operations and the relatively short
duration of their investment portfolios, we do not currently
foresee any such shortfall.
No dividends were paid to FMFC by our insurance subsidiaries
during the years ended December 31, 2006, 2005 or 2004. Our
insurance subsidiaries retained all of their earnings in order
to support the increase of their written premiums, and we expect
this retention of earnings to continue. Our insurance
subsidiaries are restricted by statute as to the amount of
dividends that they may pay without the prior approval of their
domiciliary state insurance departments. Based on the
policyholders surplus and the net income of our insurance
subsidiaries as of December 31, 2006, FMIC and ANIC may pay
dividends in 2007, if declared, of up to $15.7 million
without regulatory approval.
Effective January 1, 2007, FMIC and ANIC entered into an
intercompany pooling reinsurance agreement wherein all premiums,
losses and expenses of FMIC and ANIC are combined and
apportioned between FMIC and ANIC in accordance with fixed
percentages.
Non-insurance Subsidiaries. The
primary sources of our non-insurance subsidiaries cash are
commissions and fees, policy fees, administrative fees and
claims handling and loss control fees. The primary uses of our
non-insurance subsidiaries cash are commissions paid to
brokers, operating expenses, taxes and dividends paid to FMFC.
There are generally no restrictions on the payment of dividends
by our non-insurance subsidiaries, except as may be set forth in
our borrowing arrangements.
Cash
Flows
Our sources of funds have consisted primarily of net written
premiums, commissions and fees, investment income and proceeds
from the issuance of equity securities and debt. We use
operating cash primarily to pay operating expenses and losses
and loss adjustment expenses and for purchasing investments. A
summary of our cash flows is as follows:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended
|
|
|
|
|
|
|
March 31,
|
|
|
Year Ended December 31,
|
|
|
|
2007
|
|
|
2006
|
|
|
2006
|
|
|
2005
|
|
|
2004
|
|
|
|
(Dollars in thousands)
|
|
|
Cash and cash equivalents provided
by (used in):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Operating activities
|
|
$
|
51,628
|
|
|
$
|
17,673
|
|
|
$
|
52,890
|
|
|
$
|
52,190
|
|
|
$
|
28,912
|
|
Investing activities
|
|
|
(56,396
|
)
|
|
|
(19,029
|
)
|
|
|
(92,995
|
)
|
|
|
(99,224
|
)
|
|
|
(78,213
|
)
|
Financing activities
|
|
|
|
|
|
|
244
|
|
|
|
46,040
|
|
|
|
51,357
|
|
|
|
49,612
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Change in cash and cash equivalents
|
|
$
|
(4,768
|
)
|
|
$
|
(1,112
|
)
|
|
$
|
5,935
|
|
|
$
|
4,323
|
|
|
$
|
311
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net cash provided by operating activities for the three months
ended March 31, 2007 was primarily from cash received on
net written premiums and cash received for the unearned premiums
related to the 2006 50% quota share reinsurance contract
terminated on a cut-off basis on December 31,
2006 less cash disbursed for operating expenses and losses and
loss adjustment expenses. Net cash provided by operating
activities for the three months ended March 31, 2006 was
primarily from cash received on net written premiums, less cash
disbursed for operating expenses and losses and loss adjustment
expenses. Cash received from net written premiums for the three
months ended March 31, 2007 were retained on a funds
withheld basis in accordance with the Companys 35%
quota share reinsurance contracts resulting in increased net
cash flow provided by operations compared to the three months
ended March 31, 2006.
For 2006, 2005, and 2004, net cash provided by operating
activities totaled $52.9 million, $52.2 million, and
$28.9 million, respectively, due primarily to cash received
on net written premiums, commissions, fees, and investment
income less cash disbursed for operating expenses, losses and
loss adjustment expenses and income taxes. The increase in cash
provided by operating activities since 2004 primarily reflects
the increase in net written premiums during 2005 and 2006.
During 2006, operating cash flow was approximately level with
2005, due to the growth in ceded reinsurance premiums. The
increase in 2005 was also a result of the change in our business
model, as 2005 was the first full year that we no longer relied
on a fronting
59
arrangement, but instead wrote substantially all of our premiums
produced and ceded to third party reinsurers a portion of those
premiums, thus generating higher cash flows.
Net cash used in investing activities for the three months ended
March 31, 2007 and 2006 primarily resulted from our net
investment in short-term, debt and equity securities. The
$37.4 million increase in net cash used in investing
activities for the three months ended March 31, 2007
compared to the three months ended March 31, 2006 was
principally a result of increased net cash flow provided by
operating activities as described above.
For 2006, net cash used in investing activities totaled
$93.0 million, and was primarily invested in short-term,
debt and equity securities. The $6.2 million decrease in
net cash used in investing activities for the year ended
December 31, 2006 compared to the year ended
December 31, 2005 was a result of $5.4 million less
cash available from financing activities, a $0.7 million
increase in operating cash flow, and an increase of
$1.6 million in change in cash and cash equivalents.
For 2005, net cash used in investing activities totaled
$99.2 million resulting primarily from our investment of
operating cash flows and cash payments in connection with the
notes offering and the repurchase of shares of our minority
stockholders, which we refer to as the Holdings Transaction. For
2004, net cash used in investing activities totaled
$78.2 million resulting primarily from our net investment
of operating cash flows, our investment of cash received from
the issuance of debt and convertible preferred stock and the
acquisition of the ARPCO Group. The increase in 2005 from 2004
was primarily due to the cash used in the Holdings Transaction
offset by the timing of the maturities and the related
re-investment of short-term and debt securities.
Net cash provided by financing activities for the three months
ended March 31, 2006 resulted from the issuance of common
stock. There were no amounts provided by or used in financing
activities for the three months ended March 31, 2007.
The $46.0 million of net cash provided by financing
activities for the year ended December 31, 2006 was
primarily attributable to the proceeds from our initial public
offering and our issuance of trust preferred securities, offset
by the repurchase of common stock and the retirement of the
senior notes. The $51.4 million of net cash provided by
financing activities for the year ended December 31, 2005
was primarily the result of the issuance of $65.0 million
aggregate principal amount of senior notes in August 2005,
offset by the repayment of $2.0 million of bank debt, a
$5.0 million promissory note and $1.9 million of
subordinated capital notes. During 2004, net cash provided by
financing activities was $49.6 million and included
$36.2 million of net proceeds from the issuance of
convertible preferred stock, $20.6 million of net proceeds
from the issuance of junior subordinated debentures, the
issuance of a $5.0 million promissory note and
$1.7 million of cash received upon exercise of stock
options. Net cash provided by financing activities in 2004 was
offset in part by the $13.8 million repayment under a
revolving credit facility and other debt payments.
Based on historical trends, market conditions, and our business
plans, we believe that our existing resources and sources of
funds will be sufficient to meet our liquidity needs in the
foreseeable future. Because economic, market and regulatory
conditions may change, however, there can be no assurances that
our funds will be sufficient to meet our liquidity needs. In
addition, competition, pricing, the frequency and severity of
losses, and interest rates could significantly affect our
short-term and long-term liquidity needs.
Initial
Public Offering
We completed our initial public offering of common stock on
October 23, 2006 in which we sold 11,161,764 shares of
common stock for $189.7 million. In connection with the
offering, on October 23, 2006, we repurchased all of our
outstanding senior notes for $69.9 million, paid the holder
of our convertible preferred stock $58.0 million pursuant
to the terms of our convertible preferred stock, which was also
converted into common stock in connection with the initial
public offering, and repurchased 1,779,339 shares of
converted common stock. We used the remaining $15.2 million
of the net proceeds from the initial public offering, along with
available cash of $4.8 million, to make a
$20.0 million contribution to the capital of FMIC in
October 2006.
60
Long-term
Debt
Senior Notes. We had
$65.0 million aggregate principal amount of senior notes
outstanding, which were issued by Holdings in August 2005 in
connection with the Holdings Transaction. The senior notes were
set to mature on August 15, 2012, and bore interest at an
annual rate, reset quarterly, equal to the three month LIBOR
plus 8%. Interest was payable quarterly with $11.2 million
of interest paid during the year ended December 31, 2006.
On October 23, 2006, we repurchased all of the outstanding
senior notes for $69.9 million, including accrued interest
of $1.6 million and a prepayment penalty of
$3.3 million.
Junior Subordinated
Debentures. We have $46.4 million
cumulative principal amount of floating rate junior subordinated
debentures outstanding, $25.8 million of which were issued
in December 2006. The debentures were issued in connection with
the issuance of trust preferred stock by our wholly-owned,
non-consolidated trusts. Cumulative interest on the cumulative
principal amount of the debentures is payable quarterly in
arrears at a variable annual rate, reset quarterly, equal to the
three month LIBOR plus 3.75% for $8.2 million, the three
month LIBOR plus 4.00% for $12.4 million, and the three
month LIBOR plus 3.0% for $25.8 million principal amount of
the debentures. At March 31, 2007, the three month LIBOR
rate was 5.35%. We may defer the payment of interest for up to
20 consecutive quarterly periods; however, no such deferral has
been made.
Credit Facility. In October
2006, we entered into a credit facility which provided for
borrowings of up to $30.0 million. Borrowings under the
credit facility bear interest at our election as follows:
(i) at a rate per annum equal to the greater of the
lenders prime rate and the federal funds rate less 0.5%,
each minus 0.75%; or, (ii) a rate per annum equal to LIBOR
plus an applicable margin which is currently 0.75% or 1.0% based
on our leverage ratio. The obligations under the credit facility
are guaranteed by our material non-insurance subsidiaries. The
maturity date of borrowings made under the credit facility is
September 2011. The credit facility contains certain customary
covenants which, among other things, restrict our ability to
incur indebtedness, grant liens, make investments and sell
assets. The credit facility also has certain financial
covenants. We are not required to comply with the
financial-related covenants until we borrow under the credit
facility. There are currently no borrowings under the agreement.
Derivative Financial
Instruments. Financial derivatives are
used as part of the overall asset and liability risk management
process. We use interest rate swap agreements with a combined
notional amount of $45.0 million in order to reduce our
exposure to interest rate fluctuations with respect to our
junior subordinated debentures. Under two of our swap
agreements, which expire in August 2009, we pay interest at a
fixed rate of 4.12%; under our other swap agreement, which
expires in December 2011, we pay interest at a fixed rate of
5.013%. Under all three swap agreements, we receive interest at
the three month LIBOR, which is equal to the contractual rate
under the junior subordinated debentures. At March 31,
2007, we had minimal exposure to credit loss on the interest
rate swap agreements.
Contractual
obligations and commitments
The following table illustrates our contractual obligations and
commercial commitments as of December 31, 2006:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Payments Due by Period
|
|
|
|
|
|
|
Less Than
|
|
|
|
|
|
|
|
|
More Than
|
|
|
|
Total
|
|
|
1 Year
|
|
|
1-3 Years
|
|
|
3-5 Years
|
|
|
5 Years
|
|
|
|
(Dollars in thousands)
|
|
|
Contractual payments by period:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Long-term debt
|
|
$
|
46,394
|
|
|
$
|
|
|
|
$
|
|
|
|
$
|
|
|
|
$
|
46,394
|
|
Interest on long-term debt
|
|
|
108,689
|
|
|
|
3,771
|
|
|
|
7,543
|
|
|
|
7,543
|
|
|
|
89,832
|
|
Operating lease obligations
|
|
|
2,491
|
|
|
|
377
|
|
|
|
811
|
|
|
|
728
|
|
|
|
575
|
|
Reserve for losses and loss
adjustment expenses
|
|
|
191,013
|
|
|
|
57,937
|
|
|
|
76,305
|
|
|
|
32,219
|
|
|
|
24,552
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total
|
|
$
|
348,587
|
|
|
$
|
62,085
|
|
|
$
|
84,659
|
|
|
$
|
40,490
|
|
|
$
|
161,353
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
61
The reserve for losses and loss adjustment expenses payment due
by period in the table above are based on the reserve of loss
and loss adjustment expenses as of December 31, 2006 and
actuarial estimates of expected payout patterns by type of
business. As a result, our calculation of the reserve of loss
and loss adjustment expenses payment due by period is subject to
the same uncertainties associated with determining the level of
the reserve of loss and loss adjustment expenses and to the
additional uncertainties arising from the difficulty in
predicting when claims, including claims that have not yet been
incurred but not reported to us, will be paid. Actual payments
of losses and loss adjustment expenses by period will vary,
perhaps materially, from the above table to the extent that
current estimates of the reserve for loss and loss adjustment
expenses vary from actual ultimate claims amounts and as a
result of variations between expected and actual payout
patterns. See Risk Factors for a discussion of the
uncertainties associated with estimating the reserve for loss
and loss adjustment expenses.
The above table includes all interest payments through the
stated maturity of the related long-term debt. Variable rate
interest obligations are estimated based on interest rates in
effect at December 31, 2006, and, as applicable, the
variable rate interest included the effects of our interest rate
swaps through the expiration of those swap agreements.
Cash
and Invested Assets
Our cash and invested assets consist of fixed maturity
securities, convertible securities, and cash and cash
equivalents. At March 31, 2007, our investments had a
market value of $360.0 million and consisted of the
following investments:
|
|
|
|
|
|
|
|
|
|
|
March 31, 2007
|
|
|
|
Market Value
|
|
|
% of Portfolio
|
|
|
|
(Dollars in thousands)
|
|
|
Money Market Funds
|
|
$
|
46,519
|
|
|
|
12.9
|
%
|
Treasury Securities
|
|
|
8,444
|
|
|
|
2.3
|
%
|
Agency Securities
|
|
|
839
|
|
|
|
0.2
|
%
|
Corp/Preferred
|
|
|
37,216
|
|
|
|
10.3
|
%
|
Municipal Bonds
|
|
|
164,080
|
|
|
|
45.6
|
%
|
Asset backed Securities
|
|
|
45,544
|
|
|
|
12.7
|
%
|
Mortgages
|
|
|
32,562
|
|
|
|
9.0
|
%
|
Convertible Securities
|
|
|
24,715
|
|
|
|
6.9
|
%
|
Other
|
|
|
63
|
|
|
|
0.1
|
%
|
|
|
|
|
|
|
|
|
|
Total
|
|
$
|
359,982
|
|
|
|
100.0
|
%
|
|
|
|
|
|
|
|
|
|
62
The following table shows the composition of the investment
portfolio by remaining time to maturity at March 31, 2007.
Actual maturities may differ from contractual maturities because
borrowers may have the right to call or prepay obligations with
or without call or prepayment penalties. Additionally, the
expected maturities of our investments in putable bonds
fluctuate inversely with interest rates and therefore may also
differ from contractual maturities.
|
|
|
|
|
|
|
% of Total
|
|
Average Life
|
|
Investment
|
|
|
Less than one year
|
|
|
23.7
|
%
|
One to two years
|
|
|
10.8
|
%
|
Two to three years
|
|
|
12.1
|
%
|
Three to four years
|
|
|
19.7
|
%
|
Four to five years
|
|
|
12.9
|
%
|
Five to seven years
|
|
|
10.8
|
%
|
More than seven years
|
|
|
10.0
|
%
|
|
|
|
|
|
Total
|
|
|
100.0
|
%
|
|
|
|
|
|
The primary goals of our investment portfolio are to:
|
|
|
|
|
accumulate and preserve capital;
|
|
|
|
assure proper levels of liquidity;
|
|
|
|
optimize total after tax return subject to acceptable risk
levels;
|
|
|
|
provide an acceptable and stable level of current income; and
|
|
|
|
approximate duration match between investments and our
liabilities.
|
In keeping with these goals, we maintain an investment portfolio
consisting primarily of high grade fixed income securities. Our
investment policy is developed by the investment committee of
the board of directors and is designed to comply with the
regulatory investment requirements and restrictions to which our
insurance subsidiaries are subject.
We have structured our investment policy to manage the various
risks inherent in achieving our objectives. Credit-related risk
is addressed by limiting minimum weighted-average portfolio
credit quality to AA. Per issue credit limits have been set to
limit exposure to single issue credit events. With the exception
of convertible securities, which according to our investment
policy may comprise up to 20% of our portfolio, all investments
must be rated investment grade at the time of purchase with no
more than 30% of the aggregate portfolio held in BBB rated
securities. In addition, the convertible sector of the portfolio
must maintain a weighted average credit quality of investment
grade. Interest rate risk or duration risk management was tied
to the duration of the liability reserves. The effective
duration of the portfolio as of March 31, 2007 is
approximately 2.9 years and the tax-effected duration is
2.4 years. Excluding cash, equity and convertible
securities, the portfolio duration and tax-effected duration are
3.4 years and 2.9 years, respectively. The shorter
tax-effected duration reflects the significant portion of the
portfolio in municipal securities. The annualized investment
yield (net of investment expenses) on total investments was 4.0%
and 3.9% for three months ended March 31, 2007 and 2006,
respectively. The increase was the result of the general
increase in market rates offset by increased allocation to
municipal securities. The annualized tax equivalent yield on
total investments was 4.8% and 4.2% for the three months ended
March 31, 2007 and 2006, respectively. Our investment
policy establishes diversification requirements across various
fixed income sectors including governments, agencies, mortgage
and asset backed securities, corporate bonds, preferred stocks,
municipal bonds and convertible securities. Although our
investment policy allows for investments in equity securities,
we have virtually no current exposure nor have any current plans
to add exposure to equities. Convertible securities are utilized
as a means of achieving equity exposure with lower long-term
volatility than the broad equity market while having the added
benefit of being treated as bonds from a statutory perspective.
63
We utilize a variety of investment managers, each with its own
specialty. Each of these managers has authority and discretion
to buy and sell securities subject to guidelines established by
our investment committee. Management monitors the investment
managers as well as our investment results with the assistance
of an investment advisor that has been advising us since early
1990. Our investment advisor is independent of our investment
managers and the funds in which we invest. Each manager is
measured against a customized benchmark on a monthly basis.
Investment performance and market conditions are continually
monitored. The investment committee reviews our investment
results quarterly.
The majority of our portfolio consists of AAA or AA rated
securities with a Standard and Poors weighted average
credit quality for our aggregate fixed income portfolio of AA+
at March 31, 2007. The majority of the investments rated
BBB and below are convertible securities. Consistent with our
investment policy, we review any security if it falls below
BBB− and assess whether it should be held or sold. The
following table shows the ratings distribution of our fixed
income portfolio as of March 31, 2007 as a percentage of
total market value.
|
|
|
|
|
|
|
% of Total
|
|
S&P Rating
|
|
Investments
|
|
|
AAA
|
|
|
76.9
|
%
|
AA
|
|
|
8.7
|
%
|
A
|
|
|
7.7
|
%
|
BBB
|
|
|
5.4
|
%
|
BB
|
|
|
0.7
|
%
|
B
|
|
|
0.5
|
%
|
CCC
|
|
|
0.1
|
%
|
NR
|
|
|
0.0
|
%
|
|
|
|
|
|
Total
|
|
|
100.0
|
%
|
|
|
|
|
|
Cash and cash equivalents consisted of cash on hand of
$9.6 million at March 31, 2007.
At March 31, 2007 the total unrealized loss of all impaired
securities totaled $2.2 million. This represents
approximately 0.6% of year-end invested assets of
$360.0 million.
For the three months ended March 31, 2007, we sold
approximately $2.4 million of market value of securities,
which were trading below amortized cost while recording a
realized loss of approximately $13,000. This loss represented
0.53% of the amortized cost of the positions. We sold Treasury
issues to purchase other securities. We also sold some isolated
positions of corporate, mortgage and municipal bonds. These
sales were unique opportunities to sell specific positions due
to changing market conditions. These situations were exceptions
to our general assertion regarding our ability and intent to
hold securities with unrealized losses until they mature or
recover in value. This position is further supported by the
insignificant losses as a percentage of amortized cost for the
respective periods.
At December 31, 2006 the total unrealized loss of all
impaired securities totaled $2.7 million. This represents
approximately 0.9% of year-end invested assets of
$297.8 million. This unrealized loss position was the
result of the continual increase in short term and intermediate
term interest rates that has taken place over the past
approximately 3 years. These unrealized losses have
persisted due to the series of tightenings by the Federal
Reserve resulting in a significant increase in interest rates of
approximately 200 basis points in the intermediate part of
the yield curve over the past 36 months. These losses are
substantially all a result of bond prices dropping due to the
general increase in interest rates and not credit related
circumstances. We have viewed these market value declines as
being temporary in nature. Our portfolio is relatively short as
the duration of the portfolio is approximately 3.0 years.
We expect to hold the majority of these temporarily impaired
securities until maturity in the event that interest rates do
not decline from current levels. In light of our significant
growth over the past 24 months, liquidity needs from the
portfolio are inconsequential. As a result, we would not expect
to have to liquidate temporarily impaired securities to pay
claims or for any other purposes. There have been certain
instances over the past year, where due to market based
opportunities, we
64
have elected to sell a small portion of the portfolio. These
situations were unique and infrequent occurrences and in our
opinion, do not reflect an indication that we do not have the
intent and ability to hold these securities until they mature or
recover in value.
Below is a table that illustrates the unrecognized impairment
loss by sector. The substantial rise in interest rates was the
primary factor leading to impairment. All asset sectors were
affected by the overall increase in rates as can be seen from
the table below. In addition to the general level of rates, we
also look at a variety of other factors such as direction of
credit spreads for an individual issue as well as the magnitude
of specific securities that have declined below amortized cost.
|
|
|
|
|
|
|
Amount of Impairment
|
|
Sector
|
|
at December 31, 2006
|
|
|
|
(Dollars in thousands)
|
|
|
Debt Securities
|
|
|
|
|
U.S. government securities
|
|
$
|
(375
|
)
|
Government agency mortgage-backed
securities
|
|
|
(212
|
)
|
Government agency obligations
|
|
|
(27
|
)
|
Collateralized mortgage
obligations and other asset-backed securities
|
|
|
(245
|
)
|
Obligations of states and
political subdivisions
|
|
|
(1,200
|
)
|
Corporate bonds
|
|
|
(569
|
)
|
|
|
|
|
|
Total Debt Securities
|
|
|
(2,628
|
)
|
Preferred stocks
|
|
|
(59
|
)
|
|
|
|
|
|
Total
|
|
$
|
(2,687
|
)
|
|
|
|
|
|
The most significant risk or uncertainty inherent in our
assessment methodology is that the current credit rating of a
particular issue changes over time. If the rating agencies
should change their rating on a particular security in our
portfolio, it could lead to a reclassification of that specific
issue. The vast majority of our unrecognized impairment losses
are investment grade and AAA rated. Should the
credit quality of individual issues decline for whatever reason
then it would lead us to reconsider the classification of that
particular security. Within the non-investment grade sector, we
continue to monitor the particular status of each issue. Should
prospects for any one issue deteriorate, we would potentially
alter our classification of that particular issue.
The table below illustrates the breakdown by investment grade
and non investment grade unrealized loss as well as the duration
that these sectors have been trading below amortized cost. The
average duration of the impairment has been greater than
12 months. The average unrealized loss as a percent of
amortized cost is 1.4% of the portfolio.
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Average
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Unrealized
|
|
|
|
|
|
|
% of Total
|
|
|
Total
|
|
|
|
|
|
Loss as % of
|
|
|
% of Loss
|
|
|
|
Amortized Cost
|
|
|
Amortized Cost
|
|
|
Total Loss
|
|
|
Amortized Cost
|
|
|
> 12 Months
|
|
|
|
(Dollars in thousands)
|
|
|
Non Investment Grade
|
|
|
0.5
|
%
|
|
$
|
982
|
|
|
$
|
(35
|
)
|
|
|
(3.6
|
)%
|
|
|
100.0
|
%
|
Investment Grade
|
|
|
99.5
|
%
|
|
|
192,308
|
|
|
|
(2,652
|
)
|
|
|
(1.4
|
)%
|
|
|
74.7
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total
|
|
|
100.0
|
%
|
|
$
|
193,290
|
|
|
$
|
(2,687
|
)
|
|
|
(1.4
|
)%
|
|
|
75.1
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
For those securities trading at a loss, approximately 0.5% of
the securities are non investment grade. In general we view
these issues as having a reasonable probability of recovering
full value. These issues are continually monitored and may be
classified in the future as being other than temporarily
impaired. The balance, or 99.5% of those securities trading at a
loss, is investment grade. The majority of these securities are
AAA or AA rated.
The largest concentration of temporarily impaired securities is
obligations of states and political subdivisions at
approximately 44.6% of the total loss. These securities are
highly rated and have been affected
65
primarily by the current interest rate environment. The next
highest concentration of temporarily impaired securities is
Corporate bonds at 21.2% of the total loss. These issues have
been affected as well by the overall level of interest rates.
The next highest concentration of temporarily impaired
securities are U.S. government securities at 14.0% of the
total loss, followed by Collateralized mortgage obligations and
other asset-backed securities at 9.1%, Government agency
mortgage-backed securities at 7.9%, Preferred stocks at 2.2% and
lastly government agency obligations at 1.0%. These unrealized
losses are due to the rise in rates as well.
For 2006 and the first three months of 2007, we sold
approximately $33.5 million and $2.4 million of market
value of securities, respectively, which were trading below
amortized cost while recording a realized loss of approximately
$0.8 million and $13,000, respectively. This loss
represented 2.4% for 2006 and 0.53% for the first three months
of 2007 of the amortized cost of the positions. We sold Treasury
issues to purchase other securities. We also sold some isolated
positions of corporate, mortgage and municipal bonds. These
sales were unique opportunities to sell specific positions due
to changing market conditions. These situations were exceptions
to our general assertion regarding our ability and intent to
hold securities with unrealized losses until they mature or
recover in value. This position is further supported by the
insignificant losses as a percentage of amortized cost for the
respective periods.
Deferred
Policy Acquisition Costs
We defer a portion of the costs of acquiring insurance policies,
primarily commissions and certain policy underwriting and
issuance costs, which vary with and are primarily related to the
production of insurance business. For the three months ended
March 31, 2007, $4.7 million of the costs were
deferred. Deferred policy acquisition costs totaled
$14.5 million, or 19.9%, of unearned premiums (net of
reinsurance), at March 31, 2007.
On December 31, 2006 we elected the cut-off termination
option available to us on the expiration of our 50% quota share
contracts expiring that day in accordance with the termination
provision of the quota share contracts. As a result, we
effectively eliminated the 50% quota share reinsurance on the
December 31, 2006 unearned premiums that had been ceded 50%
up until contract expiration. The amount of the previously ceded
net unearned premium reserve that was returned to the Company as
a result of the cut-off termination election was
$39.6 million at December 31, 2006. As those premiums
are earned during 2007, they will be reported in the
Companys net earned premiums. At December 31, 2006 we
recorded the related $12.8 million in ceded commissions as
deferred acquisition costs, of which $7.1 million remained
at March 31, 2007 to be amortized during the remainder of
2007 as related unearned premiums are earned.
Loss
and Loss Adjustment Expense Reserves
Losses and loss adjustment
expenses. We maintain reserves to cover
our estimated ultimate losses under all insurance policies that
we write and our loss adjustment expenses relating to the
investigation and settlement of policy claims. The reserves for
losses and loss adjustment expenses represent our estimated
ultimate costs of all reported and unreported losses and loss
adjustment expenses incurred and unpaid at the balance sheet
date. Our reserves reflect our estimates at a given time of
amounts that we expect to pay for losses that have been
reported, which are referred to as case reserves, and losses
that have been incurred but not reported and the expected
development of losses and allocated loss adjustment expenses on
open reported cases, which are referred to as IBNR reserves. In
evaluating whether the reserves are reasonable for unpaid losses
and loss adjustment expenses, it is necessary to project future
losses and loss adjustment expense payments. Our reserves are
carried at the total estimate for ultimate expected losses and
loss adjustment expenses. We do not discount the reserves for
losses and loss adjustment expenses.
Our reserves consist entirely of reserves for liability losses,
consistent with the coverages provided for in the insurance
policies directly written or assumed by us under reinsurance
contracts. In many cases, several years may elapse between the
occurrence of an insured loss, the reporting of the loss to us
and our payment of the loss. The estimation of ultimate
liability for losses and loss adjustment expenses is an
inherently uncertain process, requiring the use of informed
estimates and judgments. Our loss and loss adjustment expense
reserves do not represent an exact measurement of liability, but
are estimates. Although we believe that our reserve
66
estimates are reasonable, it is possible that our actual loss
experience may not conform to our assumptions and may, in fact,
vary significantly from our assumptions. Accordingly, the
ultimate settlement of losses and the related loss adjustment
expenses may vary significantly from the estimates included in
our financial statements. We continually review our estimates
and adjust them as we believe appropriate as our experience
develops or new information becomes known to us. Such
adjustments are included in current results of operations. For a
further discussion of how we determine our loss and loss
adjustment expense reserves and the uncertainty surrounding
those estimates, see Critical Accounting
Policies Loss and Loss Adjustment Expense
Reserves.
Reconciliation
of Unpaid Losses and Loss Adjustment Expenses
We establish a reserve for both reported and unreported covered
losses, which includes estimates of both future payments of
losses and related loss adjustment expenses. The following table
represents changes in our aggregate reserves during 2006, 2005
and 2004:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
2006
|
|
|
2005
|
|
|
2004
|
|
|
|
(Dollars in thousands)
|
|
|
Balance, January 1
|
|
$
|
113,864
|
|
|
$
|
68,699
|
|
|
$
|
61,727
|
|
Less reinsurance recoverables
|
|
|
21,869
|
|
|
|
5,653
|
|
|
|
5,083
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net balance, January 1
|
|
|
91,995
|
|
|
|
63,046
|
|
|
|
56,644
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Incurred related to
|
|
|
|
|
|
|
|
|
|
|
|
|
Current year
|
|
|
55,090
|
|
|
|
36,052
|
|
|
|
25,157
|
|
Prior years
|
|
|
1,118
|
|
|
|
19,042
|
|
|
|
1,697
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total incurred
|
|
|
56,208
|
|
|
|
55,094
|
|
|
|
26,854
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Paid related to
|
|
|
|
|
|
|
|
|
|
|
|
|
Current year
|
|
|
1,605
|
|
|
|
2,119
|
|
|
|
498
|
|
Prior years
|
|
|
22,511
|
|
|
|
24,026
|
|
|
|
19,954
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total paid
|
|
|
24,116
|
|
|
|
26,145
|
|
|
|
20,452
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net balance, December 31
|
|
|
124,087
|
|
|
|
91,995
|
|
|
|
63,046
|
|
Plus reinsurance recoverables
|
|
|
66,926
|
|
|
|
21,869
|
|
|
|
5,653
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Balance, December 31
|
|
$
|
191,013
|
|
|
$
|
113,864
|
|
|
$
|
68,699
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
During 2006, the Company experienced approximately
$1.1 million in net prior year reserve development
principally in the 2000 accident year, offset somewhat by
favorable development on prior years unallocated loss adjustment
expense reserves. The development on accident year 2000 reserves
was concentrated primarily in the safety equipment class as a
result of obtaining new information on several high severity
cases.
During 2005, we experienced adverse development in the loss and
loss adjustment expense reserves for accident years 2000 through
2002, with respect to policies written for security classes,
especially in the safety equipment installation and service
class. The prior year reserve development occurred due to new
information which emerged during 2005 on a small number of
complex high severity cases, causing increased net case reserve
valuations or loss and loss adjustment expense payments of
$7.4 million that were not anticipated in our prior
years IBNR reserve estimates. This development was
inconsistent with our historical loss and loss and loss
adjustment expense reporting patterns. Our historic reporting
patterns for this class generally reflect minimal development
beyond the fourth year of maturity. The loss development on
policies written during 1999 to 2001 has been volatile, and more
slowly developing, compared to expectations based on our
historic loss emergence patterns that are associated with the
same classes of policies. The overall loss experience on these
policies has been significantly worse than our insurance
subsidiaries historic experience on policies written both
before and after this period. In response to the adverse loss
development in 2005, we increased our reserves applicable to
prior accident years for security classes by approximately
$12.8 million.
67
Our loss experience on policies that we wrote for the safety
equipment installation and service class during 1999 to 2001 has
been significantly worse than on policies written for other
security classes, with an average loss and loss adjustment
expense ratio of approximately 188% during those accident years.
We have written the safety equipment class throughout our
history on a profitable basis, and we expanded our writings in
this class dramatically from 1999 through 2001, primarily
through writing new policies for former customers of several
competitors who exited the property casualty markets during that
period. Our underwriters relied on loss history data provided by
the former competitors and increased premium rates accordingly
on these policies, and we expected the new policies to be
profitable.
While we increased the prices on new policies from those charged
by the previous insurers, the historical loss information we
used to underwrite some of the new policies was based on
information provided by previous insurers who left the market,
and much of that information was later found to be inaccurate or
incomplete. In retrospect, premium rates for new policies
written for the safety equipment installation and service class
during this period ultimately proved to be inadequate. The
impact of the inadequate premium rates was compounded by our
growth in the safety equipment installation and service class
during that period. In reaction to the observed deterioration in
the loss experience of the safety equipment installation and
service class, we implemented a number of changes in both the
safety equipment installation and service class and other
security classes, many of these changes coincided with and were
facilitated by the hard market conditions that
emerged during this period, and include the following:
|
|
|
|
|
Extensive re-underwriting of policies during 2001 and 2002;
|
|
|
|
Adoption of more stringent underwriting standards;
|
|
|
|
De-emphasis of unprofitable markets;
|
|
|
|
Increased premium rates from 2002 to 2005;
|
|
|
|
Implementation of many coverage exclusions, restrictions,
endorsements, and higher deductibles in 2002 and 2003;
|
|
|
|
Implementation of improved audit premium and deductible
procedures and controls; and
|
|
|
|
Beginning in June 2004, our purchase of excess reinsurance so
that we reduced our net per occurrence losses and loss
adjustment expense retention by 50%.
|
As a result of these actions, net incurred losses and loss
adjustment expenses and the net incurred loss ratios and
frequency of losses for the 2003 to 2005 accident years on
policies written for security classes have improved
significantly in comparison to the 1999 to 2002 accident years,
which resulted in overall improved calendar year loss ratios
from 2003 through 2006.
In addition, we increased our reserves applicable to policies
written for other specialty classes by approximately
$6.2 million, principally as a result of using updated
industry loss development factors, which became available to us
during 2005, in the calculations of ultimate expected losses and
reserves on those classes. These updated factors indicated that
losses are expected to emerge more slowly than what was
reflected in the previous industry development factors that we
used. We began writing for other specialty classes in 2000 and
have seven years or less of our own historical loss experience
for these classes. Consequently, we have relied significantly on
industry development factors in our reserve estimates. As our
historical experience increases, we will be able to give more
weight to our own experience and reduce the amount of weight
given to industry experience in our reserve estimates.
From 2000 through 2004, for other specialty classes we had used
an earlier set of available industry development factors from a
study published in 2000. We adopted the industry development
factors that became available during 2005 because they reflected
more recent industry experience, were separated into losses and
loss adjustment expenses and in more class and coverage limit
segments that aligned more closely with our classifications and
coverage limits, and were more closely aligned with our actual
emerging experience. The increases and decreases in incurred
losses related to prior accident years, as reflected in the
preceding table for 2004 and 2003, primarily resulted from
differences in actual versus expected loss development.
68
Loss Development. Below is a
table showing the development of our reserves for unpaid losses
and loss adjustment expenses for us for report years 1996
through 2006. The table portrays the changes in the loss and
loss adjustment expenses reserves in subsequent years relative
to the prior loss estimates based on experience as of the end of
each succeeding year, on a GAAP basis.
The first line of the table shows, for the years indicated, the
net reserve liability including the reserve for incurred but not
reported losses as originally estimated. For example, as of
December 31, 1996 it was estimated that $48.0 million
would be a sufficient reserve to settle all claims not already
settled that had occurred prior to December 31, 1996,
whether reported or unreported to our insurance subsidiaries.
The next section of the table sets forth the re-estimates in
later years of incurred losses, including payments, for the
years indicated. For example, as reflected in that section of
the table, the original reserve of $48.0 million was
re-estimated to be $32.3 million at December 31, 2006.
The increase/decrease from the original estimate would generally
be a combination of factors, including:
|
|
|
|
|
reserves being settled for amounts different from the amounts
originally estimated;
|
|
|
|
reserves being increased or decreased for individual claims that
remain open as more information becomes known about those
individual claims; and
|
|
|
|
more or fewer claims being reported after December 31, 1996
than had been reported before that date.
|
The cumulative redundancy (deficiency) represents,
as of December 31, 2006, the difference between the latest
re-estimated liability and the reserves as originally estimated.
A redundancy means that the original estimate was higher than
the current estimate for reserves; a deficiency means that the
current estimate is higher than the original estimate for
reserves. For example, because the reserves established as of
December 31, 1996 at $48.0 million were reestablished
at December 31, 2006 at $32.3 million, it was
re-estimated that the reserves which were established as of
December 31, 1996 included a $15.7 million redundancy.
The next section of the table shows, by year, the cumulative
amounts of losses and loss adjustment expenses paid as of the
end of each succeeding year. For example, with respect to the
net losses and loss expense reserve of $48.0 million as of
December 31, 1996 by December 31, 2006 (ten years
later) $32.2 million actually had been paid in settlement
of the claims which pertain to the reserve as of
December 31, 1996.
Information with respect to the cumulative development of gross
reserves (that is, without deduction for reinsurance ceded) also
appears at the bottom portion of the table.
ANICs reserves averaged approximately 13% of our total
reserves for each year in the ten year period ended
December 31, 2006. From 1996 through 2001, ANICs
reserves were primarily applicable to ANICs non-standard
personal auto and commercial multi-peril business lines, which
were discontinued in 2001. Beginning in 2002, ANICs
reserves were derived primarily from its assumed quota share of
a portion of the premiums produced by CoverX.
69
Analysis
of Unpaid Loss and Loss Adjustment Expense Development
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Year ended December 31,
|
|
|
|
1996
|
|
|
1997
|
|
|
1998
|
|
|
1999
|
|
|
2000
|
|
|
2001
|
|
|
2002
|
|
|
2003
|
|
|
2004
|
|
|
2005
|
|
|
2006
|
|
|
|
(Dollars in thousands)
|
|
|
Net reserve for unpaid losses and
loss adjustment expenses
|
|
$
|
48,018
|
|
|
$
|
37,714
|
|
|
$
|
32,023
|
|
|
$
|
31,561
|
|
|
$
|
34,498
|
|
|
$
|
46,617
|
|
|
$
|
54,507
|
|
|
$
|
56,644
|
|
|
$
|
63,046
|
|
|
$
|
91,995
|
|
|
$
|
124,087
|
|
Net reserves re-estimated at
December 31:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
One year later
|
|
|
47,044
|
|
|
|
33,364
|
|
|
|
27,286
|
|
|
|
27,926
|
|
|
|
34,677
|
|
|
|
47,744
|
|
|
|
56,023
|
|
|
|
58,342
|
|
|
|
82,087
|
|
|
|
93,113
|
|
|
|
|
|
Two years later
|
|
|
43,286
|
|
|
|
28,801
|
|
|
|
21,363
|
|
|
|
26,967
|
|
|
|
35,789
|
|
|
|
52,212
|
|
|
|
61,968
|
|
|
|
78,214
|
|
|
|
83,844
|
|
|
|
|
|
|
|
|
|
Three years later
|
|
|
38,796
|
|
|
|
22,877
|
|
|
|
19,030
|
|
|
|
27,932
|
|
|
|
37,774
|
|
|
|
59,665
|
|
|
|
81,339
|
|
|
|
80,314
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Four years later
|
|
|
33,224
|
|
|
|
21,824
|
|
|
|
19,367
|
|
|
|
28,108
|
|
|
|
40,026
|
|
|
|
73,785
|
|
|
|
83,624
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Five years later
|
|
|
32,447
|
|
|
|
22,148
|
|
|
|
18,892
|
|
|
|
28,770
|
|
|
|
45,470
|
|
|
|
76,375
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Six years later
|
|
|
32,953
|
|
|
|
21,482
|
|
|
|
18,917
|
|
|
|
30,219
|
|
|
|
47,769
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Seven years later
|
|
|
32,275
|
|
|
|
21,677
|
|
|
|
19,605
|
|
|
|
30,478
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Eight year later
|
|
|
32,330
|
|
|
|
22,255
|
|
|
|
19,541
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Nine years later
|
|
|
32,290
|
|
|
|
22,226
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Ten years later
|
|
|
32,285
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Cumulative redundancy (deficiency)
on net reserves
|
|
|
15,733
|
|
|
|
15,488
|
|
|
|
12,482
|
|
|
|
1,083
|
|
|
|
(13,271
|
)
|
|
|
(29,758
|
)
|
|
|
(29,117
|
)
|
|
|
(23,670
|
)
|
|
|
(20,798
|
)
|
|
|
(1,118
|
)
|
|
|
|
|
Cumulative amount of net liability
paid through December 31:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
One year later
|
|
|
15,064
|
|
|
|
8,224
|
|
|
|
5,810
|
|
|
|
7,855
|
|
|
|
9,791
|
|
|
|
13,999
|
|
|
|
18,757
|
|
|
|
19,955
|
|
|
|
24,025
|
|
|
|
22,511
|
|
|
|
|
|
Two years later
|
|
|
22,564
|
|
|
|
12,975
|
|
|
|
10,737
|
|
|
|
14,063
|
|
|
|
19,060
|
|
|
|
30,603
|
|
|
|
37,249
|
|
|
|
40,487
|
|
|
|
42,835
|
|
|
|
|
|
|
|
|
|
Three years later
|
|
|
26,186
|
|
|
|
16,435
|
|
|
|
13,303
|
|
|
|
19,856
|
|
|
|
27,724
|
|
|
|
43,950
|
|
|
|
55,262
|
|
|
|
55,297
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Four years later
|
|
|
28,455
|
|
|
|
18,198
|
|
|
|
15,918
|
|
|
|
24,039
|
|
|
|
33,839
|
|
|
|
56,471
|
|
|
|
66,215
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Five years later
|
|
|
29,685
|
|
|
|
19,886
|
|
|
|
17,382
|
|
|
|
26,900
|
|
|
|
38,525
|
|
|
|
64,331
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Six years later
|
|
|
31,024
|
|
|
|
20,657
|
|
|
|
18,198
|
|
|
|
28,328
|
|
|
|
43,065
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Seven years later
|
|
|
31,627
|
|
|
|
21,223
|
|
|
|
18,583
|
|
|
|
28,996
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Eight year later
|
|
|
31,984
|
|
|
|
21,584
|
|
|
|
18,924
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Nine years later
|
|
|
32,183
|
|
|
|
21,960
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Ten years later
|
|
|
32,203
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Gross reserves end of
year
|
|
|
56,308
|
|
|
|
45,221
|
|
|
|
37,653
|
|
|
|
36,083
|
|
|
|
36,150
|
|
|
|
48,143
|
|
|
|
59,449
|
|
|
|
61,727
|
|
|
|
68,699
|
|
|
|
113,864
|
|
|
|
191,013
|
|
Reinsurance recoverable on unpaid
losses
|
|
|
8,290
|
|
|
|
7,507
|
|
|
|
5,630
|
|
|
|
4,522
|
|
|
|
1,652
|
|
|
|
1,526
|
|
|
|
4,942
|
|
|
|
5,083
|
|
|
|
5,653
|
|
|
|
21,869
|
|
|
|
66,926
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net reserves end of year
|
|
|
48,018
|
|
|
|
37,714
|
|
|
|
32,023
|
|
|
|
31,561
|
|
|
|
34,498
|
|
|
|
46,617
|
|
|
|
54,507
|
|
|
|
56,644
|
|
|
|
63,046
|
|
|
|
91,995
|
|
|
|
124,087
|
|
Gross reserves
re-estimated at
12/31/06
|
|
|
39,452
|
|
|
|
29,524
|
|
|
|
26,986
|
|
|
|
35,205
|
|
|
|
51,221
|
|
|
|
81,041
|
|
|
|
90,243
|
|
|
|
86,894
|
|
|
|
91,497
|
|
|
|
116,014
|
|
|
|
|
|
Reinsurance recoverable on unpaid
losses re-estimated at
12/31/06
|
|
|
7,167
|
|
|
|
7,298
|
|
|
|
7,445
|
|
|
|
4,727
|
|
|
|
3,452
|
|
|
|
4,666
|
|
|
|
6,619
|
|
|
|
6,580
|
|
|
|
7,653
|
|
|
|
22,901
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net reserves
re-estimated at
12/31/06
|
|
|
32,285
|
|
|
|
22,226
|
|
|
|
19,541
|
|
|
|
30,478
|
|
|
|
47,769
|
|
|
|
76,375
|
|
|
|
83,624
|
|
|
|
80,314
|
|
|
|
83,844
|
|
|
|
93,113
|
|
|
|
|
|
Cumulative redundancy (deficiency)
on gross reserves
|
|
|
16,856
|
|
|
|
15,697
|
|
|
|
10,667
|
|
|
|
878
|
|
|
|
(15,071
|
)
|
|
|
(32,898
|
)
|
|
|
(30,794
|
)
|
|
|
(25,167
|
)
|
|
|
(22,798
|
)
|
|
|
(2,150
|
)
|
|
|
|
|
Factors contributing to the reserve development in the preceding
table are as follows:
From 1996 through 1998, our insurance subsidiaries experienced
significant favorable development of their reserves, reflecting
redundancies in all years. This development was significantly
influenced by the police and public officials classes of
business which FMICs predecessor organization, First
Mercury Syndicate (FMS) began writing in 1991, and
FMIC stopped writing in 1996. Early reported losses and loss
adjustment expense emergence in those classes was worse than
industry experience, and estimated ultimate losses and loss
70
adjustment expenses and related reserves were based on a
continuation of the adverse trend and use of industry
development factors. In addition, FMSs loss and loss
adjustment experience data only went back to FMSs
formation in 1985, so greater weight was given to industry data
compared to our claims experience in establishing IBNR. As our
policies in the accident years matured, the loss trends
moderated and ultimate losses and loss adjustment expenses
emerged lower than the industry data indications.
From 2000 through 2004, the reserves gave greater weight to loss
development patterns from our historical experience through
1998, and were adjusted for differences between actual and
expected development as losses and loss adjustment expenses
emerged. During 2005, a significant amount of adverse
development occurred related to accident years 2000 through
2002, and our insurance subsidiaries increased their reserves
accordingly. In addition, we increased our reserves applicable
to other specialty classes, principally as a result of using
updated industry loss development factors, which became
available during 2005, in the calculations of ultimate expected
losses and reserves on other specialty classes.
During 2006, the Company experienced approximately
$1.1 million in net prior year reserve development
primarily in the 2000 accident year, offset somewhat by
favorable development on prior years unallocated loss adjustment
expense reserves. The development on accident year 2000 reserves
was concentrated primarily in the safety equipment class as a
result of obtaining new information on several high severity
cases.
Because the loss table above is prepared on a reported year
basis, the $20.8 million and $22.8 million in
unfavorable net reserve and gross reserve development,
respectively, on the December 31, 2004 net and gross
reported reserves appears in the applicable reported year that
coincides with the related accident years affected and is
repeated in each subsequent year through 2005.
For policies written from the middle of 2002 through the
present, historical experience for security classes has improved
due to the underwriting initiatives taken in response to the
deterioration in loss experience for the 1999 through 2001
accident years, especially in the safety equipment installation
and service class.
Reinsurance
Our insurance subsidiaries cede insurance risk to reinsurers to
diversify their risks and limit their maximum loss arising from
large or unusually hazardous risks or catastrophic events.
Additionally, our insurance subsidiaries use reinsurance in
order to limit the amount of capital needed to support their
operations and to facilitate growth. Reinsurance involves a
primary insurance company transferring, or ceding, a portion of
its premium and losses in order to control its exposure. The
ceding of liability to a reinsurer does not relieve the
obligation of the primary insurer to the policyholder. The
primary insurer remains liable for the entire loss if the
reinsurer fails to meet its obligations under the reinsurance
agreement.
In June 2004, following the investment in our convertible
preferred stock, FMFC contributed additional capital to FMIC,
resulting in an increase in FMICs statutory surplus of
$26.0 million. Shortly thereafter, A.M. Best raised
FMICs financial strength rating to A−
and size rating to VII, thus qualifying it to be the
direct writer of substantially all of the premiums produced by
CoverX. On May 1, 2005, the prior assumed reinsurance
contracts terminated. By December 31, 2005, substantially
all premiums produced were written directly by FMIC. In March
2007, A.M. Best raised FMICs size rating to
VIII. Effective January 1, 2007 FMIC and
ANIC entered into an intercompany pooling reinsurance agreement
wherein all premiums, losses and expenses of FMIC and ANIC are
combined and apportioned between FMIC and ANIC along fixed
percentages. On May 4, 2007 A.M. Best assigned
the financial strength rating A− to the First
Mercury Group pool and its members, FMIC and ANIC. ANICs
A.M. Best rating was upgraded to A− as a
result.
FMIC entered into ceding reinsurance contracts effective June
2004, ceding per occurrence coverages in excess of
$500,000 per risk, and ceding 39% of its net retention to
an unaffiliated reinsurer (30%) and to ANIC (9%), increasing the
combined net retention of our insurance subsidiaries to 70% of
the first $500,000 per occurrence. We increased the
premiums ceded under quota share agreements with unaffiliated
reinsurers to 40% in July 2005 and 50% in January 2006.
71
During 2006, we maintained a 50% quota share on all of our
business other than our legal professional liability class, for
which we maintained a variable 70% to 85% quota share, and our
umbrella policies, for which we maintained a 90% quota share.
On December 31, 2006 we elected the cut-off termination
option available to us on the expiration of our 50% quota share
contracts expiring that day in accordance with the termination
provisions of these quota share contracts. As a result, we
effectively eliminated the 50% quota share reinsurance on the
$39.6 million unearned premiums as of December 31,
2006 that had been ceded prior to contract expiration. This
amount of previously ceded net unearned premium reserve was
returned to the Company as a result of the cut-off termination
election. As those premiums are earned during 2007, they will be
reported in the Companys net earned premiums. We had
previously recorded $12.8 million in ceded commissions
related to the $39.6 million of unearned premiums as a
reduction in deferred acquisition costs. Those commissions are
included in deferred acquisition costs reported at
December 31, 2006, and will be amortized during 2007 as the
related unearned premiums are earned.
Effective January 1, 2007, we purchased 35% quota share
reinsurance to replace the expiring 50% for policies issued with
effective dates beginning January 1, 2007. Our excess of
loss reinsurance is used to limit our maximum exposure per claim
occurrence. We currently maintain a $500,000 excess of
$500,000 per occurrence coverage, which was renewed on
January 1, 2007. On April 1, 2007, we extended the 90%
quota share reinsurance applicable to umbrella policies through
March 31, 2008. On May 1, 2007, we amended our 35%
quota share reinsurance treaties to include the legal
professional liability class.
We have historically adjusted our level of quota share
reinsurance based on our premiums produced and our level of
capitalization, as well as our risk appetite for a particular
type of business. We believe that the current reinsurance market
for the lines of business that we insure is stable in both
capacity and pricing. In addition, we do not anticipate
structural changes to our reinsurance strategies, but rather
will continue to adjust our level of quota share and excess of
loss reinsurance based on our premiums produced, level of
capitalization and risk appetite. As a result, we believe that
we will continue to be able to execute our reinsurance
strategies on a basis consistent with our historical and current
reinsurance structures.
The following table illustrates our direct written premiums and
premiums ceded for the three months ended March 31, 2007
and 2006 and for the years ended December 31, 2006, 2005
and 2004:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended
|
|
|
Year Ended
|
|
|
|
March 31,
|
|
|
December 31,
|
|
|
|
2007
|
|
|
2006
|
|
|
2006
|
|
|
2005
|
|
|
2004
|
|
|
|
(Dollars in thousands)
|
|
|
Direct written premiums
|
|
$
|
59,334
|
|
|
$
|
55,537
|
|
|
$
|
213,842
|
|
|
$
|
168,223
|
|
|
$
|
53,121
|
|
Ceded written premiums
|
|
|
26,140
|
|
|
|
29,768
|
|
|
|
75,255
|
|
|
|
70,195
|
|
|
|
19,171
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net written premiums
|
|
$
|
33,194
|
|
|
$
|
25,769
|
|
|
$
|
138,587
|
|
|
$
|
98,028
|
|
|
$
|
33,950
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Ceded written premiums as
percentage of direct written premiums
|
|
|
44.1
|
%
|
|
|
53.6
|
%
|
|
|
35.2
|
%
|
|
|
41.7
|
%
|
|
|
36.1
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
The following table illustrates the effect of our reinsurance
ceded strategies on our results of operations:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended
|
|
|
Year Ended
|
|
|
|
March 31,
|
|
|
December 31,
|
|
|
|
2007
|
|
|
2006
|
|
|
2006
|
|
|
2005
|
|
|
2004
|
|
|
|
(Dollars in thousands)
|
|
|
Ceded written premiums
|
|
$
|
26,140
|
|
|
$
|
29,768
|
|
|
$
|
75,255
|
|
|
$
|
70,195
|
|
|
$
|
19,171
|
|
Ceded premiums earned
|
|
|
11,064
|
|
|
|
21,278
|
|
|
|
101,408
|
|
|
|
48,571
|
|
|
|
4,279
|
|
Losses and loss adjustment
expenses ceded
|
|
|
3,981
|
|
|
|
10,856
|
|
|
|
53,237
|
|
|
|
20,962
|
|
|
|
2,261
|
|
Ceding commissions
|
|
|
3,021
|
|
|
|
6,586
|
|
|
|
30,763
|
|
|
|
14,805
|
|
|
|
1,036
|
|
72
Our net cash flows relating to ceded reinsurance activities
(premiums paid less losses recovered and ceding commissions
received) were approximately $17.2 million net cash paid
for the three months ended March 31, 2007 compared to net
cash paid of $21.0 million for the three months ended
March 31, 2006.
Our net cash flows relating to ceded reinsurance activities
(premiums paid less losses recovered and ceding commissions
received) were approximately $48.7 million net cash paid
for the year ended December 31, 2006 compared to net cash
paid of $48.4 million for the year ended December 31,
2005. We paid approximately $12.8 million for the year
ended December 31, 2004. As a result of the above described
election to exercise the cut-off termination option with respect
to the 2006 50% ceded quota share reinsurance contracts,
$26.8 million was due to the Company from the quota share
reinsurers at December 31, 2006. This amount was reported
in premiums and reinsurance balances receivable in our
December 31, 2006 balance sheet. We received
$21.5 million from the quota share reinsurers during the
three months ended March 31, 2007.
The assuming reinsurer is obligated to indemnify the ceding
company to the extent of the coverage ceded. The inability to
recover amounts due from reinsurers could result in significant
losses to us. To protect us from reinsurance recoverable losses,
FMIC seeks to enter into reinsurance agreements with financially
strong reinsurers. Our senior executives evaluate the credit
risk of each reinsurer before entering into a contract and
monitor the financial strength of the reinsurer. On
March 31, 2007, all reinsurance contracts to which we were
a party were with companies with A.M. Best ratings of
A or better. In addition, ceded reinsurance
contracts contain trigger clauses through which FMIC can
initiate cancellation including immediate return of all ceded
unearned premiums at its option, or which result in immediate
collateralization of ceded reserves by the assuming company in
the event of a financial strength rating downgrade, thus
limiting credit exposure. On March 31, 2007, there was no
allowance for uncollectible reinsurance, as all reinsurance
balances were current and there were no disputes with reinsurers.
On March 31, 2007 and December 31, 2006, FMFC had a
net amount of recoverables from reinsurers of $98.8 million
and $99.6 million, respectively, on a consolidated basis.
The following is a summary of our insurance subsidiaries
net reinsurance recoverables by reinsurer:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net Amount
|
|
|
Net Amount
|
|
|
|
A.M.
|
|
|
Recoverable as of
|
|
|
Recoverable as of
|
|
|
|
Best Rating
|
|
|
March 31, 2007
|
|
|
December 31, 2006
|
|
|
|
|
|
|
(Dollars in thousands)
|
|
|
ACE Property & Casualty
Insurance Company
|
|
|
A
|
+
|
|
|
62,436
|
|
|
$
|
69,093
|
|
Swiss Reinsurance America
Corporation
|
|
|
A
|
|
|
|
25,900
|
|
|
|
18,010
|
|
Platinum Underwriters Reinsurance,
Inc.
|
|
|
A
|
|
|
|
4,326
|
|
|
|
5,883
|
|
Berkley Insurance Company
|
|
|
A
|
|
|
|
1,103
|
|
|
|
1,644
|
|
Other
|
|
|
(1
|
)
|
|
|
5,004
|
|
|
|
4,988
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total
|
|
|
|
|
|
$
|
98,769
|
|
|
$
|
99,618
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
(1) |
|
- all other reinsurers carry an A.M. Best rating of
A and above |
The reinsurance market moves in pricing cycles which are
correlated with the primary insurance market. Thus, after
experiencing adverse reserve development due to inadequate
pricing during the soft market, the amount of capacity in the
reinsurance market has decreased. This has in turn placed upward
pressure on reinsurance prices and restricted terms.
Recent
Accounting Pronouncements
In September 2006, the FASB issued SFAS No. 157,
Fair Value Measurements
(SFAS 157), which defines fair value,
establishes a framework for measuring fair value in generally
accepted accounting principles, and expands disclosures about
fair value measurements. SFAS No. 157 does not require
any new fair value measurements, but provides guidance on how to
measure fair value by providing a fair value hierarchy used to
classify the source of the information. This statement is
effective for fiscal years beginning
73
after November 15, 2007. The Company is currently assessing
the potential impact that the adoption of SFAS No. 157
will have on its financial statements.
In February 2007, the FASB issued SFAS No. 159,
The Fair Value Option for Financial Assets and
Financial Liabilities (SFAS 159),
which provides reporting entities an option to report
selected financial assets, including investment securities
designated as available for sale, and liabilities, including
most insurance contracts, at fair value. SFAS 159
establishes presentation and disclosure requirements designed to
facilitate comparisons between companies that choose different
measurement attributes for similar types of assets and
liabilities. The standard also requires additional information
to aid financial statement users understanding of a
reporting entitys choice to use fair value on its earnings
and also requires entities to display on the face of the balance
sheet the fair value of those assets and liabilities for which
the reporting entity has chosen to measure at fair value.
SFAS 159 is effective as of the beginning of a reporting
entitys first fiscal year beginning after
November 15, 2007. The Company has not elected the early
adoption provisions of this standard. Because application of the
standard is optional, any impacts are limited to those financial
assets and liabilities to which SFAS 159 would be applied,
which has yet to be determined, as is any decision concerning
the early adoption of the standard.
Quantitative
and Qualitative Disclosures About Market Risk
Market risk is the potential economic loss principally arising
from adverse changes in the fair value of financial instruments.
The major components of market risk affecting us are credit risk
and interest rate risk.
Credit
Risk
Credit risk is the potential economic loss principally arising
from adverse changes in the financial condition of a specific
debt issuer or a reinsurer.
We address the risk associated with debt issuers by investing in
fixed maturity securities that are investment grade, which are
those securities rated BBB or higher by
Standard & Poors. We monitor the financial
condition of all of the issuers of fixed maturity securities in
our portfolio. Our outside investment managers assist us in this
process. We utilize a variety of tools and analysis to as part
of this process. If a security rated BBB
or higher by Standard & Poors at the time
that we purchase it and is then downgraded below
BBB while we hold it, we evaluate the
security for impairment, and after discussing the security with
our investment advisors, we make a decision to either dispose of
the security or continue to hold it. Finally, we employ
stringent diversification rules that limit our credit exposure
to any single issuer or business sector.
We address the risk associated with reinsurers by generally
targeting reinsurers with A.M. Best financial strength
ratings of A− or better. In an effort to
minimize our exposure to the insolvency of our reinsurers, we
evaluate the acceptability and review the financial condition of
each reinsurer annually. In addition, we continually monitor
rating downgrades involving any of our reinsurers. At
March 31, 2007, all reinsurance contracts were with
companies with A.M. Best ratings of A or better.
Interest
Rate Risk
Interest rate risk is the risk that we may incur economic losses
due to adverse changes in interest rates. The primary market
risk to the investment portfolio is interest rate risk
associated with investments in fixed maturity securities.
Fluctuations in interest rates have a direct impact on the
market valuation of these securities. We manage our exposure to
interest rate risk through an asset and liability matching
process. In the management of this risk, the characteristics of
duration, credit and variability of cash flows are critical
elements. These risks are assessed regularly and balanced within
the context of our liability and capital position. Our outside
investment managers assist us in this process. We have
$46.4 million cumulative principal amount of floating rate
junior subordinated debentures outstanding. We have entered into
interest rate swap agreements through 2009 with a combined
notional amount of $20.0 million and through 2011 with a
notional amount of $25.0 million in order to fix the
interest rate on this debt, thereby reducing our exposure to
interest rate fluctuations with respect to our debentures.
74
BUSINESS
We are a provider of insurance products and services to the
specialty commercial insurance markets, primarily focusing on
niche and underserved segments where we believe that we have
underwriting expertise and other competitive advantages. During
our 34 years of underwriting security risks, we have
established
CoverX®
as a recognized brand among insurance agents and brokers and
developed the underwriting expertise and cost-efficient
infrastructure which have enabled us to underwrite such risks
profitably. Over the last seven years, we have leveraged our
brand, expertise and infrastructure to expand into other
specialty classes of business, particularly focusing on smaller
accounts that receive less attention from competitors. As part
of this extension of our business, we have increased our
underwriting staff and opened offices in Chicago, Dallas,
Naples, Florida, Boston and Irvine, California.
As primarily an excess and surplus, or E&S, lines
underwriter, our business philosophy is to generate an
underwriting profit by identifying, evaluating and appropriately
pricing and accepting risk using customized forms tailored for
each risk. Our combined ratio, a customary measure of
underwriting profitability, has averaged 67.1% over the past
three years. A combined ratio is the sum of the loss ratio and
the expense ratio. A combined ratio under 100% generally
indicates an underwriting profit. A combined ratio over 100%
generally indicates an underwriting loss. As an E&S lines
underwriter, we have more flexibility than standard property and
casualty insurance companies to set and adjust premium rates and
customize policy forms to reflect the risks being insured. We
believe this flexibility has a beneficial impact on our
underwriting profitability and our combined ratio.
In addition, through our insurance services business, which
provides underwriting, claims and other insurance services to
third parties, we are able to generate significant fee income
that is not dependent upon our underwriting results. For our
entire business, we generated an average annual return on
stockholders equity of 25.8% over the past three calendar
years.
Our CoverX subsidiary is a licensed wholesale insurance broker
that produces and underwrites all of the insurance policies for
which we retain risk and receive premiums. As a wholesale
insurance broker, CoverX markets our insurance policies through
a nationwide network of wholesale and retail insurance brokers
who then distribute these policies through retail insurance
brokers. CoverX also provides underwriting services with respect
to the insurance policies it markets in that it reviews the
applications submitted for insurance coverage, decides whether
to accept all or part of the coverage requested and determines
applicable premiums. We participate in the risk on insurance
policies sold through CoverX, which we refer to as policies
produced by CoverX, generally by directly writing the policies
through our insurance subsidiaries and then retaining all or a
portion of the risk. The portion of the risk that we decide not
to retain is ceded to, or assumed by, reinsurers in exchange for
paying the reinsurers a proportionate amount of the premium
received by us for issuing the policy. This cession is commonly
referred to as reinsurance. Depending on market conditions, we
can retain a higher or lower amount of premiums produced by
CoverX.
Prior to June 2004, when our insurance subsidiarys rating
was upgraded by A.M. Best Company, Inc., or A.M. Best,
to A−, we did not directly write a significant
amount of insurance policies produced by CoverX, but instead
utilized fronting arrangements under which we contracted with
third party insurers, or fronting insurers, to directly write
the policies produced by CoverX. Under these fronting
arrangements, we then controlled the cession of the insurance
from the fronting insurer and either assumed most of the risk
under these policies as a reinsurer or arranged for it to be
ceded directly to other reinsurers. In connection with our
insurance subsidiarys rating upgrade, we were able to
eliminate most of our fronting relationships by May 2005 and
become the direct writer of substantially all of the policies
produced by CoverX.
Effective January 1, 2007, FMIC and ANIC entered into an
intercompany pooling reinsurance agreement wherein all premiums,
losses and expenses of FMIC and ANIC are combined and
apportioned between FMIC and ANIC in accordance with fixed
percentages. On May 4, 2007, A.M. Best assigned the
financial strength rating A− to the First
Mercury Group pool and its members, FMIC and ANIC. ANICs
A.M. Best rating was upgraded to A− as a
result.
75
Premiums produced, which consists of all premiums billed by
CoverX, grew from $146.9 million in 2004 to $230.1 million in
2006. Premiums produced were $116.3 million for the five
months ended May 31, 2007 and $99.4 million for the five
months ended May 31, 2006.
Our direct and assumed written premiums grew from
$92.1 million in 2004 to $218.2 million in 2006. These
amounts do not include $54.8 million and $11.9 million
of premiums in 2004 and 2006, respectively, that were produced
and underwritten by CoverX and directly written by our fronting
insurers. A discussion of how the shift from relying on fronting
relationships to directly writing insurance has impacted our
financial presentation and our direct and assumed written
premiums is set forth in Managements discussion and
analysis of financial condition and results of
operations Overview.
We have written general liability insurance for the security
industry, which includes security guards and detectives, alarm
installation and service businesses, and safety equipment
installation and service businesses, for 34 years. We focus
on small and mid-size accounts that are often underserved by
other insurance companies. For 2006 and the three months ended
March 31, 2007, our direct and assumed written premiums
from security classes represented 31.2% and 26.8%, respectively,
of our total direct and assumed written premiums. Our loss and
allocated loss adjustment expense ratio on a weighted average
basis for security classes has been 61.2% over the past 20
accident years and 39.8% over the past three accident years. A
loss and allocated loss adjustment expense ratio consists of the
total net incurred losses and allocated loss adjustment expenses
related to a specified class or classes of business divided by
the total net earned premium related to a specified class or
classes of business over the same time period. We believe that
this calculation is useful in providing information on the
historical long term underwriting performance of our business
from security classes and is an indicator of how an insurance
company has managed its risk exposure.
We have leveraged our nationally recognized CoverX brand, our
broad distribution channels through CoverX, and our underwriting
and claims expertise to expand our business into other specialty
classes. For example, we have leveraged our experience in
insuring the security risks of the contractors that install
safety and fire suppression equipment, which often involves
significant plumbing work and exposure, into the underwriting of
other classes of risks for plumbing contractors. We write
general liability insurance for other specialty classes
primarily consisting of contractor classes of business,
including roofing contractors, plumbing contractors, electrical
contractors, energy contractors, and other artisan and service
contractors, legal professional liability, and, most recently,
hospitality and employer general liability coverage. As part of
this extension of our business, we have increased our
underwriting staff and opened regional offices in Chicago,
Dallas, Naples, Florida, Boston and Irvine, California. For 2006
and the three months ended March 31, 2007, our direct and
assumed written premiums from other specialty classes
represented 68.8% and 73.2%, respectively, of our total direct
and assumed written premiums. Our loss and allocated loss
adjustment expense ratio on a weighted average basis for other
specialty classes has been 42.7% over the past three accident
years and 47.2% over the past seven accident years, which
represents the period in which we have expanded our business in
other specialty classes. We believe this calculation is useful
in providing information on the underwriting performance of
business from other specialty classes for the seven-year period.
Because we have limited experience in these classes compared to
security classes, loss and allocated loss adjustment expense
ratio may not be indicative of the long term underwriting
performance of our business from other specialty classes.
Our insurance services business provides underwriting, claims
and other insurance services to third parties, including
insurance carriers and customers, and generated
$10.9 million in commission and fee income in 2006. Most of
this revenue is generated by American Risk Pooling Consultants,
Inc. and its subsidiaries, which we refer to as ARPCO, through
which we provide third party administration services for risk
sharing pools of governmental entity risks, including
underwriting, claims, loss control and reinsurance services.
For the year ended December 31, 2006, our operating income
was $50.2 million, a 24% increase over the prior year, and
our net income was $21.9 million, a 4% decrease over the
prior year. For the three months ended March 31, 2007, our
operating income was $16.3 million, a 53% increase over the
three months ended March 31, 2006, and our net income was
$10.0 million, an 85% increase from the same period in
2006. As of March 31, 2007, we had total assets of
$566.7 million and stockholders equity of
$182.8 million. The changes
76
in net income from 2005 to 2006 and from the three months ended
March 31, 2006 compared to the corresponding period in 2007
were not comparable to the respective changes in operating
income due to interest expense incurred after August 17,
2005 on the $65.0 million in senior notes issued in August
2005 and repaid in October 2006.
Competitive
Strengths
The following competitive strengths drive our ability to execute
our business plan and growth strategy:
|
|
|
|
|
Recognized Brand and Nationwide Distribution
Platform. Our CoverX brand has been
well-known among insurance brokers and agents for over
30 years. Brokers and agents have depended upon us to
provide a consistent insurance market since 1973 for security
guards and detectives, alarm installation and service businesses
and safety equipment installation and service businesses. We
have developed relationships with numerous brokers nationwide,
and produced business from approximately 1,000 different brokers
in 2006. Throughout our history, we have successfully leveraged
our brand and broker distribution network to enter into other
specialty classes of business.
|
|
|
|
Proprietary Data and Underwriting
Expertise. Recognizing the importance of
the collection of claims and loss information, we have developed
and maintained an extensive database of underwriting and claims
information that we believe is unmatched by our competitors and
which includes over 20 years of loss information. We
believe our database and underwriting expertise allow us to
price the risks that we insure more appropriately than our
competitors. We also enhance our historical risk database by
using our knowledge to draft extensively customized forms which
precisely define the exposures that we insure.
|
|
|
|
Opportunistic Business
Model. Because CoverX controls a broad
policy distribution network through its relationships with
brokers and possesses significant underwriting expertise, we
have the ability to selectively increase or decrease the
underwriting exposure we retain based upon the pricing
environment and how the exposure fits with our underwriting and
capital management criteria. We have the ability to offset lower
net written premiums by generating higher fee income by either
underwriting through CoverX on behalf of third party insurance
carriers or ceding more risk to reinsurers.
|
|
|
|
Cost-Efficient Operating
Structure. We believe that our
cost-efficient operating structure allows us to focus on
underserved, small accounts more profitably than our
competitors. We streamlined our underwriting and claims
processes to create a paperless interactive process that
requires significantly less administration. While the premiums
generated from insurance policies produced by CoverX increased
from $28.1 million in 2000 to $230.1 million in 2006,
our total employees over that same period only increased from
110 to 142.
|
|
|
|
Significant Commission and Fee Income
Earnings. We have demonstrated the
ability to generate non-risk bearing commissions and fees that
provide a significant recurring source of income, and as a
result, our revenue and net income are not solely dependent upon
our underwriting results.
|
|
|
|
Proven Leadership and Highly Experienced
Employees. Our management team, led by
our Chairman, President and Chief Executive Officer, Richard H.
Smith, has an average of over 25 years of insurance
experience. Additionally, both our underwriters and our senior
claims personnel average over 20 years of experience in the
insurance industry.
|
Business
Challenges
We face the following challenges in conducting our business:
|
|
|
|
|
Our Continued Success is Dependent Upon Our Ability to
Maintain Our Third Party Ratings to Continue to Engage in Direct
Insurance writing. Any downgrade in the
rating that FMIC receives from A.M. Best could prevent us from
engaging in direct insurance writing or being able to obtain
adequate reinsurance on competitive terms, which could lead to
decreased revenue and earnings.
|
77
|
|
|
|
|
We Need to Maintain Adequate
Reserves. Our actual incurred losses may
exceed the loss and loss adjustment expense reserves we
maintain, which could have a material adverse effect on our
results of operations and financial condition.
|
|
|
|
We Bear Credit Risk with Respect to Our
Reinsurers. We continue to have primary
liability on risks we cede to reinsurers. If any of these
reinsurers fails to pay us on a timely basis or at all, we could
experience losses.
|
|
|
|
Our Continued Success is Dependent Upon Our Ability to
Obtain Reinsurance on Favorable Terms. We
use significant amounts of reinsurance to manage our exposure to
market and insurance risks and to enable us to write policies in
excess of the level that our capital supports. Without adequate
levels of appropriately priced reinsurance, the level of
premiums we can underwrite could be materially reduced.
|
|
|
|
A Substantial Portion of Our Business is Concentrated
in the Security Industry. Our direct and
assumed written premiums from security classes represented 31.2%
and 26.8% of our total premiums produced in 2006 and the three
months ended March 31, 2007, respectively. As a result, any
adverse changes in the security insurance market could reduce
our premiums.
|
|
|
|
We Operate in a Highly Competitive
Market. It is difficult to attract and
retain business in the highly competitive market in which we
operate. As a result of this intense competition, prevailing
conditions relating to price, coverage and capacity can change
very rapidly and we might not be able to effectively compete.
|
Strategy
We intend to grow our business while enhancing underwriting
profitability and maximizing capital efficiency by executing the
following strategies:
|
|
|
|
|
Profitably Underwrite. We will
continue to focus on generating an underwriting profit in each
of our classes, regardless of market conditions. Our average
combined ratio for the last three years was 67.1%, comprised of
an average loss ratio of 50.3% and an average expense ratio of
16.8%. Our ability to achieve similar underwriting results in
the future depends on numerous factors discussed in the
Risk factors section and elsewhere in this
prospectus, many of which are outside of our control.
|
|
|
|
Opportunistically Grow. We plan
to opportunistically grow our business in markets where we can
use our expertise to generate consistent profits. Our ability to
opportunistically grow our business may be impeded by factors
such as our vulnerability to adverse events affecting our
existing lines, the ability to acquire and retain additional
underwriting expertise, and the ability to attract and retain
business in the competitive environment in which we operate. Our
growth strategy includes the following:
|
|
|
|
|
|
Selectively Retain More of the Premiums Generated from
Insurance Policies Produced by CoverX. In
2006, our insurance subsidiaries retained 62.1% of the premiums
generated from insurance policies produced by CoverX, either by
directly writing these premiums or by assuming these premiums
under our fronting arrangements. The remaining portion, or
37.9%, of these premiums were ceded to reinsurers through quota
share and excess of loss reinsurance or retained by the issuing
fronting carriers. We intend to continue to selectively retain
more of these premiums and to use quota share and other
reinsurance arrangements.
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Selectively Expand Geographically and into
Complementary Classes of General Liability
Insurance. We provide general liability
insurance to certain targeted niche market segments where we
believe our experience and infrastructure give us a competitive
advantage. We believe there are numerous opportunities to expand
our existing general liability product offerings both
geographically and into complementary classes of specialty
insurance. We intend to identify additional classes of risks
that are related to our existing insurance products where we can
leverage our experience and data to profitably expand.
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Enter into Additional Niche Markets and Other Specialty
Commercial Lines of Business. We plan to
leverage our brand recognition, extensive distribution network,
and underwriting expertise to enter
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78
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into new E&S lines or admitted markets in which we believe
we can capitalize on our underwriting and claims platform. We
intend to expand into these markets and other lines through
internal growth, as well as by making acquisitions and hiring
teams of experienced underwriters.
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Actively Pursue Opportunities for Commission and Fee
Income Growth. To the extent we have more
market opportunities than we choose to underwrite on our own
balance sheet, we plan to pursue and leverage these
opportunities to generate commission and fee income by providing
our distribution, underwriting and claims services to third
party carriers or insureds.
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Continue to Focus on Opportunistic Business
Model. We intend to selectively increase
or decrease the underwriting exposure we retain based upon the
pricing environment and how the exposure fits with our
underwriting and capital management criteria. The efficient
deployment of our capital, in part, requires that we
appropriately anticipate the amount of premiums that we will
write and retain. Changes in the amount of premiums that we
write or retain may cause our financial results to be less
comparable from period to period.
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Efficiently Deploy Capital. To
the extent the pursuit of the growth opportunities listed above
require capital that is in excess of our internally generated
capital, we may raise additional capital in the form of debt or
equity in order to pursue these opportunities. We have no
current specific plans to raise additional capital and do not
intend to raise or retain more capital than we believe we can
profitably deploy in a reasonable time frame. Maintaining at
least an A− rating from A.M. Best is critical
to us, and will be a principal consideration in our decisions
regarding capital as well as our underwriting, reinsurance and
investment practices.
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Industry
Background
Overview
We compete in the property and casualty, or P&C, insurance
industry and, more specifically, the E&S lines sector of
that industry which generated $33.3 billion of premium in
2005, the most recent year for which such industry data was
available, according to A.M. Best.
Admitted
Insurance Companies Compared to E&S Lines Insurance
Companies
The majority of the insurance companies in the U.S. are
known as standard, or admitted, carriers. Admitted insurance
carriers are often required to be licensed in each state in
which they write business and to file policy forms and fixed
rate plans with these states insurance regulatory bodies.
Businesses with unique risks often cannot find coverage
underwritten by admitted insurance companies because admitted
insurance companies do not have the policy form or rate
flexibility to properly underwrite such risks. While some
businesses choose to self-insure when they cannot find
acceptable insurance coverage in the standard insurance market,
many look for coverage in the E&S lines market. E&S
lines insurance companies need state insurance department
authorization to write insurance in most of the states in which
they do business, but they do not typically have to file policy
forms or fixed rate plans. The E&S lines insurance market
fills the insurance needs of businesses with unique risk
characteristics because E&S lines insurance carriers have
the policy form and rate flexibility to underwrite these risks
individually.
Competition in the E&S lines market tends to focus less on
price and more on availability and quality of service. The
E&S lines market is significantly affected by the
conditions of the insurance market in general. During times of
hard market conditions (i.e., those favorable to insurers), as
rates increase and coverage terms become more restrictive,
business tends to move from the admitted market back to the
E&S lines market. When soft market conditions are
prevalent, standard insurance carriers tend to loosen
underwriting standards and seek to expand market share by moving
into business lines traditionally characterized as E&S
lines.
Growth
and Size of the Market
The property and casualty insurance industry has historically
experienced market cycles in which pricing was more or less
competitive. However, because casualty claims emerge over time,
the industry does not
79
always recognize inadequate pricing until losses emerge and as a
result companies may have less capital to deploy. The 1990s was
a period of particularly intense price competition. As a result,
the industry suffered from inadequate premium levels, less
favorable policy terms and conditions and reduced profitability.
Significant industry losses began to emerge in 1998 and
continued throughout 1999. By 2000, price increases and tighter
contract terms were widespread as companies reacted to the
frequency and severity of claims emerging from earlier in the
decade and from asbestos and environmental exposures written
prior to 1987.
The trend toward higher pricing and narrower coverage
accelerated in 2001 as a result of the following factors:
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losses caused by the terrorist attacks of September 11,
2001, which resulted in one of the largest insured losses in
history, estimated at $30 billion to $40 billion by
A.M. Best;
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the low interest rate environment that forced property and
casualty companies to adopt more profitable underwriting
practices as investment returns decreased;
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the existence of substantial reserve deficiencies, resulting
from asbestos, environmental and directors and officers
liability related claims and from poor underwriting practices in
the late 1990s;
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substantial investment losses as a result of a decline in the
global equity markets and significant credit losses, with
Insurance Services Offices, which we refer to as ISO, estimating
that the U.S. property and casualty industry as a whole had
realized and unrealized losses from the end of 2000 through the
end of 2002 of $33 billion;
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the exit or insolvency of several large insurance market
participants, each of which either exited particular lines of
business or significantly reduced their activities;
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the ratings downgrades of a significant number of insurers and
reinsurers; and
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the general lack of capacity in certain specialty classes of
insurance.
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We believe that these trends have slowed and that the current
insurance market has become more competitive in terms of pricing
and policy terms and conditions. New competitors have entered
the E&S lines market, including several
start-up
companies and larger standard insurers.
While the standard P&C insurance market is significantly
larger than the E&S lines market in terms of total premiums
written, the E&S lines market has been one of the fastest
growing sectors of the P&C industry. According to
A.M. Best, over the
10-year
period from 1995 through 2005, the surplus lines market grew
from an estimated $9.2 billion in direct premiums written
to $33.3 billion, representing an increase of 262%. In
contrast, the U.S. property and casualty industry grew more
moderately from $273.9 billion in direct premiums written
to $488.7 billion over the same time period, representing
an increase of 78%. During this period, the surplus lines market
as a percentage of the total property and casualty industry grew
from approximately 3.4% to 6.8%.
Underwriting
Operations
Security
Classes
We underwrite and provide several classes of general liability
insurance for the security industry, including security guards
and detectives, alarm installation and service businesses, and
safety equipment installation and service businesses. In 2006,
$71.9 million of our premiums produced were within security
classes of specialty insurance, which represented 31.2% of our
total premiums produced for that year.
For security classes, we focus on underwriting for small
(premiums less than $10,000) and mid-sized (premiums from
$10,000 to $50,000) accounts. Approximately 57.9% of our
premiums produced in 2006 for security classes consisted of
premium sizes of $50,000 or below. In 2006, our average premium
size for security classes was $8,300. Pursuing these smaller
accounts helps us avoid competition from larger competitors. As
of December 31, 2006, we had approximately 8,600 policies
in force for security classes. The majority of these policies
have policy limits of $1.0 million per occurrence.
Although, we have reinsurance
80
arrangements in place that would allow us to selectively
underwrite policies with limits of up to $6.0 million per
occurrence, because of our current risk tolerance, less than 5%
of the policies we write for security classes have limits in
excess of $1.0 million. Our policy limits typically do not
include defense costs.
The table below indicates the percentage of our premiums
produced for security classes for our five largest states and
all other states in 2006.
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December 31, 2006
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Amount
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% of Total
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(Dollars in thousands)
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California
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$
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21,875
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30.4
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%
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Texas
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10,422
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14.5
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%
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New York
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6,742
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9.4
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%
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Florida
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4,497
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|
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6.3
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%
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Arizona
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2,454
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3.4
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%
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All other states
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25,892
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|
36.0
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%
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|
|
|
|
|
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Total
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$
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71,882
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100.0
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%
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Security Guards and
Detectives. Approximately 38.5% of our
premiums produced for security classes in 2006 consisted of
coverages for security guards and detectives. Coverages are
available for security guards, patrol agency personnel, armored
car units, private investigators and detectives.
Alarm Installation and Service
Businesses. Approximately 28.7% of our
premiums produced for security classes in 2006 were composed of
coverages for security alarm manufacturers and technicians.
Coverages are available for sales, service and installation of
residential and commercial alarm systems as well as alarm
monitoring.
Safety Equipment Installation and Service
Businesses. Approximately 32.8% of our
premiums produced for security classes in 2006 were composed of
coverages for fire suppression companies. Coverages are
available for sales, service and installation of fire
extinguishers and sprinkler and chemical systems, both on
residential and commercial systems.
Other
Specialty Classes
We have underwritten various other specialty classes of
insurance at different points throughout our history. We have
leveraged our core strengths used to build our business for
security classes, which include our nationally recognized CoverX
brand, our broad wholesale broker distribution through CoverX,
and our underwriting and claims expertise to expand our business
into other specialty classes. For example, we have leveraged our
experience in insuring the security risks of the contractors
that install safety and fire suppression equipment, which often
involves significant plumbing work and exposure, into the
underwriting of other classes of risks for plumbing contractors.
We provide general liability insurance for other specialty
classes consisting primarily of contractor classes of business,
including roofing contractors, plumbing contractors, electrical
contractors, energy contractors, and other artisan and service
contractors, legal professional liability, and, most recently,
hospitality and employer general liability coverage. Our senior
underwriters for the other specialty classes have extensive
industry experience and longstanding relationships with the
brokers and agents that produce the business.
Our underwriting policies and targets for other specialty
classes are similar to our policies and targets for security
classes. Our target account premium size is $50,000 and below.
Approximately 56.5% of our premiums produced in 2006 for other
specialty classes consisted of premium sizes of $50,000 or
below. In 2006, we wrote approximately 7,400 policies with an
average premium size of approximately $21,000. The majority of
our policies for other specialty classes have coverage limits of
$1.0 million, although we have the ability to selectively
underwrite policies with limits of $6.0 million per
occurrence. Less than 7% of our policies for other specialty
classes have limits in excess of $1.0 million. Our policy
limits typically do not include defense costs.
81
The table below indicates the percentage of premiums for other
specialty classes produced by CoverX for our five largest states
and all other states in 2006. Due to the historical regulatory
and legal environment, we choose to underwrite very little for
other specialty classes in California other than legal
professional liability; however, we believe that this
environment has improved, and California, as the largest
E&S lines market in the country, will be an opportunity for
expansion and growth.
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December 31, 2006
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Amount
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|
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% of Total
|
|
|
|
(Dollars in thousands)
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|
|
Texas
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|
$
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27,302
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|
|
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17.3
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%
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Washington
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|
|
22,991
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|
|
|
14.5
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%
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Arizona
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|
|
20,108
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|
|
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12.7
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%
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Florida
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|
|
16,150
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|
|
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10.2
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%
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New York
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13,277
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|
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8.4
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%
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All other states
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|
58,339
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36.9
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%
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|
|
|
|
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|
Total
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|
$
|
158,167
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|
|
|
100.0
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%
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Insurance
Services Operations
Our insurance services business provides underwriting, claims
and other insurance services to third parties, including
insurance carriers and customers. We generated
$10.9 million in fee income in 2006 from our insurance
services operations. These insurance services operations are
conducted through ARPCO and CoverX.
ARPCO has multi-year contracts with five public entity pools in
four states as well as an excess reinsurance risk-sharing pool
utilized by all of the public entity risk pools. Each pool is
composed of public entity members (such as cities, townships,
counties, etc.) that have joined together by means of an
intergovernmental contract to pool their insurance risk and
provide related insurance services to its members. The pooling
is authorized by state statute or as noted in the enabling
legislation. Pooling provides a risk sharing alternative to the
traditional purchase of commercial insurance. These governmental
risk-sharing pools are located in the Midwest. ARPCO provides
underwriting, claims, loss control, reinsurance placement and
other third party administration services to these pools. ARPCO
receives fees for providing or subcontracting the underwriting,
marketing, accounting, claims supervision, investing and
reinsurance services from the individual pools.
Distribution
All of the insurance policies that we write or assume are
distributed and underwritten through our subsidiary, CoverX. We
distribute our products through a nationwide network of licensed
E&S lines wholesalers as well as certain large retail
agencies with a specialty in the markets that we serve. In 2006,
we placed business with approximately 830 brokers and agents for
security classes of general liability insurance and 425 brokers
and agents for the other specialty classes.
CoverX is well known within the security industry due to its
long presence in the marketplace and, as a result, has developed
significant brand awareness. Because an individual brokers
relationship is with CoverX and not the insurance companies,
CoverX is able to change the insurance carrier providing the
underwriting capacity without significantly affecting its
revenue stream. We typically do not grant our agents and brokers
any underwriting or claims authority. We have entered into
contractual relationships with underwriters with respect to our
legal professional liability, employers general liability,
hospitality general liability, and New York habitational
classes. We select our agents and brokers based on industry
expertise, historical performance and business strategy.
Our longstanding presence in the security industry has enabled
us to write policies within security classes from a variety of
sources. We generate business from traditional E&S lines
insurance wholesalers and specialists that focus on security
guards and detectives, alarm installation and service
businesses, and safety
82
equipment installation and service businesses. In 2006, our top
five wholesale brokers represented 29.2% of our premiums
produced for security classes and no individual wholesale broker
accounted for more than 15% of our premiums produced.
We generate the majority of our business for other specialty
classes from traditional E&S lines insurance wholesalers.
The underwriters in our regional offices often have longstanding
relationships with local and regional wholesale brokers who
provide business to them. In addition, we have leveraged our
CoverX brand to facilitate the development of new relationships
with wholesalers in other specialty classes. In 2006, our top
five wholesale brokers represented 37.3% of our premiums
produced for other specialty classes and no wholesale broker
accounted for more than 17% of our premiums produced.
Our underwriting personnel regularly visit key agents and
brokers in order to review performance and to discuss our
insurance products. Additionally, we monitor the performance of
the policies produced by each broker and generally will
terminate the relationship with an agent or broker if the
policies he or she sells produce excessive losses. We typically
pay a flat commission rate of 15.0% of premium to our agents and
brokers, although commissions can range from below 12.0% to
17.5%. By distributing our products through CoverX rather than a
third party managing general agent, or MGA, we avoid the
additional commission payments of 10.0% or more that many
traditional E&S lines insurance carriers must pay to access
MGAs as a distribution source. Our name recognition in the
industry allows us to use this strategy without losing the
opportunity to generate business. We have not entered into any
contingent commission arrangements with agents or brokers.
Underwriting
Our underwriting is an intensive process using policy
applications, our proprietary information and industry data, as
well as inspections, credit reports and other validation
information. Our long-term success depends upon the efforts of
our underwriting department to appropriately understand and
underwrite risks and provide appropriate contract language to
manage those risks. All submissions are reviewed by a company
underwriter with expertise in the class of business being
reviewed. Our policy is to review each file individually to
determine whether coverage will be offered, and, if an offer is
made, to determine the appropriate price, terms, endorsements
and exclusions of coverage. We write most coverage as an
E&S lines carrier, which provides the flexibility to match
price and coverage for each individual risk. We generally do not
delegate underwriting authority outside of the Company; however
we have entered into contractual relationships with underwriters
with respect to our legal professional liability, employers
general liability, hospitality general liability and New York
habitational classes delegating such authority.
We use industry standard policy forms customized by endorsements
and exclusions that limit coverage to these risks underwritten
and acceptable to us. For example, most security policies have
exclusions
and/or
limitations for operations outside the normal duties identified
by an applicant. The use of firearms might be prohibited,
operations such as work in bars or nightclubs might be
prohibited, or the location of operations of the policyholder
may be restricted. All policies currently being written have
mold, asbestos, and silica exclusions. Many policies also
contain employment practices liability exclusions and
professional services exclusions.
We maintain proprietary loss cost information for security
classes. In order to price policies for other specialty classes,
we begin with the actuarial loss costs published by ISO. We make
adjustments to pricing based on our loss experience and our
knowledge of market conditions. We attempt to incorporate the
unique exposures presented by each individual risk in order to
price each coverage appropriately. Through our monitoring of our
underwriting results, we seek to adjust prices in order to
achieve a sufficient rate of return on each risk we underwrite.
We have more latitude in adjusting our rates as an E&S
lines insurance carrier than a standard admitted carrier. Since
we typically provide coverage for risks that standard carriers
have refused to cover, the demand for our products tends to be
less price sensitive than standard carriers.
An extensive information reporting process is in place for
management to review all appropriate near term and longer term
underwriting results. We do not have production volume
requirements for our
83
underwriters. Incentive compensation is based on multiple
measures representing quality and profitability of the results.
As of December 31, 2006, we had 14 underwriters that
underwrite for security classes out of our headquarters in
Southfield, Michigan. Our strategy is to receive a submission
for as many risks for the security classes that we target as
possible and generate a high quote and bind rate. In 2006, we
received over 15,000 policy submissions within security classes,
we quoted over 11,000 of those submissions, and bound over 8,600
policies.
As of December 31, 2006, we had 12 underwriters that
underwrite for other specialty classes out of our five regional
underwriting offices. Because other specialty classes encompass
a broader range of classes compared to security classes, we tend
to receive submissions outside of our targeted other specialty
classes and are more selective in deciding which submissions to
quote. In 2006, we received over 34,000 policy submissions
within other specialty classes and bound approximately 7,400
policies.
In our insurance services business operated by ARPCO, we have
three employees who provide underwriting or underwriting review
services for the public entity pools that we manage.
Claims
Our claims department consists of 24 people supporting our
underwriting operations and 17 people supporting our
insurance services operations. Since 1985, substantially all of
our claims, including the claims for the years when fronting
companies were utilized, have been handled by our claims
department.
Our claims policy is to investigate all potential claims and
promptly evaluate claims exposure, which permits us to establish
claims reserves early in the claims process. Reserves are set at
an estimate of full settlement value at all times. We attempt to
negotiate all claims to the earliest appropriate resolution.
Our claims department has established authorization levels for
each claims professional, based on experience, capability and
knowledge of the issues. Claims files are regularly reviewed by
management and higher exposure cases are reviewed by a broader
round-table group, which may include underwriting
representatives
and/or
senior management, where appropriate. We have substantial legal
opinions, legal interpretation, and case experience to guide us
in the development of appropriate policy language. The claims
and underwriting departments frequently meet to discuss emerging
trends or specific case experiences to guide those efforts. A
management information and measurement process is in place to
measure results and trends of the claims department. All claims
operations use imaging technology to produce a paperless
environment with all notes, communications and correspondence
being a part of our files. Claims adjusters have complete access
to the imaged underwriting files, including all policy history,
to enable them to better understand coverage issues, underwriter
intention, and all other documentation.
For the security guard and detective portion of security
classes, we typically receive claims related to negligence,
incompetence or improper action by a security guard or
detective. Alarm claims for security classes include
installation errors by alarm technicians or alarm malfunctions.
Claims related to safety equipment installation and service
business are similar to those of the alarm program. We insure
that the insureds safety or fire suppression systems
operate as represented by the insured.
The nature of claims on policies for other specialty classes are
similar to those of security classes because the general
liability coverage is essentially the same. Instead of receiving
claims relating to the actions of a security guard or detective,
however, the claims relate to the negligence or improper action
of a contractor, manufacturer, or owners, landlords and tenants
or to the failure of a contractors completed
operations or a manufacturers product to function
properly.
There were approximately 2,500 new claims reported to us during
2006, and we had a total of 2,000 pending claims as of
December 31, 2006.
The claims professionals supporting our insurance services
operations provide services through ARPCO. For each of the pools
which ARPCO administers, ARPCO provides oversight and claims
management services
84
over the third party administrators providing claims adjusting
services for the individual pools, and in some cases ARPCO also
directly provides claims adjusting services. ARPCO receives fees
for these services.
Reinsurance
We enter into reinsurance contracts to diversify our risks and
limit our maximum loss arising from large or unusually hazardous
risks or catastrophic events and so that, given our capital
constraints, we can provide the aggregate limits that our
clients require. Additionally, we use reinsurance to limit the
amount of capital necessary to support our operations and to
facilitate growth. Reinsurance involves a primary insurance
company transferring, or ceding, a portion of its
premium and losses in order to control its exposure. The ceding
of liability to a reinsurer does not relieve the obligation of
the primary insurer to the policyholder. The primary insurer
remains liable for the entire loss if the reinsurer fails to
meet its obligations under the reinsurance agreement.
Our treaty reinsurance is contracted under both quota share and
excess of loss reinsurance contracts. We have historically
adjusted our level of quota share reinsurance based on our
premiums produced and our level of capitalization, as well as
our risk appetite for a particular type of business. During
2006, we maintained a 50% quota share on all of our business
other than our legal professional liability class, for which we
maintain a variable 70% to 85% quota share, and our umbrella
policies, for which we maintain a 90% quota share. On
December 31, 2006 we elected the cut-off termination option
available to us on the expiration of our 50% quota share
contracts expiring that day in accordance with the termination
provision of the quota share contracts. As a result, we
effectively eliminated the 50% quota share reinsurance on the
December 31, 2006 unearned premiums that had been ceded 50%
during 2006 up until contract expiration. Effective
January 1, 2007, we purchased 35% quota share reinsurance
to replace the expiring 50% quota share reinsurance for policies
issued with effective dates beginning January 1, 2007. As a
result of the cut-off termination of the 2006 50% quota share
treaties on December 31, 2006 and the January 1, 2007
purchase of the 35% quota share reinsurance, our net earned
premium retention increased in 2007. Our excess of loss
reinsurance is used to limit our maximum exposure per claim
occurrence. We maintained a $500,000 excess of $500,000 per
occurrence coverage through December 31, 2006, and we have
purchased $500,000 excess of $500,000 per occurrence
coverage for 2007. On April 1, 2007, we extended the 90%
quota share reinsurance applicable to umbrella policies through
March 31, 2008. On May 1, 2007, we amended our 35%
quota share reinsurance treaties to include the legal
professional liability class.
In addition to our treaty reinsurance, we also may occasionally
purchase facultative reinsurance, which is obtained on a
case-by-case
basis for all or part of the insurance provided by a single
risk, exposure, or policy. We also currently assume reinsurance
from fronting carriers on a small portion of our business and
have historically assumed a significant portion of our business
from various fronting carriers. See Managements
discussion and analysis of financial condition and results of
operations Overview for a complete discussion
of our historic fronting arrangements.
For a more detailed discussion of our reinsurance structure over
time, see Managements discussion and analysis of
financial condition and results of operations
Reinsurance and Risk factors Risks
relating to our business.
The following is a summary of our significant treaty ceded
reinsurance programs:
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|
|
Policy Type
|
|
Company Policy Limit
|
|
Reinsurance Coverage
|
|
Company Retention
|
|
Primary Security and Specialty
General Liability
|
|
Up to $1.0 million per
occurrence
|
|
$500,000 excess of
$500,000 per occurrence
|
|
Up to $325,000 per occurrence
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|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
35% on $500,000
per occurrence
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Umbrella Security and Specialty
General Liability
|
|
Up to $5.0 million excess of
$1.0 million per occurrence
|
|
90% quota share up to
$5.0 million per occurrence
|
|
Up to $500,000 per occurrence
|
85
Technology
We believe that advanced information processing is important in
order for us to maintain our competitive position. We have
developed an extensive data warehouse of underwriting and claims
data for security classes and have implemented advanced
management information systems to run substantially all of our
principal data processing and financial reporting software
applications. We use the Phoenix system by Allenbrook for policy
administration and claims systems. We are also implementing
imaging and workflow systems to eliminate the need for paper
files and reduce processing errors. Our operating systems allow
all of our offices to access files at the same time while
discussing underwriting policies regarding certain accounts.
Competition
The property and casualty insurance industry is highly
competitive. We compete with domestic and international
insurers, many of which have greater financial, marketing and
management resources and experience than we do and many of which
have both admitted and E&S lines insurance affiliates and,
therefore, may be able to offer a greater range of products and
services than we can. We also may compete with new market
entrants in the future as the E&S lines market has low
barriers to entry. Competition is based on many factors,
including the perceived market and financial strength of the
insurer, pricing and other terms and conditions, services, the
speed of claims payment, the reputation and experience of the
insurer and ratings assigned by independent rating organizations
such as A.M. Best.
Our primary competitors with respect to security classes are
managing general agents, or MGAs, supported by various insurance
or reinsurance partners. These MGAs include All Risks, Ltd.,
Brownyard Programs, Ltd., Mechanics Group and RelMark Program
Managers. These MGAs provide services similar to CoverX, and
they typically do not retain any insurance risk on the business
they produce. These MGAs also typically do not handle the claims
on the business they produce, as claims handling is retained by
the company assuming the insurance risk or outsourced to third
party administrators. We also face competition from U.S. and
non-U.S. insurers,
including American International Group, Inc. (Lexington
Insurance Company) in the security guard segment, The Hartford
Financial Services Group, Inc. in the alarm segment, and ACE
Limited in the safety segment.
Our primary competitors with respect to other specialty classes
tend to be E&S lines insurance carriers. Competitors vary
by region and market, but include W.R. Berkley Corp. (Admiral
Insurance Company), Argonaut Group (Colony Insurance Company),
RLI Corp, American International Group, Inc. (Lexington
Insurance Company) and International Financial Group, Inc.
(Burlington Insurance Co.).
Competition in the E&S lines market tends to focus less on
price and more on availability and quality of service. The
E&S lines market is significantly affected by the
conditions of the insurance market in general. During times of
hard market conditions (i.e., those favorable to insurers), as
rates increase and coverage terms become more restrictive,
business tends to move from the admitted market back to the
E&S lines market. When soft market conditions are
prevalent, standard insurance carriers tend to loosen
underwriting standards and seek to expand market share by moving
into business lines traditionally characterized as E&S
lines.
Ratings
Many insurance buyers, agents and brokers use the ratings
assigned by A.M. Best and other rating agencies to assist
them in assessing the financial strength and overall quality of
the companies from which they are considering purchasing
insurance. First Mercury Insurance Company, which we refer to as
FMIC, was assigned a letter rating of A− by
A.M. Best following the completion of the investment by
Glencoe Capital, LLC in June 2004 and maintained such rating
after the issuance of the debt in August 2005. An
A− rating is the fourth highest of 15 rating
categories used by A.M. Best and is the lowest rating
necessary to compete in our targeted markets. A.M. Best
assigns each insurance company a Financial Size Category, or
FSC. The FSC is designed to provide a convenient indicator of
the size of a company in terms of its statutory surplus and
related accounts. There are 15 categories with FSC I being the
smallest and FSC XV being the largest. As of March 31,
2007, A.M. Best has assigned FMIC an FSC VIII based on
Adjusted Policyholders Surplus between $100.0 million and
$250.0 million. Effective January 1, 2007, FMIC and
ANIC entered into an
86
intercompany pooling reinsurance agreement wherein all premiums,
losses and expenses of FMIC and ANIC are combined and
apportioned between FMIC and ANIC in accordance with fixed
percentages. On May 4, 2007, A.M. Best assigned the
financial strength rating A− to the First
Mercury Group pool and its members, FMIC and ANIC. ANICs
A.M. Best rating was upgraded to A− as a
result. In evaluating a companys financial and operating
performance, A.M. Best reviews the companys
profitability, indebtedness and liquidity, as well as its book
of business, the adequacy and soundness of its reinsurance, the
quality and estimated market value of its assets, the adequacy
of its unpaid loss and loss adjustment expense, the adequacy of
its surplus, its capital structure, the experience and
competence of its management and its market presence. This
rating is intended to provide an independent opinion of an
insurers financial strength and its ability to meet
ongoing obligations to policyholders and is not directed toward
the protection of investors. Ratings by rating agencies of
insurance companies are not ratings of securities or
recommendations to buy, hold or sell any security. See
Risk factors Risks relating to our
business Any downgrade in the A.M. Best rating
of FMIC would prevent us from successfully engaging in direct
insurance writing or obtaining adequate reinsurance on
competitive terms, which would lead to a decrease in revenue and
net income.
Properties
Our executive offices are located in Southfield, Michigan in
approximately 14,000 square feet of office space leased by
CoverX. CoverX also leases office space in California, Florida,
Illinois, Massachusetts and Texas. Additionally, FMIC owns a
building in Southfield, Michigan with approximately
25,000 square feet. We believe our current space is
adequate for our current operations.
Employees
As of March 31, 2007, we had 156 full-time employees
and 6 part-time employees. Our employees have no union
affiliations and we believe our relationship with our employees
is good. We have employment agreements with certain of our
executive officers, which are described under
Management Employment and related
agreements.
Legal
Proceedings
We are, from time to time, involved in various legal proceedings
in the ordinary course of business, including litigation
involving claims with respect to policies that we write. We do
not believe that the resolution of any currently pending legal
proceedings, either individually or taken as a whole, will have
a material adverse effect on our business, results of operations
or financial condition.
87
INSURANCE
AND OTHER REGULATORY MATTERS
Insurance
Regulation
Our insurance subsidiaries are subject to regulation under the
insurance statutes of various jurisdictions, including Illinois,
the domiciliary state of FMIC, and Minnesota, the domiciliary
state of ANIC. In addition, we are subject to regulation by the
state insurance regulators of other states and foreign
jurisdictions in which we or our operating subsidiaries do
business. State insurance regulations generally are designed to
protect the interests of policyholders, consumers or claimants
rather than stockholders, noteholders or other investors. The
nature and extent of state regulation varies by jurisdiction,
and state insurance regulators generally have broad
administrative power relating to, among other matters, setting
capital and surplus requirements, licensing of insurers and
agents, establishing standards for reserve adequacy, prescribing
statutory accounting methods and the form and content of
statutory financial reports, regulating certain transactions
with affiliates and prescribing the types and amounts of
investments.
In recent years, the state insurance regulatory framework has
come under increased federal scrutiny, and some state
legislatures have considered or enacted laws that alter and, in
many cases, increase state authority to regulate insurance
companies. Although the federal government is not the primary
direct regulator of the insurance business, federal initiatives
often affect the insurance industry and possible increased
regulation of insurance by the federal government continues to
be discussed by lawmakers.
In addition to state imposed insurance laws and regulations, our
insurance subsidiaries are subject to the statutory accounting
practices and reporting formats established by the National
Association of Insurance Commissioners, or NAIC. The NAIC also
promulgates model insurance laws and regulations relating to the
financial and operational regulation of insurance companies.
These model laws and regulations generally are not directly
applicable to an insurance company unless and until they are
adopted by applicable state legislatures or departments of
insurance. All states have adopted the NAICs financial
reporting form, which is typically referred to as the NAIC
annual statement, and all states generally follow
the codified statutory accounting practices promulgated by the
NAIC. In this regard, the NAIC has a substantial degree of
practical influence and is able to accomplish certain
quasi-legislative initiatives through amendments to the NAIC
annual statement and applicable accounting practices and
procedures.
Insurance companies also are affected by a variety of state and
federal legislative and regulatory measures and judicial
decisions that define and qualify the risks and benefits for
which insurance is sought and provided. These include redefining
risk exposure in such areas as product liability, environmental
damage and workers compensation. In addition, individual
state insurance departments may prevent premium rates for some
classes of insureds from adequately reflecting the level of risk
assumed by the insurer for those classes. Such developments may
result in adverse effects on the profitability of various lines
of insurance. In some cases, these adverse effects on
profitability can be minimized, when possible, through the
repricing of coverages to the extent permitted by applicable
regulations, or the limitation or cessation of the affected
business, which may be restricted by state law.
Required
Licensing
FMIC operates on a non-admitted or surplus lines basis and is
authorized in 51 states and jurisdictions. While FMIC does
not have to apply for and maintain a license in those states, it
is subject to meeting and maintaining eligibility standards or
approval under each particular states surplus lines laws
in order to be an eligible surplus line carrier. FMIC maintains
surplus line approvals or eligibility in all states in which it
operates and therefore FMIC is not subject to the rate and form
filing requirements applicable to licensed or
admitted insurers.
Surplus lines insurance must be written through agents and
brokers who are licensed as surplus lines brokers. The broker or
their retail insurance agents generally are required to certify
that a certain number of licensed admitted insurers had been
offered and declined to write a particular risk prior to placing
that risk with us.
88
ANIC is licensed and can operate on an admitted basis in its
home state of Minnesota and in 14 other states. Insurers
operating on an admitted basis must file premium rate schedules
and policy forms for review and, in some states, approval by the
insurance regulators in each state in which they do business on
an admitted basis. Admitted carriers also are subject to other
market conduct regulation and examinations in the states in
which they are licensed. Insurance regulators have broad
discretion in judging whether an admitted insurers rates
are adequate, not excessive and not unfairly discriminatory.
Insurance
Holding Company Regulation
Our insurance subsidiaries operate as part of an insurance
holding company system and are subject to holding company
regulation in the jurisdictions in which they are licensed.
These regulations require that each insurance company that is
part of a holding company system register with the insurance
department of its state of domicile and furnish information
concerning contracts, transactions, and relationships between
those insurance companies and companies within the holding
company system. Transactions between insurance subsidiaries and
their parents and affiliates generally must be disclosed to the
state regulators, and prior approval or nondisapproval of the
applicable state insurance regulator generally is required for
any material or other specified transactions. The insurance laws
similarly provide that all transactions and agreements between
an insurance company and members of a holding company system
must be fair and reasonable. FMIC and ANIC are parties to
various agreements, including underwriting agreements, a
management service agreement, and a tax sharing agreement with
members of the holding company system and are parties to
reinsurance agreements with each other, all of which are subject
to regulation under state insurance holding company acts.
In addition, a change of control of an insurer or of any
controlling person requires the prior approval of the domestic
state insurance regulator. Generally, any person who acquires
10% or more of the outstanding voting securities of the insurer
or its parent company is presumed to have acquired control of
the insurer. A person seeking to acquire control, directly or
indirectly, of an insurance company or of any person controlling
an insurance company generally must file with the domestic
insurance regulatory authority a statement relating to the
acquisition of control containing certain information about the
acquiring party and the transaction required by statute and
published regulations and provide a copy of such statement to
the insurer and obtain the prior approval of such regulatory
agency for the acquisition.
Quarterly
and Annual Financial Reporting
Our insurance subsidiaries are required to file quarterly and
annual financial reports with state insurance regulators
utilizing statutory accounting practices (SAP)
rather than accounting principles generally accepted in the
United States of America (GAAP). In keeping with the
intent to assure policyholder protection, SAP emphasize solvency
considerations. See Note 16 to our consolidated financial
statements incorporated by reference in this prospectus for
further information.
Periodic
Financial and Market Conduct Examinations
The insurance departments of our insurance subsidiaries
states of domicile may conduct
on-site
visits and examinations of the affairs of our insurance
subsidiaries, including their financial condition and their
relationships and transactions with affiliates, typically every
three to five years, and may conduct special or target
examinations to address particular concerns or issues at any
time. Insurance regulators of other states in which we do
business also may conduct examinations. The results of these
examinations can give rise to regulatory orders requiring
remedial, injunctive or other corrective action. Insurance
regulatory authorities have broad administrative powers to
regulate trade practices and to restrict or rescind licenses or
other authorizations to transact business and to levy fines and
monetary penalties against insurers, insurance agents and
brokers found to be in violation of applicable laws and
regulations. During the past five years, the insurance
subsidiaries have had periodic financial reviews and have not
been the subject of market conduct or other investigations or
been required to pay any material fines or penalties.
89
Risk-based
Capital
Risk-based capital, or RBC, requirements laws are designed to
assess the minimum amount of capital that an insurance company
needs to support its overall business operations and to ensure
that it has an acceptably low expectation of becoming
financially impaired. Regulators use RBC to set capital
requirements considering the size and degree of risk taken by
the insurer and taking into account various risk factors
including asset risk, credit risk, underwriting risk and
interest rate risk. As the ratio of an insurers total
adjusted capital and surplus decreases relative to its
risk-based capital, the RBC laws provide for increasing levels
of regulatory intervention culminating with mandatory control of
the operations of the insurer by the domiciliary insurance
department at the so-called mandatory control level. At
December 31, 2006, our insurance subsidiaries maintained
RBC levels in excess of amounts that would require any
corrective actions on our part.
IRIS
Ratios
The NAIC Insurance Regulatory Information System, or IRIS, is
part of a collection of analytical tools designed to provide
state insurance regulators with an integrated approach to
screening and analyzing the financial condition of insurance
companies operating in their respective states. IRIS is intended
to assist state insurance regulators in targeting resources to
those insurers in greatest need of regulatory attention. IRIS
consists of two phases: statistical and analytical. In the
statistical phase, the NAIC database generates key financial
ratio results based on financial information obtained from
insurers annual statutory statements. The analytical phase
is a review of the annual statements, financial ratios and other
automated solvency tools. The primary goal of the analytical
phase is to identify companies that appear to require immediate
regulatory attention. A ratio result falling outside the usual
range of IRIS ratios is not considered a failing result; rather,
unusual values are viewed as part of the regulatory early
monitoring system. Furthermore, in some years, it may not be
unusual for financially sound companies to have several ratios
with results outside the usual ranges. An insurance company may
fall out of the usual range for one or more ratios because of
specific transactions that are in themselves immaterial. As of
December 31, 2006, FMIC had IRIS ratios outside the usual
range in three of the thirteen IRIS tests. The three ratios
outside the usual range related to net written premiums,
policyholders surplus and loss reserve development. As of
December 31, 2006, ANIC had IRIS ratios outside the usual
range in one of the IRIS tests relating to adjusted
policyholders surplus. An insurance company may become the
subject of increased scrutiny when four or more of its IRIS
ratios fall outside the range deemed usual by the NAIC. The
nature of increased regulatory scrutiny resulting from IRIS
ratios that are outside the usual range is subject to the
judgment of the applicable state insurance department, but
generally will result in accelerated review of annual and
quarterly filings. Depending on the nature and severity of the
underlying cause of the IRIS ratios being outside the usual
range, increased regulatory scrutiny could range from increased
but informal regulatory oversight to placing a company under
regulatory control.
As of December 31, 2006, FMIC had IRIS ratios outside of
the usual range, as set forth in the following table:
|
|
|
|
|
|
|
|
|
Ratio
|
|
Usual Range
|
|
|
Actual Results
|
|
|
Change in net written premiums
|
|
|
−33% to 33%
|
|
|
|
38
|
%
|
Gross change in
policyholders surplus
|
|
|
−10% to 50%
|
|
|
|
66
|
%
|
Two-year reserve development to
policyholders surplus
|
|
|
< 20%
|
|
|
|
35
|
%
|
The change in net written premiums and the gross change in
policyholders surplus correlate favorably since surplus
growth was higher than premium growth, indicating reduced
premium to surplus leverage. FMICs net written premiums
increased 38% in 2006, which is higher than the usual change in
net written premiums by 5 percentage points. The change in
net written premiums was primarily the result of the
$26.0 million capital contribution made to FMIC in June
2004 and the $40.0 million in capital contributions in the
fourth quarter of 2006 which permitted FMIC to write and retain
more premium. FMIC has experienced growth in statutory surplus
above the usual range in 2006 due to growth in surplus from
operating results of $11.0 million, and due to the
aforementioned $40.0 million capital contribution from FMFC
during the fourth quarter of 2006.
90
The unusual range result with respect to the two-year reserve
development to policyholders surplus is due to changes in
reserves made during 2005 with respect to adverse development
for accident years 2000 to 2002 in the security industry classes
assumed during 1999 to 2001. See Managements
Discussion and Analysis and Results of Operations
Loss and Loss Adjustment Expense Reserves.
As of December 31, 2006, ANIC had one IRIS ratio outside of
the usual range, as set forth in the following table:
|
|
|
|
|
|
|
|
|
Ratio
|
|
Usual Range
|
|
|
Actual Results
|
|
|
Net change in adjusted
policyholders surplus
|
|
|
−10% to 25%
|
|
|
|
25
|
%
|
ANIC has experienced growth in surplus from operating results
during 2006 of $3.0 million.
Restrictions
on Paying Dividends
We are a holding company with no business operations of our own.
Consequently, our ability to pay dividends to stockholders and
meet our debt payment obligations is dependent on dividends and
other distributions from our subsidiaries. State insurance laws
restrict the ability of our insurance company subsidiaries to
declare stockholder dividends. State insurance regulators
require insurance companies to maintain specified levels of
statutory capital and surplus. Generally, dividends may be paid
only out of earned surplus, and the amount of an insurers
surplus following payment of any dividends must be reasonable in
relation to the insurers outstanding liabilities and
adequate to meet its financial needs. Further, prior approval
from the insurance departments of our insurance
subsidiaries states of domicile generally is required in
order for our insurance subsidiaries to declare and pay
extraordinary dividends to us. For FMIC, Illinois
defines an extraordinary dividend as any dividend or
distribution that, together with other distributions made within
the preceding 12 months, exceeds the greater of 10% of
FMICs surplus as of the preceding December 31, or
FMICs net income for the 12 month period ending the
preceding December 31, in each case determined in
accordance with statutory accounting principles. FMIC must give
the Illinois insurance regulator written notice of every
dividend or distribution, whether or not extraordinary, within
the time periods specified under applicable law. With respect to
ANIC, Minnesota imposes a similar restriction on extraordinary
dividends and requires a similar notice of all dividends after
declaration and before paid. For ANIC, Minnesota defines an
extraordinary dividend as any dividend or distribution that,
together with other distributions made within the preceding
12 months, exceeds the greater of 10% of the insurers
surplus as of the preceding December 31, or ANICs net
income, not including realized capital gains, for the
12 month period ending the preceding December 31, in
each case determined in accordance with statutory accounting
principles. Based on the policyholders surplus and the net
income of our insurance subsidiaries as of December 31,
2006, FMIC and ANIC may pay dividends in 2007, if declared, of
up to $15.7 million without regulatory approval. In 2006
and 2005, our insurance subsidiaries would have been permitted
to pay up to $9.7 million and $8.9 million,
respectively, in ordinary dividends without the prior regulatory
approval. State insurance regulatory authorities that have
jurisdiction over the payment of dividends by our insurance
subsidiaries may in the future adopt statutory provisions more
restrictive than those currently in effect. No dividends were
paid by either FMIC or ANIC during the year ended
December 31, 2006.
Investment
Regulation
Our insurance subsidiaries are subject to state laws which
require diversification of their investment portfolios and
impose limits on the amount of their investments in certain
categories. Failure to comply with these laws and regulations
would cause non-conforming investments to be treated as
non-admitted assets in the states in which they are licensed to
sell insurance policies for purposes of measuring statutory
surplus and, in some instances, would require them to sell those
investments. At December 31, 2006, we had no investments
that would be treated as non-admitted assets.
Guaranty
Funds
Under state insurance guaranty fund laws, insurers doing
business on an admitted basis in a state can be assessed for
certain obligations of insolvent insurance companies to
policyholders and claimants. The
91
maximum guaranty fund assessments in any one year typically is
between 1.0% to 2.0% of a companys net direct written
premium written in the state for the preceding calendar year on
the types of insurance covered by the fund. In most states,
guaranty fund assessments can be recouped at least in part
through future premium increases or offsets to state premium tax
liability. In most states, FMIC is not subject to state guaranty
fund assessments because of its status as a surplus lines
insurer.
Licensing
of Agents, Brokers and Adjusters
CoverX is licensed as a resident producer and surplus lines
broker in the State of Michigan and as a non resident
producer/agency
and/or
surplus lines broker in other states. CoverX and our insurance
subsidiaries have obligations to ensure that they pay
commissions to only properly licensed insurance
producers/brokers.
In certain states in which we operate, insurance claims
adjusters also are required to be licensed and in some states
must fulfill annual continuing education requirements.
Privacy
Regulations
In 1999, the United States Congress enacted the Gramm Leach
Bliley Act, which, among other things, protects consumers from
the unauthorized dissemination of certain personal information
by financial institutions. Subsequently, all states have
implemented similar or additional regulations to address privacy
issues that are applicable to the insurance industry. These
regulations limit disclosure by insurance companies and
insurance producers of nonpublic personal
information about individuals who obtain insurance or
other financial products or services for personal, family, or
household purposes. The Gramm Leach Bliley Act and the
regulations generally apply to disclosures to nonaffiliated
third parties, subject to specified exceptions, but not to
disclosures to affiliates. The federal Fair Credit Reporting Act
imposes similar limitations on the disclosure and use of certain
types of consumer information among affiliates.
State privacy laws also require ANIC to maintain appropriate
procedures for managing and protecting certain personal
information of its applicable customers and to disclose to them
its privacy practices. In 2002, to further facilitate the
implementation of the Gramm Leach Bliley Act, the NAIC adopted
the Standards for Safeguarding Customer Information Model
Regulation. A majority of states have adopted similar provisions
regarding the safeguarding of nonpublic personal information.
ANIC has adopted a privacy policy for safeguarding nonpublic
personal information, and ANIC follows procedures pertaining to
applicable customers to comply with the Gramm Leach Bliley
Acts related privacy requirements. We may also be subject
to future privacy laws and regulations, which could impose
additional costs and impact our results of operations or
financial condition.
Trade
Practices
The manner in which insurance companies and insurance agents and
brokers conduct the business of insurance is regulated by state
statutes in an effort to prohibit practices that constitute
unfair methods of competition or unfair or deceptive acts or
practices. Prohibited practices include, but are not limited to,
disseminating false information or advertising, unfair
discrimination, rebating and false statements.
Unfair
Claims Practices
Generally, insurance companies, adjusting companies and
individual claims adjusters are prohibited by state statutes
from engaging in unfair claims practices on a willful basis or
with such frequency to indicate a general business practice.
Unfair claims practices include, but are not limited to,
misrepresenting pertinent facts or insurance policy provisions;
failing to acknowledge and act reasonably promptly upon
communications with respect to claims arising under insurance
policies; and attempting to settle a claim for less than the
amount to which a reasonable person would have believed such
person was entitled.
92
Investigation
of Broker Compensation Practices
The recent investigations and legal actions brought by the New
York State Attorney General and other attorneys general and
state insurance departments relating to broker compensation
practices, as well as other measures (such as proposed
legislation) that have been taken to address some of the
practices at issue in those investigations and actions, may
result in potentially far-reaching changes in industry broker
compensation practices. These investigations are continuing, and
market practices are still evolving in response to these
developments. We cannot predict what practices the market will
ultimately adopt or how these changes will affect our
competitive standing with brokers and agents or our commission
rates.
Restrictions
on Cancellation, Non-renewal or Withdrawal
Many states have laws and regulations that limit the ability of
an insurance company licensed by that state to exit a market.
Some states prohibit an insurer from withdrawing from one or
more lines of business in the state, except pursuant to a plan
approved by the state insurance regulator. Regulators may
disapprove a plan that may lead to market disruption. Some state
statutes explicitly, or by interpretation, apply these
restrictions to insurers operating on a surplus line basis.
Terrorism
Exclusion Regulatory Activity
The Terrorism Risk Insurance Act of 2002, as extended and
amended by the Terrorism Risk Insurance Extension Act of 2005,
or TRIA, provides insurers with federally funded reinsurance for
acts of terrorism. TRIA also requires insurers to
make coverage for acts of terrorism available in
certain commercial property/casualty insurance policies and to
comply with various other provisions of TRIA. For applicable
policies in force on or after November 26, 2002, we are
required to provide coverage for losses arising from acts of
terrorism as defined by TRIA on terms and in amounts which may
not differ materially from other policy coverages. To be covered
under TRIA, aggregate industry losses from a terrorist act must
exceed $50.0 million in 2006 and $100.0 million in
2007, the act must be perpetrated within the U.S. or in
certain instances outside of the U.S. on behalf of a
foreign person or interest and the U.S. Secretary of the
Treasury must certify that the act is covered under the program.
We generally offer coverage only for those acts covered under
TRIA. As of December 31, 2006, we estimate that less than
4% of our policyholders in our E&S lines markets had
purchased TRIA coverage.
The federal reinsurance assistance under TRIA is scheduled to
expire on December 31, 2007 unless Congress decides to
further extend it. We cannot predict whether or when another
extension may be enacted or what the final terms of such
legislation would be.
While the provisions of TRIA and the purchase of terrorism
coverage described above mitigate our exposure in the event of a
large scale terrorist attack, our effective deductible is
significant. Generally, we exclude acts of terrorism outside of
the TRIA coverage, such as domestic terrorist acts. Regardless
of TRIA, some state insurance regulators do not permit terrorism
exclusions for various coverages or causes of loss.
OFAC
The Treasury Departments Office of Foreign Asset Control,
or OFAC, maintains various economic sanctions regulations
against certain foreign countries and groups and prohibits
U.S. Persons from engaging in certain
transactions with certain persons or entities in or associated
with those countries or groups. One key element of these
sanctions regulations is a list maintained by the OFAC of
Specifically Designated Nationals and Blocked
Persons, or the SDN List. The SDN List identifies persons
and entities that the government believes are associated with
terrorists, rogue nations and /or drug traffickers.
OFACs regulations, among other things, prohibit insurers
and others from doing business with persons or entities on the
SDN List. If the insurer finds and confirms a match, the insurer
must take steps to block or reject the transaction, notify the
affected person and file a report with OFAC. The focus on
insurers responsibilities with respect to the sanctions
regulations compliance has increased significantly since the
terrorist attacks of September 11, 2001.
93
Federal
Regulation of Insurance
While the business of insurance traditionally has been subject
to regulation by the states, there continue to be discussions
among lawmakers and members of the insurance industry over the
possible expanded role of the federal government in regulating
the insurance industry. There have been recent calls by insurer
and broker trade associations for optional federal chartering of
insurance companies, similar to the federal chartering of banks
in the United States. In October 2006, the U.S. House of
Representatives approved the Nonadmitted and Reinsurance Reform
Act, which would greatly reduce the overlap in state regulation
of surplus lines transactions and reinsurer financial oversight.
The measure was not brought up for consideration in the Senate;
however, similar legislation has been introduced in both the
House and the Senate in 2007. We cannot predict whether or not
these or similar federal regulatory schemes will be enacted or,
if enacted, what effect they may have on our insurance
subsidiaries.
94
MANAGEMENT
The following persons are our directors, executive officers and
other key members of management as of the date of this
prospectus:
|
|
|
|
|
|
|
Name
|
|
Age
|
|
Position
|
|
Richard H. Smith*
|
|
|
56
|
|
|
Chairman, President, CEO and
Director
|
John A. Marazza*
|
|
|
47
|
|
|
Executive Vice President, Chief
Financial Officer, Treasurer and Corporate Secretary
|
Jeffrey R. Wawok*
|
|
|
30
|
|
|
Executive Vice President
|
John Brockschmidt
|
|
|
51
|
|
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Senior Vice President
ARPCO
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John C. Bures
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42
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Vice President
Security Underwriting
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Thomas B. Dulapa
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46
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Senior Vice President
Operations
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William A. Kindorf
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29
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Vice President
Corporate Development
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Joseph D. Knox
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60
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Chief Claims Officer
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Edward A. LaFramboise
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27
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Vice President Finance
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Marcia M. Paulsen
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52
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Vice President
Administration
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Jerome M. Shaw
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63
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Chairman Emeritus and Director
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James M. Thomas
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60
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Senior Vice President
Product Management
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William S. Weaver
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64
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Senior Vice President
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Thomas Kearney
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50
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Director
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Louis J. Manetti
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51
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Director
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Hollis W. Rademacher
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72
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Director
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Steven A. Shapiro
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42
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Director
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William C. Tyler
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64
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Director
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* |
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Executive officer as defined by SEC regulations |
Richard H. Smith, Chairman, President, Chief Executive
Officer and Director. Mr. Smith has
served as our President and Chief Executive Officer since 2005.
Mr. Smith became our Chairman, President and Chief
Executive Officer in November 2006. He joined the Company as its
President and Chief Operating Officer in 1996. Mr. Smith
began his insurance career with Providian Corporation in 1975
and held various financial positions before becoming Chief
Financial Officer of Providian Direct Insurance in 1989 and
President and Chief Operating Officer of Providian Direct Auto
Insurance in 1993. Mr. Smith has served as a member of our
Board of Directors since 1996.
John A. Marazza, Executive Vice President, Chief Financial
Officer, Treasurer and Corporate
Secretary. Mr. Marazza has served as our
Executive Vice President, Chief Financial Officer, Treasurer and
Corporate Secretary since July 2006. From 2003 to 2005, he
served as the Chief Operating Officer and Secretary of
ProCentury Corporation, formerly known as ProFinance Holdings
Corporation. From 2000 to 2003, he was the Executive Vice
President, Treasurer and Secretary of ProCentury Corporation.
Mr. Marazza was also a director of ProCentury Corporation
from 2000 to 2005. From 1991 to 2000, Mr. Marazza served as
a financial or operational executive with four insurance
enterprises and from 1982 to 1991 was with KPMG LLP serving
insurance industry clients. Mr. Marazza is a Certified
Public Accountant (non-practicing).
Jeffrey R. Wawok, Executive Vice
President. Mr. Wawok joined the Company
as its Executive Vice President in 2006. Mr. Wawok began
his career in 1999 with Cochran, Caronia & Co., a
boutique investment bank focused on the insurance industry,
most-recently serving as a Vice President with a specialty in
working with property & casualty insurance carriers on
a variety of transactions, including mergers &
acquisitions, divestitures, and private and public capital
raising. Mr. Wawok has been awarded the Chartered Financial
Analyst designation.
95
John Brockschmidt, Senior Vice President
ARPCO. Mr. Brockschmidt has served as
our Senior Vice President overseeing the operations of ARPCO
since 2002. Before joining the Company, Mr. Brockschmidt
held various positions with Willis, an insurance brokerage firm,
between 1988 and 2002, including Marketing Manager for its
Michigan and Ohio offices. Mr. Brockschmidts career
began with Home Insurance Company in 1978 where he held various
underwriting positions including Casualty Underwriting Manager.
Mr. Brockschmidt holds CPCU and ARM designations.
John C. Bures, Vice President Security
Underwriting. Mr. Bures has served as
our Vice President overseeing Security Underwriting since
joining the Company in 2001. Prior to joining the Company,
Mr. Bures held positions at various insurance companies
most recently as Vice President/Branch Manager at
Royal & Sun Alliance from 2000 to 2001. Mr. Bures
holds a CPCU Designation.
Thomas B. Dulapa, Senior Vice President
Operations. Mr. Dulapa has served as our
Senior Vice President in charge of Operations since 2007.
Previous to that position, he served as Vice
President Operations since 1997. In his present
position, he oversees operations for FMIC and ANIC and related
entities. He joined the Company in 1990, serving as our
Controller from 1990 to 1997. Prior to joining the Company, he
held various positions including Accounting Manager and
Assistant Treasurer for The First Reinsurance Company of
Hartford from 1988 to 1990 and Russell Reinsurance Agency from
1984 to 1988.
William A. Kindorf, Vice President Corporate
Development. Mr. Kindorf joined the
Company as its Vice President in charge of Corporate Development
in 2006. Prior to joining the Company, Mr. Kindorf worked
for Madison Capital Funding LLC, a subsidiary of New York Life
Investment Management from 2003 to 2006. At Madison Capital, he
focused on analyzing senior debt and equity co-investments to
support private equity-backed leveraged buyouts,
recapitalizations and growth-oriented investments. From 2000 to
2003 he worked as an analyst and most recently as an associate
with Cochran, Caronia & Co., a boutique investment
banking firm focused on the insurance industry. Mr. Kindorf
has been awarded the Chartered Financial Analyst designation.
Joseph D. Knox, Chief Claim
Officer. Mr. Knox joined the Company as
its Chief Claims Officer in 2005. Prior to joining the Company,
Mr. Knox was the Vice President, Claims for Broadspire
Services, Inc. from 2003 to 2005 and the Corporate Head of the
Special Investigative Unit. He worked for Kemper Insurance from
1976 to 2003, most recently serving as a Vice President of
Claims. Mr. Knox holds the CPCU, AIM and AIC designations.
Edward A. LaFramboise, Vice President
Finance. Mr. LaFramboise joined the
Company as its Vice President in charge of Finance in 2007. He
oversees the accounting functions of our regulated companies.
Prior to joining the Company, Mr. LaFramboise worked for
BDO Seidman, LLP, serving insurance industry clients.
Mr. LaFramboise is a Certified Public Accountant.
Marcia M. Paulsen, Vice President
Administration. Ms. Paulsen has served
as our Vice President in charge of Administration since 1980.
Her responsibilities include management of our regulatory
compliance affairs for our various entities. She has held
various positions since joining the Company in 1975, including
positions related to research and development, underwriting and
administration. Prior to joining the Company, Ms. Paulsen
was employed in various underwriting and administrative
capacities by the St. Paul Insurance Companies from 1971 to 1975.
Jerome Shaw, Director. Mr. Shaw
has served as a member of our Board of Directors since 1973. In
March 2007, he was given the title Chairman Emeritus of the
Company. From 1973 to 2005, he was our Chief Executive Officer.
He is the founder of the Company. Mr. Shaw entered the
insurance business in 1967 and formed CoverX in 1973.
James M. Thomas, Senior Vice President Product
Management. Mr. Thomas has served as our
Senior Vice President in charge of Product Management since
2007. Previous to that position, he served as Vice
President Finance since 1998. From 1997 to 1998 he
was employed by PRS International, Inc. From 1993 to 1996 he
served as a Vice President of the Greentree Group.
Mr. Thomas began his career in public accounting in 1972,
where his clients included several insurance carriers.
Mr. Thomas is a Certified Public Accountant.
96
William S. Weaver, Senior Vice
President. Mr. Weaver currently serves
as a Senior Vice President. Mr. Weaver served as our Senior
Vice President, Treasurer and Chief Financial Officer from 1994
to July 2006. He joined the Company in 1986. From 1973 to 1986,
Mr. Weaver was a partner with the accounting firm of
Grant & Silverman. Mr. Weaver is a Certified
Public Accountant.
Thomas Kearney,
Director. Mr. Kearney has served as a
member of our Board of Directors since November 2006.
Mr. Kearney has been a partner and Chief Marketing Officer
of Insight Catastrophe Group since June 2005. Prior to that
position, he had been Executive Vice President and Chief
Marketing Officer of Benfield U.S., a subsidiary of the Benfield
Group from June 2000.
Louis J. Manetti,
Director. Mr. Manetti has served as a
member of our Board of Directors since November 2006.
Mr. Manetti is a Managing Director with Glencoe Capital,
LLC and has been with the firm since 2001. As Director of
Portfolio Management, he is responsible for monitoring the
performance of the operating companies in which Glencoe has an
investment. Prior to joining Glencoe, Mr. Manetti had
20 years of experience in different aspects of business
with Kodak, Bell & Howell Company and PriceWaterhouse.
Mr. Manetti received his JD from The John Marshall Law
School, an MBA from Northwestern University, and is a Certified
Public Accountant.
Hollis W. Rademacher,
Director. Mr. Rademacher has served as a
member of our Board of Directors since 2004. Mr. Rademacher
is currently self-employed in the fields of consulting and
investments. Mr. Rademacher held various positions with
Continental Bank, N.A., from 1957 to 1993, most recently serving
as Chief Financial Officer of Continental Bank Corporation from
1988 to 1993. Mr. Rademacher serves as a director of
Schawk, Inc. and Wintrust Financial Corporation.
Steven A. Shapiro,
Director. Mr. Shapiro has served as a
member of our Board of Directors since 2004. Mr. Shapiro is
a Vice President of SF Investments, Inc., a registered
broker/dealer and investment advisor. Mr. Shapiro is also a
manager of Millennium Group, LLC, which is the general partner
in a series of investment limited partnerships.
William C. Tyler,
Director. Mr. Tyler has served as a
member of our Board of Directors since November 2006.
Mr. Tyler was a Senior Vice President and stockholder of
McKinley Inc., a national real estate company, from May 1971 to
November 2004, where he was responsible for major transactions,
refinancings and restructurings.
Board
Composition
Our Bylaws provide for the division of our Board of Directors
into three classes with staggered three year terms. The terms of
each class will expire at successive annual meetings so that the
stockholders elect one class, as nearly equal to one-third of
Directors as possible, at each annual meeting. Our board of
directors currently consists of seven members whose terms of
office are divided as follows:
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Class I, whose terms will expire at the 2010 annual
stockholder meeting;
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Class II, whose terms will expire at the 2009 annual
stockholder meeting; and
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Class III, whose terms will expire at the 2008 annual
stockholder meeting.
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Class I consists of Steven A. Shapiro, Jerome M. Shaw and
Richard H. Smith; Class II consists of Thomas Kearney and
William C. Tyler; and Class III consists of Louis J.
Manetti and Hollis W. Rademacher. This classification of the
Board of Directors may have the effect of delaying or preventing
changes in control or management of our Company.
Board
Committees
Our board of directors has established an audit committee, a
compensation committee and a nominating and corporate governance
committee. A majority of the members of each committee is
independent, and all of the members of each committee will be
independent before October 17, 2007, the first anniversary
of our initial public offering.
97
Audit
Committee
The Audit Committee has functions that include appointing,
terminating, evaluating, and setting the compensation of our
independent registered public accounting firm; meeting with the
independent registered public accounting firm to review the
scope, accuracy and results of the audit; and making inquiries
as to the adequacy of our accounting, financial and operating
controls. Mr. Rademacher is the Chair and
Messrs. Manetti and Tyler are the other members of the
Audit Committee. The Board of Directors has determined that
Messrs. Rademacher and Tyler are independent in
accordance with the New York Stock Exchanges
(NYSE) listing standards and the rules and
regulations of the Securities and Exchange Commission (the
SEC) and related federal law. In addition, the Board
of Directors has also determined that all members of the Audit
Committee are Audit Committee Financial Experts in
accordance with the standards established by the SEC.
Mr. Manetti is not independent under the rules and
regulations of the SEC or the NYSE listing standards due to his
employment with Glencoe Capital, LLC. Under
Rule 10A-3(b)(1)(iv)(A)
under the Securities Exchange Act of 1934 and the NYSE listing
standards, our Audit Committee is not required to be comprised
of exclusively independent directors until October 17,
2007, the first anniversary of our initial public offering, and
the Company is relying on this exemption. The Company does not
believe that its reliance on this exemption from the
independence requirements materially adversely affects the
ability of the Audit Committee to act independently and to
satisfy the other requirements of the SEC rules with respect to
audit committees of public companies. The Audit Committees
charter is available on our website. See Where You Can
Find More Information.
Compensation
Committee
Mr. Shapiro is the Chair and Messrs. Kearney and Shaw
are the other members of the Compensation Committee. The Board
has determined that Messrs. Kearney and Shapiro are
independent in accordance with the NYSE listing
standards. Mr. Shaw is not independent under these rules.
Under the NYSE listing standards, the Compensation Committee is
not required to be comprised of exclusively independent
directors until October 17, 2007, the first anniversary of
our initial public offering.
The Compensation Committee Charter is available on our website.
See Where You Can Find More Information. The
Compensation Committees responsibilities, which are
discussed in detail in its charter, include, among other duties,
the responsibility to:
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establish the base salary, incentive compensation and any other
compensation for the Chief Executive Officer and review and
approve the Chief Executive Officers recommendations for
the compensation of all executive officers;
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monitor management incentive and equity compensation plans,
retirement and welfare plans and discharge the duties imposed on
the Committee by the terms of those plans; and
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annually review and make recommendations regarding compensation
for non-management directors.
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During Committee meetings at which compensation actions
involving the Chief Executive Officer are discussed, the Chief
Executive Officer does not participate in the discussions if the
Committee so chooses. As Chief Executive Officer, Mr. Smith
recommends compensation decisions involving the executive
officers and discusses these recommendations and related issues
with the Compensation Committee. During Committee meetings at
which compensation actions involving executive officers are
discussed, Mr. Smith has taken an active part in the
discussions.
The agenda for meetings of the Compensation Committee is
determined by its Chair with the assistance of Mr. Smith.
Compensation Committee meetings are regularly attended by the
Chief Executive Officer. At each meeting, the Compensation
Committee has the opportunity to meet in executive session. The
Compensation Committees Chair reports the Committees
recommendations on executive compensation to the Board.
The Compensation Committee has the sole authority to retain and
terminate outside advisors with respect to executive and
director compensation. The Committee has retained AON Consulting
as its outside compensation consultant. AON Consulting provides
the Compensation Committee competitive information
98
regarding executive officer compensation, including benchmarking
of peer practices and general industry best practices. AON
Consulting also prepares detailed compensation data analysis.
The Committee approves fees paid to AON Consulting.
Nominating
and Corporate Governance Committee
The Committee has functions that include developing and
recommending to the Board of Directors criteria for board and
committee membership, reviewing the qualifications of candidates
for Director, nominating candidates for election to the Board of
Directors, overseeing our corporate governance policies and
practices, developing and recommending to the Board of Directors
corporate governance guidelines, and overseeing a review of the
performance of the Board of Directors and its committees at
least annually. Mr. Tyler is the Chair and
Messrs. Kearney and Shapiro are the other members of the
Nominating and Corporate Governance Committee. The Board of
Directors has determined that each member of the Committee is
independent in accordance with the NYSE listing
standards. The Nominating and Corporate Governance Committee
charter is available on our website. See Where You Can
Find More Information.
Compensation
Committee Interlocks and Insider Participation
Mr. Smith participated in discussions with the Compensation
Committee with respect to the compensation packages of each of
the executive officers, but did not participate in the portion
of meetings of the Compensation Committee at which his own
compensation package was discussed. Our board of directors
believes it is wise and prudent to have our Chief Executive
Officer participate in these determinations, because his
evaluation and recommendation with respect to compensation and
benefits paid to executives are extremely valuable to the
Compensation Committee. Our full board of directors made all
compensation decisions prior to the creation of our Compensation
Committee in 2006.
Except for Mr. Shaw, none of the Compensation Committee
members:
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has ever been an officer or employee of the Company;
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is or was a participant in a related person
transaction in 2006; or
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is an executive officer of another entity, at which one of our
executive officers serves on the board of directors.
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Mr. Shaw is a named executive officer of the Company for
2006 and engaged in certain transactions with the Company as
described below under Employment and Related
Agreements and Certain Relationships and Related
Person Transactions. The Compensation Committee is not
required to be composed of exclusively independent directors
until October 17, 2007, the first anniversary of our
initial public offering, at which time Mr. Shaw will be
replaced on the Compensation Committee with a person who is
deemed independent under the rules of the NYSE.
99
Directors
Compensation
Directors who are employees receive no additional compensation
for serving on the Board or its committees. In 2006, we provided
the following compensation to Directors who are not employees.
Mr. Smith is a Director, but receives no director-related
compensation since he is also an employee.
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Fees
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earned
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or paid
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Stock
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in cash
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awards
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Total
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Name
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($)
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($)(1)
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($)
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Thomas Kearney(2)
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$
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8,250
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$
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6,250
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$
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14,500
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Louis J. Manetti(2)
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8,250
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6,250
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14,500
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Hollis W. Rademacher
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12,750
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6,250
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19,000
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Steven A. Shapiro
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12,750
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6,250
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19,000
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Jerome M. Shaw(3)
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9,750
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6,250
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16,000
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William C. Tyler(2)
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8,250
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6,250
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14,500
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Jon Burgman(4)
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5,000
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5,000
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David Evans(4)
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(1) |
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Reflects the grant date fair value of restricted stock awards
issued in March 2007 to Directors for services in the fourth
quarter of 2006 (301 shares). |
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(2) |
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Messrs. Kearney, Manetti and Tyler joined the Board in
November 2006. |
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(3) |
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In addition to the amounts set forth above, Mr. Shaw
received compensation as an employee of the Company. See the
Summary compensation table. Mr. Shaws
employment with the Company ended on October 17, 2006, at
which time he became a consultant of the Company. See
Employment and Related Agreements below. |
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(4) |
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Messrs. Evans and Burgman resigned from the Board of
Directors in May 2006 and November 2006, respectively. |
Under our Bylaws, our Directors may receive such compensation
and reimbursement of expenses for their services as may be
determined by the Board of Directors. Prior to the completion of
our initial public offering in October 2006, we paid our
Directors a per meeting fee of $1,500. On November 29,
2006, the Board of Directors, based upon the recommendation of
the Compensation Committee, modified the amounts paid to
non-employee directors to provide them with compensation
comparable to similar publicly traded companies. Non-employee
directors receive annual cash compensation of $25,000 and
restricted stock awards having a value of $25,000. In addition,
each non-employee director receives $2,000 for each Board
meeting attended. The Board of Directors also approved
additional annual cash retainers of $10,000 for the Chair of the
Audit Committee, $5,000 for the Chair of the Compensation
Committee and $2,500 for the Chair of the Nominating and
Corporate Governance Committee. The restricted stock awarded to
Directors vests immediately, but is not transferable for one
year after the date of grant. We also reimburse the Directors
for reasonable expenses they incur in attending Board of
Directors or committee meetings.
Compensation
Discussion and Analysis
Executive
Compensation Philosophy
Our executive compensation philosophy is to attract, retain and
motivate the most talented and dedicated executives possible
consistent with achieving outstanding business performance and
stockholder value at a reasonable cost. We are guided by the
following principles:
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Compensation should reward performance. Our compensation
programs should promote excellence in our executives by
adjusting compensation upwards for strong performance and
downwards for individual performance that falls short of
expectations
and/or when
Company performance lags the industry. Even in periods of
temporary downturns in Company performance, however, the
compensation
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100
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programs should continue to ensure that successful,
high-achieving employees will remain motivated and committed to
the Company.
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Compensation should be based on the level of job responsibility,
individual performance, and Company performance. As employees
progress to higher levels in the organization, an increasing
proportion of their pay should be linked to Company performance
and stockholder returns, because the employees are more able to
affect our operating results.
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A strong link should exist between incentive compensation and
corporate profitability. A meaningful equity position for
executives leads them to manage from an owners perspective.
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A total rewards package should be competitive with other
mid-size companies in the insurance industry.
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A simple program design is easy to communicate and understand
and is motivational. Performance-based compensation programs
should enable employees to easily understand how their efforts
can affect their pay, both directly through individual
performance accomplishments and indirectly through contributing
to the Companys achievement of its strategic and
operational goals.
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In addition to competitive base salaries, we reward our
executive officers with both annual cash bonuses linked to the
achievement of short-term corporate and individual performance
goals and long-term equity incentive awards linked to growth,
profitability and stockholder returns. We believe that our
compensation packages align the interests of our executive
officers with the interests of our stockholders.
In this Compensation Discussion and Analysis, we discuss the
compensation packages and 2006 compensation of Richard H. Smith,
our Chairman, President and Chief Executive Officer, John A.
Marazza, our Executive Vice President, Chief Financial Officer,
Treasurer and Corporate Secretary, and Jeffrey R. Wawok, our
Executive Vice President. We also discuss the compensation of
William S. Weaver, our former Chief Financial Officer, and
Jerome M. Shaw, our former Vice Chairman. All of these
individuals comprise our named executive officers. Further
details relating to the compensation paid to these named
executive officers in 2006 and their employment arrangements
with the Company can be found in the Summary Compensation
Table and the supplemental tables that follow it.
Changes
in 2006
The 2006 year was a transformational year for our Company
and our senior management. In October 2006, we completed our
initial public offering and our common stock became listed on
the New York Stock Exchange. In connection with our initial
public offering and repurchase of common stock held by Glencoe
Capital, LLC, Glencoe Capital, LLC no longer was our majority
and controlling stockholder. In addition, our management changed
in anticipation of our status as a public company. In January
2006, we hired Jeffrey R. Wawok as an Executive Vice President
to focus on new business development, our insurance services
business and the initial public offering. In July 2006, we hired
John A. Marazza as our new Chief Financial Officer and
Treasurer. William S. Weaver, our former Chief Financial
Officer, resigned as Chief Financial Officer but continued his
service as a Senior Vice President. In October 2006, Jerome M.
Shaw, our founder and former Chief Executive Officer, left the
employment of the Company and assumed a consulting role. We
provided payments to each of Messrs. Weaver and Shaw in
connection with these employment changes, as discussed below
under Executive Compensation Employment and
Related Agreements. Most of the compensation awarded in
2006 occurred when we were a private company and were undergoing
a change in our executive officer group and therefore may not be
indicative of how we will award compensation to our executive
officers in the future as a public company.
Prior to the completion of our initial public offering, the
Board of Directors played an active role in approving the
compensation awarded to the named executive officers. All of the
compensation awarded in 2006 to the named executive officers was
approved by the Board of Directors. With the completion of our
initial public offering, the Compensation Committee has played a
more prominent role in the compensation of our executive
officers.
101
Decision-Making
by the Compensation Committee
The Compensation Committee is appointed by the Board, in part,
to oversee the programs under which performance is evaluated and
compensation is paid or awarded to our executive officers. AON
Consulting became the Compensation Committees outside
compensation consultant in connection with our initial public
offering in October 2006. An affiliate of AON Consulting also
acts as a broker for the Company. Information on the role of the
Compensation Committee and our compensation consultant are
described above in this prospectus under the section entitled
Compensation Committee. The Compensation Committee
set and approved all compensation awarded to our executive
officers after the completion of our initial public offering.
Our
Process for Setting Executive Compensation Levels
Employment
Agreements
Each of our executive officers has a written employment
agreement or employment letter that governs the principal terms
of his compensation, which are discussed below under
Executive Compensation Employment and Related
Agreements. In 2006, our executive officers had guaranteed
target bonus levels and were entitled to grants of equity awards
under the terms of their employment agreements or letters,
further details about which can be found below under
Executive Compensation Employment and Related
Agreements.
We plan to enter into new executive employment agreements with
each of our executive officers in 2007.
Corporate
Benchmarking
In conjunction with the Compensation Committee, we have compared
our executive compensation program with a peer group of
publicly-traded and privately held insurance companies that, in
the aggregate, both we and the Compensation Committee believe
best represents our peers in terms of profitability, stockholder
returns, growth, size, focus and competition for executive
talent. We believe using a peer group is an appropriate method
to understand the executive talent market in which we must
compete to attract and retain top-quality talent.
Our compensation consultant (in consultation with management)
proposed our peer group, which was reviewed and approved by the
Compensation Committee. The Compensation Committee intends to
monitor and adjust the companies included in the peer group with
the assistance of outside consultants and management. For 2006,
our peer group consisted of the following companies:
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Ace Limited
Alleghany Corporation
Argonaut Group Inc.
W. R. Berkley Corporation
Chubb Corp.
CNA Surety Corporation
HCC Insurance Holdings, Inc.
Horace Mann Educators Corporation
LandAmerica Financial Group, Inc.
Markel Corporation
Mercury General Corporation
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The Midland Company
National Interstate Corp.
Philadelphia Consolidated Holding Corp.
PMA Capital Corporation
RLI Corp.
SCPIE Holdings Inc.
Seabright Insurance Holdings, Inc.
Selective Insurance Group Inc.
St. Paul Travelers Companies, Inc.
Tower Group Inc.
Zenith National Insurance Corp.
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The Compensation Committee also relies on proprietary
compensation data from AON Consulting and other survey data
sources.
Overall, we structure the elements of our compensation program
to be competitive within a range slightly above the
50th percentile of our peer group. However, we strongly
believe in engaging the most dedicated and talented executives
in critical functions, and this may entail negotiations with
individual executives who have significant compensation packages
in place with their current employer. The Compensation Committee
may determine that it is appropriate to provide compensation
outside of the normal range to individuals to address
(a) job and position responsibilities, (b) strategic
investment in individuals deemed critical to our leadership
102
succession plans, (c) retention of critical talent,
(d) outstanding individual performance, (e) prior
applicable work experience and (f) internal pay equity. The
Compensation Committee does not assign specific weights to these
criteria. Therefore, for some executives, some elements of pay
may fall outside the 50th percentile range.
Components
of Executive Compensation for 2006
Our executive compensation package is comprised of base salary,
annual incentive bonus opportunities, long-term incentive
compensation and employee benefits and perquisites. In addition,
the compensation for our executive officers includes severance
and change of control protection. In general, the Compensation
Committee intends that each compensation component should
reflect the competitive marketplace. At the same time, we
recognize that the costs of our compensation program impact our
financial performance. Consistent with balancing these
objectives, our short-term and long-term incentives are
primarily based on improving financial results over the previous
year so as to provide the executive with performance based
compensation only when the stockholders receive added value. The
other compensation elements allow us to retain executives at a
reasonable cost when we do not improve financial performance
over the previous year.
Base
Salary
Each of our executive officers has a minimum base salary that is
set by his employment agreement or letter. Potential increases
to base salaries are reviewed annually by the Compensation
Committee, with adjustments made based primarily on the
recommendations of the Chief Executive Officer for officers
other than himself. In reviewing base salaries, we review
competitive market data supplied by our compensation consultant.
Using this market data as a guideline, we consider various
factors, including the position of the executive officer, the
compensation of officers in our peer group, the performance of
the executive officer with respect to specific objectives and
increases in responsibilities. The specific objectives for each
executive officer vary each year in accordance with the scope of
the officers position, the potential inherent in that
position for impacting our operating and financial results and
the actual operating and financial contributions produced by the
officer in previous years.
Base salary decisions are intended to adequately compensate
executive officers for performing their duties and in a manner
that maintains internal equitable treatment. Overall, base
salary levels for executive officers are targeted, on average,
around the 50th percentile for similar positions in our
peer group and survey data. For 2007, base salaries for our
executive officers were established upon completion of an
external market analysis of our peer group conducted by AON
Consulting. Based upon this analysis, our Compensation Committee
resolved to increase Mr. Smiths base salary as
discussed below.
2006
Bonuses and Annual Incentive Bonuses
Although we had no formal bonus plan in 2006, the Compensation
Committee, in consultation with Mr. Smith for executive
officers other than himself and AON Consulting, determined the
2006 bonus amounts based upon the terms of each executive
officers employment agreement and an assessment of how
each executive officer helped us achieve identified performance
goals such as the completion of our initial public offering.
Each of our executive officers has a cash bonus target and a
minimum 2006 bonus floor in his employment agreement. The 2006
bonus amounts were in excess of these minimum amounts based upon
the Compensation Committees evaluation of the outstanding
performance of each executive officer with respect to our
initial public offering and their efforts in delivering growth
and profitability targets in 2006.
Prior to our initial public offering, our Board of Directors and
stockholders approved The First Mercury Financial Corporation
Performance-Based Annual Incentive Plan, which we refer to as
the annual incentive plan. The annual incentive plan is designed
to provide annual cash awards that satisfy the conditions for
performance-based compensation under Section 162(m) of the
Code. Under the annual incentive plan, the Compensation
Committee has the authority to grant annual incentive awards to
our key employees (including our executive officers) or the key
employees of our subsidiaries. Each annual incentive award will
be paid out of an incentive pool established for a performance
period. Typically, the performance period will be a fiscal
103
year. The incentive pool will equal a percentage of our
operating income for the fiscal year as determined by the
Compensation Committee. The Compensation Committee will allocate
an incentive pool percentage to each designated participant for
each performance period. In no event may the incentive pool
percentage for any one participant exceed 40% of the total pool
for that performance period. Each participants incentive
award will be determined by the Compensation Committee based on
the participants allocated portion of the incentive pool
and attainment of specified performance measures subject to
adjustment in the sole discretion of the Compensation Committee.
In March 2007, the Compensation Committee adopted performance
criteria for 2007 bonuses for our executive officers pursuant to
the annual incentive plan. The performance criteria consist of
the return on equity and the growth in premiums produced in
2007. The Compensation Committees policy is to set
reasonable corporate performance goals that can be achieved with
superior performance. The attainment of these performance
criteria is expected to result in 2007 bonuses to our executive
officers that are slightly above the 50th percentile of the
bonuses awarded by our peer group. We use the operational
measure premiums produced to identify premiums
generated from insurance policies sold through our subsidiary
CoverX Corporation on insurance policies that we produce and
underwrite on behalf of our insurance subsidiaries and under
fronting relationships. The Compensation Committee also has
discretion to award additional bonus amounts to executive
officers to reward more subjective and unquantifiable individual
performance that contributes to the success of our Company.
Our Chief Executive Officer has discretion over determining the
annual bonuses for employees who are not executive officers, and
can set those bonuses due to specific facts and circumstances,
either relating to the Company itself or to the individual
performance of the employee.
Long-term
Equity Compensation
We are committed to long-term incentive programs for our
executives that promote our long-term growth and encourage
employee retention and stock ownership. We believe that our
long-term equity compensation program achieves the goal of
aligning the executives compensation with our long-term
growth, and thus aligns the executives interests with our
stockholders interests. Accordingly, we believe that our
executive officers should be rewarded with a proprietary
interest in the Company for continued long-term performance and
to attract, motivate and retain qualified and talented
executives.
We adopted the First Mercury Financial Corporation Omnibus
Incentive Plan of 2006 (the Omnibus Plan) in
connection with our initial public offering. The Omnibus Plan
permits the issuance of long-term incentive awards to our
employees and non-employee directors and employees of our
subsidiaries to promote the interests of our company and our
stockholders. It is designed to promote these interests by
providing such employees and eligible non-employee directors
with a proprietary interest in pursuing the long-term growth,
profitability and financial success of our company. The Omnibus
Plan is administered by our Compensation Committee. The
aggregate number of shares of our common stock that may be
issued under the Omnibus Plan will not exceed 1,500,000 (subject
to adjustment). No participant may receive in any calendar year
awards relating to more than 500,000 shares of our common
stock. Awards may consist of stock options (incentive stock
options or nonqualified stock options), stock appreciation
rights, or SARs, restricted stock, restricted stock units, or
RSUs, deferred stock units, or DSUs, performance shares,
performance cash awards, and other stock or cash awards. The
exercise price of any stock option must be equal to or greater
than the fair market value of the shares on the date of the
grant, unless it is a substitute or assumed stock option,
restricted stock, restricted stock unit or deferred stock unit,
performance share, performance cash award, stock awards, other
stock or cash awards. The term of any award made under this plan
cannot be longer than ten years.
We intend to make annual grants of equity to our executive
officers under our Omnibus Plan. We do not have any formal
policy with respect to allocations between stock options and
restricted stock awards although we plan to use stock options as
our primary long-term incentive vehicle. Together with the
Compensation Committee, we believe that stock options align
employees interests with stockholders because the employee
realizes no value when the price of the stock remains the same
or declines from the price at grant. The number of stock options
awarded to an executive officer is based on the
individuals level in the organization,
104
competitive practices, individual performance and internal pay
equity. The Compensation Committee does not assign specific
weights to these criteria. Targeted long-term incentive
positions for executive officers were established after
reviewing an external market competitiveness analysis conducted
by AON Consulting. If stock options are awarded, the exercise
price of the option may not be less than 100% of the fair market
value of our common stock on the option grant date.
In March 2006, in connection with Mr. Wawoks
employment with the Company, we granted Mr. Wawok an option
to purchase 76,312 shares at an exercise price of
$6.49 per share, which we believe was the per share fair
market value of our common stock on the date of this grant.
These options were awarded under our 1998 Stock Compensation
Plan (the 1998 Plan). We do not intend to grant any
additional awards under the 1998 Plan now that we are a public
company. The options vested upon the completion of our initial
public offering. In October 2006, we awarded 48,100 shares
of restricted stock to Mr. Marazza, half of which vested
upon the date of grant and the remainder of which vested in
April 2007. In addition, on the date of our initial public
offering, Messrs. Smith, Marazza and Wawok received options
to purchase 100,000, 50,000 and 50,000 shares of common
stock, respectively, under our Omnibus Plan. These options vest
in equal amounts over the first three anniversaries of the
option grant and have a seven year term. The stock option award
levels were determined based upon the initial public offering
price of $17.00 per share. The options were awarded based
upon peer market data and the role of the executive officers in
our initial public offering. In March 2007, the Compensation
Committee granted to Messrs. Smith, Marazza and Wawok
options to purchase 55,188, 55,000 and 40,000 shares of
common stock, respectively, under our Omnibus Plan. The per
share exercise price for these options was the closing market
price of our common stock on the New York Stock Exchange on the
date of grant. These options vest in equal amounts over the
first three anniversaries of the option grant and have a ten
year term. The stock option award levels were determined based
upon peer market data and vary among the executive officers
based upon their positions with the Company.
Employee
Benefits and Perquisites
We offer our executive officers standard employee benefits,
including the ability to participate in our group life, health,
dental, vision, disability insurance and our 401(k) Plan. We
match contributions made by our executive officers to our 401(k)
Plan of up to 40% per year, consistent with the matching
contribution for all participants of the plan. In order to
attract and retain executive officers, the Committee has also
approved arrangements providing executive officers with certain
perquisites, such as use of a Company-leased automobile and gas
allowance (for which they are reimbursed all maintenance costs
and provided insurance coverage), or the equivalent
reimbursement for a personally owned or leased car and gas
allowance. In addition, we provided housing benefits to
Mr. Marazza in connection with the commencement of his
employment with the Company. A listing of the total costs
incurred for perquisites on behalf of named executive officers
is set forth in the All Other Compensation table.
Deferred
Compensation
Prior to our initial public offering, in October 2006, our Board
of Directors and stockholders approved the First Mercury
Financial Corporation Non-Qualified Deferred Compensation Plan,
which is designed to provide a select group of highly
compensated employees, and non-employee directors, the benefits
of a non-qualified, unfunded plan of deferred compensation
subject to Section 201(2) of ERISA and the provisions of
Section 409A of the Internal Revenue Code. Under the plan,
executive officers will be entitled to make an irrevocable
election to defer receipt of up to 75% of base salary and up to
100% of any bonus. We also may make discretionary contributions
to participants deferred accounts. The purpose of the plan
is to provide a tax-deferred retirement savings alternative for
amounts exceeding the Internal Revenue Code limitations on
qualified programs. This plan is not currently implemented by
the Company.
As discussed below under Compensation of our Chief
Executive Officer, the Compensation Committee is currently
in the process of implementing a Supplemental Executive
Retirement Plan (the SERP) and intends to contribute
$500,000 of Mr. Smiths 2006 long-term incentive
compensation to Mr. Smiths account under this SERP.
It is anticipated that the contributions made under the SERP
will not begin to vest until seven years after the contribution
is made with full vesting occurring ten years after the
contribution date,
105
subject to earlier vesting in the event of death, disability, or
attaining age sixty while employed by the company. Amounts
contributed to the SERP would not be distributed unless vested
and until Mr. Smiths separation from service with the
Company. The purpose of the plan is to provide Mr. Smith
with a meaningful long-term retention incentive.
Compensation
of Our Chief Executive Officer
In November 2006, the Compensation Committee approved 2006 and
2007 compensation amounts for Richard H. Smith, our Chief
Executive Officer. For 2006, Richard H. Smith received
compensation consisting of a base salary of $550,000 (which
includes amounts allocated to a noncompetition covenant), a
bonus of $750,000 and long-term incentive compensation of
$750,000. Based upon an analysis of the base salaries of chief
executive officers within our peer group, the Compensation
Committee had authorized an increase in Mr. Smiths
2006 base salary to $750,000, but Mr. Smith declined to
accept such increase. Since Mr. Smith already has an
interest in 7.2% of our outstanding common stock, the
Compensation Committee concluded that providing
Mr. Smiths long-term incentive compensation
exclusively in the form of stock options or other equity awards
would not achieve our goal in awarding long-term equity
compensation (that is, the further alignment of the
executives compensation with our long-term growth and the
goal of motivating the executive to remain at the Company).
Consequently, the Compensation Committee determined that
two-thirds of Mr. Smiths 2006 long-term incentive
compensation, or $500,000, would be a contribution to the SERP
and one-third, or $250,000, would be in the form of stock
options, which are described above.
For 2007, the Compensation Committee approved a base salary for
Mr. Smith of $750,000, a bonus of 50% to 150% of his base
salary under the annual incentive plan, and long-term incentive
compensation of 50% to 150% of his base salary, in such amount
and form to be further determined by the Compensation Committee.
Mr. Smith will also continue to be entitled to customary
benefits pursuant to his employment agreement, which is
discussed below under Executive Compensation
Employment and Related Agreements.
Termination
and Change in Control Payments
The employment agreements for our executive officers contain
customary non-compete, non-solicit, non-disparagement and
confidentiality covenants that restrict these executives during
the terms of their employment and for certain periods after
their termination equal to the terms of their agreements. The
employment agreements also obligate us to pay our executive
officers severance in connection with a change in control and
certain terminations. See Potential Payments Upon
Termination of Employment below for additional details.
These agreements were entered into prior to our initial public
offering. The change in control arrangements are designed to
retain executives and provide continuity of management in the
event of an actual or threatened change in control.
Stock
Ownership Guidelines
Although we have no formal guidelines on stock ownership by our
executive officers, in order to link the interests of management
and stockholders, executive officers are encouraged to use
shares obtained on the exercise of their stock options and
receipt of performance shares, after satisfying the cost of
acquisition and taxes, to maintain or to establish a significant
level of direct stock ownership.
Securities
Trading Policy
Members of the Board of Directors, executives and other
employees may not engage in any transaction in which they may
profit from short-term speculative swings in the value of our
securities. This includes short sales (selling
borrowed securities which the seller hopes can be purchased at a
lower price in the future) or short sales against the
box (selling owned, but not delivered securities),
put and call options (publicly available
rights to sell or buy securities within a certain period of time
at a specified price or the like) and hedging transactions. In
addition, this policy is designed to ensure compliance with all
insider trading rules.
106
Internal
Revenue Code Section 162(m)
Favorable accounting and tax treatment of the various elements
of our compensation program is an important consideration in
their design, but it is not the sole consideration.
Section 162(m) of the Internal Revenue Code limits the
deductibility of certain items of compensation paid to the Named
Executive Officers to $1,000,000 annually, unless the
compensation qualifies as performance based
compensation or is otherwise exempt under
Section 162(m). To maintain flexibility in compensating
executive officers in a manner designed to promote varying
corporate goals, the Compensation Committee has not adopted a
policy that all compensation must be deductible. In this regard,
we believe that Section 162(m) will not prevent us from
receiving a tax deduction in 2006 for the compensation paid to
our named executive officers because compensation amounts
awarded prior to the completion of our initial public offering
or disclosed in the Companys registration statement
relating to the initial public offering are not included in
compensation that is subject to the $1,000,000 limit. In
addition, under a transition rule for new public companies, the
deduction limits under Section 162(m) do not apply to any
compensation paid pursuant to a compensation plan or agreement
that existed during the period in which the corporation was not
publicly held, to the extent that the prospectus accompanying
the initial public offering disclosed information concerning
those plans or agreements that satisfied all applicable
securities laws then in effect. The Company believes that it can
rely on this transition rule until the Companys 2010
annual meeting of stockholders. While we consider the potential
impact of Section 162(m) on our compensation decisions, we
may approve compensation for an executive officer that does not
meet the deductibility requirements of Section 162(m) in
the future in order to maintain competitive compensation
packages and attract talented leaders.
In 2006, we began expensing equity awards in accordance with
FAS 123(R). Like many of the companies within our peer
group, we have taken measures to ensure that our equity granting
practice remains competitive.
Executive
Compensation Tables
The following table sets forth aggregate amounts of compensation
paid or accrued by us for the year ended December 31, 2006
for services rendered in all capacities by our named executive
officers.
Summary
Compensation Table(1)
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Stock
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Option
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All Other
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Salary
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Bonus
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Awards
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Awards
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Compensation
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Total
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Name and Principal Position
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Year
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($)
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($)
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($)(2)
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($)\(2)
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($)(3)
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($)
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Richard H. Smith
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2006
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$
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550,000
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(4)
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$
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750,000
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$
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$
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28,488
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$
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929,851
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$
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2,258,339
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Chief Executive Officer
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John A. Marazza(5)
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2006
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162,744
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300,000
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234,000
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14,244
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36,043
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747,031
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Executive Vice President
Chief Financial Officer
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Jeffrey R. Wawok(6)
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2006
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215,729
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250,000
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120,319
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6,104
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592,152
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Executive Vice President
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William S. Weaver(7)
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2006
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225,000
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300,000
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1,066,188
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1,591,188
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Senior Vice President
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Jerome M. Shaw(8)
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2006
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1,211,021
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6,250
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1,984,921
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3,202,192
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Former Vice Chairman
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(1) |
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No non-equity incentive plan compensation was awarded for 2006. |
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(2) |
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See the table Grants of Plan-Based Awards in 2006
for information on these stock and option awards. A discussion
of the assumptions used in calculating these values may be found
in Note 14 to our 2006 audited consolidated financial
statements incorporated by reference in this prospectus. In
addition, in March 2007, the Company granted 55,188, 55,000 and
40,000 options to purchase common stock to Messrs. Smith,
Marazza and Wawok, respectively. These options vest on the first
three anniversaries of the grant date and have a ten year term. |
107
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(3) |
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All Other Compensation is as follows: |
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Company
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Group-term
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401(K)
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Life Insurance
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Matching
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Car
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Travel and
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Premium
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Name
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Year
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Contribution
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Allowance
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Housing
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Payment
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Other Items
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Total
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Richard H. Smith
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2006
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$
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8,000
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$
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4,410
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$
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$
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774
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$
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916,667
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(a)
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$
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929,851
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John A. Marazza
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2006
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6,000
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1,420
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28,500
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(b)
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123
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36,043
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Jeffrey R. Wawok
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2006
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6,000
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104
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6,104
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William S. Weaver
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2006
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8,000
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7,000
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1,188
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1,050,000
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(c)
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1,066,188
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Jerome M. Shaw
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2006
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8,931
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990
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1,975,000
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(d)
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1,984,921
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(3a) |
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In June 2006, we forgave a loan to Mr. Smith in the amount
of $750,000. The amounts included in the table also include a
$166,667 vested portion of the Company contribution to the SERP
which is in the process of being finalized. It is anticipated
that the contributions made under the SERP will not begin to
vest until seven years after the contribution is made, subject
to earlier vesting in the event of death, disability or
attaining age sixty while employed by the Company. Amounts
contributed to the SERP would not be distributed unless vested
and until Mr. Smiths separation from service with the
Company. |
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(3b) |
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In connection with his relocation from Florida to Michigan,
Mr. Marazza received $4,000 per month from July
through December, 2006 to cover housing and related expenses.
Mr. Marazza will continue to receive $4,000 per month
for the first half of 2007. Additionally, Mr. Marazza was
reimbursed $4,500 for commuting expenses in connection with his
relocation. |
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(3c) |
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Mr. Weaver received a one-time payout of $1,050,000 in July
2006 in connection with the termination of his previous
employment agreement. See Employment and Related
Transactions. |
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(3d) |
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In June 2006, Mr. Shaw received a payment of $1,975,000
under a non-competition and confidentiality agreement. |
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(4) |
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Includes $200,000 allocated to a covenant not to compete. |
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(5) |
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Mr. Marazza joined the Company in July 2006.
Mr. Marazza received a $50,000 bonus upon the initiation of
his employment. |
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(6) |
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Mr. Wawok joined the Company in January 2006. |
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(7) |
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Mr. Weaver was the Companys Chief Financial Officer
until July 2006. |
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(8) |
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In October 2006, Mr. Shaw terminated his employment with
the Company and entered into a consulting agreement pursuant to
which the Company pays him $1,000,000 annually. Mr. Shaw
also received Director fees and a restricted stock award for
services as a Director for the fourth quarter of 2006 which are
set forth in the table on Directors compensation above. |
Grants of
Plan-based Awards in 2006
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
All Option
|
|
|
|
|
|
|
|
|
|
|
|
|
All Stock
|
|
|
Awards:
|
|
|
Exercise or
|
|
|
Grant Date
|
|
|
|
|
|
|
Awards:
|
|
|
Number of
|
|
|
Base Price
|
|
|
Fair Value
|
|
|
|
|
|
|
Number of
|
|
|
Securities
|
|
|
of Option
|
|
|
of Stock
|
|
|
|
|
|
|
Shares of
|
|
|
Underlying
|
|
|
Awards
|
|
|
and Option
|
|
Name
|
|
Grant Date
|
|
|
Stock (#)
|
|
|
Options (#)(1)
|
|
|
($/Sh)
|
|
|
Awards(2)
|
|
|
Richard H. Smith
|
|
|
10/17/2006
|
|
|
|
|
|
|
|
100,000
|
|
|
$
|
17.00
|
(4)
|
|
$
|
410,234
|
|
John A. Marazza
|
|
|
10/4/2006
|
|
|
|
48,100
|
(3)
|
|
|
|
|
|
|
|
|
|
|
468,000
|
|
|
|
|
10/17/2006
|
|
|
|
|
|
|
|
50,000
|
|
|
|
17.00
|
(4)
|
|
|
205,117
|
|
Jeffrey R. Wawok
|
|
|
3/21/2006
|
|
|
|
|
|
|
|
76,312
|
|
|
|
6.49
|
(5)
|
|
|
106,074
|
|
|
|
|
10/17/2006
|
|
|
|
|
|
|
|
50,000
|
|
|
|
17.00
|
(4)
|
|
|
205,117
|
|
William S. Weaver
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Jerome M. Shaw
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
(1) |
|
Mr. Wawoks 76,312 options were granted under the 1998
Plan. All other option awards were granted under the Omnibus
Plan. |
108
|
|
|
(2) |
|
Reflects the value of stock and option awards based on an
aggregate grant date fair value determined pursuant to
FAS 123(R). A discussion of the assumptions used in
calculating these values may be found in Note 14 to our
2006 audited consolidated financial statements incorporated by
reference in this prospectus. |
|
(3) |
|
Mr. Marazzas restricted stock was granted pursuant to
a restricted stock unit award agreement. Half of the restricted
stock vested on the date of grant and the remaining half vested
on April 17, 2007. The grant date fair value of the
restricted shares was based upon the Companys
determination of the per share fair market value of common stock
on the date of grant. |
|
(4) |
|
Grant price represents the price of our initial public offering
on October 17, 2006. |
|
(5) |
|
Mr. Wawoks options for 76,312 shares vested on
October 17, 2006, the date of our initial public offering.
The exercise price for these options was based upon the
Companys determination of the per share fair market value
of common stock on the date of grant. |
Outstanding
Equity Awards at 2006 Fiscal Year End
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Option Awards
|
|
|
Stock Awards
|
|
|
|
Number of
|
|
|
Number of
|
|
|
|
|
|
|
|
|
Number of
|
|
|
Market Value
|
|
|
|
Securities
|
|
|
Securities
|
|
|
|
|
|
|
|
|
Shares or
|
|
|
of Shares or
|
|
|
|
Underlying
|
|
|
Underlying
|
|
|
|
|
|
|
|
|
Units of
|
|
|
Units of
|
|
|
|
Unexercised
|
|
|
Unexercised
|
|
|
Option
|
|
|
|
|
|
Stock That
|
|
|
Stock That
|
|
|
|
Options
|
|
|
Options
|
|
|
Exercise
|
|
|
Option
|
|
|
Have Not
|
|
|
Have not
|
|
|
|
(#)
|
|
|
(#)
|
|
|
Price
|
|
|
Expiration
|
|
|
Vested
|
|
|
Vested
|
|
Name
|
|
Exercisable
|
|
|
Unexercisable(1)
|
|
|
($)
|
|
|
Date
|
|
|
(#)
|
|
|
($)(2)
|
|
|
Richard H. Smith
|
|
|
52,540
|
|
|
|
|
|
|
$
|
1.51
|
|
|
|
7/14/2013
|
|
|
|
|
|
|
|
|
|
|
|
|
48,840
|
|
|
|
|
|
|
|
1.62
|
|
|
|
7/14/2013
|
|
|
|
|
|
|
|
|
|
|
|
|
45,880
|
|
|
|
|
|
|
|
1.73
|
|
|
|
7/14/2013
|
|
|
|
|
|
|
|
|
|
|
|
|
40,700
|
|
|
|
|
|
|
|
1.95
|
|
|
|
7/14/2013
|
|
|
|
|
|
|
|
|
|
|
|
|
289,062
|
|
|
|
|
|
|
|
1.73
|
|
|
|
3/1/2009
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
100,000
|
|
|
|
17.00
|
|
|
|
10/16/2013
|
|
|
|
|
|
|
|
|
|
John A. Marazza
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
24,050
|
(3)
|
|
$
|
565,656
|
|
|
|
|
|
|
|
|
50,000
|
|
|
|
17.00
|
|
|
|
10/16/2013
|
|
|
|
|
|
|
|
|
|
Jeffrey R. Wawok
|
|
|
76,312
|
|
|
|
|
|
|
|
6.49
|
|
|
|
3/20/2016
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
50,000
|
|
|
|
17.00
|
|
|
|
10/16/2016
|
|
|
|
|
|
|
|
|
|
William S. Weaver
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Jerome M. Shaw
|
|
|
52,540
|
|
|
|
|
|
|
|
1.51
|
|
|
|
3/1/2009
|
|
|
|
|
|
|
|
|
|
|
|
|
48,840
|
|
|
|
|
|
|
|
1.62
|
|
|
|
7/14/2013
|
|
|
|
|
|
|
|
|
|
|
|
|
45,880
|
|
|
|
|
|
|
|
1.73
|
|
|
|
7/14/2013
|
|
|
|
|
|
|
|
|
|
|
|
|
40,700
|
|
|
|
|
|
|
|
1.95
|
|
|
|
7/14/2013
|
|
|
|
|
|
|
|
|
|
|
|
|
(1) |
|
The options included in this column vest in one-third increments
on the first three anniversaries of the grant date and expire
seven years from the grant date. |
|
(2) |
|
Assumes a stock price of $23.52, the closing price on
December 29, 2006, the last trading day of 2006. |
|
(3) |
|
This restricted stock vested on April 17, 2007. |
Option
Exercises and Stock Vested in 2006
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Option Awards
|
|
|
Stock Awards
|
|
|
|
Number of
|
|
|
|
|
|
Number of
|
|
|
|
|
|
|
Shares Acquired
|
|
|
Value Realized
|
|
|
Shares Acquired
|
|
|
Value Realized
|
|
|
|
on Exercise
|
|
|
on Exercise
|
|
|
on Vesting
|
|
|
on Vesting
|
|
Name
|
|
(#)
|
|
|
($)
|
|
|
(#)
|
|
|
($)
|
|
|
Richard H. Smith
|
|
|
|
|
|
$
|
|
|
|
|
|
|
|
$
|
|
|
John A. Marazza
|
|
|
|
|
|
|
|
|
|
|
24,050
|
|
|
|
234,000
|
(2)
|
Jeffrey R. Wawok
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
William S. Weaver
|
|
|
268,065
|
|
|
|
1,604,182
|
(1)
|
|
|
|
|
|
|
|
|
Jerome M. Shaw
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
109
|
|
|
(1) |
|
Amount reflects the difference between the exercise price of the
options and the value realized at the time of exercise. |
|
(2) |
|
Amount reflects the market value of the stock on the date the
stock vested. |
NONQUALIFIED
DEFERRED COMPENSATION
The table below sets forth, for each of our named executive
officers, information regarding his participation in our
Supplemental Executive Retirement Plan during 2006.
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Executive
|
|
|
Registrant
|
|
|
Aggregate
|
|
|
|
|
|
Aggregate
|
|
|
|
Contributions
|
|
|
Contributions
|
|
|
Earnings
|
|
|
Aggregate
|
|
|
Balance at
|
|
|
|
in Last
|
|
|
in Last
|
|
|
in Last
|
|
|
Withdrawals/
|
|
|
Last Fiscal
|
|
|
|
Fiscal Year
|
|
|
Fiscal Year
|
|
|
Fiscal Year
|
|
|
Distributions
|
|
|
Year-end
|
|
Name
|
|
($)
|
|
|
($)
|
|
|
($)
|
|
|
($)
|
|
|
($)
|
|
|
Richard H. Smith
|
|
|
|
|
|
$
|
166,667
|
(1)
|
|
|
|
|
|
|
|
|
|
|
|
|
John A. Marazza
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Jeffrey R. Wawok
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
William S. Weaver
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Jerome M. Shaw
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
(1) |
|
Reflects the proposed 2006 Company contribution to a SERP that
is in the process of being finalized. Amounts contributed to the
SERP are not expected to begin vesting until seven years after
the contribution is made, subject to earlier vesting in the
event of death, disability, or attaining age sixty while
employed by the Company. Amounts contributed to the SERP would
not be distributed unless vested and until Mr. Smiths
separation from service with the Company. |
Employment
and Related Agreements
Agreements
With Mr. Smith
We have an employment agreement with Richard H. Smith pursuant
to which Mr. Smith serves as our Chief Executive Officer.
The agreement was entered into in November 2003 and remains in
effect until terminated by us or Mr. Smith. We may
terminate the agreement for cause, upon a change of control or
without cause upon 90 days notice. Mr. Smith may
terminate the agreement without cause upon 90 days
notice, in the event of a material breach by us under the
agreement or the institution of bankruptcy proceedings against,
or the involuntary dissolution of, the Company. Under the
agreement, Mr. Smith is entitled to an annual base salary
of $550,000 plus benefits and reimbursement of reasonable
business expenses. Mr. Smiths annual base salary of
$550,000 includes $200,000 allocated to the non-competition
covenant in the agreement. In addition, we may, but are not
obligated to, pay Mr. Smith additional compensation in the
form of a bonus, as determined by our board of directors in
their sole discretion at the end of each calendar year. As noted
above, the Compensation Committee made adjustments to
Mr. Smiths compensation under this agreement. In the
event we terminate Mr. Smiths employment without
cause, we are required to pay Mr. Smith severance in an
amount equal to two times his base salary plus any bonus which
he received in the calendar year prior to the year of
termination. If Mr. Smith is terminated for any other
reason (including a change of control), we are not required to
pay any severance obligations. Mr. Smith is subject to
non-competition and non-solicitation covenants during the term
of the agreement and for a period of three years after
termination of the agreement. We plan to enter into a new
executive employment agreement with Mr. Smith in 2007.
Agreements
With Mr. Shaw
Prior the completion of our initial public offering, we had an
employment agreement with Mr. Shaw under which
Mr. Shaw served as our Vice Chairman. Under his employment
agreement, Mr. Shaw received an annual salary of
$1,000,000, but was not entitled to an incentive bonus.
Mr. Shaws agreement terminated upon consummation of
our initial public offering and was replaced with a consulting
agreement. Mr. Shaws consulting agreement has a three
year term and provides for an annual consulting fee of
$1,000,000. If
110
Mr. Shaws consulting agreement is terminated by us
for any reason (including upon a change of control),
Mr. Shaw is entitled to receive his consulting fee pursuant
to his agreement for the remainder of the three year term;
provided however, that if Mr. Shaw is in breach of a
protective covenant described below, he is not entitled to
receive such consulting fee. Under a separate non-competition
and confidentiality agreement with us, Mr. Shaw is subject
to non-competition and non-solicitation covenants which will
expire in June 2011. Mr. Shaw is also subject to perpetual
non-disparagement and confidentiality covenants under the
agreement. Mr. Shaw also had a non-competition and
confidentiality agreement that was entered into in connection
with our acquisition of ARPCO under which Mr. Shaw received
$250,000 per year. This agreement (and the payments
thereunder) expired upon consummation of our initial public
offering.
Upon the closing of our senior notes offering and our share
repurchase in 2005, we entered into a non-competition and
confidentiality agreement with Mr. Shaw containing
covenants substantially similar to Mr. Shaws
non-competition and confidentiality agreement in connection with
our acquisition of ARPCO described above. The covenants under
this agreement will expire on the date that is the later of
(i) August 2012 and (ii) the date on which
Mr. Shaw owns less than 5% of our fully diluted common
stock. We paid Mr. Shaw $3.95 million under this
agreement, with the last payment occurring in June 2006.
Agreement
With Mr. Marazza
In July 2006, we had entered into a letter agreement with
Mr. Marazza under which Mr. Marazza serves as our
Executive Vice President, Chief Financial Officer, Treasurer and
Corporate Secretary. Under the letter agreement,
Mr. Marazzas minimum annual base salary is $325,000
and his cash bonus target is 50% of his base salary, with a
minimum guaranteed bonus for 2006 of $125,000. Mr. Marazza
shall receive an annual long term incentive plan target award of
$250,000 to $300,000 as determined by the Compensation
Committee. In connection with his commencement of employment
with the Company, Mr. Marazza received 48,100 shares
of restricted common stock, 50% of which was vested on the date
of grant and 50% of which vested on April 17, 2007.
Mr. Marazza received a $50,000 signing bonus in lieu of
relocation expenses and has a monthly living expense allowance
of $4,000 per month through June 2007.
Mr. Marazzas employment may be terminated by us for
cause or by Mr. Marazza for good reason, which includes a
reduction in base salary, title or job responsibilities,
disability or the failure of Mr. Smith to continue serving
as our CEO. Mr. Marazza is entitled to severance benefits
equal to his base salary; his target bonus for the immediately
prior year; if unpaid, and the year in which the termination
occurred; vesting of all equity incentive awards; and customary
employee benefits for 12 months. In the event of a change
in control of the Company, Mr. Marazza will receive such
severance benefits for (a) 24 months if the change of
control occurs prior to June 30, 2008;
(b) 18 months if the change of control occurs between
July 1, 2008 and June 30, 2009; or
(c) 12 months if the change of control occurs on or
after July 1, 2009. Mr. Marazza is subject to a
non-competition and non-solicitation covenant which lasts for
the duration of his severance payments. We plan to enter into a
new executive employment agreement with Mr. Marazza in 2007.
Agreement
With Mr. Wawok
In March 2006, we entered into a letter agreement with
Mr. Wawok pursuant to which Mr. Wawok serves as our
Executive Vice President. Mr. Wawoks minimum annual
base salary is $225,000 and his cash bonus target is 100% of his
base salary, with a minimum guaranteed bonus for 2006 of
$225,000. Mr. Wawok is entitled to severance benefits equal
to 24 months of his base salary and bonus if his employment
is terminated by us for any reason (including upon a change of
control) other than for cause. In connection with the
commencement of his employment, Mr. Wawok was granted an
option to purchase 76,312 shares with an exercise price of
$6.49 per share, all of which are fully vested. We plan to
enter into a new executive employment agreement with
Mr. Wawok in 2007.
Agreement
With Mr. Weaver
Mr. Weaver serves as our Senior Vice President and served
as our Chief Financial Officer prior to July 2006. We have
entered into a new employment agreement with Mr. Weaver
which provides for an annual base salary of $225,000 plus
benefits, but no bonus or future equity participation, through
March 2008. Mr. Weaver
111
has also granted us an option to repurchase 73,815 shares
of the common stock he holds for a price of $6.46 per
share. Mr. Weaver previously served as our Senior Vice
President, Treasurer and Chief Financial Officer. We paid
Mr. Weaver $1,050,000 in July 2006 in connection with the
termination of his prior employment agreement.
Potential
Payments Upon Termination
The tables below reflect the amount of compensation to each of
the named executive officers in the event of termination of his
employment or consulting arrangement with the Company. The
amount of compensation payable to each named executive officer
upon termination without cause, termination for good reason,
voluntary termination, involuntary termination for cause or in
the event of disability, death or retirement of the person is
shown below. The amounts shown assume that such termination was
effective as of December 31, 2006, and thus includes
amounts earned through such time and are estimates of the
amounts which would be paid upon termination. The actual amounts
to be paid out can only be determined at the time of
termination. Payments due upon a change of control are discussed
above under Employment and Related Agreements.
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Equity
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Value of
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Accelerated
|
|
|
|
|
|
|
|
|
|
Cash Severance
|
|
|
Unvested
|
|
|
Benefit
|
|
|
|
|
|
|
Base Salary
|
|
|
Bonus
|
|
|
Equity(1)
|
|
|
Continuation
|
|
|
Total
|
|
|
Richard H. Smith(2)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
without cause
|
|
$
|
1,100,000
|
|
|
$
|
1,500,000
|
|
|
$
|
652,000
|
|
|
$
|
|
|
|
$
|
3,252,000
|
|
for good reason
|
|
|
|
|
|
|
|
|
|
|
652,000
|
|
|
|
|
|
|
|
652,000
|
|
voluntary
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
for cause
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
disability
|
|
|
|
|
|
|
|
|
|
|
652,000
|
|
|
|
|
|
|
|
652,000
|
|
retirement
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
death
|
|
|
|
|
|
|
|
|
|
|
652,000
|
|
|
|
|
|
|
|
652,000
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
John A. Marazza(3)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
without cause
|
|
|
650,000
|
|
|
|
325,000
|
|
|
|
891,656
|
|
|
|
10,051
|
|
|
|
1,876,707
|
|
for good reason
|
|
|
650,000
|
|
|
|
325,000
|
|
|
|
891,656
|
|
|
|
10,051
|
|
|
|
1,876,707
|
|
voluntary
|
|
|
|
|
|
|
|
|
|
|
565,656
|
|
|
|
|
|
|
|
565,656
|
|
for cause
|
|
|
|
|
|
|
|
|
|
|
565,656
|
|
|
|
|
|
|
|
565,656
|
|
disability
|
|
|
650,000
|
|
|
|
325,000
|
|
|
|
891,656
|
|
|
|
10,051
|
|
|
|
1,876,707
|
|
retirement
|
|
|
|
|
|
|
|
|
|
|
565,656
|
|
|
|
|
|
|
|
565,656
|
|
death
|
|
|
|
|
|
|
|
|
|
|
891,656
|
|
|
|
|
|
|
|
891,656
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Jeffrey R. Wawok(4)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
without cause
|
|
|
450,000
|
|
|
|
450,000
|
|
|
|
326,000
|
|
|
|
|
|
|
|
1,226,000
|
|
for good reason
|
|
|
|
|
|
|
|
|
|
|
326,000
|
|
|
|
|
|
|
|
326,000
|
|
voluntary
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
for cause
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
disability
|
|
|
|
|
|
|
|
|
|
|
326,000
|
|
|
|
|
|
|
|
326,000
|
|
retirement
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
death
|
|
|
|
|
|
|
|
|
|
|
326,000
|
|
|
|
|
|
|
|
326,000
|
|
112
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Equity
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Value of
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Accelerated
|
|
|
|
|
|
|
|
|
|
Cash Severance
|
|
|
Unvested
|
|
|
Benefit
|
|
|
|
|
|
|
Base Salary
|
|
|
Bonus
|
|
|
Equity(1)
|
|
|
Continuation
|
|
|
Total
|
|
|
William S. Weaver(5)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
without cause
|
|
|
225,000
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
225,000
|
|
for good reason
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
voluntary
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
for cause
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
disability
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
retirement
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
death
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Jerome M. Shaw(6)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
without cause
|
|
|
2,794,521
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
2,794,521
|
|
for good reason
|
|
|
2,794,521
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
2,794,521
|
|
voluntary
|
|
|
2,794,521
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
2,794,521
|
|
for cause
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
disability
|
|
|
2,794,521
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
2,794,521
|
|
retirement
|
|
|
2,794,521
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
2,794,521
|
|
death
|
|
|
2,794,521
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
2,794,521
|
|
|
|
|
(1) |
|
All of the payments made in respect of the equity grants
referred to above contain the following provisions: |
|
|
|
|
|
Death or Total Disability: All option
shares vest as of the date of death or total disability and may
be exercised in the case of grants issued under (a) the
1998 Plan, for a period of ninety days thereafter or
(b) the Omnibus Plan, for a period of six months thereafter. |
|
|
|
Voluntary Termination: Unvested option
shares terminate upon voluntary termination. Vested option
shares may be exercised for a period thereafter of
(a) thirty days under the 1998 Plan and (b) ninety
days under the Omnibus Plan. |
|
|
|
Retirement: For grants under the 1998
Plan, if an optionee has attained age 55 or older and has
completed at least eight years of service, the optionee may
exercise, to the extent vested at the time of termination,
options for a period of ninety days after the termination. For
grants under the Omnibus Plan, if an optionee has attained
age 55 or older and has completed ten years of service,
then the option shares continue to vest upon the given vesting
schedule and may be exercised until their expiration. |
|
|
|
Involuntary Termination with
Severance: If an optionee is terminated by us
without cause or leaves for good reason, all options of such
optionee are exercisable for a period of ninety days after such
termination, and then terminate and are forfeited after such
period. Under the 1998 Plan, the options do not continue to vest
during the ninety day period, and under the Omnibus Plan, the
options do continue to vest during such ninety day period. |
|
|
|
For Cause Termination: If an optionee
is terminated for cause, all vested and unvested options are
forfeited on the date of termination and may not be exercised. |
|
|
|
Change of Control: Upon a change of
control, under the Omnibus Plan, all options fully-vest. All
options granted under the 1998 Plan have fully-vested. |
|
|
|
(2) |
|
Under Mr. Smiths employment agreement, upon his
death, his beneficiary or estate is entitled to receive his base
salary for the remainder of the calendar year in which his death
occurs. If his death occurs on December 31 of a given year,
the severance payment under this employment agreement is $0. If
his death occurs on January 1 of a given year, the severance
payment under his employment agreement is $550,000. |
113
|
|
|
(3) |
|
Mr. Marazza does not have a formal employment agreement,
and his employment terms are covered by an executed letter
agreement outlining the terms of employment. |
|
(4) |
|
Mr. Wawok does not have a formal employment agreement, and
his employment terms are covered by an executed letter agreement
outlining the terms of employment. |
|
(5) |
|
Mr. Weaver does not have a written employment agreement,
but under his employment arrangement he is entitled to receive
his base salary through March 2008. |
|
(6) |
|
Mr. Shaw is not an employee but has entered into a
consulting agreement with the Company. |
114
CERTAIN
RELATIONSHIPS AND RELATED PERSON TRANSACTIONS
Since the completion of our initial public offering, our policy
has been to refer any proposed related person transaction to the
Nominating and Corporate Governance Committee for consideration
and approval, and it is then discussed by the full Board of
Directors. Our Code of Business Conduct and Ethics sets forth
standards applicable to all directors and officers that prohibit
the giving or accepting of personal benefits that could result
in a conflict of interest. Any waiver of this Code for a
director or an officer may only be granted by the Board of
Directors. Any waiver of this Code that is granted to a director
or an officer must be disclosed on a
Form 8-K,
as required by applicable law or the rules and regulations of
the New York Stock Exchange. We may in the future adopt a
separate related person transactions policy. The following
transactions were entered into prior to our initial public
offering and were not approved by the Nominating and Corporate
Governance Committee.
ARPCO
Transactions
Prior to our acquisition of ARPCO in June 2004, we shared our
office space and some of our resources with ARPCO, whose
shareholders included Mr. Shaw and Mr. Weaver.
Subsequent to our acquisition of ARPCO, these transactions and
agreements were no longer in effect.
On June 14, 2004, we acquired all of the outstanding common
stock of ARPCO and Public Entity Risk Services of Ohio, Inc.
from Mr. Shaw, Mr. Weaver and Larry Spilkin for
aggregate consideration of $20.0 million, consisting of
$15.0 million in cash and $5.0 million of promissory
notes payable to Messrs. Shaw, Weaver and Spilkin. The
promissory notes bore interest at the rate of 8.0% and were
repaid in full in August 2005. In connection with our
acquisition of ARPCO, ARPCO entered into a non-competition and
confidentiality agreement with Mr. Shaw. See
Employment and Related Agreements above.
Florida
Homeowners Insurance Business
We provide management and administrative services to First Home
Insurance Agency, LLC, or FHIA, a wholly owned subsidiary of
First Home Acquisition Company, LLC, or FHAC. FHIA is the
licensed managing general agency that provides management and
administrative services for First Home Insurance Company, or
FHIC. FHIC is also a wholly owned subsidiary of FHAC. FHIC is a
property and casualty insurance company authorized to write
homeowners, dwelling fire and allied lines insurance in Florida.
FHIA manages the insurance operations of FHIC by providing, or
supervising subcontractors in providing, underwriting and policy
issuance services, reinsurance services, claims management
services, premium collection services, regulatory and
governmental compliance services, policy advisory and consulting
services, advertising and marketing services, and other
management and administrative services related to FHICs
business. Our services include marketing, claims analysis,
supervisory accounting, information services, product and
underwriting development and management, regulatory compliance,
human resource benefits and technology services. We receive a
management fee of up to 1.5% of the direct written premiums
associated with the policies to be serviced, with the actual
amount, if any, subject to agreement of the parties in
accordance with the management agreement between us and FHIA. In
addition to a management fee, if any, we are also reimbursed by
FHIA for all facilities and overhead expenses incurred by us for
providing management services to FHIA. During 2005, we billed
FHIA $0.7 million in management fees and allocated
expenses. We also paid $0.3 million of expenses on behalf
of FHIA and provided working capital advances of
$0.3 million. During 2006, we billed FHIA $0.6 million
in management fees and allocated expenses. We received
$1.8 million from FHIA under this agreement during 2006,
including repayments of $0.6 million and $1.2 million
related to 2006 and 2005, respectively. We had $20,000 in
outstanding accounts receivable from FHIA as of
December 31, 2006. The term of the services agreement
expires on May 31, 2008; however, the agreement may be
terminated prior to such date in connection with a
recapitalization of FHAC, which is currently under review by the
Florida Office of Insurance Regulation. Glencoe Capital, LLC is
the manager of FHAC, and an affiliate of Glencoe owns
approximately 36% of the capital stock of Glencoe Acquisition,
Inc., the sole member of FHAC. Mr. Shaw and Mr. Smith
each own approximately 3% of the capital stock of Glencoe
Acquisition, Inc., the sole member of FHAC.
115
Loan to
Mr. Smith
In the second quarter of 2005 and prior to our initial public
offering, we made an unsecured loan to Mr. Smith in an
aggregate principal amount of $750,000 to provide funds for him
to make an investment in FHAC. The loan was evidenced by a
promissory note which bore interest at a compound annual rate of
1.0%, payable annually in arrears. The principal balance of the
note was payable in three equal installments commencing in May
2006. In May 2006 and prior to our initial public offering, we
forgave this loan.
Advances
to Executive Officers
In 2005, we advanced $130,200 to Mr. Smith and $92,628 to
Mr. Weaver to pay certain income tax liabilities incurred
by them in connection with their exercise of stock options at
the time of Glencoes original investment. Mr. Smith
and Mr. Weaver repaid these amounts in June 2006 prior to
our initial public offering.
Stockholder
Promissory Notes
During the third quarter of 2003, we issued seven unsecured,
non-convertible subordinated notes having an aggregate principal
amount of $1,915,000, including $1,000,000 of which was issued
to Mr. Shaw and $70,000 of which was issued to
Mr. Weaver. The notes held by Mr. Shaw and
Mr. Weaver bore interest at 10.25%, payable quarterly. The
notes were repaid in full in August 2005.
Transactions
with Glencoe Capital, LLC
In connection with Glencoe Capital, LLCs investment in
June 2004, we entered into a stockholders agreement, a
securities purchase agreement, a management services agreement
and a registration rights agreement with Glencoe Capital, LLC.
The stockholders agreement contained restrictions on transfer,
rights of first refusal, co-sale, drag-along and preemptive
rights, and voting provisions relating to the composition of the
company board of directors, all of which terminated upon
consummation of our initial public offering in October 2006.
Under the management services agreement, Glencoe provided
management services, including services and assistance with
respect to strategic planning, budgeting, cash management,
record keeping, quality control, advisory and administrative
services, finance, tax, consumer affairs, public relations,
accounting, risk management, procurement and supervision of
third party service providers, contract negotiation, and
providing economic, investment and acquisition analysis with
respect to investments and acquisitions or potential investments
and acquisitions. As compensation for the services it provided
under the agreement, we paid Glencoe an annual management fee of
$750,000, plus reimbursement of reasonable expenses. The
management services agreement terminated upon consummation of
our initial public offering in October 2006 at which time we
paid Glencoe a $300,000 fee in connection with such termination.
Glencoe is participating in the offering as a selling
stockholder.
Repurchase
of Glencoe Shares
In connection with our initial public offering, we repurchased
1,779,339 shares of our common stock held by Glencoe
Capital, LLC for a purchase price of $17.00 per share and
paid Glencoe $58.0 million pursuant to the terms of our
convertible preferred stock, which was converted into common
stock in connection with our initial public offering.
Registration
Rights Agreement with Glencoe and Mr. Shaw
Under the amended and restated registration rights agreement
that we entered into in October 2006, each of Glencoe Capital,
LLC and Mr. Shaw has the right to request that we register
for public sale, on two occasions, shares of common stock having
an aggregate value of at least $10,000,000. Glencoe Capital, LLC
and Mr. Shaw are participating in this offering as selling
stockholders. Glencoes rights under the amended and
restated registration rights agreement will terminate upon the
consummation of this offering. In addition, Mr. Shaw has
piggyback registration rights which allows him to
participate in any registered offerings of common stock by the
Company for our own account or for the account of others (except
non-underwritten registrations initiated by the other party).
116
Repurchase
of Shares Held by Mr. Weaver
In September 2006, William S. Weaver exercised options to
purchase 268,065 shares of common stock. After such
exercise, we entered into an agreement with Mr. Weaver by
which we repurchased 92,500 shares of
Mr. Weavers common stock for an aggregate purchase
price of $597,500.
Agreements
With Jerome M. Shaw
We have entered into various transactions with Mr. Shaw.
See Employment and Related Agreements above.
117
PRINCIPAL
AND SELLING STOCKHOLDERS
The table below sets forth information as of June 13, 2007
regarding the beneficial ownership of our outstanding common
stock by:
|
|
|
|
|
each person beneficially owning more than 5% of the outstanding
shares of our common stock,
|
|
|
|
each director of the Company,
|
|
|
|
each named executive officer of the Company listed in the
Summary Compensation Table,
|
|
|
|
all of our directors and executive officers as a group, and
|
|
|
|
each stockholder that is selling shares in this offering.
|
We have agreed to bear the expenses (other than underwriting
discounts and commissions) of the selling stockholders in
connection with this offering and to indemnify them against
certain liabilities, including liabilities under the Securities
Act of 1933.
The number of shares beneficially owned by each stockholder and
each stockholders percentage ownership set forth in the
following table is based on 17,340,979 shares of common
stock outstanding before this offering as of June 13, 2007
and 17,540,979 shares of common stock outstanding following
this offering. Beneficial ownership is determined in accordance
with rules of the SEC and includes shares over which the
indicated beneficial owner exercises voting
and/or
investment power. Except as otherwise indicated, we believe the
beneficial owners of the common stock listed below, based on
information furnished by them, have sole voting and investment
power with respect to the number of shares listed opposite their
names. Except pursuant to applicable community property laws and
except as otherwise indicated, each stockholder possesses sole
voting and investment power with respect to its, his or her
shares. Except as expressly indicated, the address for each
person listed is c/o First Mercury Financial Corporation,
29110 Inkster Road, Suite 100, Southfield, Michigan 48034.
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Number
|
|
|
|
|
|
Percentage
|
|
|
|
Number
|
|
|
Percentage
|
|
|
of Shares of
|
|
|
Number
|
|
|
of Shares
|
|
|
|
of Shares
|
|
|
of Shares
|
|
|
Common
|
|
|
of Shares
|
|
|
Beneficially
|
|
|
|
Beneficially
|
|
|
Beneficially
|
|
|
Stock
|
|
|
Beneficially
|
|
|
Owned
|
|
|
|
Owned Before
|
|
|
Owned Before
|
|
|
Offered
|
|
|
Owned After
|
|
|
Following
|
|
Name
|
|
Offering
|
|
|
Offering(1)
|
|
|
Hereby
|
|
|
Offering
|
|
|
Offering(1)
|
|
|
Jerome M. Shaw
|
|
|
3,845,691
|
(2)
|
|
|
21.9
|
%
|
|
|
1,300,000
|
|
|
|
2,545,691
|
|
|
|
14.4
|
%
|
Glencoe Capital, LLC
|
|
|
1,729,260
|
(3)
|
|
|
10.0
|
%
|
|
|
1,729,260
|
|
|
|
|
|
|
|
*
|
|
Richard H. Smith
|
|
|
1,314,488
|
(4)
|
|
|
7.4
|
%
|
|
|
|
|
|
|
1,314,488
|
|
|
|
7.3
|
%
|
The Guardian Life Insurance
Company of America(5)
|
|
|
868,610
|
|
|
|
5.0
|
%
|
|
|
|
|
|
|
868,610
|
|
|
|
5.0
|
%
|
William S. Weaver
|
|
|
212,565
|
(6)
|
|
|
1.2
|
%
|
|
|
37,000
|
|
|
|
175,565
|
|
|
|
1.0
|
%
|
John A. Marazza
|
|
|
68,100
|
|
|
|
*
|
|
|
|
|
|
|
|
68,100
|
|
|
|
*
|
|
Jeffrey R. Wawok
|
|
|
91,312
|
(7)
|
|
|
*
|
|
|
|
|
|
|
|
91,312
|
|
|
|
*
|
|
Thomas Kearney
|
|
|
11,890
|
|
|
|
*
|
|
|
|
|
|
|
|
11,890
|
|
|
|
*
|
|
Louis J. Manetti
|
|
|
698
|
|
|
|
*
|
|
|
|
|
|
|
|
698
|
|
|
|
*
|
|
Hollis W. Rademacher
|
|
|
6,890
|
|
|
|
*
|
|
|
|
|
|
|
|
6,890
|
|
|
|
*
|
|
Steven A. Shapiro
|
|
|
27,371
|
|
|
|
*
|
|
|
|
|
|
|
|
27,371
|
|
|
|
*
|
|
William C. Tyler
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|
|
2,890
|
|
|
|
*
|
|
|
|
|
|
|
|
2,890
|
|
|
|
*
|
|
Thomas B. Dulapa
|
|
|
91,511
|
|
|
|
*
|
|
|
|
35,000
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|
|
|
56,511
|
|
|
|
*
|
|
All directors and executive
officers as a group (9 persons)
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|
|
5,369,330
|
|
|
|
29.7
|
%
|
|
|
1,300,000
|
|
|
|
4,069,330
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|
|
|
22.3
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%
|
|
|
|
(1) |
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Represents the percent of ownership of total outstanding shares
of capital stock with the * indicating that the amount of
ownership represents less than 1% of outstanding capital stock. |
118
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|
(2) |
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Includes 3,166,833 shares held by the Jerome M. Shaw
Revocable Trust, which is controlled by Mr. Shaw, and
options to purchase 187,960 shares of common stock which
are exercisable currently or within 60 days of the date of
this prospectus. |
|
(3) |
|
Glencoe Capital, LLC, as the manager of FMFC Holdings, LLC, may
be deemed to be the beneficial owner of these shares. The
manager of Glencoe is DSE Manager, Inc., whose President and
sole director is David S. Evans, Chairman of Glencoe. Each of
Glencoe, DSE Manager, Inc. and Mr. Evans disclaims any
beneficial ownership in these shares, except to the extent of
its respective pecuniary interest therein. The address for
Glencoe is 222 West Adams Street, Suite 1000, Chicago,
Illinois 60606. |
|
(4) |
|
Includes options to purchase 477,022 shares of common stock
which are exercisable currently or within 60 days of the
date of this prospectus. |
|
(5) |
|
The address of this stockholder is 7 Hanover Square, H-26-E, New
York, NY 10004. |
|
(6) |
|
Shares of common stock are held by The William S. Weaver
Revocable Trust, which is controlled by Mr. Weaver. |
|
(7) |
|
Includes options to purchase 76,312 shares that are
currently exercisable or exercisable within 60 days of
March 20, 2007. |
119
DESCRIPTION
OF CAPITAL STOCK
Our authorized capital stock consists of 100,000,000 shares
of common stock, par value $0.01 per share, and
10,000,000 shares of undesignated preferred stock, par
value $0.01 per share. The following description of our
capital stock is intended as a summary only and is qualified in
its entirety by reference to our amended and restated
certificate of incorporation and amended and restated bylaws
filed as exhibits to the registration statement, of which this
prospectus forms a part, and to Delaware corporate law. We refer
in this section to our amended and restated certificate of
incorporation as our certificate of incorporation and we refer
to our amended and restated bylaws as our bylaws.
Common
Stock
Holders of common stock are entitled to one vote per share in
the election of directors and on all other matters on which
stockholders are entitled or permitted to vote. Subject to the
terms of any outstanding series of preferred stock, the holders
of common stock are entitled to dividends in amounts and at
times as may be declared by the board of directors out of funds
legally available for that purpose. Upon liquidation or
dissolution, holders of common stock are entitled to share
ratably in all net assets available for distribution to
stockholders, after payment in full to creditors and payment of
any liquidation preferences to holders of preferred stock.
Holders of common stock have no redemption, conversion or
preemptive rights. All outstanding shares of common stock are
fully paid and nonassessable, and the shares of common stock to
be issued upon the closing of this offering will be fully paid
and nonassessable. As of June 13, 2007, there were
17,340,979 shares of common stock issued and outstanding.
Undesignated
Preferred Stock
In addition, our certificate of incorporation provides that we
may issue up to 10,000,000 shares of preferred stock in one
or more series as may be determined by our board of directors.
Our board of directors has broad discretionary authority with
respect to the rights of any new series of preferred stock and
may take several actions without any vote or action of the
stockholders, including:
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To determine the number of shares to be included in each series;
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To fix the designation, voting powers, preferences and relative
rights of the shares of each series and any qualifications,
limitations or restrictions; and
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To increase or decrease the number of shares of any series.
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We believe that the ability of our board of directors to issue
one or more series of preferred stock will provide us with
flexibility in structuring possible future financings and
acquisitions, and in meeting other corporate needs that might
arise. The authorized shares of preferred stock, as well as
shares of common stock, will be available for issuance without
action by our stockholders, unless such action is required by
applicable law or the rules of any stock exchange or automated
quotation system on which our securities may be listed or traded.
The board of directors may authorize, without stockholder
approval, the issuance of preferred stock with voting and
conversion rights, that could adversely affect the voting power
and other rights of holders of common stock. Preferred stock
could be issued quickly with terms designed to delay or prevent
a change in the control of our company or to make the removal of
our management more difficult. This could have the effect of
decreasing the market price of our common stock.
Although our board of directors has no intention at the present
time of doing so, it could issue a series of preferred stock
that could, depending on the terms of such series, impede the
completion of a merger, tender offer or other takeover attempt
of our company. Our board of directors will make any
determination to issue such shares based on its judgment as to
our companys best interest and the best interests of our
stockholders. Our board of directors could issue preferred stock
having terms that could discourage an acquisition attempt
through which an acquirer may be able to change the composition
of the board of directors, including a tender
120
offer or other transaction that some, or a majority, of our
stockholders might believe to be in their best interests or in
which stockholders might receive a premium for their stock over
the then-current market price.
We have no present plans to issue any shares of our preferred
stock.
Listing
Our shares of common stock are listed on the New York Stock
Exchange under the symbol FMR.
Delaware
Law and Charter and Bylaw Provisions Anti-takeover
Effects
We have elected to be governed by the provisions of
Section 203 of the Delaware General Corporation Law, which
we refer to as Section 203. In general, Section 203
prohibits a publicly held Delaware corporation from engaging in
a business combination with an interested
stockholder for a three-year period following the time
that this stockholder becomes an interested stockholder, unless
the business combination is approved in a prescribed manner. A
business combination includes, among other things, a
merger, asset sale or other transaction resulting in a financial
benefit to the interested stockholder. An interested
stockholder is a person who, together with affiliates and
associates, owns (or, in some cases, within three years prior,
did own) 15% or more of the corporations voting stock, or
is an affiliate of the corporation and owned 15% or more of the
corporations voting stock at any time during the three
years prior to the time that the determination of an interested
stockholder is made. Under Section 203, a business
combination between the corporation and an interested
stockholder is prohibited unless it satisfies one of the
following conditions:
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before the stockholder became interested, the board of directors
approved either the business combination or the transaction
which resulted in the stockholder becoming an interested
stockholder; or
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upon consummation of the transaction which resulted in the
stockholder becoming an interested stockholder, the interested
stockholder owned at least 85% of the voting stock of the
corporation outstanding at the time the transaction commenced
(excluding, for purposes of determining the number of our shares
outstanding, shares owned by (a) persons who are directors
and also officers and (b) employee stock plans, in some
instances); or
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after the stockholder became interested, the business
combination was approved by the board of directors of the
corporation and authorized at an annual or special meeting of
the stockholders by the affirmative vote of at least two-thirds
of the outstanding voting stock which is not owned by the
interested stockholder.
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Our bylaws provide for the division of our board of directors
into three classes as nearly equal in size as possible with
staggered three-year terms. Approximately one-third of our board
will be elected each year. We refer you to
Management. In addition, our bylaws provide that
directors may be removed only for cause and then only by the
affirmative vote of the holders of a majority of the outstanding
voting power of our capital stock outstanding and entitled to
vote generally in the election of directors. Under our bylaws,
any vacancy on our board of directors, however occurring,
including a vacancy resulting from an enlargement of our board,
may only be filled by vote of a majority of our directors then
in office even if less than a quorum. The classification of our
board of directors and the limitations on the removal of
directors and filling of vacancies could have the effect of
making it more difficult for a third party to acquire, or of
discouraging a third party from attempting to acquire, control
of us.
Our bylaws provide that special meetings of the stockholders may
only be called by the chairman of the board of directors or by
the board of directors. Our bylaws further provide that
stockholders at an annual meeting may only consider proposals or
nominations specified in the notice of meeting or brought before
the meeting by or at the direction of the board or by a
stockholder who was a stockholder of record on the record date
for the meeting, who is entitled to vote at the meeting and who
has given to our corporate secretary the required written
notice, in proper form, of the stockholders intention to
bring that proposal or nomination before the meeting. In
addition to other applicable requirements, for a stockholder
proposal or nomination to be properly brought before an annual
meeting by a stockholder, the stockholder generally must have
given notice in proper written form to the corporate secretary
not less than 90 days nor more than 120 days prior to
121
the anniversary date of the immediately preceding annual meeting
of stockholders, unless the date of the annual meeting is
advanced by more than 30 days or delayed by more than
60 days from the anniversary date, in which case the notice
must be delivered no later than the 10th day following the
day on which public announcement of the meeting is first made.
Although our bylaws do not give the board the power to approve
or disapprove stockholder nominations of candidates or proposals
regarding other business to be conducted at a special or annual
meeting, our bylaws may have the effect of precluding the
consideration of some business at a meeting if the proper
procedures are not followed or may discourage or defer a
potential acquiror from conducting a solicitation of proxies to
elect its own slate of directors or otherwise attempting to
obtain control of us.
Our certificate of incorporation also provides that any action
required or permitted to be taken by our stockholders at an
annual meeting or special meeting of stockholders may only be
taken at a stockholders meeting and may not be taken by written
consent in lieu of a meeting. Our certificate of incorporation
includes a constituency provision that permits (but
does not require) a director of our company in taking any action
(including an action that may involve or relate to a change or
potential change in control of us) to consider, among other
things, the effect that our actions may have on other interests
or persons (including our employees, clients, suppliers,
customers and the community) in addition to our stockholders.
The Delaware corporate law provides generally that the
affirmative vote of a majority of the shares entitled to vote on
any matter is required to amend a corporations certificate
of incorporation or bylaws or to approve mergers, consolidations
or the sale of all or substantially all its assets, unless a
corporations certificate of incorporation or bylaws, as
the case may be, requires a greater percentage. Our certificate
of incorporation requires the affirmative vote of the holders of
at least two-thirds of the shares of common stock outstanding at
the time such action is taken to amend or repeal the
constituency provision of our certificate of incorporation. Our
bylaws may be amended or repealed by a majority vote of the
board of directors, subject to any limitations set forth in the
bylaws, and may also be amended by the stockholders by the
affirmative vote of the holders of at least two-thirds of the
total voting power of all outstanding shares of capital stock.
The two-thirds stockholder vote would be in addition to any
separate class vote that might in the future be required
pursuant to the terms of any series of preferred stock that
might be outstanding at the time any of these amendments are
submitted to stockholders.
Limitation
of Liability and Indemnification
Our certificate of incorporation and bylaws provide that:
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we must indemnify our directors and officers to the fullest
extent permitted by Delaware law, as it may be amended from time
to time;
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we may indemnify our other employees and agents to the same
extent that we indemnify our officers and directors, unless
otherwise required by law, our certificate of incorporation or
our bylaws; and
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we must advance expenses, as incurred, to our directors and
officers in connection with legal proceedings to the fullest
extent permitted by Delaware law, subject to very limited
exceptions.
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In addition, our certificate of incorporation provides that our
directors will not be liable for monetary damages to us for
breaches of their fiduciary duty as directors, except for:
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any breach of their duty of loyalty to us or our stockholders;
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acts or omissions not in good faith or which involve intentional
misconduct or a knowing violation of law;
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under Section 174 of the Delaware General Corporation Law,
with respect to unlawful dividends or redemptions; or
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any transaction from which the director derived an improper
personal benefit.
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We also plan to obtain director and officer insurance providing
for indemnification for our directors and officers for certain
liabilities, including liabilities under the Securities Act of
1933.
122
These provisions may discourage stockholders from bringing a
lawsuit against our directors for breach of their fiduciary
duty. These provisions may also have the effect of reducing the
likelihood of derivative litigation against directors and
officers, even though such an action, if successful, might
otherwise benefit us and our stockholders. Furthermore, a
stockholders investment may be adversely affected to the
extent we pay the costs of settlement and damage awards against
directors and officers pursuant to these indemnification
provisions. We believe that these provisions, the insurance and
the indemnity agreements are necessary to attract and retain
talented and experienced directors and officers.
At present, there is no pending litigation or proceeding
involving any of our directors or officers where indemnification
will be required or permitted. We are not aware of any
threatened litigation or proceeding that might result in a claim
for such indemnification.
Transfer
Agent and Registrar
The transfer agent and registrar for our common stock is
Computershare Trust Company, N.A.
123
SHARES
ELIGIBLE FOR FUTURE SALE
Sales of substantial amounts of our common stock in the public
market could adversely affect prevailing market prices of our
common stock. Furthermore, since some shares of common stock
will not be available for sale shortly after this offering
because of the contractual and legal restrictions on resale
described below, sales of substantial amounts of common stock in
the public market after these restrictions lapse could adversely
affect the prevailing market price and our ability to raise
equity capital in the future.
We have 17,340,979 shares of common stock outstanding, not
including currently outstanding options. Upon completion of this
offering, we will have 17,540,979 shares of common stock
outstanding, not including currently outstanding options. Of
these shares, the 11,161,764 shares sold in our initial
public offering, the 3,301,260 shares sold in this
offering, plus any additional shares sold upon the exercise of
the underwriters over-allotment option, are or will be
freely tradable without restrictions or further registration
under the Securities Act of 1933, as amended, unless those
shares are purchased by affiliates, as that term is
defined in Rule 144 under the Securities Act. The
4,069,330 shares of common stock held by our executive
officers and directors (including options exercisable within
60 days) are subject to the
90-day
lock-up
period described below.
Rule 144
In general, under Rule 144, a person who has beneficially
owned shares of our common stock for at least one year is
entitled to sell within any three-month period a number of
shares that does not exceed the greater of:
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1% of the number of shares of common stock then outstanding,
which will equal approximately 175,409 shares immediately
after this offering; or
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the average weekly trading volume of the common stock on the New
York Stock Exchange during the four calendar weeks preceding the
filing of a notice on Form 144 with respect to the sale.
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Sales under Rule 144 also are subject to manner of sale
provisions and notice requirements and to the availability of
current public information about us.
Rule 144(k)
In general, under Rule 144(k), a person may sell shares of
common stock acquired from us immediately upon completion of
this offering, without regard to manner of sale, the
availability of public information or volume, if:
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the person is not an affiliate of us and has not been an
affiliate of us at any time during the three months preceding
such a sale; and
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the person has beneficially owned the shares proposed to be sold
for at least two years, including the holding period of any
prior owner other than an affiliate.
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Lock-up
Agreements
We, our executive officers and directors have agreed that, for a
period of 90 days from the date of this prospectus, we and
they will not, without the prior written consent of
J.P. Morgan Securities Inc. and Keefe, Bruyette &
Woods, Inc., dispose of or hedge any shares of our common stock
or any securities convertible into or exchangeable for our
common stock, subject to customary exceptions. J.P. Morgan
Securities Inc. and Keefe, Bruyette & Woods, Inc. in
their sole discretion may release any of the securities subject
to these
lock-up
agreements at any time without notice.
Registration
Rights Agreement
Under our amended and restated registration rights agreement,
Mr. Shaw has the right to request that we register for
public sale, on two occasions, shares of common stock having an
aggregate value of at least
124
$10,000,000. In addition, Mr. Shaw has
piggyback registration rights which allows him to
participate in any registered offerings of our common stock for
our own account or for the account of others (except
non-underwritten registrations initiated by the other party).
Stock
Options
We have filed a registration statement to register for resale
the shares of common stock which are reserved and available for
issuance under our omnibus incentive plan. Accordingly, shares
issued upon the exercise of stock options granted under our
stock option plans, will, subject to vesting provisions and in
accordance with Rule 144 volume limitations applicable to
our affiliates, be eligible for resale in the public market from
time to time.
125
MATERIAL
U.S. FEDERAL INCOME TAX CONSIDERATIONS FOR
NON-U.S. HOLDERS
General
The following is a general discussion of certain United States
federal income and estate tax consequences of the ownership and
disposition of our common stock by a
Non-U.S. Holder.
Generally, for purposes of this discussion, a
Non-U.S. Holder
is a beneficial owner of our common stock who or which is, for
United States federal income tax purposes, a non-resident alien
individual, a foreign corporation, or a foreign estate or trust.
In general, an individual is a non-resident alien individual
with respect to a calendar year if he or she is not a United
States citizen (and in certain circumstances is not a former
United States citizen) and, with respect to such calendar year
(i) has at no time had the privilege of residing
permanently in the United States and (ii) is not present in
the United States a specified number of days in the current year
and the prior two years. Different rules apply for United States
federal estate tax purposes. We refer you to Federal
Estate Taxes below.
The following discussion is based upon current provisions of the
Internal Revenue Code of 1986, as amended, which we refer to as
the Code, existing, proposed and temporary regulations
promulgated under the Code and administrative and judicial
interpretations, all of which are subject to change, possibly on
a retroactive basis. The following discussion does not address
aspects of United States federal taxation other than income and
estate taxation, and does not address all aspects of United
States federal income and estate taxation. The discussion does
not consider any specific facts or circumstances that might
apply to a particular
Non-U.S. Holder
and does not address all aspects of United States federal income
and estate tax law that might be relevant to a
Non-U.S. Holder
subject to special treatment under the Code, for example,
insurance companies, tax-exempt organizations, financial
institutions or broker-dealers. This discussion does not address
the tax treatment of partnerships or persons who hold their
interests through a partnership or other pass-through entity. In
addition, this discussion does not address state, local or
non-United
States tax consequences that might be relevant to a
Non-U.S. Holder,
and does not address the applicability or effect of any specific
tax treaty. Accordingly, prospective purchasers of our common
stock are urged to consult their tax advisors regarding the
United States federal, state and local tax consequences, as well
as
non-United
States tax consequences, of acquiring, holding and disposing of
shares of our common stock.
Dividends
In general, if we were to make distributions with respect to our
common stock, such distributions would be treated as dividends
to the extent of our current or accumulated earnings and profits
as determined under the Code. Any distribution that is not a
dividend will be applied in reduction of the
Non-U.S. Holders
basis in our common stock. To the extent the distribution
exceeds such basis, the excess will be treated as gain from the
disposition of our common stock.
Subject to the discussion below, dividends paid to a
Non-U.S. Holder
of our common stock generally will be subject to withholding of
United States federal income tax at a 30% rate. A lower rate may
apply if the
Non-U.S. Holder
is a qualified tax resident of a country with which the
U.S. has an income tax treaty and if certain procedural
requirements are satisfied by the
Non-U.S. Holder.
A
Non-U.S. Holder
generally will have to file IRS
Form W-8BEN
or successor form in order to be eligible to claim the benefits
of a U.S. income tax treaty. Special rules may apply in the
case of dividends paid to or through an account maintained
outside the United States at a financial institution, for which
certain documentary evidence procedures must be followed.
Withholding generally will not apply in respect of dividends if
(i) the dividends are effectively connected with the
conduct of a trade or business of the
Non-U.S. Holder
within the United States or (ii) a tax treaty applies, the
dividends are effectively connected with the conduct of a trade
or business of the
Non-U.S. Holder
within the United States and are attributable to a United States
permanent establishment (or a fixed base through which certain
personal services are performed) maintained by the
Non-U.S. Holder.
To claim relief from withholding on this basis, a
Non-U.S. Holder
generally must file IRS
Form W-8ECI
or successor form, with the payor of the dividend.
126
Dividends received by a
Non-U.S. Holder
that are effectively connected with the conduct of a trade or
business within the United States or, if a tax treaty applies,
are effectively connected with the conduct of a trade or
business within the United States and attributable to a United
States permanent establishment (or a fixed base through which
certain personal services are performed), are subject to United
States federal income tax on a net income basis (that is, after
allowance for applicable deductions) at applicable graduated
individual or corporate rates. Any such dividends received by a
Non-U.S. Holder
that is a corporation may, under certain circumstances, be
subject to an additional branch profits tax at a 30%
rate or such lower rate as may be specified by an applicable
income tax treaty.
A
Non-U.S. Holder
eligible for a reduced rate of withholding of United States
federal income tax may obtain a refund of any excess amounts
withheld by timely filing an appropriate claim for refund with
the United States Internal Revenue Service.
Gain on
Disposition of Common Stock
A
Non-U.S. Holder
generally will not be subject to United States federal income
tax with respect to gain recognized on a sale, exchange, or
other disposition of our common stock (including a redemption of
our common stock treated as a sale for federal income tax
purposes) unless (i) the gain is effectively connected with
the conduct of a United States trade or business of the
Non-U.S. Holder,
(ii) the
Non-U.S. Holder
is an individual who holds our common stock as a capital asset,
is present in the United States for 183 or more days in the
taxable year of the sale or other disposition, and either the
individual has a tax home in the United States or
the sale is attributable to an office or other fixed place of
business maintained by the individual in the United States,
(iii) the
Non-U.S. Holder
is subject to tax under U.S. tax law provisions applicable
to certain U.S. expatriates (including former citizens or
residents of the United States), or (iv) we are or have
been a United States real property holding
corporation within the meaning of Section 897(c)(2)
of the Code at any time within the shorter of the five-year
period ending on the date of disposition or the
Non-U.S. Holders
holding period and certain other conditions are met. We do not
believe that we are, or are likely to become, a United
States real property holding corporation.
The 183-day
rule summarized above applies only in limited circumstances
because generally an individual present in the United States for
183 days or more in the taxable year of the sale, exchange,
or other disposition will be treated as a resident for United
States federal income tax purposes and therefore will be subject
to United States federal income tax at graduated rates
applicable to individuals who are United States persons for such
purposes.
Non-U.S. Holders
should consult applicable tax treaties, which may result in
United States federal income tax treatment on the sale, exchange
or other disposition of the common stock different from that
described above.
Backup
Withholding Tax and Information Reporting
We must report annually to the IRS and to each
Non-U.S. Holder
any dividend income that is subject to withholding, or that is
exempt from U.S. withholding tax pursuant to a tax treaty.
Copies of these information returns may also be made available
under the provisions of a specific treaty or agreement to the
tax authorities of the country in which the
Non-U.S. Holder
resides.
A
Non-U.S. Holder
of common stock that fails to establish that it is entitled to
an exemption or to provide a correct taxpayer identification
number and other information to the payor in accordance with
applicable U.S. Treasury regulations may be subject to
information reporting and backup withholding on payments of
dividends. The rate of backup withholding is currently 28% but
is scheduled to increase in the year 2011. Backup withholding
may apply to the payment of disposition proceeds by or through a
non-U.S. office
of a broker that is a U.S. person or a
U.S. related person unless certification
requirements are established or an exemption is otherwise
established and the broker has no actual knowledge that the
holder is a U.S. person.
127
The payment of proceeds from the disposition of common stock to
or through the United States office of any broker, U.S. or
foreign, will be subject to information reporting and possible
backup withholding unless the owner certifies as to its
non-U.S. status
under penalty of perjury or otherwise establishes its
entitlement to an exemption from information reporting and
backup withholding, provided that the broker does not have
actual knowledge that the holder is a U.S. person or that
the conditions of an exemption are not, in fact, satisfied. The
payment of proceeds from the disposition of common stock to or
through a
non-U.S. office
of a
non-U.S. broker
that is not a U.S. related person will not be
subject to information reporting or backup withholding. For this
purpose, a U.S. related person is a foreign
person with one or more enumerated relationships with the United
States.
In the case of the payment of proceeds from the disposition of
common stock to or through a
non-U.S. office
of a broker that is either a U.S. person or a
U.S. related person, the regulations require information
reporting (but not backup withholding) on the payment unless the
broker has documentary evidence in its files that the owner is a
Non-U.S. Holder
and the broker has no knowledge to the contrary.
Any amounts withheld under the backup withholding rules from a
payment to a
Non-U.S. Holder
will be allowed as a refund or a credit against such
Non-U.S. Holders
U.S. federal income tax liability provided the requisite
procedures are followed.
Federal
Estate Taxes
An individual
Non-U.S. Holder
who is treated as the owner of our common stock at the time of
his death generally will be required to include the value of
such common stock in his gross estate for United States federal
estate tax purposes and may be subject to United States federal
estate tax on such value, unless an applicable tax treaty
provides otherwise. For United States federal estate tax
purposes, a
Non-U.S. Holder
is an individual who is neither a citizen nor a domiciliary of
the United States. In general, an individual acquires a domicile
in the United States for United States estate tax purposes by
living in the United States, for even a brief period of time,
with the intention of remaining in the United States
indefinitely.
128
UNDERWRITING
Subject to the terms and conditions stated in the underwriting
agreement dated the date of this prospectus, each underwriter
named below has severally agreed to purchase, and we and the
selling stockholders have agreed to sell to that underwriter,
the number of shares set forth opposite the underwriters
name.
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Number
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Underwriter
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of Shares
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J.P. Morgan Securities
Inc.
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1,650,630
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Keefe, Bruyette & Woods,
Inc.
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1,650,630
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|
|
|
|
|
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Total
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|
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3,301,260
|
|
|
|
|
|
|
The underwriting agreement provides that the obligations of the
underwriters to purchase the shares included in this offering
are subject to approval of legal matters by counsel and to other
conditions. The underwriters are obligated to purchase all the
shares (other than those covered by the over-allotment option
described below) if they purchase any of the shares.
We have granted to the underwriters an option, exercisable for
30 days from the date of this prospectus, to purchase up to
495,189 additional shares of common stock at the offering
price less the underwriting discount. The underwriters may
exercise the option solely for the purpose of covering
over-allotments, if any, in connection with this offering. To
the extent the option is exercised, each underwriter must
purchase a number of additional shares approximately
proportionate to that underwriters initial purchase
commitment.
We, our executive officers and directors have agreed that, for a
period of 90 days from the date of this prospectus, we and
they will not, without the prior written consent of a
representative, dispose of or hedge any shares of our common
stock or any securities convertible into or exchangeable for our
common stock, subject to customary exceptions. The underwriters
in their sole discretion may release any of the securities
subject to these
lock-up
agreements at any time without notice.
Our shares of common stock are listed on the New York Stock
Exchange under the symbol FMR.
The following table shows the underwriting discounts that we and
the selling stockholders are to pay to the underwriters in
connection with this offering. These amounts are shown assuming
both no exercise and full exercise of the underwriters
option to purchase additional shares of common stock.
Paid by
the Company
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No
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Full
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|
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Exercise
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Exercise
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Per share
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$
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1.06
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$
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1.06
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Total
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$
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212,000
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|
$
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736,900
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Paid by
the Selling Stockholders
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|
|
|
|
|
|
|
|
|
|
No
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|
Full
|
|
|
Exercise
|
|
Exercise
|
|
Per share
|
|
$
|
1.06
|
|
|
$
|
1.06
|
|
Total
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|
$
|
3,287,336
|
|
|
$
|
3,287,336
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|
In connection with this offering, the underwriters may purchase
and sell shares of common stock in the open market. These
transactions may include short sales, syndicate covering
transactions and stabilizing transactions. Short sales involve
syndicate sales of common stock in excess of the number of
shares to be purchased by the underwriters in this offering,
which creates a syndicate short position. Covered
short sales are sales of shares made in an amount up to the
number of shares represented by the underwriters
over-allotment option. In determining the source of shares to
close out the covered syndicate short position, the underwriters
will consider, among other things, the price of shares available
for purchase in the open market as compared to the price at
which they may purchase shares through the over-allotment
option. Transactions to
129
close out the covered syndicate short involve either purchases
of the common stock in the open market after the distribution
has been completed or the exercise of the over-allotment option.
The underwriters may also make naked short sales of
shares in excess of the over-allotment option. The underwriters
must close out any naked short position by purchasing shares of
common stock in the open market. A naked short position is more
likely to be created if the underwriters are concerned that
there may be downward pressure on the price of the shares in the
open market after pricing that could adversely affect investors
who purchase in this offering. Stabilizing transactions consist
of bids for or purchases of shares in the open market while this
offering is in progress.
The underwriters also may impose a penalty bid. Penalty bids
permit the underwriters to reclaim a selling concession from a
syndicate member when the underwriters repurchase shares
originally sold by that syndicate member in order to cover
syndicate short positions or make stabilizing purchases.
Any of these activities may have the effect of preventing or
retarding a decline in the market price of the common stock.
They may also cause the price of the common stock to be higher
than the price that would otherwise exist in the open market in
the absence of these transactions. The underwriters may conduct
these transactions on the New York Stock Exchange or in the
over-the-counter
market, or otherwise. If the underwriters commence any of these
transactions, they may discontinue them at any time.
We estimate that our portion of the total expenses of this
offering (other than underwriting discounts) will be
$0.5 million.
The underwriters have performed investment banking and advisory
services for us from time to time for which they have received
customary fees and expenses. The underwriters may, from time to
time, engage in transactions with and perform services for us in
the ordinary course of their business. We maintain a credit
facility with JPMorgan Chase Bank, N.A., an affiliate of
J.P. Morgan Securities Inc., pursuant to which we pay
customary fees and expenses.
We and the selling stockholders have agreed to indemnify the
underwriters against certain liabilities, including liabilities
under the Securities Act of 1933, or to contribute to payments
the underwriters may be required to make because of any of those
liabilities.
LEGAL
MATTERS
The validity of the common stock offered hereby will be passed
upon for us by McDermott Will & Emery LLP, Chicago,
Illinois. Certain legal matters related to this offering will be
passed upon for us by Foley & Lardner LLP. Certain
legal matters relating to this offering will be passed upon for
the underwriters by Mayer, Brown, Rowe & Maw LLP,
Chicago, Illinois.
EXPERTS
The consolidated financial statements incorporated by reference
in this prospectus have been audited by BDO Seidman, LLP, an
independent registered public accounting firm, as stated in its
report which is incorporated by reference in this prospectus,
and are incorporated by reference in this prospectus in reliance
upon such report given on the authority of such firm as experts
in accounting and auditing.
WHERE YOU
CAN FIND MORE INFORMATION
We have filed a registration statement on
Form S-1
with the Securities and Exchange Commission for the common stock
we are offering by this prospectus. This prospectus does not
include all of the information
130
contained in the registration statement. You should refer to the
registration statement and its exhibits for additional
information. Whenever we make reference in this prospectus to
any of our contracts, agreements or other documents, the
references are not necessarily complete, and you should refer to
the exhibits attached to the registration statement for copies
of the actual contract, agreement or other document. We are also
required to file annual, quarterly and special reports, proxy
statements and other information with the SEC. All of these
filings are publicly available free of charge on our website at
www.firstmercury.com as soon as practicable after filing
such documents with the SEC. Information contained on our
website is not incorporated by reference into this prospectus
and should not be considered to be part of this prospectus. Our
website address is included here only as a reference. Anyone may
inspect the registration statement and its exhibits and
schedules without charge at the SECs public reference
facilities at 100 F Street, N.E.,
Washington, D.C. 20549. You may obtain copies of all or any
part of these materials from the SEC upon the payment of
duplicating fees prescribed by the SEC. You may obtain further
information about the operation of the SECs Public
Reference Room by calling the SEC at
1-800-SEC-0330,
or you may inspect the reports and other information without
charge at the SECs website, www.sec.gov. First
Mercury Financial Corporation maintains a website at
www.firstmercury.com. Our Bylaws, Corporate Governance
Guidelines, Code of Business Conduct and Ethics, Audit Committee
Charter, Compensation Committee Charter and Nominating and
Corporate Governance Committee Charter are available on this
website under Investor Relations and Corporate
Governance. In addition, you may obtain a copy of any of
these documents without charge by sending a request to First
Mercury Financial Corporation, 29110 Inkster Road,
Suite 100, Southfield, Michigan 48034, Attn: Corporate
Secretary.
INCORPORATION
OF CERTAIN DOCUMENTS BY REFERENCE
The SEC allows us to incorporate by reference in
this prospectus the information in other documents that we file
with it, which means that we can disclose important information
to you by referring to those documents. The information
incorporated by reference is an important part of this
prospectus. We incorporate by reference the documents listed
below:
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our Annual Report on Form 10-K for the year ended December 31,
2006, filed on March 15, 2007;
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our Proxy Statement relating to our annual meeting held on May
9, 2007, filed on April 9, 2007 (other than any portions of such
Proxy Statement that are furnished rather than filed under the
Exchange Act); and
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our Quarterly Report for the quarter ended March 31, 2007, filed
on May 10, 2007.
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We will provide to each person, including any beneficial owner,
to whom a prospectus is delivered, a copy of the reports and
documents that have been incorporated by reference in this
prospectus at no cost. Any such request may be made in writing
or by telephoning us at the following address or phone number:
First Mercury Financial Corporation, 29110 Inkster Road, Suite
100, Southfield, Michigan 48034, (800) 762-6837, Attn: Corporate
Secretary.
These documents may also be accessed through our internet
website at www.firstmercury.com or as described under
Where You Can Find More Information above.
Information contained on our website is not incorporated by
reference into this prospectus and should not be considered to
be part of this prospectus.
131
GLOSSARY
OF SELECTED INSURANCE TERMS
Accident year The annual accounting period in
which loss events occurred, regardless of when the losses are
actually reported, recorded or paid.
Admitted assets Assets of an insurer
permitted by a state to be taken into account in determining the
insurers financial condition for statutory purposes.
Admitted insurers Insurers operating on an
admitted basis that file premium rate schedules and policy forms
for review and, in some states, approval by the insurance
regulators in each state in which they do business. Admitted
carriers also are subject to other market conduct regulation and
examinations in the states in which they are licensed.
Allocated loss adjustment expenses Loss
adjustment expenses specifically identified and allocated to a
particular claim.
Assume To accept from the primary insurer or
reinsurer all or a portion of the liability underwritten by such
primary insurer or reinsurer.
Assumed reinsurance Insurance liabilities
acquired from a ceding company through reinsurance.
Calendar year The calendar year in which loss
events were recorded, regardless of when the losses are actually
reported or paid.
Capacity The percentage of surplus, or the
dollar amount of exposure, that an insurer or reinsurer is
willing or able to place at risk. Capacity may apply to a single
risk, a program, a line of business or an entire book of
business. Capacity may be constrained by legal restrictions,
corporate restrictions, or indirect restrictions.
Case reserves Loss reserves established with
respect to outstanding, individually reported claims.
Casualty insurance Coverage primarily for the
liability of an individual or organization that results from
negligent acts
and/or
omissions, that cause bodily injury
and/or
property damage to a third party.
Combined ratio The sum of the loss and loss
adjustment expense ratio and the expense ratio, each determined
in accordance with GAAP or SAP, as applicable. A combined ratio
under 100% generally indicates an underwriting profit. A
combined ratio over 100% generally indicates an underwriting
loss.
Earned premium The portion of premiums
written that is allocable to the expired portion of the policy
term.
Excess and surplus (E&S)
lines Insurance coverage generally not available
from an admitted company in the regular market; thus, a surplus
lines broker agent representing an applicant seeks coverage in
the surplus lines market from a nonadmitted insurer according to
the insurance regulations of a particular state.
Excess of loss reinsurance Reinsurance that
indemnifies the reinsured against all or a specified portion of
losses under reinsured policies in excess of a specified dollar
amount or retention.
Expense ratio The ratio of (i) the
amortization of deferred acquisition expenses plus other
operating expenses, less expenses related to insurance services
operations, less commissions and fee income related to
underwriting operations to (ii) net earned premiums. (For
statutory purposes, the ratio of underwriting expenses incurred
to net written premiums.)
Fronting The process by which a primary
insurer cedes all or virtually all of the insurance risk of loss
to a reinsurer who also controls the underwriting
and/or
claims handling process either directly or through a managing
general agent.
General liability insurance Coverage
primarily for the liability of an individual or organization
that results from negligent acts
and/or
omissions that cause bodily injury
and/or
property damage on the premises of a business, when someone is
injured as the result of using the product manufactured or
distributed by a business or when someone is injured in the
general operation of a business.
G-1
Hard market The up phase of the
underwriting cycle where competition is less intense,
underwriting standards become more stringent, the supply of
insurance is limited due to the depletion of capital and, as a
result, rates rise. The prospect of higher profits draws more
capital into the marketplace, leading to more competition and
the corresponding down or soft phase of
the cycle.
IBNR claims or IBNR reserves See
Incurred but not reported
Incurred but not reported (IBNR)
reserves Reserves for estimated losses and loss
adjustment expenses which have been incurred but not yet
reported to the insurer.
Incurred losses Paid loss and loss adjustment
expenses, case reserves for estimated losses and loss adjustment
expenses and IBNR reserves.
Insurance Regulatory Information System (IRIS)
ratios Financial ratios calculated by the NAIC to
assist state insurance departments in monitoring the financial
condition of insurance companies.
Liability insurance Coverage for sums that
the insured becomes legally obligated to pay because of bodily
injury or property damage, and sometimes other wrongs to which
an insurance policy applies.
Loss An occurrence that is the basis for
submission
and/or
payment of a claim and the costs of indemnification of such a
claim. Losses may be covered, limited, or excluded from
coverage, depending on the terms of the policy.
Loss adjustment expenses The expenses of
settling claims, including legal and other fees and the portion
of internal operating expenses allocated to claim settlement
costs.
Loss and loss adjustment expense reserves or LAE
reserves A balance sheet liability for unpaid
losses and loss adjustment expenses which represents estimates
of amounts needed to pay losses and loss adjustment expenses,
both on claims which have been reported but have not yet been
resolved and on claims which have occurred but have not yet been
reported.
Loss ratios The ratio of incurred losses and
loss adjustment expenses to net earned premiums.
Loss reserves Liabilities established by
insurers and reinsurers to reflect the estimated cost of claims
incurred that the insurer or reinsurer will ultimately be
required to pay in respect of insurance or reinsurance it has
written. Reserves are established for losses and consist of case
reserves and IBNR reserves.
Losses and loss adjustment expenses The sum
of losses and loss adjustment expenses incurred.
Losses incurred The total losses sustained by
an insurance company under a policy or policies, whether paid or
unpaid. Losses incurred include a provision for IBNR.
National Association of Insurance Commissioners
(NAIC) An organization of the insurance
commissioners or directors of all 50 states and the
District of Columbia organized to promote consistency of
regulatory practice and statutory accounting standards
throughout the United States.
Net earned premiums The portion of premiums
written that is recognized for accounting purposes as revenue
during a period, i.e., the portion of premiums written allocable
to the expired portion of policies after the assumption and
cessation of reinsurance.
Net written premiums Direct written premiums
plus assumed written premiums less premiums ceded to reinsurers.
P&C See Property insurance
and Casualty insurance.
Policyholders surplus As determined
under SAP, the amount remaining after all liabilities, including
loss reserves, are subtracted from all admitted assets.
Policyholder surplus is also referred to as statutory
surplus, surplus or surplus as regards
policyholders for statutory accounting purposes.
Premiums produced Premiums billed by CoverX
on insurance policies that it produces and underwrites on behalf
of FMIC and other third party insurers.
G-2
Professional liability Coverage for
specialists in various professional fields. Since basic
liability policies do not protect against situations arising out
of business or professional pursuits, professional liability
insurance is purchased by individuals who hold themselves out to
the general public as having greater than average expertise in
particular areas.
Property insurance Insurance that provides
coverage to a person with an insurable interest in tangible
property for that persons property loss, damage or loss of
use.
Quota share reinsurance Reinsurance under
which the insurer cedes an agreed fixed percentage of
liabilities, premiums, and losses for each policy covered on a
pro rata basis.
Rates Amounts charged per unit of insurance.
Redundancy (deficiency) Estimates in reserves
change as more information becomes known about the frequency and
severity of claims for each year. A redundancy (deficiency)
exists when the liability is less (greater) than the posted
reserves. The cumulative redundancy (deficiency) is the
aggregate net change in estimates over time subsequent to
establishing the original liability estimate.
Reinsurance Form of insurance that insurance
companies buy for their own protection, i.e., a sharing of
insurance. An insurer reduces its possible maximum loss on
either an individual risk or a large number of risks by giving a
portion of its liability to another insurance company.
Reinsurance recoverables Recoverables on paid
and unpaid losses and loss adjustment expenses, plus ceded
unearned premiums (also referred to as prepaid reinsurance
premiums), less ceded reinsurance balances payable (ceded
premiums payable net of ceding commissions receivable including
any profit sharing ceding commissions).
Reserves or loss reserves Estimated
liabilities established by an insurer to reflect the estimated
costs of claims payments that the insurer will ultimately be
required to pay with respect to insurance it has written.
Retention See Risk retention.
Risk-based capital (RBC) A
measure adopted by the NAIC and enacted by states for
determining the minimum statutory capital and surplus
requirements of insurers with required regulatory and company
actions that apply when an insurers capital and surplus is
below these minimums.
Risk retention The amount or portion of a
risk an insurer retains for its own account after ceded
reinsurance. Losses above the stated retention level are
collectible from the reinsurer. The retention level may be
stated as a percentage or dollar amount.
Soft market The down phase of the
underwriting cycle, characterized by the drop in premium rates
as insurance companies compete vigorously to increase market
share. As the market softens to the point that profits diminish
or vanish completely, the capital needed to underwrite new
business is depleted, leading to less competition and the
corresponding up or hard phase of the
cycle.
Specialty insurance Coverage for businesses
whose risks are harder to assess because of the nature of the
endeavor or limited number of potential insured, where
underwriters have been reluctant to write coverages, or when new
kinds of businesses emerge.
Statutory accounting principles
(SAP) The accounting principles
required by statute, regulation, or rule, or permitted by
specific approval by the insurance department in the insurance
companys state of domicile for recording transactions and
preparing financial statements.
Statutory surplus See
Policyholders surplus.
Subrogation A principle of law incorporated
in insurance policies, which enables an insurance company, after
paying a loss to its insured, to recover the amount of the loss
from another who is legally liable for it.
Surplus See Policyholders
surplus.
G-3
Third party administrator Performance of
managerial and clerical functions related to an insurance plan
by an unaffiliated individual or company.
Third party liability A liability owed to a
claimant (or third party) who is not one of the two
parties to the insurance contract. Insured liability claims are
referred to as third party claims.
Treaty reinsurance A reinsurance agreement
between the ceding company and the reinsurer, usually for one
year or longer, which stipulates the technical particulars
applicable to the reinsurance of some class or classes of
business. Reinsurance treaties may be divided into two broad
classifications: (1) the participating type (proportional)
which provides for sharing of risks between the ceding company
and the reinsurer; and (2) the excess type
(non-proportional) which provides for indemnity by the reinsurer
only for a loss that exceeds some specified predetermined
monetary amount.
Unallocated loss adjustment expenses Loss
adjustment expenses not specifically identified to a particular
case, including claims department expenses, and general overhead
and administrative expenses associated with the adjustment and
processing of claims. These expenses are based on internal cost
studies and analyses.
Underwriter An individual who examines,
accepts, or rejects risks and classifies accepted risks in order
to charge an appropriate premium for each accepted risk. The
underwriter is expected to select business that will produce an
average risk of loss no greater than that anticipated for the
class of business.
Underwriting The insurers or
reinsurers process of reviewing applications for insurance
coverage, and the decision whether to accept all or part of the
coverage and determination of the applicable premiums; also
refers to the acceptance of such coverage.
Underwriting expenses All costs associated
with acquiring and servicing business, including commissions,
premium taxes, and general and administrative expenses.
Underwriting profit or underwriting loss
results The pre-tax profit or loss experienced by a
property and casualty insurance company after deducting loss and
loss adjustment expenses and underwriting expenses. This profit
or loss calculation includes reinsurance assumed and ceded but
excludes investment income.
Unearned premium The portion of premiums
written that is allocable to the unexpired portion of the policy
term.
Writing The issuance by an insurance company
of an insurance policy. Direct writing occurs when the insurance
company issues the insurance policy and has primary liability to
the policyholder. Indirect writing occurs when an insurance
company assumes a portion of the risk under a policy from the
issuer of the insurance policy as a reinsurer or through quota
share arrangements.
G-4
3,301,260 shares
First Mercury
Financial Corporation
Common Stock
PROSPECTUS
June 14, 2007
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JPMorgan |
Keefe,
Bruyette & Woods |