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U.S. SECURITIES AND
EXCHANGE COMMISSION
WASHINGTON D.C. 20549
[Check one]
[ ] Registration Statement Pursuant to Section 12 of the Securities Exchange Act of 1934
or
[X] Annual Report Pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934
For the fiscal year ended: December 31, 2005 Commission File Number: 1-15212
KINGSWAY FINANCIAL SERVICES INC.
_________________
(Exact name of Registrant as specified in its charter)
| Ontario | 6331 | Not Applicable |
| (Province or Other Jurisdiction of | (Primary Standard Industrial | (I.R.S. Employer Identification |
| Incorporation or Organization) | Classification Code Number) | Number, if applicable) |
5310 Explorer Drive, Suite 200, Mississauga, Ontario, Canada L4W 5H8
(905) 629-7888
_________________
(Address and telephone number of Registrant’s principal executive offices)
Kelly Marketti
Kingsway America Inc.
150 Northwest Point Blvd. 6th Floor Elk Grove Village, Illinois 60007
(847) 871-6400
_________________
(Name, address
(including zip code) and telephone number (including area code)
of agent for service in the United States)
Securities registered or to be registered pursuant to Section 12(b) of the Act.
| Title of each class | Name of each exchange on which registered | |
| Common Shares, no par value | New York Stock Exchange, Inc. |
Securities registered or to be registered pursuant to Section 12(g) of the Act. N/A
Securities for which there is a reporting obligation pursuant to Section 15(d) of the Act. N/A
For annual reports, indicate by check mark the information filed with this Form:
| [X] Annual information form | [X] Audited annual financial statements |
Indicate the number of outstanding shares of each of the issuer’s classes of capital or common stock as of the close of the period covered by the annual report.
56,480,453 Common Shares outstanding as of December 31, 2005
Indicate by check mark whether the Registrant by filing the information contained in this Form is also thereby furnishing the information to the Commission pursuant to Rule 12g3-2(b) under the Securities Exchange Act of 1934 (the “Exchange Act”). If “Yes” is marked, indicate the filing number assigned to the Registrant in connection with such Rule.
Yes ____ 82-____ No X
Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days.
Yes X No
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This Amendment No. 1 to the Annual Report of Kingsway Financial Services Inc. (the “Company”) on Form 40-F for the year ended December 31, 2005 is filed herewith for the sole purpose of providing certain additional information contained in the Company’s Amended Management’s Discussion and Analysis of Financial Condition and Results of Operation (“Amended MD&A”). The Amended MD&A was prepared at the request of the Ontario Securities Commission to add certain information related to the Company’s evaluation of its disclosure controls and procedures. The additional disclosure can be found on page 53 of the Amended MD&A.
This 40-F/A consists of a cover page, this explanatory note, the above-described Amended MD&A, the signature page and certifications made by the Chief Executive Officer and Chief Financial Officer of the Registrant pursuant to Section 302 and Section 906 of the Sarbanes-Oxley Act of 2002.
Other than as expressly set forth above, this Form 40-F/A does not and does not purport to, update, or restate the information in any Item of the Form 40-F or reflect any events that have occurred after the Form 40-F was filed.
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DOCUMENTS FILED UNDER COVER OF THIS FORM
| Item | Description | Sequential Page Number | |||
| 3. | Management’s Discussion and Analysis of Financial Condition and Results of Operations. | 4 |
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Document No. 3
The following discussion of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and related notes included elsewhere in this annual report. The commentary is current as of March 17, 2006. Our financial statements are prepared in accordance with Canadian Generally Accepted Accounting Principles (GAAP). See note 17 of the consolidated financial statements for a reconciliation of Canadian and United States GAAP. Additional information relating to Kingsway is available on SEDAR at www.sedar.com which can also be accessed from our website www.kingsway-financial.com. This annual report, including the following discussion, contains forward-looking statements that involve risks and uncertainties. Our actual results could differ substantially from those anticipated in these forward-looking statements as a result of several factors, including those set forth under the section entitled “Risk Factors” and elsewhere in this annual report.
From time to time, we make written and oral forward-looking statements, in this annual report, in other filings with Canadian regulators or the U.S. Securities and Exchange Commission (SEC), and in other communications. Forward-looking statements include, among others, statements regarding the Company’s objectives and strategies to achieve them. Forward-looking statements are typically identified by words such as “believe”, “expect”, “may” and “could”. By their very nature, these statements are subject to inherent risks and uncertainties, general and specific, which may cause actual results to differ materially from the expectations expressed in the forward-looking statements. Some of the factors that could cause such differences are discussed under the section of this annual report entitled “Risk Factors” and in other regulatory filings made in Canada and with the SEC. The discussion of factors under the section entitled “Risk Factors” is not exhaustive of all possible factors, and other factors could also adversely affect the Company’s results.
All such factors should be considered carefully when making decisions with respect to the Company, and undue reliance should not be placed on the Company’s forward-looking statements. The Company does not undertake to update any forward-looking statements, written or oral, that may be made from time to time by or on its behalf.
All of the dollar amounts in this annual report are expressed in U.S. dollars, except where otherwise indicated. References to “U.S. dollars”, “dollars” or “US$” are to U.S. dollars and any references to “Canadian dollars” or “C$” are to Canadian dollars. As presented in this annual report, our Canadian and U.S. segment information includes the results of our Bermuda and Barbados reinsurance subsidiaries, respectively.
Exhibit Index appears on Page 79
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Non-GAAP Measures
The Company uses both GAAP and certain non-GAAP measures to assess performance. Securities regulators require that companies caution readers about non-GAAP measures that do not have a standardized meaning under GAAP and are unlikely to be comparable to similar measures used by other companies. Kingsway, like many insurance companies, analyzes performance based on underwriting ratios such as combined, expense and loss ratios. These terms are defined in the glossary of terms section beginning on page 81 of the Annual Report. The Company also uses investment portfolio per share information which is calculated based on the fair value of the investment portfolio divided by the number of issued and outstanding common shares. The Company uses net operating income information which is calculated as net income excluding after-tax net realized gains and losses on investments. A reconciliation of net income to net operating income is presented below.
| (In thousands of U.S. dollars) | 2005 | 2004 | 2003 | ||||
| Net income, as reported | $ 135,008 | $ 101,014 | $ 60,877 | ||||
| Net realized gains before taxes, as reported | 38,239 | 20,392 | 41,466 | ||||
| Tax effect on net realized gains | 9,589 | 3,669 | 8,836 | ||||
| Net realized gains after tax | 28,650 | 16,723 | 32,630 | ||||
| Net operating income | $ 106,358 | $ 84,291 | $ 28,247 | ||||
Change in Reporting Currency
As the majority of the Company’s operations are in the United States or are conducted in U.S. dollars, effective December 31, 2005, the Company has prepared its financial statements and its Management’s Discussion and Analysis in U.S. dollars in order to provide more meaningful information to its users. However, the Company’s functional currency will remain Canadian dollars for Canadian and head office operations and U.S. dollars for U.S. operations. To effect this conversion, figures contained in this report have been translated into U.S. dollars using the current rate method, pursuant to which the consolidated statements of earnings and cash flows have been translated using the average rate of exchange for the relevant year, all assets and liabilities have been translated using the relevant year end rate of exchange and share capital has been translated using the rates of exchange in effect as of the dates of various capital transactions. Foreign exchange differences arising from the translation as described above have been recorded in the currency translation account which is included as a separate component of shareholders’ equity. All relevant financial information has been restated to reflect the company’s results as if they had been historically reported in U.S. dollars.
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Our Company
Kingsway is a specialty provider of personal and commercial lines of property and casualty insurance in the United States and Canada. Our principal lines of business are trucking and non-standard automobile insurance. According to A.M. Best gross premiums written data, we are the largest truck insurer in North America and the seventh largest non-standard auto-mobile insurer in North America. We are also the largest writer of motorcycle insurance in Canada and the largest writer of taxi cab insurance in Chicago, Illinois and Las Vegas, Nevada.
Non-standard automobile insurance covers drivers who do not qualify for standard automobile insurance coverage because of their payment history, driving record, place of residence, age, vehicle type or other factors. Such drivers typically represent higher than normal risks and usually pay higher insurance rates for comparable coverage. We also provide standard automobile insurance as well as insurance for commercial and public vehicles, including taxis.
We also provide motorcycle insurance, specialized commercial and personal property coverages and other specialty coverages, such as customs, bail and surety bonds. For the year ended December 31, 2005, we derived 31% of our gross premiums written from trucking insurance, 29% from non-standard auto, 13% from commercial and personal property coverages, 12% from commercial automobile, 7% from standard automobile, 3% from motorcycle and 5% from other specialty lines.
We are the leading provider of non-standard automobile in Canada and have a prominent position in several U.S. markets in which we currently operate, such as Illinois and Florida. We are the third largest writer of non-standard automobile insurance in Illinois and the seventh largest in Florida according to A.M. Best data. We are the second largest writer of trucking insurance in the United States and a leading trucking insurer in Canada, making us the largest trucking insurer in North America according to A.M. Best data.
Kingsway Financial is the holding company for all of our subsidiaries and Kingsway America is the holding company for all of our U.S. operating subsidiaries. We operate our business through our insurance subsidiaries which include Kingsway General Insurance Company, York Fire & Casualty Insurance Company, and Jevco Insurance Company in Canada and Universal Casualty Company, Southern United Fire Insurance Company, American Service Insurance Company, Inc., Lincoln General Insurance Company, U.S. Security Insurance Company, American Country Insurance Company and Zephyr Insurance Company Inc. in the United States. We also have wholly owned reinsurance subsidiaries domiciled in Bermuda and Barbados. During the year ended December 31, 2005, we generated 68% of our gross premiums written from the United States and 32% from Canada.
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In 2005, our gross premiums written were $1.89 billion, compared to $2.00 billion in 2004. Our return on equity averaged 15.0% for the five fiscal years 2001 to 2005, and for the year ended December 31, 2005, was 18.4% compared to 16.6% in 2004. As of December 31, 2005, we had total assets of $3.80 billion. During the year ended December 31, 2005, shareholders’ equity increased 21% to $804.7 million.
The property and casualty insurance industry is highly competitive and fragmented. However, we generally seek to identify and operate in specialty markets which present opportunities for us to compete effectively due to the narrow scope or limited size of the market or the specialty nature of the coverage or risk. These specialty markets may be defined by geographic area, type of insurance or other factors. We focus on specialty lines of automobile, property and casualty insurance where we believe competition is more limited. We emphasize underwriting profit and will not knowingly underwrite risks at rates which we believe are unprofitable in order to increase our premium volume. We believe that by executing this strategy we will be able to deliver returns that will exceed the average in our industry over a long period of time.
We use the claims ratio, the expense ratio and the combined ratio as important measures of our performance. The claims ratio is derived by dividing the amount of net claims incurred by net premiums earned. The expense ratio is derived by dividing the sum of commissions and premium taxes and general and administrative expenses by net premiums earned. The combined ratio is the sum of the claims ratio and the expense ratio. A combined ratio below 100% demonstrates underwriting profit whereas a combined ratio over 100% demonstrates an underwriting loss. We believe that underwriting profit is the true measure of performance of the core business of a property and casualty insurance company. We have reported an underwriting profit in 13 years out of 16 since the Company’s first full year of operations in 1990 and in four of the last five years. Management’s incentive compensation is directly linked to our combined ratio and our return on equity objectives.
In recent years, the North American property and casualty insurance market, including the trucking and non-standard automobile markets, have been less price competitive than in the late 1990’s. Many insurers significantly reduced premium rates from 1998 to 2000 due to higher investment returns and an over-capitalization of the industry which subsequently led to poor underwriting results in 2001 and 2002, investment impairments and an erosion of capital. As a result, premium rates began to rise and the industry posted improved underwriting results for 2003 and 2004 but a slight deterioration is expected for 2005 based on available industry estimates.
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Following the improved results in 2003 and 2004 certain automobile markets experienced pressure from governments to reduce premium rates in 2005. 2005 was also a year in which there was significant storm activity in the southern United States leading to a substantial loss of capital to reinsurers. Short-term interest rates also increased modestly during 2005 from historically low levels, but are still at levels which are much lower than those of the late 1990’s. As a result of these trends, we expect that 2006, like 2005, will be a year with good results, slow premium growth and increased reinsurance costs for insurance companies both in the United States and Canada. We believe insurance companies which have traditionally relied extensively on reinsurance capacity to support their premium levels will find this environment particularly challenging. We believe that the combination of these factors will lead to a modest deterioration in underwriting results for the property and casualty industry which will be partially offset by increased investment income in 2006.
Our strategy is to specialize in areas of insurance where we have developed expertise such as trucking, non-standard automobile, motorcycle and taxis. We will then bring this expertise, underwriting discipline and knowledge to a broad range of geographic markets so our risks are well diversified.
Our strategy is to build long-term shareholder value and is characterized by the following principles:
| • | Strong claims operations tailored to local markets. We seek to protect our business through diligent claims management. Our claims are managed by our experienced personnel located in our regional operating subsidiaries and by selected program managers. We maintain a culture of rigorously investigating claims, promptly paying legitimate claims, preventing fraud and litigating our claims as necessary before final settlement. |
| • | Distinctive underwriting capabilities in target specialty markets. We manage our business with a strict focus on underwriting profit rather than on premium growth or market share and have demonstrated our willingness to increase pricing or reduce or increase premium volumes based on market conditions. Over the five year period ended December 31, 2005, our combined ratio averaged 99.1%. For the year ended December 31, 2005, our combined ratio was 97.2%. |
| We seek to identify market segments where we believe competition is more limited, presenting the potential for above average underwriting results. We operate through a network of regionally based operating subsidiaries. Our decentralized operating structure allows us to target specialized markets and products based on our underwriting expertise and knowledge of local market conditions. |
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| We rely on our detailed understanding of our regional markets to take advantage of favourable conditions or trends. We look for opportunities to expand our specialty focus into selected regional markets and to increase the distribution of our core products in our existing territories. We may also look for opportunities to acquire books of business or other companies which are in line with our specialty focus. |
| • | Rigorous industry leading program management capabilities. Our program management begins with a thorough due diligence review of agents’ operations and understanding of their historical results. This review is performed by a team of individuals with extensive underwriting, actuarial and claims management expertise. |
| We maintain strict control over programs by limiting the claims authority granted to agents and structuring the agents agreements so that we have all pricing and reinsurance authority. Our program managers have the opportunity to significantly increase their compensation through commission incentives which are strictly tied to our underwriting profit on their program. |
| Each program manager is subject to regular and vigorous audits to ensure disciplined underwriting and claims processes are in place and being followed in accordance with the agreement. |
| • | An extensive network of independent agents and program managers focused on specialty markets. We are committed to our distribution network of independent agents, program managers and brokers. We continually strive to provide the highest level of service to our agents, program managers and brokers and to build relationships at the local level in the markets in which we operate. We communicate with our network through a variety of channels and we look for opportunities to increase efficiency and further reduce our operating costs, including through the use of technology and automation. We also look for opportunities to expand our distribution relationships and enhance our product mix. |
| • | Shared corporate support function. Our corporate structure helps to meet varied local conditions under a cohesive set of policies and procedures designed to provide underwriting discipline, consistency and control. We believe we can derive efficiencies and cost savings by sharing corporate support functions such as investment management, information systems development, purchasing of reinsurance, procurement and accommodation. |
| • | Outstanding management. Each of our eleven operating subsidiaries is led by an experienced executive team with expertise in their chosen niche lines of business and extensive knowledge of their local markets. The average experience of the president of each subsidiary exceeds twenty years. |
| The operating subsidiaries are supported and guided by an executive management team at Kingsway Financial Services Inc.. The individuals on this team average more than 23 years of experience and are led by Bill Star, our President and Chief Executive Officer, who has over fifty years of industry experience. |
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Through our wholly owned subsidiaries in Canada and the United States, we are licensed to write a broad range of property and casualty insurance in all Canadian provinces and territories and in all states and the District of Columbia in the United States. We distribute all of our products through independent agents, program managers, and brokers.
We conduct our operations through our subsidiaries to, among other things:
| • | maintain discrete brand identities; and |
| • | develop expertise and organizational cultures that best serve the individual markets in which we operate. |
We believe that the markets for our insurance products differ greatly by community because regulations, legal decisions, government interference, traffic, law enforcement, cultural attitudes, insurance agents, medical services and auto repair services vary greatly by jurisdiction and by community.
Critical Accounting Estimates
Our significant accounting policies are described in note 2 to the audited consolidated financial statements included on pages 63 to 64 of the annual report. The preparation of financial statements in conformity with generally accepted accounting principles in Canada requires management to make certain estimates and assumptions, some of which may relate to matters that are uncertain. As more information becomes known, these estimates and assumptions could change and thus have a material impact on the Company’s financial condition and results of operations in the future. The most significant estimates and assumptions used in preparing our financial statements are described below.
Provision for unpaid claims
A significant degree of judgement is required to determine amounts recorded in the financial statements for the provision for unpaid claims. The process for establishing the provision for unpaid claims reflects the uncertainties and significant judgemental factors inherent in predicting future results of both known and unknown claims. Further information regarding our provision for unpaid claims is discussed in the Provision for Unpaid Claims section of Management’s Discussion and Analysis and in note 10 to the consolidated financial statements.
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Impairment of investments
The establishment of an other-than-temporary impairment on an investment security requires a number of judgements and estimates. Management performs a quarterly analysis of our investment holdings to determine if declines in market value are other than temporary. Further information regarding our detailed analysis and factors considered in establishing an other-than-temporary impairment on an investment security are discussed within the portfolio monitoring section in the investment and investment income section of Management’s Discussion and Analysis.
Goodwill and intangible assets
Goodwill and intangible assets with an indefinite life are assessed for impairment at least annually by applying a fair value based test. In determining fair value, valuation models such as price-to-earnings ratios and other multiples are used. Management must make estimates and assumptions in determining the fair value of a business segment which may affect any resulting impairment write-down. Additional information regarding our goodwill and intangible asset accounting policy is included in note 2(f) to the consolidated financial statements.
Income taxes
The provision for income taxes is calculated based on the expected tax treatment of transactions recorded in our consolidated financial statements. In determining our provision for income taxes, we interpret tax legislation in a variety of jurisdictions and make assumptions about the expected timing of the reversal of future tax assets and liabilities and the valuation of future income tax assets related to tax loss carryforwards. Additional information regarding our income tax provision is included in note 2(l) and note 9 to the consolidated financial statements.
Revenues reflected in our consolidated financial statements are derived from insurance premiums earned, investment income and net realized investment gains. Our total revenues increased 3% to $1.92 billion in 2005 from $1.87 billion in 2004 which was an increase of 4% over the $1.81 billion in 2003.
We compete on the basis of numerous factors such as distribution strength, pricing, agency and broker relationships, service, reputation and financial strength. We are the largest truck insurer in North America and the seventh largest non-standard auto insurer. In Canada, where we are the largest insurer of non-standard auto, our main competitor is Pembridge Insurance Company, a subsidiary of The Allstate Corporation. Our main Canadian competition for trucking is Markel Insurance Company, a subsidiary of Northbridge Financial Corporation. In the United States, we face competition in our
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non-standard automobile lines from Progressive, Allstate, State Farm and GEICO and in our trucking lines from Old Republic General Group, Zurich Financial Services Group and Canal Insurance Company. We also compete in both Canada and the United States with numerous smaller insurance companies in our regional markets. Many of our larger competitors have greater financial and other resources than we do, have more favourable A.M. Best ratings and offer more diversified insurance coverages. In the fragmented non-standard automobile markets in the United States, however, many of our competitors are small companies with limited capital resources who generally have less favourable A.M. Best ratings and who have traditionally relied upon the support of reinsurers to supplement their capital. We believe that recent reinsurance market conditions will lead to a contraction of this capital support by reinsurers.
Our competitors include other companies that, like us, serve the independent agency market, as well as companies that sell insurance directly to customers. Direct underwriters do not typically operate in specialty lines of insurance, but may have certain competitive advantages over agency underwriters in standard insurance lines, including increased name recognition, loyalty of the customer base to the insurer rather than an independent agency and, potentially, reduced policy acquisition costs.
Our markets may attract competition from time to time from new or temporary entrants in our niche markets. In some cases, these entrants may, because of inexperience, desire for growth or other reasons, price their insurance below the rates that we believe provide an acceptable premium for the related risk. We believe that it is generally not in our best interest to compete solely on price, and may from time to time experience a loss of market share during periods of intense price competition or “soft” market conditions.
We believe that our ability to compete successfully in our industry will be based on:
| • | our ability to identify specialty markets which are more likely to produce an underwriting profit; |
| • | our disciplined underwriting approach; |
| • | our diversified product and geographic platforms; |
| • | our prudent claims management; |
| • | cost containment and the economics of shared support functions; and |
| • | the service and competitive commissions we provide to our independent agents, program managers and brokers. |
Any new, proposed or potential legislative or industry developments could further increase competition in our markets. New competition from these developments could cause the prices for insurance to fall, which would adversely affect our underwriting profitability.
We employ stringent underwriting standards to develop a broad spread of risk and to receive an appropriate premium for each risk. Our underwriting philosophy stresses receiving an adequate premium and spread of risks for the business we accept. Rather than attempt to select individual risks, we seek to set premium rates at levels that
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should generate profitable underwriting. Once we have set premium rates that we believe are adequate, we are generally willing to accept as much business within our underwriting guidelines as is available to us. We regularly monitor premium adequacy by territory and class of business and make adjustments as required. We do not reduce our pricing when competitors offer to underwrite certain classes of business at premium rates which are below what we believe is an acceptable level. Instead, we elect to maintain our premium per risk rather than write a large number of risks at premiums which we consider to be inadequate. In such instances, our premium volumes may decrease. Underwriting profitability is primarily dependent on the claims amounts incurred on the policies sold in relation to net premiums earned. At the time premium levels are established, the claims amounts to be incurred on the policies sold is unknown, and the process for estimating claims is inherently uncertain and imprecise.
We regularly consider and implement various initiatives to address adverse profitability trends in our business. These initiatives vary by jurisdiction, but include tightening of underwriting requirements, price increases, reduction in agent commissions, policy non-renewals (where permitted) and other administrative changes. All companies writing automobile insurance in Canada and all lines of business in most U.S. jurisdictions must have their premium rates approved by the applicable regulatory authority. Once these rates are approved, an insurance company is prohibited from altering them without regulatory approval for new rates.
We market and distribute our automobile insurance products through a network of over 2,900 independent agents and approximately 22 program managers in the United States and over 3,000 independent brokers across Canada. We maintain an “open market” approach which allows these agents and brokers to place business with us with no minimum commitments and provides us with a broad, flexible and easily scalable distribution network. We believe that this approach is different from that used by many automobile insurance companies.
We focus on developing and maintaining strong relationships with our independent agents, program managers and brokers. We continually strive to provide excellent service in the local markets in which we operate, and communicate with them through a variety of channels and we look for opportunities to increase efficiency and reduce operating costs.
Our independent agents, program managers and brokers generally have the authority to bind policies on our behalf with respect to specified insurance coverages within our prescribed underwriting guidelines. These guidelines prescribe the kinds and amounts of coverage that may be written and the premium rates that may be charged for specified categories of risk. In most cases, we do not delegate authority to settle or adjust claims, establish underwriting guidelines, develop rates or enter into other transactions or commitments with our independent agents, program managers or brokers. Certain program managers have greater authority than our independent agents and brokers. These relationships are subject to a rigorous audit process to ensure that they adhere to our underwriting standards and claims handling procedures.
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We write automobile insurance primarily for the non-standard automobile and trucking markets. We also write insurance in selected other lines of business for both individuals and commercial customers. Other coverages that we provide for individuals include motorcycle, homeowners and selected specialty lines. Our commercial coverages include automobile (including taxis), trucking, property and selected specialty lines such as customs bonds. Our personal lines business accounted for 44% of our gross premiums written for the year ended December 31, 2005 and 56% were generated from our commercial lines.
Our automobile insurance products provide coverage in three major areas: liability, accident benefits and physical damage. Liability insurance provides coverage, where our insured is responsible for an automobile accident, for the payment for injuries and property damage to third parties. Accident benefit policies or personal injury protection policies provide coverage for loss of income, medical and rehabilitation expenses for insured persons who are injured in an automobile accident, regardless of fault. Physical damage coverages provide for the payment of damages to an insured automobile arising from a collision with another object or from other risks such as fire or theft. Automobile physical damage and liability coverages generally provide more predictable results than automobile personal injury insurance.
Our gross premiums written were $1.89 billion in 2005, compared to $2.00 billion in 2004. In 2005, we experienced an increase of 5% in gross premiums written for our Canadian operations and a decrease of 9% for our U.S. operations.
The following table sets forth our gross premiums written by line of business for the periods indicated:
| 2005 | 2004 | |||||||||
|---|---|---|---|---|---|---|---|---|---|---|
| Non-Standard Automobile | $ 551.3 | 29.1 | % | $ 706.3 | 35.3 | % | ||||
| Standard Automobile | 130.0 | 6.9 | 127.3 | 6.3 | ||||||
| Motorcycle | 59.5 | 3.2 | 47.0 | 2.3 | ||||||
| Property (including liability) | 59.5 | 3.1 | 39.3 | 2.0 | ||||||
| Other Specialty Lines | 42.4 | 2.2 | 21.0 | 1.1 | ||||||
| Total Personal | $ 842.7 | 44.5 | % | $ 940.9 | 47.0 | % | ||||
| Trucking | $ 587.4 | 31.0 | % | $ 582.6 | 29.1 | |||||
| Commercial Automobile | 226.8 | 12.0 | 236.8 | 11.8 | ||||||
| Property (including liability) | 185.5 | 9.8 | 199.5 | 10.0 | ||||||
| Other Specialty Lines | 52.3 | 2.7 | 42.0 | 2.1 | ||||||
| Total Commercial | $ 1,052.0 | 55.5 | % | $ 1,060.9 | 53.0 | % | ||||
| Total Gross Premiums Written | $ 1,894.7 | 100.0 | % | $ 2,001.8 | 100.0 | % | ||||
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We conduct our business in the United States and Canada. The following table sets forth our gross premiums written by state and province for the periods indicated:
| 2005 | 2004 | |||||||||
|---|---|---|---|---|---|---|---|---|---|---|
| California | $269.5 | 14.2 | % | $271.3 | 13.6 | % | ||||
| Illinois | 210.3 | 11.1 | 207.8 | 10.4 | ||||||
| Florida | 186.3 | 9.8 | 208.3 | 10.4 | ||||||
| Texas | 113.8 | 6.0 | 156.8 | 7.8 | ||||||
| New Jersey | 50.0 | 2.7 | 58.3 | 2.9 | ||||||
| Pennsylvania | 41.3 | 2.2 | 45.6 | 2.3 | ||||||
| Alabama | 32.2 | 1.7 | 37.2 | 1.9 | ||||||
| Other | 381.3 | 20.1 | 433.0 | 21.6 | ||||||
| Total United States | $ 1,284.7 | 67.8 | % | $ 1,418.3 | 70.9 | % | ||||
| Ontario | $ 381.4 | 20.1 | % | $ 343.0 | 17.1 | % | ||||
| Québec | 101.7 | 5.4 | 94.6 | 4.7 | ||||||
| Alberta | 94.0 | 5.0 | 108.4 | 5.4 | ||||||
| Other | 32.9 | 1.7 | 37.5 | 1.9 | ||||||
| Total Canada | $ 610.0 | 32.2 | % | $ 583.5 | 29.1 | % | ||||
| Total | $ 1,894.7 | 100.0 | % | $ 2,001.8 | 100.0 | % | ||||
Non-standard automobile insurance accounted for 29% and 35% of our gross premiums written for the years ended December 31, 2005 and 2004, respectively. Non-standard automobile insurance is principally provided to individuals who do not qualify for standard automobile insurance coverage because of their payment history, driving record, place of residence, age, vehicle type or other factors. Such drivers typically represent higher than normal risks and pay higher insurance rates for comparable coverage. As underwriting standards for providing standard coverages have become more restrictive and many jurisdictions now require insurance regardless of driving record, high risk individuals have been forced to seek non-standard coverage and have contributed to the increase in the size of the non-standard automobile insurance market.
Non-standard automobile insurance is generally accompanied by increased loss exposure, higher claims experience and a higher incidence of consumer and service provider fraud. In addition, policy renewal rates tend to be low for non-standard automobile policies as policyholders often lapse their policies because of non-payment of premiums and subsequently reapply as new policyholders. This creates an ongoing requirement to replace non-renewing policyholders with new policyholders and to react promptly to issue cancellation notices for non-payment of premiums to mitigate potential bad debt write-offs. However, these factors are mitigated to some extent by higher premium rates, the tendency of high-risk individuals to own low value automobiles, and generally lower limits of insurance coverage.
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The insuring of non-standard drivers is often transitory, and when their driving records improve, insureds may qualify to obtain insurance in the standard market at lower premium rates. As a result, our non-standard automobile insurance policies experience a retention rate that is lower than that experienced for standard market risks. Most of our insureds pay their premiums on a monthly instalment basis. We typically limit our risk of non-payment of premiums by requiring a deposit for two months of insurance premiums and the prepayment of subsequent instalments.
In the United States and Canada, automobile insurers are generally required to participate in various involuntary residual market pools and assigned risk plans that provide automobile insurance coverages to individuals or other entities that are unable to purchase such coverage in the voluntary market. For example, in Ontario, every insurer is required to be a member of the Facility Association, an entity that was created to ensure the availability of automobile insurance to every motorist. The Facility Association selects designated carriers to provide coverage and claims handling services to drivers who are unable to purchase insurance through private carriers, in return for an administration fee. Assessments from the Facility Association increased our underwriting profit by $4.3 million in 2005 and by $3.4 million in 2004. Participation in these pools in most jurisdictions is in proportion to voluntary writings of selected lines of business in that jurisdiction.
In Canada, we are the largest writer of non-standard automobile insurance and operate primarily in Ontario, Québec and Alberta, with Ontario being our largest market in 2005. The non-standard automobile insurance market in Canada is primarily focused on providing drivers with minimum levels of liability coverage with accident benefit insurance.
In the United States, we write non-standard automobile insurance in Illinois, South Carolina, Florida, Mississippi, Alabama, Missouri, Indiana, Texas, Georgia, California, Louisiana, Ohio and Virginia. Our business in Illinois is presently concentrated in the Chicago metropolitan area, although we are expanding into other areas. In the United States, non-standard automobile insurance policies generally have lower limits of insurance commensurate with the minimum coverage requirement under the statute of the state in which we write the business. These limits of liability are typically not greater than $40,000 per occurrence.
During the year, we entered into a program management agreement with the Robert Plan Corporation to assume its non-standard automobile risks commencing January 1, 2006. In states where non-standard automobile risks are assigned to standard automobile insurance companies, the Robert Plan, through one of our subsidiaries, offers to assume these assigned risks from the standard insurer for a pre-agreed buy-out fee.
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We provide coverage for liability, accident benefits, physical damage, cargo and comprehensive general liability under a package program throughout both Canada and the United States. In Canada, we may offer policies with limits of liability of up to C$10 million as many of our insured trucks travel throughout the U.S. and Canada. We then purchase reinsurance to limit our exposure for any one risk or occurrence to C$2.5 million. In the United States we do not offer policies for trucking liability in excess of $1 million per risk. Recent market conditions have allowed us to increase our prices and expand our relationships. We are now the largest trucking insurer in North America as well as the second largest in both Canada and the United States.
In the year ended December 31, 2005, gross premiums written from trucking were $587.4 million compared to $582.6 million in 2004. Trucking insurance accounted for 31% and 29% of our gross premiums written for the years ended December 31, 2005 and 2004, respectively.
Commercial automobile policies provide coverage for taxis, rental car fleets and garage risks. Through American Service and American Country, we are the largest writer of taxi risks in Chicago, Illinois and Las Vegas, Nevada. In the year ended December 31, 2005, gross premiums written from commercial automobile decreased by 4% to $226.8 million compared to $236.8 million in 2004.
Standard automobile insurance provides coverage for drivers of standard risk private passenger automobiles. Premiums for these types of policies are usually lower than premiums charged in the non-standard market for comparable coverages. However, the frequency and severity of accidents and other loss events are also typically lower. Our standard automobile business is written in Ontario and Alberta. In the year ended December 31, 2005, gross premiums written from standard automobile increased by 2% to $130.0 million compared to $127.3 million in 2004.
Motorcycle insurance consists primarily of liability, physical damage and personal injury insurance coverages. In Canada, we are the leading writer of motorcycle insurance, writing over 30% of the total market, and we write motorcycle insurance in the provinces of Ontario, Alberta and Québec. We also write motorcycle insurance in the United States. In the year ended December 31, 2005, gross premiums written from motorcycle increased by 27% to $59.5 million compared to $47.0 million in 2004.
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We write property (including liability) insurance for businesses and individuals in Canada and the United States. This business focuses on insuring against damage to property and accidents that may occur on such property. Our commercial property and liability business consists of risks that are difficult to place due to class, age, location or occupancy of the risk. These risks are characterized by high premiums and deductibles and limited coverage. We generally limit our exposure to no more than C$0.5 million in Canada and $0.5 million in the United States on any one risk.
Our specialty property business includes insurance for restaurants, rental properties and garages. We also write non-hydrant protected homeowners insurance and habitational risks which do not qualify for coverage by writers of standard insurance. We also offer pet health insurance in the United States.
We provide coverage on a very itemized named perils basis with relatively high rates and high deductibles for risks that are considered substandard by other companies. We believe these risks provide us with the opportunity to achieve attractive returns.
During the year, we acquired Zephyr Insurance Company Inc., a provider of residential wind insurance coverage in the state of Hawaii. Zephyr’s operating niche complements our core strategy of providing products and services to specific, defined segments of the insurance marketplace. Zephyr is protected by a reinsurance program further described in the reinsurance section of Management’s Discussion and Analysis.
Our strategy is to operate as a niche underwriter of classes of property business that are more difficult to underwrite and offer the potential to achieve higher levels of underwriting profitability. We underwrite this business using our carefully developed underwriting methodology based on a stringent set of criteria. This type of property business is seldom subject to a high degree of competition and we have often been able to write these policies at relatively high rates with fairly restricted coverage.
Our other specialty lines include customs, bail and surety bonds written in both the United States and Canada. Custom bonds involve insuring the timely payment of customs duties on goods imported into the United States and Canada, as well as any penalties incurred due to late payment of the duties or administrative non-compliance. Such duties generally represent less than 5% of the face value of the imported goods. We also write contract payment and performance and other miscellaneous surety bonds as well as bail bonds in California.
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In our warranty insurance business, we assume the liability for performance under the terms of service contracts and limited warranties issued by retailers of automobiles, home appliances, furniture and electronics and by residential home builders. This coverage indemnifies the consumer against loss resulting from service contract claims that occur during a specified period after expiration of the manufacturer’s or builder’s warranty which is typically several years later than the year in which the premium is written. We discontinued writing any new warranty business during 2003.
Overview & Strategy
Our business philosophy stresses the importance of both underwriting profits and investment returns to build shareholder value. We manage our investment portfolio primarily to support the liabilities of our insurance operations and to generate investment returns. We invest predominantly in corporate, government and municipal bonds with relatively short durations. We also invest in preferred and common equity securities and other interest-bearing instruments, and we consider our finance premium receivables to be a part of our investment portfolio. Our overall investment strategy is aimed at maximizing returns without compromising liquidity and risk control. All of our investments are managed by professional, third party investment management firms and their performance is actively monitored by management and the Investment Committee of the Board of Directors.
Our investment guidelines stress the preservation of capital, market liquidity to support payment of our liabilities and the diversification of risk. With respect to fixed maturity securities, we generally purchase securities with the expectation of holding them to their maturity.
Portfolio Composition
At December 31, 2005, we held cash and investments with a fair value of $2.93 billion and a carrying value of $2.91 billion, resulting in a net unrealized gain of $18.2 million. We currently maintain and intend to maintain an investment portfolio comprised primarily of fixed income securities. Our insurance subsidiaries’ investments must comply with applicable regulations which prescribe the type, quality and concentration of investments. These regulations in the various jurisdictions in which our insurance subsidiaries are domiciled, permit investments in government, state, provincial, municipal and corporate bonds, and preferred and common equities, within specified limits and subject to certain qualifications. Our U.S. operations typically invest in U.S. dollar denominated investments, and our Canadian operations primarily invest in Canadian dollar investments to minimize their exposure to currency rate fluctuations.
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The following table summarizes the fair value of our investment portfolio, including cash and cash equivalents and premium finance receivables, at the dates indicated:
| 2005 | 2004 | ||||
| Type of investment | |||||
| Term deposits | $ 381.17 | $ 264.3 | |||
| Government bonds | 427.8 | 493.1 | |||
| Corporate debt securities | 1,561.5 | 1,386.3 | |||
| Subtotal | $ 2,371.0 | $ 2,143.7 | |||
| Common shares | $ 363.9 | $ 326.1 | |||
| Preferred shares | 1.4 | -- | |||
| Finance premiums | 85.7 | 87.2 | |||
| Cash and cash equivalents | 111.0 | 87.1 | |||
| Total | $ 2,933.0 | $ 2,644.1 | |||
The fair value of equity investments represented 12% of our investment portfolio at December 31, 2005 and December 31, 2004.
Investment results before the effect of income taxes were as follows:
| 2005 | 2004 | ||||
| Average investments at cost | $ 2,771.9 | $ 2,351.4 | |||
| Investment income after expenses | $ 93.0 | $ 74.3 | |||
| Percent earned on average Investments (annualized) | 3.4 | % | 3.2 | % | |
| Net realized gains | $ 38.2 | $ 20.4 | |||
| Total realized yield | 4.7 | % | 4.0 | % | |
| Change in unrealized investment gains | $ (43.1 | ) | $ 20.1 | ||
| Total return yield | 3.2 | % | 4.9 | % | |
Our investment income, including net realized gains increased by 39% to $131.2 million in 2005, compared to $94.7 million in 2004. The percentages earned on average investments shown in the preceding table compare with the Lehman Brothers Eurodollar Aa or Higher 1-5 Years Index of 1.6% and 2.3% for the Scotia Capital 1-5 Year Euro Canadian Index, 4.9% for the S&P Index and 24.3% for the S&P TSX Index for the twelve months ended December 31, 2005.
The following table summarizes the fair value by contractual maturities of our fixed maturity investment portfolio, excluding cash and cash equivalents, at the dates indicated.
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| 2005 | 2004 | ||||||||
| Due in less than one year | $ 712.7 | 30.1 | % | $ 479.3 | 22.4 | % | |||
| Due in one through five years | 1,057.4 | 44.6 | 1,237.3 | 57.7 | |||||
| Due after five through ten years | 467.5 | 19.7 | 293.7 | 13.7 | |||||
| Due after ten years | 133.4 | 5.6 | 133.4 | 6.2 | |||||
| Total | $ 2,371.0 | 100.0 | % | $ 2,143.7 | 100.0 | % | |||
At December 31, 2005, 75% of our fixed income securities, including treasury bills, bankers’ acceptances, government bonds and corporate bonds have contractual maturities of five years or less compared to 80% as at December 31, 2004.
Actual maturities may differ from contractual maturities because certain issuers have the right to call or prepay obligations with or without call or prepayment penalties. Currently, we maintain a liquid portfolio to ensure there is sufficient cash available for the payment of claims on a timely basis. We believe that our high quality, liquid investment portfolio and our success in underwriting provide us with sufficient liquidity to meet our obligations to our policyholders.
The following table summarizes the composition of the fair value of our fixed maturity investment portfolio, excluding cash and cash equivalents, at the dates indicated, by rating as assigned by S&P or Moody’s Investors Service, using the higher of these ratings for any security where there is a split rating.
| 2005 | 2004 | |||
|---|---|---|---|---|
| Rating | ||||
| AAA/Aaa | 57.1% | 55.1% | ||
| AA/Aa2 | 18.8% | 17.9% | ||
| A/A2 | 20.0% | 24.2% | ||
| Percentage rated A/A2 or better | 95.9% | 97.2% | ||
| BBB/Baa2 | 2.0% | 1.0% | ||
| BB/Ba2 | 0.9% | 0.2% | ||
| B/B2 | 0.5% | 0.1% | ||
| CCC/Caa or lower, or not rated | 0.7% | 1.5% | ||
| Total | 100.0% | 100.0% | ||
The following chart shows how the fair value of our investment portfolio and cash flow from operations has grown over the last nine years.
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| Investment Portfolio at Fair Value (in millions) |
Investment Portfolio Per Share Outstanding (in dollars) |
Cash Flow Generated from Operations (in millions) | |
|---|---|---|---|
| 1996 | $ 138 | $ 5.22 | $ 33 |
| 1997 | 244 | 6.82 | 33 |
| 1998 | 409 | 11.40 | 43 |
| 1999 | 457 | 13.43 | 23 |
| 2000 | 522 | 15.32 | 62 |
| 2001 | 775 | 15.92 | 134 |
| 2002 | 1,346 | 27.59 | 382 |
| 2003 | 2,124 | 38.04 | 471 |
| 2004 | 2,644 | 47.04 | 392 |
| 2005 | 2,933 | 51.93 | 274 |
Market risk is the risk that we will incur losses due to adverse changes in interest, equity or currency exchange rates and prices. Our primary market risk exposures are to changes in interest rates and equity prices. We have a smaller exposure to changes in the U.S. to Canadian dollar foreign currency exchange rate.
Because most of our investment portfolio is comprised of fixed income securities which are usually held to maturity, periodic changes in interest rate levels generally impact our financial results to the extent that reinvestment yields are different than the original yields on maturing securities. During periods of rising interest rates, the market value of our existing fixed income securities will generally decrease and our realized gains on fixed income securities will likely be reduced. The reverse is true during periods of declining interest rates.
Duration is a measure used to estimate the extent to which market values change with changes in interest rates. Using this measure, it is estimated that an immediate hypothetical 100 basis point parallel increase in interest rates would decrease the market value of our fixed maturity investments by $66.9 million, representing 2.8% of the $2,371.0 million fair value fixed maturity investment portfolio.
Fluctuations in value of our equity securities, representing approximately 12% of the fair value of the investment portfolio at December 31, 2005, due to changes in general economic or stock market conditions, affect the level and timing of recognition of gains and losses on securities we hold, causing changes in realized and unrealized gains and losses.
We do not hedge any foreign currency exposure that may exist in the portfolio. Our U.S. operations generally hold their investments in U.S. dollar denominated investments, and our Canadian operations in Canadian dollar investments.
With the exception of U.S. and Canadian government bonds, it is our policy to limit our investment concentration at each of our subsidiary companies in any one issuer or related groups to less than 5% of the subsidiary company’s investment portfolio.
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Premiums for property and casualty insurance are typically payable at the time a policy is placed in force or renewed. To assist our insureds in making their payments to us, in some instances we offer premium financing either directly or through a separate premium finance company, whereby the insured can pay a portion of the premium in monthly instalments. The insured pays an additional amount for this option, reflecting handling costs and the income we would have earned on such premium, had we received the total amount at the beginning of the policy period. We typically collect sufficient premiums in advance of the period of risk which ensures that in the event of payment default by the insured, we should not have uncollectible balances. The option of monthly premium payments is available only where permitted under the laws or regulations of the specific jurisdictions. Some jurisdictions require the option of monthly premium payments at a specific annual interest rate or monthly charge.
Certain U.S. public companies include this income in computing their combined ratio and underwriting profit. We, however, consider our income from our premium finance activities to be a part of investment income, because this additional amount is essentially an interest payment on the balance of unpaid premium. At December 31, 2005, the balance of our financed premiums receivable was $85.7 million compared to $87.2 million at December 31, 2004. The fair value of financed premiums approximates their carrying amount.
All of our investments are managed by professional, third-party investment management firms and we monitor their performance. We have engaged Conning Asset Management, Royal Bank of Canada (Caribbean), Deans Knight Capital Management Limited and J. Zechner Associates Inc. to oversee the majority of the fixed income investment portfolio. In addition, Burgundy Asset Management, Burgundy International Asset Management, Deans Knight Capital Management Limited, Marquest Investment Counsel, SFE Investment Counsel and Kingwest and Company have each been engaged to manage portions of our subsidiaries’ equity investment portfolios.
We comply with Statement of Financial Accounting Standards No. 115 related to Accounting for Certain Investments in Debt and Equity Securities and recognized losses on securities whose decline in market value was deemed to be other than temporary. We recognized charges of $4.8 million, $1.3 million and $2.5 million for investment value impairment that was considered other than temporary for the years ended December 31, 2005, 2004 and 2003, respectively.
We perform a quarterly analysis of our investment holdings to determine if declines in market value are other than temporary. The analysis includes some or all of the following procedures:
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| • | identifying all security holdings in an unrealized loss position that has existed for at least six months; |
| • | obtaining a valuation analysis from third party investment managers regarding the intrinsic value of these holdings based on their knowledge, experience and other market based valuation techniques; |
| • | reviewing the trading range of certain securities over the preceding calendar period; |
| • | assessing if declines in market value are other than temporary for debt security holdings based on the investment grade credit rating from third party security rating agencies; |
| • | assessing if declines in market value are other than temporary for any debt security holding with a non-investment grade credit rating based on the continuity of its debt service record; and |
| • | determining the necessary provision for declines in market value that are considered other than temporary based on the analyses performed. |
The risks and uncertainties inherent in the assessment methodology used to determine declines in market value that are other than temporary include, but may not be limited to, the following:
| • | the opinion of professional investment managers could be incorrect; |
| • | the past trading patterns of individual securities may not reflect future valuation trends; |
| • | the credit ratings assigned by independent credit rating agencies may be incorrect due to unforeseen or unknown facts related to a company’s financial situation; and |
| • | the debt service pattern of non-investment grade securities may not reflect future debt service capabilities and may not reflect a company’s unknown underlying financial problems. |
The length of time securities may be held in an unrealized loss position may vary based on the opinion of our appointed investment managers and their respective analyses related to valuation and to the various credit risks that may prevent us from recapturing our principal investment. In cases where our appointed investment manager determines that there is little or no risk of default prior to the maturity of a holding, we would elect to hold the security in an unrealized loss position until the price recovers or the security matures.
In situations where facts emerge that might increase the risk associated with recapture of principal, securities would be traded and losses realized. Due to the current volatility of the equity markets, we believe there are a number of securities currently trading at values below their respective intrinsic values based on historical valuation measures. In these situations, holdings may be maintained in an unrealized loss position for different periods of time based on the underlying economic assumptions driving the investment manager’s valuation of the holding. In cases where the economic realities divert from the underlying assumptions driving the investment manager’s valuation, securities would be traded and losses realized. In cases
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where the economic assumptions coincide with valuation assumptions, the holding would be maintained until the market value of the security recovers in the public markets.
At December 31, 2005, and December 31, 2004, the gross unrealized losses amounted to $45.8 million and $16.1 million, respectively. The unrealized loss attributable to non-investment grade fixed income securities at December 31, 2005 and December 31, 2004 was $1.3 million and nil, respectively.
At December 31, 2005 and December 31, 2004, unrealized losses related to government bonds and term deposits were considered temporary as there was no evidence of default risk. Corporate bonds, even those below investment grade, in a material unrealized loss position, continued to pay interest and were not subject to material changes in their respective debt ratings. We concluded that a default risk did not exist at the time and, therefore, the decline in value was considered temporary. As we have the capacity to hold these securities to maturity, no investment impairment provision was considered necessary. Common stock positions in an unrealized loss position for more than six months may not be considered impaired based on the underlying fundamentals of the respective holdings. In making our investment impairment decisions, we utilized the professional expertise of our investment advisors, analyzed independent economic indicators and reviewed stock market trends.
In deciding whether to reduce the carrying value of common shares, we take into account a number of factors, including whether the decline in market value is more than 20% and has persisted for a period exceeding six months. In the case of fixed income securities, we also take into account whether the issuer is in financial distress (unable to pay interest or some other situation that would question the issuer’s ability to satisfy their debt obligations).
The table below segregates the gross unrealized losses at December 31, 2005 and December 31, 2004 by security type or industry sector.
| (In thousands of U.S. dollars) | December 31, 2005 | December 31, 2004 | |||
| Mortgage backed | $ 6,359 | $ 474 | |||
| Government | 3,235 | 5,401 | |||
| Provincial, State, Municipal | 154 | 21 | |||
| Financial Services | 12,664 | 3,343 | |||
| Energy | 1,298 | 859 | |||
| Telecommunications | 141 | 23 | |||
| Information Technology | 630 | 59 | |||
| Consumer Products | 6,533 | 841 | |||
| Metals & Mining | 1,810 | 76 | |||
| Industrials | 9,719 | 3,706 | |||
| Utilities | 222 | 70 | |||
| Media | 1,176 | 121 | |||
| Medical | 130 | 28 | |||
| Pharmaceuticals | 1,625 | 523 | |||
| Retail | 68 | 591 | |||
| Real Estate | 45 | -- | |||
| Total | $45,809 | $16,136 | |||
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Claims management is the procedure by which an insurance company determines the validity and amount of a claim. We focus on rigorous claims management. We investigate the actual circumstances of the incident that gave rise to the claim and the actual loss suffered. An important part of claims management is verifying the accuracy of the information provided to the insurance company at the time the policy is underwritten. The nature of non-standard automobile insurance typically requires more thorough claims management and in particular, more thorough investigative procedures than other types of insurance. Insurance claims on our policies are investigated and settled by our local claims adjusters, and we may also employ independent adjusters, private investigators, various experts and legal counsel to adjust claims. We believe that effective claims management is fundamental to our operations.
We establish a provision for unpaid claims to reflect the estimated ultimate cost of both reported but unsettled claims and also unreported claims. Our provision for unpaid claims is based on estimated liabilities on individual reported claims (case reserves), estimated provisions for claims that have not yet been reported and expected future development on case reserves; our provision for unpaid claims also includes an estimate of internal or unallocated claims adjustment expenses which we expect to incur in the future. The provision for claims not yet reported and future development on existing case reserves are sometimes referred to as provisions for incurred but not reported claims (IBNR).
The following table shows the amounts of total case reserves and IBNR as at December 31, 2005 and 2004. During 2005 we continued to significantly strengthen reserves on individual claim files (case reserves) in the U.S. and Canadian operations. IBNR reserves were also strengthened in the Canadian operations to reflect growth in the premium volume.The IBNR reserves were reduced for the U.S. operations as a result of the reduction in earned premium volume and the reduction of the inventory of open claims.
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During 2005, our U.S. operations increased case reserves by 7% and decreased IBNR reserves by 8% with a slight increase of 1% in total reserves compared to December 31, 2004. Our Canadian operations increased case reserves by 19%, IBNR by 22% and total reserves by 20% in Canadian dollars and 24% in U.S. dollars.
| 2005 | 2004 | (%) Increase | |||||
| U.S. Operations | |||||||
| Case Reserves | $ 665,309 | $ 620,819 | 7 | % | |||
| IBNR | 419,534 | 457,076 | (8 | %) | |||
| Total unpaid claims | $1,084,843 | $1,077,895 | 1 | % | |||
| Canadian Operations (C$ in 000’s) | |||||||
| Case Reserves | $ 562,121 | $ 472,471 | 19 | % | |||
| IBNR | 321,024 | 262,348 | 22 | % | |||
| Total unpaid claims | $ 883,145 | $ 734,819 | 20 | % | |||
| Total (U.S.$ in 000’s) | $ 759,368 | $ 611,330 | 24 | % | |||
| Consolidated unpaid claims | $1,844,211 | $1,689,225 | 9 | % | |||
The process for establishing the provision for unpaid claims reflects the uncertainties and significant judgemental factors inherent in predicting future results of both known and unknown claims. As such, the process is inherently complex and imprecise and we are constantly refining our estimates. Factors affecting the provision for unpaid claims include the continually evolving and changing regulatory and legal environment, actuarial studies, professional experience and expertise of our claims personnel and independent adjustors retained to handle individual claims, the quality of the data used for projection purposes, existing claims management practices, including claims handling and settlement practices, the effect of inflationary trends on future claims settlement costs, court decisions, economic conditions and public attitudes. In addition, time can be a critical part of the provisions’ determination, because the longer the span between the incidence of a loss and the payment or settlement of the claims, the more variable the ultimate settlement amount can be. Accordingly, short-tailed claims, such as property claims, tend to be more predictable than long-tailed claims, such as general liability and automobile accident benefit claims, which are less predictable. We do not have exposure to asbestos, environmental or other products liability exposure. Our provision for unpaid claims is not discounted to reflect the time value of expected future payouts of claims.
The process of establishing the provision for unpaid claims relies on the judgement and opinions of a large number of individuals, on historical precedent and trends, on prevailing legal, economic, social and regulatory trends and on expectations as to future developments. The process of determining the provision necessarily involves risks that the actual results will deviate, perhaps substantially, from the best estimates made. This evaluation includes a
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re-estimation of the liability for unpaid claims relating to each preceding financial year compared to the liability that we originally established. In addition, we conduct a review of all open claims each quarter and consider all factors into the provisions’ calculation. Accordingly, as experience develops and new information becomes known, we adjust our reserves as necessary following these evaluations. Any adjustments are reflected in our consolidated statement of income in the period in which they become known and are accounted for as changes in estimates. Even after such adjustments, ultimate liability or recovery may exceed or be less than the revised estimates.
Each operating company separately establishes, maintains and evaluates its respective provisions for unpaid claims for statutory reporting purposes. The process undertaken by each operating company includes evaluating all of its respective policy coverages and paid and open claim level data to ascertain claim frequency and severity trends, as well as the effects, if any, inflation or changes in operating structure or process may have on future loss settlements. The management of each operating company has responsibility to ensure that the IBNR reserve methodologies are appropriate, based on lines of business and geographic region. Management incorporates all of the above information to record its best estimate of liabilities for unpaid claims.
Once an amount for liabilities for unpaid claims is established by management of each of our insurance subsidiaries, our independent appointed actuary, Towers Perrin Inc., reviews management’s methodologies, data and work papers to ascertain whether the provision for unpaid claims as established by management is reasonably stated and within the appointed independent actuary’s range of reserve estimates. As these processes are undertaken independently, the provision recorded by management can differ from the actuary’s point estimate. The provisions for unpaid claims established by each operating company are then consolidated. In accordance with actuarial standards, in the United States the independent actuary develops a range of reserve estimates and a recommended point estimate of reserves, and in Canada they develop a point estimate. The point estimate is intended to represent the independent actuary’s best estimate and will not necessarily be at the mid-point of the high and low estimates of their range.
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The range of reserve estimates for unpaid claims for our U.S. subsidiaries estimated by our independent appointed actuary and the actual carried provision for unpaid claims were as follows:
| Low | High | Carried | |||||
| U.S. Operations | |||||||
| Lincoln General Insurance Company | $ 689.5 | $ 859.9 | $ 761.7 | ||||
| Universal Casualty Insurance Company | 42.1 | 48.7 | 44.3 | ||||
| American Service Insurance Company | 72.3 | 83.7 | 78.2 | ||||
| American Country Insurance Company | 115.4 | 134.3 | 120.2 | ||||
| U.S. Security Insurance Company | 57.0 | 66.0 | 62.5 | ||||
| Southern United Fire Insurance Company | 15.0 | 17.3 | 16.3 | ||||
| Kingsway Reinsurance Corporation (Barbados) | 1.6 | 1.6 | 1.6 | ||||
| $ 992.9 | $ 1,211.5 | $ 1,084.8 | |||||
| Canadian Operations | |||||||
| Kingsway General Insurance Company | $ 587.5 | ||||||
| York Fire & Casualty Insurance Company | 123.9 | ||||||
| Jevco Insurance Company | 48.0 | ||||||
| $ 759.4 | |||||||
| Total Consolidated Provision for Unpaid Claims | $ 1,844.2 | ||||||
| Low | High | Carried | |||||
| U.S. Operations | |||||||
| Lincoln General Insurance Company | $ 669.0 | $ 856.6 | $ 759.8 | ||||
| Universal Casualty Insurance Company | 35.0 | 46.8 | 43.8 | ||||
| American Service Insurance Company | 58.9 | 71.3 | 65.6 | ||||
| American Country Insurance Company | 109.5 | 130.8 | 120.2 | ||||
| U.S. Security Insurance Company | 58.5 | 66.3 | 61.5 | ||||
| Southern United Fire Insurance Company | 22.1 | 25.3 | 23.4 | ||||
| Kingsway Reinsurance Corporation (Barbados) | 3.6 | 3.6 | 3.6 | ||||
| $ 956.6 | $ 1,200.7 | $ 1,077.9 | |||||
| Canadian Operations | |||||||
| Kingsway General Insurance Company | $ 476.0 | ||||||
| York Fire & Casualty Insurance Company | 91.2 | ||||||
| Jevco Insurance Company | 44.1 | ||||||
| $ 611.3 | |||||||
| Total Consolidated Provision for Unpaid Claims | $ 1,689.2 | ||||||
To the extent that management’s estimates of reserve levels at our individual insurance subsidiaries are less than the point estimates recommended by our independent actuary, our policy is that those reserve levels will be increased to levels that are no less than the recommended point estimate. Under Canadian actuarial practice the appointed actuary does not provide a range of reserve estimates, but provides a point estimate for estimated claims liabilities. At December 31, 2005 and December 31, 2004, each of our Canadian subsidiaries recorded at least 100% of the point estimate recommended by the independent appointed actuary.
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The following table summarizes the provision for unpaid claims, net of recoveries from reinsurers, established as at the end of the years 1995 through 2004 for our Canadian operations and at the end of years 1998 to 2004 for our U.S. operations. The table compares the re-estimation of those liabilities as at December 31, 2005.
| As at December 31, 2005 | |||||||||||||||||||||||
| (In thousands of U.S. dollars, except percentages) |
2005 | 2004 | 2003 | 2002 | 2001 | 2000 | 1999 | 1998 | 1997 | 1996 | 1995 | ||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Unpaid claims - | |||||||||||||||||||||||
| originally established - | |||||||||||||||||||||||
| end of year, gross | 1,844,211 | 1,689,225 | 1,310,623 | 765,322 | 358,431 | 287,589 | 306,400 | 291,642 | 132,421 | -- | -- | ||||||||||||
| Less: | |||||||||||||||||||||||
| Reinsurance recoverable | |||||||||||||||||||||||
| on unpaid losses | 181,660 | 225,945 | 122,013 | 85,584 | 64,450 | 61,703 | 83,120 | 88,084 | 44,968 | -- | -- | ||||||||||||
| Unpaid claims - | |||||||||||||||||||||||
| originally established - | |||||||||||||||||||||||
| end of year, net | 1,662,551 | 1,463,280 | 1,188,610 | 679,738 | 293,981 | 225,886 | 223,280 | 203,558 | 87,453 | 47,776 | 17,831 | ||||||||||||
| Cumulative paid (net of currency | |||||||||||||||||||||||
| translation impact) as of: | |||||||||||||||||||||||
| One year later | 652,063 | 584,926 | 319,762 | 190,592 | 123,401 | 102,014 | 84,189 | 35,519 | 24,094 | 10,015 | |||||||||||||
| Two years later | 961,581 | 588,722 | 264,540 | 197,048 | 159,852 | 134,514 | 52,746 | 32,615 | 14,039 | ||||||||||||||
| Three years later | 774,237 | 361,004 | 237,490 | 206,022 | 171,143 | 64,776 | 40,829 | 18,011 | |||||||||||||||
| Four years later | 428,345 | 284,187 | 224,388 | 198,501 | 76,710 | 44,424 | 22,356 | ||||||||||||||||
| Five years later | 313,360 | 247,982 | 204,960 | 85,312 | 48,324 | 22,995 | |||||||||||||||||
| Six years later | 263,347 | 217,441 | 86,367 | 50,461 | 25,008 | ||||||||||||||||||
| Seven years later | 225,133 | 89,301 | 51,309 | 25,072 | |||||||||||||||||||
| Eight years later | 93,877 | 52,403 | 24,991 | ||||||||||||||||||||
| Nine years later | 54,090 | 24,511 | |||||||||||||||||||||
| Ten years later | 25,602 | ||||||||||||||||||||||
| Re-estimated liability as of: | |||||||||||||||||||||||
| One year later | 1,487,513 | 1,241,806 | 818,220 | 363,478 | 246,236 | 220,130 | 198,477 | 78,744 | 45,592 | 20,312 | |||||||||||||
| Two years later | 1,399,699 | 915,439 | 424,140 | 274,450 | 228,163 | 200,535 | 80,657 | 47,690 | 19,683 | ||||||||||||||
| Three years later | 984,681 | 475,385 | 313,491 | 241,142 | 206,453 | 82,584 | 48,527 | 22,225 | |||||||||||||||
| Four years later | 496,804 | 335,425 | 263,761 | 217,153 | 84,973 | 48,622 | 22,712 | ||||||||||||||||
| Five years later | 343,174 | 274,120 | 226,096 | 90,521 | 49,763 | 23,039 | |||||||||||||||||
| Six years later | 275,388 | 230,652 | 94,191 | 51,853 | 23,790 | ||||||||||||||||||
| Seven years later | 231,725 | 96,355 | 53,747 | 24,667 | |||||||||||||||||||
| Eight years later | 96,107 | 54,506 | 25,093 | ||||||||||||||||||||
| Nine years later | 54,989 | 25,257 | |||||||||||||||||||||
| Ten years later | 25,237 | ||||||||||||||||||||||
| As at December 31, 2005 | |||||||||||||||||||||||
| Cumulative deficiency | 24,233 | 211,089 | 304,944 | 202,823 | 117,288 | 52,108 | 28,167 | 8,654 | 7,214 | 7,405 | |||||||||||||
| Cumulative deficiency as a % | |||||||||||||||||||||||
| of reserves originally | |||||||||||||||||||||||
| established - net | 1.66 | % | 17.76 | % | 44.86 | % | 68.99 | % | 51.92 | % | 23.34 | % | 13.84 | % | 9.90 | % | 15.10 | % | 41.53 | % | |||
| Re-estimated liability - gross | 1,713,087 | 1,557,886 | 1,115,566 | 582,492 | 415,819 | 363,846 | 334,591 | 141,901 | -- | -- | |||||||||||||
| Less: Re-established | |||||||||||||||||||||||
| resinsurance recoverable | 225,573 | 158,187 | 130,885 | 85,688 | 72,645 | 88,458 | 102,866 | 45,794 | -- | -- | |||||||||||||
| Re-estimated liability - net | 1,487,514 | 1,399,699 | 984,681 | 496,804 | 343,174 | 275,388 | 231,725 | 96,107 | -- | -- | |||||||||||||
| Cumulative deficiency - gross | 23,862 | 247,263 | 350,244 | 224,061 | 128,230 | 57,446 | 42,949 | 9,480 | -- | -- | |||||||||||||
| % of reserves originally | |||||||||||||||||||||||
| established - gross | 1.41 | % | 18.87 | % | 45.76 | % | 62.51 | % | 44.59 | % | 18.75 | % | 14.73 | % | 7.16 | % | -- | -- | |||||
Page 31 of 83
The foregoing table presents the development of unpaid claims liabilities reflected on our balance sheets as at each year end December 31, 1995 through December 31, 2005. The top line of the table presents the estimated liability for unpaid claims recorded at the balance sheet date for each of the indicated years. This liability represents the estimated amount of losses and loss adjustment expenses for claims unpaid at the balance sheet date, including losses that had been incurred and not reported. The table also presents the re-estimated liabilities for unpaid claims on a gross basis, with separate disclosure of the re-estimated reinsurance recoverable on unpaid claims for years 1997 through 2004. Information related to gross unpaid claims development is not available for years 1996 and prior.
The development of the provision for unpaid claims is shown by the difference between estimates of claims as of the initial year end and the re-estimated liability at each subsequent year end. This is based on actual payments in full or partial settlement of claims, plus re-estimates of the payments required for claims still open or claims still unreported. Favourable development (reserve redundancy) means that the original claim estimates were higher than subsequently determined. Unfavourable development (reserve deficiency) means that the original claim estimates were lower than subsequently determined.
The table presents the cumulative amount paid with respect to the previously recorded liability as of the end of each succeeding year and the re-estimated amount of the previously recorded liability based on experience as of the end of the succeeding year. The estimate is increased or decreased as more information about the claims becomes known for individual years. For example, as of December 31, 2005, we had paid $774.2 million of the currently estimated $979.3 million of claims that had been incurred through the end of 2002; thus an estimated $205.1 million of losses incurred prior to December 31, 2002 remain unpaid as of December 31, 2005.
The cumulative development represents the aggregate change in the estimates over all prior years. For example, unpaid claims at December 31, 1995 have developed adversely by $7.4 million over the subsequent ten years and unpaid claims at December 31, 1998 have developed adversely by $28.2 million over the subsequent seven years. The effects on income during the past three years due to changes in estimates of unpaid claims is shown in note 10(b) to the consolidated financial statements as the “prior years” contribution to incurred losses.
Each cumulative development amount includes the effects of all changes in amounts during the current year for prior periods and the impact of currency translation. For example, the amount of the development related to losses settled in 2005, but incurred in 1999, will be included in the cumulative development amounts for years 1999, 2000, 2001, 2002, 2003 and 2004. In addition, the deficiency identified during the year 2005 of $24.2 million was attributable to unpaid claims as at December 31, 2004 for unpaid claims for the year 2004 and all prior years. There was a redundancy of $133.7 million related to claims occurring in accident year 2004 and deficiencies of $88.7 million related to claims occurring in accident year 2003, $47.8 million to claims in 2002, $13.7 million to claims occurring in 2001 and $7.7 million to claims occurring in 2000 and prior years.
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The following table is derived from the unpaid claims re-estimates on the previous page and summarizes the effect of re-estimates, net of reinsurance, on calendar year consolidated operations for the nine-year period ended December 31, 2005. The first number in each row details the amount of reserve re-estimates included in the indicated calendar year and shows the accident year to which the re-estimates apply.
(In thousands of U.S. dollars, except percentages)
| By Accident Year | 2005 | 2004 | 2003 | 2002 | 2001 | 2000 | 1999 | 1998 | 1997 | 1996 & prior |
|||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| By Calendar Year | |||||||||||||||||||||
| 2005 | (24,233 | ) | (133,660 | ) | 88,651 | 47,823 | 13,670 | 6,481 | 195 | 1,321 | (731 | ) | 483 | ||||||||
| 2004 | (53,196 | ) | (44,023 | ) | 45,974 | 29,311 | 11,575 | 5,803 | 2,392 | 1,405 | 759 | ||||||||||
| 2003 | (138,482 | ) | 77,820 | 21,621 | 16,422 | 13,676 | 5,273 | 1,776 | 1,894 | ||||||||||||
| 2002 | (69,497 | ) | 41,283 | 15,235 | 2,279 | 5,152 | 3,458 | 2,090 | |||||||||||||
| 2001 | (20,350 | ) | 12,317 | 2,118 | 3,529 | 1,248 | 1,141 | ||||||||||||||
| 2000 | 3,150 | (5,208 | ) | 131 | 1,832 | 95 | |||||||||||||||
| 1999 | 5,081 | (6,994 | ) | 1,076 | 837 | ||||||||||||||||
| 1998 | 8,709 | (10,807 | ) | 2,098 | |||||||||||||||||
| 1997 | 2,184 | (2,184 | ) | ||||||||||||||||||
| Total | (24,233 | ) | (186,856 | ) | (93,854 | ) | 102,120 | 85,535 | 65,180 | 23,941 | 19,513 | 1,441 | 7,213 | ||||||||
| Combined ratio as reported | 97.2 | % | 97.8 | % | 101.6 | % | 99.8 | % | 99.1 | % | 101.0 | % | 102.6 | % | 93.9 | % | 95.8 | % | |||
| Net reserve re-estimates | (1.4 | )% | (10.5 | )% | (5.5 | )% | 9.2 | % | 15.2 | % | 17.9 | % | 8.0 | % | 9.2 | % | 1.2 | % | |||
| Accident year combined ratio | 95.8 | % | 87.3 | % | 96.1 | % | 109.0 | % | 114.3 | % | 118.9 | % | 110.6 | % | 103.1 | % | 97.0 | % | |||
The following table shows the effect of these re-estimates on our Canadian and U.S. operations combined ratios:
| By Accident Year | 2005 | 2004 | 2003 | 2002 | 2001 | 2000 | 1999 | 1998 | 1997 | ||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Canadian Operations | |||||||||||||||||||
| Combined ratio as reported | 96.1 | % | 97.9 | % | 111.8 | % | 108.4 | % | 103.1 | % | 101.8 | % | 104.8 | % | 92.0 | % | 95.8 | % | |
| Net reserve re-estimates | (0.4 | )% | (18.0 | )% | (19.0 | )% | 10.6 | % | 17.5 | % | 30.3 | % | 16.6 | % | 18.6 | % | 1.2 | % | |
| Accident year combined ratio | 95.7 | % | 79.9 | % | 92.8 | % | 119.0 | % | 120.6 | % | 132.1 | % | 121.4 | % | 110.6 | % | 97.0 | % | |
| By Accident Year | 2005 | 2004 | 2003 | 2002 | 2001 | 2000 | 1999 | 1998 | |||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| U.S. Operations | |||||||||||||||||||
| Combined ratio as reported | 97.7 | % | 97.7 | % | 98.3 | % | 97.2 | % | 96.8 | % | 100.9 | % | 100.6 | % | 97.0 | % | |||
| Net reserve re-estimates | (1.8 | )% | (7.6 | )% | (1.4 | )% | 8.8 | % | 13.8 | % | 7.1 | % | 0.5 | % | (1.5 | )% | |||
| Accident year combined ratio | 95.9 | % | 90.1 | % | 96.9 | % | 106.0 | % | 110.6 | % | 108.0 | % | 101.1 | % | 95.5 | % | |||
Page 33 of 83
Information with respect to our liability for unpaid claims and the subsequent development of those claims is presented in the following tables.
| Liability for Unpaid Claims December 31, | |||||
|---|---|---|---|---|---|
| Line of Business | 2005 | 2004 | |||
| (In thousands of U.S. dollars) | |||||
| Non-Standard Auto | $ 472,459 | $ 495,013 | |||
| Standard Auto | 111,491 | 80,661 | |||
| Commercial Auto | 211,341 | 184,001 | |||
| Trucking | 682,380 | 620,141 | |||
| Motorcycle | 89,052 | 66,621 | |||
| Property & Liability | 232,236 | 199,463 | |||
| Other | 45,252 | 43,325 | |||
| Total | $1,844,211 | $1,689,225 | |||
| Liability for Unpaid Claims – Net of Reinsurance Recoverables – December 31, | |||||
|---|---|---|---|---|---|
| Line of Business | 2005 | 2004 | |||
| (In thousands of U.S. dollars) | |||||
| Non-Standard Auto | $ 459,574 | $ 460,025 | |||
| Standard Auto | 107,414 | 77,123 | |||
| Commercial Auto | 208,555 | 176,901 | |||
| Trucking | 602,451 | 519,615 | |||
| Motorcycle | 66,229 | 49,958 | |||
| Property & Liability | 178,944 | 142,782 | |||
| Other | 39,384 | 36,876 | |||
| Total | $1,662,551 | $1,463,280 | |||
These net increases in prior years incurred claims, net of reinsurance, for the years ended December 31, 2005, 2004 and 2003 were $24.2 million, $53.2 million and $138.5 million, respectively. The following tables identify the relative contribution of the increases (decreases) in incurred claims attributable to the respective products and incurred loss years.
| Year Ended December 31, 2005 (In thousands of U.S. dollars) | |||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Motorcycle | Trucking | Standard Auto |
Non- Standard Auto |
Property & Liability |
Other | Total | |||||||||
| 2000 & prior | $ 197 | $ (230 | ) | $ (638 | ) | $ 4,883 | $ 2,301 | $ 1,236 | $ 7,749 | ||||||
| 2001 | (933 | ) | 5,012 | 341 | 4,611 | 3,248 | 1,391 | 13,670 | |||||||
| 2002 | 1,946 | 15,851 | 1,379 | 13,462 | 8,565 | 6,620 | 47,823 | ||||||||
| 2003 | (636 | ) | 46,305 | 938 | 17,601 | 17,472 | 6,972 | 88,651 | |||||||
| 2004 | (3,762 | ) | (32,695 | ) | (12,164 | ) | (62,944 | ) | (13,128 | ) | (8,968 | ) | (133,660 | ) | |
| Total | $(3,188 | ) | $ 34,243 | $(10,144 | ) | $(22,387 | ) | $ 18,458 | $ 7,251 | $ 24,233 | |||||
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| Year Ended December 31, 2004 (In thousands of U.S. dollars) | |||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Motorcycle | Trucking | Standard Auto |
Non- Standard Auto |
Property & Liability |
Other | Total | |||||||||
| 1999 & prior | $ 1,647 | $ 1,302 | $ 337 | $ 5,197 | $ 1,201 | $ 675 | $ 10,359 | ||||||||
| 2000 | 455 | 1,834 | 853 | 6,922 | 230 | 1,281 | 11,575 | ||||||||
| 2001 | 2,736 | 7,430 | 1,562 | 14,939 | 1,233 | 1,411 | 29,311 | ||||||||
| 2002 | 284 | 27,895 | 1,266 | 13,368 | (2,230 | ) | 5,391 | 45,974 | |||||||
| 2003 | (5,279 | ) | (7,735 | ) | (2,443 | ) | (22,122 | ) | (7,503 | ) | 1,059 | (44,023 | ) | ||
| Total | $ (157 | ) | $ 30,726 | $ 1,575 | $ 18,304 | $(7,069 | ) | $9,817 | $ 53,196 | ||||||
| Year Ended December 31, 2003 (In thousands of U.S. dollars) | |||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Motorcycle | Trucking | Standard Auto |
Non- Standard Auto |
Property & Liability |
Other | Total | |||||||||
| 1998 & prior | $ 107 | $ 2,485 | $ 861 | $ 4,254 | $ 1,378 | $ (142 | ) | $ 8,943 | |||||||
| 1999 | 196 | 578 | 1,142 | 9,581 | 1,479 | 700 | 13,676 | ||||||||
| 2000 | 1,357 | 1,219 | 3,431 | 8,247 | 1,585 | 583 | 16,422 | ||||||||
| 2001 | 277 | 10,237 | 1,863 | 13,119 | 1,343 | (5,218 | ) | 21,621 | |||||||
| 2002 | (539 | ) | 8,314 | 2,341 | 42,468 | 5,501 | 19,735 | 77,820 | |||||||
| Total | $ 1,398 | $22,833 | $9,638 | $77,669 | $11,286 | $ 15,658 | $138,482 | ||||||||
The following table shows the sources of the prior years’ development in the U.S. and Canada by line of business.
| Increase (decrease) in claims incurred for unpaid claims arising from prior periods net for external reinsurance | |||||||
|---|---|---|---|---|---|---|---|
| for the year ended December 31, | |||||||
| 2005 | 2004 | 2003 | |||||
| (in millions of U.S. dollars) | |||||||
| United States Operations | |||||||
| Trucking | $ 29.5 | $ 23.8 | $ 13.0 | ||||
| Southern United non-standard automobile | (2.4 | ) | 4.1 | 3.4 | |||
| Commercial automobile | 3.1 | 3.3 | 10.8 | ||||
| Lincoln General program non-standard automobile | (19.4 | ) | 2.9 | 14.8 | |||
| Florida non-standard automobile | (2.8 | ) | 0.6 | 13.5 | |||
| Other | 14.2 | (12.5 | ) | 9.8 | |||
| Subtotal U.S. Operations | $ 22.2 | $ 22.2 | $ 65.3 | ||||
| Canadian Operations | |||||||
| Alberta non-standard automobile | $ 12.6 | $ 15.7 | $ 24.3 | ||||
| Commercial automobile | 2.9 | 7.6 | 13.1 | ||||
| Trucking | 4.7 | 6.9 | 9.9 | ||||
| Ontario private passenger automobile | (10.5 | ) | 4.8 | 23.1 | |||
| Other | (7.7 | ) | (4.0 | ) | 2.8 | ||
| Subtotal Canadian Operations | $ 2.0 | $ 31.0 | $ 73.2 | ||||
| Total increase in claims incurred for | |||||||
| unpaid claims arising from prior periods | $ 24.2 | $ 53.2 | $ 138.5 | ||||
| As a % of unpaid claims at prior year end | 1.4 | % | 4.1 | % | 18.1 | % | |
Page 35 of 83
The “other” category includes all development both favourable and unfavourable on other lines of business that the Company’s subsidiaries write and geographic portions of existing lines of business, already disclosed, where there has been little favourable or unfavourable development. The other lines of business include surety, workers’ compensation and property and liability lines of business.
United States Operations
Long-Haul Trucking
At December 31, 2005 and 2004 the provision for unpaid claims for our U.S. long-haul trucking business was $519.1 million, and $485.0 million, respectively. Adverse development related to long-haul trucking business in the U.S. was $29.5 million for the year ended December 31, 2005 compared to $23.8 million in 2004. Development was experienced at Lincoln General on the trucking liability line of business for accident years 2003 and 2002. This development was the result of Lincoln General being able to bring the claims settlement process in-house for terminated programs, increased staffing for in-house programs and additional oversight for active programs where third party administrators continue to be utilized.
Commercial Automobile
At December 31, 2005 and 2004 the provision for unpaid claims for our U.S. commercial automobile business was $153.2 million, and $133.9 million, respectively. Adverse development related to commercial automobile in the U.S. was $3.1 million for the year ended December 31, 2005 compared to $3.3 million in 2004. During 2003 we carried out a more extensive analysis of both internal and external data to determine appropriate levels of indemnity and allocated loss adjustment expenses for our taxi business. We now incorporate a more extensive analysis of both internal and external data as well as a redefinition of the internal costs to be allocated to loss adjustment expenses.
Non-Standard Automobile
Lincoln General experienced favourable development on its non-standard automobile programs of $19.4 million in 2005 and adverse development of $2.9 million in 2004. The development experienced during 2004 and 2003 has been alleviated due to improved trends in loss settlement which, led to favourable development on several non-standard automobile programs at Lincoln General in 2005. The problems experienced in Florida during 2003 were related to personal injury protection litigation which gave rise to increased estimates for allocated loss adjustment expenses. These issues were addressed in the claims handling procedures by U.S. Security and have allowed them to show favourable development of $2.8 million in 2005 on the Florida non-standard automobile business.
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Canadian Operations
Alberta Non-Standard Automobile
Alberta non-standard automobile business contributed $12.6 million of prior years’ claims development in 2005, compared to $15.7 million in 2004. An increase in average reserves due to the continued escalation in bodily injury claim settlements as well as the standardization of our reserving methodology was the reason for the adverse claims development in 2004 in Alberta, where we increased existing case reserves based on actual settlement patterns.
Ontario Private Passenger Automobile
Ontario automobile business contributed $10.5 million of prior years’ favourable claims development in 2005, an improvement over the $4.8 million of adverse development experienced in 2004. The improvement in the Ontario results reflect changes made beginning in 2002, when we revised our reserve methodology to react to the changing claims settlement environment. Although our average claims reserves at December 31, 2005 exceeded our average settlements in 2005, we expect claim settlements to approximate our current reserving position in the future.
Trucking and Commercial Automobile
Trucking and commercial automobile business contributed $7.6 million of development in 2005, an improvement over the $14.5 million reported in 2004. Increases in reserves were due to larger than anticipated settlements, particularly in the U.S., which required upward adjustments to open claim files. Average claim file reserves were increased to reflect this pattern of settlement. Case reserves were increased to reflect the increased cost on injury claims similar to the development experienced on the Ontario automobile business during 2002 and 2003.
Reinsurance
We purchase reinsurance from third parties in order to reduce our liability on individual risks and our exposure to catastrophic events. Reinsurance is insurance purchased by one insurance company from another for part of the risk originally underwritten by the purchasing insurance company. The practice of ceding insurance to reinsurers allows an insurance company to reduce its exposure to loss by size, geographic area, type of risk or on a particular policy. An effect of ceding insurance is to permit an insurance company to write additional insurance for risks in greater
Page 37 of 83
number or in larger amounts than it would otherwise insure independently, having regard to its statutory capital, risk tolerance and other factors.
We generally purchase reinsurance to limit our net exposure to a maximum amount on any one loss of C$0.5 million in Canada and $0.5 million in the United States with respect to property claims and C$2.5 million in Canada and $1.0 million in the United States with respect to liability claims. In addition, we purchase catastrophe reinsurance which provides coverage in the event of a series of claims arising out of a single occurrence, which limits this exposure in Canada to C$5.0 million per occurrence to a maximum coverage of C$145.0 million, and in the United States to $2.0 million per occurrence to a maximum coverage of $18.0 million. Zephyr is protected by a separate catastrophe reinsurance program under a 95% quota-share treaty and excess of loss treaty. Under this program Zephyr retains up to $7.3 million in net losses subject to a maximum cover of $911 million. Our net exposure for Canadian automobile business claims is C$2.5 million. For most of the non-standard automobile business that we write in the United States, the liability is limited to the minimum statutory liability limits, which are typically not greater than $40,000 per occurrence, depending on the state.
On April 1, 2004, the Company entered into two quota share reinsurance arrangements in Canada and the United States. These treaties were not renewed in 2005. These were taken out with reinsurers rated A+ or better by A.M. Best. Under both treaties, the Company had the option to vary the amount of premiums ceded in any quarter, which provided flexibility in managing premium leverage. These treaties increased the ceded reinsurance in 2004 by $194.3 million or 9.7% of gross premiums written and by $40.8 million or 2.2% in 2005, and decreased net income for the year ended December 31, 2004 by $3.7 million and for the year ended December 31, 2005 by $1.1 million. Overall our external reinsurance ceded represented 4.5% of gross premiums written for the year ended December 31, 2003, 13.1% for the year ended December 31, 2004 and 3.7% for the year ended December 31, 2005.
Reinsurance ceded does not relieve us of our ultimate liability to our insureds in the event that any reinsurer is unable to meet its obligations under its reinsurance contracts. We therefore enter into reinsurance contracts with only those reinsurers who we believe have sufficient financial resources to provide the requested coverage. Reinsurance treaties are generally subject to cancellation by our reinsurers or us on the anniversary date and are subject to renegotiation annually. We regularly evaluate the financial condition of our reinsurers and monitor the concentrations of credit risk to minimize our exposure to significant losses as a result of insolvency of a reinsurer. We believe that the amounts we have recorded as reinsurance recoverables are appropriately established. However, estimating amounts of reinsurance recoverables is subject to various uncertainties and the amounts ultimately recoverable may vary from amounts currently recorded. As of December 31, 2005, we had $223.0 million recoverable from third party reinsurers and other insurers. At December 31, 2005, approximately 90% of the receivables were due from reinsurers that were rated “A-” or higher.
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Estimating amounts of reinsurance recoverables is also impacted by the uncertainties involved in the establishment of provision for unpaid claims. As our underlying reserves continue to develop, the amount ultimately recoverable may vary from amounts currently recorded. Our reinsurance recoverables are generally unsecured. We regularly evaluate our reinsurers, and the respective amounts recoverable, and an allowance for uncollectible reinsurance is provided for, if needed.
The following table summarizes the composition of the amounts due from reinsurers at December 31, 2005, by the rating as assigned by A.M. Best or Standard & Poor’s to the applicable reinsurers.
| December 31 | |||||
|---|---|---|---|---|---|
| A.M. Best / S&P Rating | 2005 | 2004 | |||
| A++ | 9.1 | % | 21.2 | % | |
| A+ | 16.6 | % | 31.5 | % | |
| A | 41.4 | % | 31.3 | % | |
| A- | 22.8 | % | 9.0 | % | |
| B++/B+/B- | 4.2 | % | 6.3 | % | |
| C++/C | 0.2 | % | 0.1 | % | |
| Not Rated | 5.7 | % | 0.6 | % | |
| Total | 100.0 | % | 100.0 | % | |
The decline in the percentage of amounts due from reinsurers rated A++ and A+ is caused by the non-renewal in 2005 of the two quota-share agreements entered into in April, 2004. Collateral is held or a provision has been made against approximately 45% of the amounts due from reinsurers with a credit rating below A-.
Results of Operations
For the years ended December 31, 2005 and 2004
Gross Premiums Written
During the year ended December 31, 2005, gross premiums written were $1.89 billion compared to $2.00 billion in 2004. For the year ended December 31, 2005, gross premiums written for our U.S. operations were $1.28 billion, a 9% decrease from 2004, and for our Canadian operations were $609.9 million, an increase of 5% over 2004.
For the year ended December 31, 2005, gross premiums written from trucking and commercial automobile decreased 1% to $814.2 million, from $819.5 million in 2004. Gross premiums written for non-standard automobile decreased 22% to $551.3 million compared with $706.3 million in 2004 due to competitive conditions in several markets and the termination of certain programs.
The amount of premium rate increases for trucking and non-standard automobile moderated in 2005. We experienced more competitive conditions in Florida and Texas where gross premiums declined by 11% to $186.2
Page 39 of 83
million and 27% to $113.8 million, respectively. In Ontario, favourable market conditions led to an increase of 11% in gross premiums written to $381.1 million. The political environment, including regulated rate freezes and premium roll-backs, caused us to continue to reduce our gross premiums written in Alberta by 13% to $94.0 million in 2005.
Net Premiums Written
Net premiums written increased 5% to $1.82 billion compared with $1.74 billion for the year ended December 31, 2004 as lower levels of gross premiums written were more than offset by a decrease in the percentage ceded to reinsurers. Net premiums written from our U.S. operations were unchanged at $1.24 billion. Net premiums written from our Canadian operations increased 17% to $582.7 million compared with $499.0 million for the year ended December 31, 2004 due primarily to a reduction in the premiums ceded to reinsurers.
Net Premiums Earned
Net premiums earned increased 1% to $1.79 billion for the year ended December 31, 2005, compared with $1.78 billion for 2004. For our U.S. operations, net premiums earned decreased 5% to $1.21 billion in the year ended December 31, 2005 compared with $1.28 billion in 2004, and for our Canadian operations increased by 16% to $582.5 million compared with $501.9 million in 2004.
Investment Income
Investment income increased by 25% to $93.0 million compared with $74.3 million for the year ended December 31, 2004. The fair value of the investment portfolio increased by 11% in 2005 due to positive cash flow from operations and financing activities. Our annualized investment yield for the year ended December 31, 2005 has increased to 3.4% compared to 3.2% in 2004. This increase is due to the reinvestment of maturing fixed income securities into higher yielding securities as short and medium term yields have increased over the past year.
Net Realized Gains
Net realized gains amounted to $38.2 million in the year ended December 31, 2005 compared with net realized gains of $20.4 million in 2004. The majority of these gains were realized from the disposal of equity investments. Net unrealized gains at December 31, 2005 were $18.2 million compared to $61.3 million at December 31, 2004.
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Claims Incurred
We conducted detailed claim file reviews throughout our Canadian and U.S. operations during 2004 and 2005 to determine the adequacy of case reserving. Revised guidelines have been established for setting reserves for many of our lines, including bodily injury and accident benefit claims in all provinces of Canada which were responsible for a significant portion of the claims development experience in the prior years. As a result of these initiatives, consolidated case reserves were increased 13% during 2005 and IBNR was increased 3%. Overall, unpaid claims have increased 9% while levels of unearned premium reserves have remained relatively flat during 2005.
Our claims ratio for 2005 was 68.3%, compared to 70.9% for 2004. The claims ratio for our U.S. operations was 68.4%, compared with 70.3% for 2004. The claims ratio for our Canadian operations was 68.3% compared to 72.3% for 2004. The results for 2005 and 2004 reflect increases in provision for unpaid claims occurring prior to December 31, 2004 and December 31, 2003, respectively. These increases amounted to approximately $24.2 million, which increased the claims ratio by 1.4% for 2005, compared to $53.2 million and 3.0%, respectively, for 2004.
For our U.S. operations, prior years’ claims development increased the claims incurred by $22.2 million, a 1.8% increase to the claims ratio in 2005 compared to $22.2 million, a 1.7% increase to the claims ratio in 2004. In 2005, the source of the prior years’development in the U.S. operations was primarily long haul trucking on terminated programs ($29.5 million). We adjusted our initial loss development factors on a number of our programs to reflect actual loss trends experienced in 2004 and these new loss development factors will be used in the prospective reserving process.
For our Canadian operations, prior years’ claims development increased the claims incurred by $2.0 million, a 0.4% increase to the claims ratio in 2005 compared to $31.0 million, a 6.2% increase to the claims ratio in 2004. Kingsway General’s Alberta non-standard automobile business contributed $12.6 million of the prior years’ claims development in 2005, compared to $15.7 million in 2004. An increase in average reserves due to the continued escalation in bodily injury claim settlements was the reason for the adverse claims development in both 2004 and 2005 for Alberta non-standard automobile, where we increased existing case reserves based on actual settlement patterns. Our Ontario private passenger automobile business contributed $10.5 million of favourable prior years’ claims development in 2005, compared to adverse development of $4.8 million in 2004. Our Canadian trucking business contributed $4.7 million to the 2005 prior years’ claims development, compared to $6.9 million in 2004. Increases in reserves were due to larger than anticipated settlements, particularly in the U.S., which required upward adjustments to open claim files. Average claim file reserves were increased in 2005 to reflect this pattern of settlement. Our commercial automobile business in Canada contributed $2.9 million of the prior years’ claims development in 2005 compared to $7.6 million in 2004. Case reserves were increased to reflect the increased cost on injury claims similar to the development experienced on the Ontario automobile business.
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Underwriting Expenses
Our expense ratio for 2005 was 28.9% compared to 26.9% in 2004. The expense ratio for our Canadian operations for 2005 was 27.8%, compared to 25.8% in 2004 and the expense ratio for our U.S. operations was 29.4% and 27.4%, respectively, in 2005 and 2004.
Combined Ratio
The combined ratio improved to 97.2% in 2005 compared with 97.8% in 2004, which produced a record underwriting profit of $49.8 million compared with $39.4 million in 2004. For 2005, our U.S. operations combined ratio was 97.7% (97.7% in 2004) and for our Canadian operations, combined ratio improved to 96.1% (98.1% in 2004). The improvement in the combined ratio is a result of less adverse development experienced in 2005, thereby lowering the loss ratio. Prior years’ claims development increased the combined ratio by 1.3% and 3.0% for the year ended December 31, 2005 and 2004, respectively. For our U.S. operations, prior year claims development increased the combined ratio by 1.8% in 2005 and 1.7% in 2004, and for the Canadian operations by 0.4% in 2005 and 6.2% in 2004. Assessments from the residual market (Facility Association) resulted in an increase to underwriting profit of $4.3 million in 2005 and $3.4 million in 2004 which also improved the Canadian operations combined ratio by 0.7% in both 2005 and 2004 .
Interest Expense
Interest expense for 2005 was $25.9 million, compared to $21.2 million in 2004, reflecting the increased borrowings used to support the growth in operations.
Net Income and Earnings Per Share
Income before income taxes for 2005 increased by 37% to $154.3 million, compared to $112.4 million in 2004. Net income for 2005 was $135.0 million, a 34% increase over the $101.0 million reported for 2004. Diluted earnings per share were $2.37 for 2005, an increase of 32% over the $1.79 for 2004. The improvement in net income is the result of improvement in the combined ratio in Canadian operations and increased investment income.
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Book Value Per Share and Return on Equity
Book value per share increased by 20% to $14.25 at December 31, 2005 from $11.86 at December 31, 2004. Our return on equity was 18.4% for 2005 compared to 16.6% in 2004.
Balance Sheet
Total assets as at December 31, 2005 grew to $3.80 billion, compared to $3.52 billion as at December 31, 2004. The investment portfolio, including cash increased to $2,914.8 million (fair value $2,933.0 million), compared to $2,582.8 million (fair value $2,644.1 million) as at December 31, 2004. The fair value of the investment portfolio per share outstanding increased 10% to $51.93 compared to $47.04 as at December 31, 2004. Net unrealized gains on the investment portfolio were $18.2 million ($0.32 per share outstanding) at December 31, 2005 compared to $61.3 million ($1.09 per share) at December 31, 2004.
Results of Operations
For the years ended December 31, 2004 and 2003
Gross Premiums Written
During the year ended December 31, 2004, gross premiums written were $2.00 billion compared to $1.89 billion in 2003. For the year ended December 31, 2004, gross premiums written for our U.S. operations were $1.42 billion, a nil increase from 2003, and for our Canadian operations were $583.5 million, an increase of 23% over 2003.
For the year ended December 31, 2004, gross premiums written from trucking and commercial automobile increased 4% to $819.5 million, from $788.0 million in 2003. Gross premiums written from non-standard automobile increased 2% to $706.3 million compared with $693.0 million in 2003.
The amount of premium rate increases for trucking and non-standard automobile moderated in 2004. We experienced more competitive conditions in Florida and South Carolina where gross premiums declined by 35% to $208.3 million and 50% to $40.5 million, respectively. In Ontario favourable market conditions together with rate increases implemented during 2003 led to an increase of 56% in gross premiums written to $343.0 million. The political environment, including regulatory rate freezes and premium roll-backs, effected the premium writings in Alberta where gross premiums written were $108.4 million in 2004 compared with $105.8 million in 2003.
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Net Premiums Written
Net premiums written decreased 4% to $1.74 billion compared with $1.80 billion for the year ended December 31, 2003 as a result of lower levels of gross premiums written and an increase in the percentage ceded to reinsurers. Net premiums written from our U.S. operations decreased 9% to $1.24 billion compared with $1.36 billion in the year ended December 31, 2003. Net premiums written from our Canadian operations increased 12% to $499.0 million, compared with $445.0 million for the year ended December 31, 2003.
Net Premiums Earned
Net premiums earned decreased 4% to $1.78 billion for the year ended December 31, 2004, compared with $1.71 billion for 2003. For our U.S. operations, net premiums earned decreased 3% to $1.28 billion in the year ended December 31, 2004 compared with $1.31 billion in 2003, and for our Canadian operations increased by 25% to $501.9 million compared with $400.0 million in 2003.
Investment Income
Investment income increased by 32% to $74.3 million compared with $56.2 million for the year ended December 31, 2003. The fair value of the investment portfolio increased by 25% in 2004 due to positive cash flow from operations and capital raised. Our annualized investment yield for the year ended December 31, 2004 remained stable at 3.2% compared to 2003.
Net Realized Gains
Net realized gains amounted to $20.4 million in the year ended December 31, 2004 compared with net realized gains of $41.5 million in 2003. The majority of these gains were realized from the disposal of equity investments, which in 2003 included the disposal of an investment in USA Insurance Group amounting to $14.3 million. Net unrealized gains increased to $61.3 million at December 31, 2004 compared to $41.2 million at December 31, 2003.
Claims Incurred
We conducted detailed claim file reviews throughout our Canadian and U.S. operations during 2003 and 2004 to determine the adequacy of case reserving. Revised guidelines were established for setting reserves for many of our lines, including bodily injury and accident benefit claims in all provinces of Canada which were responsible for a significant portion of the claims development experience in the prior years. As a result of these initiatives, consolidated case reserves were increased 40% during 2004 and IBNR was increased 15%. Overall, unpaid claims have increased 22% while levels of unearned premium reserves remained flat during 2004.
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Our claims ratio for 2004 was 70.9%, compared to 74.5% for 2003. The claims ratio for our U.S. operation was 70.3%, compared with 71.5% for 2003. The claims ratio for our Canadian operations was 72.3% compared to 84.1% for 2003. The results for 2004 and 2003 reflect increases in provision for unpaid claims occurring prior to December 31, 2003 and December 31, 2002, respectively. These increases amounted to approximately $53.2 million, which increased the claims ratio by 3.0% for 2004, compared to $138.5 million and 8.1%, respectively, for 2003.
For our U.S. operations, prior years’ claims development increased the claims incurred by $22.2 million, a 1.7% increase to the claims ratio, in 2004 compared to $65.3 million, a 5.0% increase to the claims ratio in 2003. In 2004, the source of the prior years’development in the U.S. operation was primarily long haul trucking on terminated programs ($23.8 million). We adjusted our initial loss development factors on a number of our programs to reflect actual loss trends experienced in 2003 and these new loss development factors will be used in the prospective reserving process.
For our Canadian operations, prior years’ claims development increased the claims incurred by $31.0 million, a 6.2% increase in the claims ratio, in 2004 compared to $73.2 million, an 18.3% increase in the claims ratio, in 2003. Kingsway General’s Alberta non-standard automobile business contributed $15.7 million of the prior years’ claims development in 2004, compared to $24.3 million in 2003. An increase in average reserves due to the continued escalation in bodily injury claim settlements was the reason for the adverse claims development in both 2003 and 2004 for Alberta non-standard automobile, where we increased existing case reserves based on actual settlement patterns. Our Ontario private passenger automobile business contributed $4.8 million of the prior years’claims development in 2004, compared to $23.1 million in 2003. Continued health care cost inflation and bodily injury award increases beyond expected levels required reserve levels to be increased on open files for Ontario non-standard automobile on average by approximately 22% in 2004. Our Canadian trucking business contributed $6.9 million to the 2004 prior years’ claims development, compared to $9.9 million in 2003. Increases in reserves were due to larger than anticipated settlements, particularly in the U.S., which required upward adjustments to open claim files. Average claim file reserves were increased in 2004 to reflect this pattern of settlement. Our commercial automobile business in Canada contributed $7.6 million of the prior years’ claims development in 2004 compared to $13.1 million in 2003. Case reserves were increased to reflect the increased cost on injury claims similar to the development experienced on the Ontario automobile business.
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Underwriting Expenses
Our expense ratio for 2004 improved to 26.9% compared to 27.1% in 2003. The expense ratio for our Canadian operations for 2004 was 25.8%, compared to 28.0% in 2003 and the expense ratios for our U.S. operations were 27.4% and 26.8%, respectively, in 2004 and 2003.
Combined Ratio
The combined ratio improved to 97.8% compared with 101.6% in 2003, which produced a record underwriting profit of $39.4 million compared with an underwriting loss of $27.2 million in 2003. For 2004, our U.S. operations combined ratio was 97.7% (98.4% in 2003) and for our Canadian operations, the combined ratio improved to 98.1% (112.2% in 2003). The improvement in the combined ratio was a result of less adverse development experienced in 2004 thereby lowering the loss ratio and the lower commission rates paid to brokers in Canada. Prior years’ claims development increased the combined ratio by 3.0% and 8.1% for the year ended December 31, 2004 and 2003, respectively. For our U.S. operations prior year claims development increased the combined ratio by 1.7% in 2004 and 5.0% in 2003, and for the Canadian operations by 6.2% in 2004 and 18.8% in 2003. Assessments from the residual market (Facility Association) resulted in an increase to underwriting profit of $3.4 million in 2004 and an increase in our underwriting loss of $4.7 million in 2003 which also improved the Canadian operations combined ratio by 0.7% in 2004 and increased the Canadian operations combined ratio by 1.2% in 2003.
Interest Expense
Interest expense for 2004 was $21.2 million, compared to $15.1 million in 2003, reflecting the increased borrowings used to support the growth in operations.
Net Income and Earnings Per Share
Income before income taxes for 2004 increased by 105.3% to $112.4 million, compared to $54.7 million in 2003. Net income for 2004 was $101.0 million, a 66% increase over the $60.9 million reported for 2003. Diluted earnings per share were $1.79 for 2004, an increase of 56% over the $1.15 for 2003. The improvement in net income was the result of improvement in the combined ratio in both Canadian and U.S. operations.
Book Value Per Share and Return on Equity
Book value per share increased by 20% to $11.86 at December 31, 2004 from $9.91 at December 31, 2003. Our return on equity was 16.6% for 2004 compared to 12.9% in 2003.
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Balance Sheet
Total assets as at December 31, 2004 grew to $3.52 billion, compared to $2.85 billion as at December 31, 2003. The investment portfolio, including cash increased to $2,582.8 million (fair value $2,644.1 million), compared to $2,082.4 million (fair value $2,123.6 million) as at December 31, 2003. The fair value of the investment portfolio per share outstanding increased 24% to $47.04 compared to $38.04 as at December 31, 2003. Net unrealized gains on the investment portfolio were $61.3 million ($1.09 per share outstanding) at December 31, 2004 compared to $41.2 million ($0.74 per share) at December 31, 2003.
Financial Condition
Liquidity and Capital Resources
The purpose of liquidity management is to ensure that there is sufficient cash to meet all financial commitments and obligations as they fall due. The liquidity requirements of the Company’s business have been met primarily by funds generated from operations, asset maturities and income and other returns received on investments. Cash provided from these sources is used primarily for claims and claim adjustment expense payments and operating expenses. The timing and amount of catastrophe claims are inherently unpredictable and may create increased liquidity requirements. The cash requirements of each quarterly dividend payment to shareholders of 6.25 cents (Canadian) per share is approximately C$3.5 million based on the number of shares outstanding as at December 31, 2005. The dividend for the first quarter of 2006 will be paid on March 31, 2006.
We believe that we have the flexibility to obtain, from internal sources, the funds needed to fulfill our cash requirements, including the quarterly dividend, during the current financial year and also to satisfy regulatory capital requirements. However, such funds may not provide sufficient capital to enable us to pursue additional market opportunities.
The Board of Directors voted at its meeting held on November 3, 2005 to commence a normal course issuer bid (NCIB) to repurchase up to 2,823,000 common shares of the Company, being approximately five percent of the total number of common shares then outstanding. Purchases were eligible to commence on November 8, 2005 and must end no later than November 7, 2006. As at December 31, 2005 no common shares had been repurchased under the NCIB. Between January 1, 2006 and March 17, 2006 the Company repurchased 87,900 common shares at a total cost of $2,080,459. All of these common shares have been cancelled.
Net cash provided from the growth in operations in 2003 was $471.3 million, in 2004 was $391.7 million and in 2005 was $273.7 million which significantly increased our investment portfolio. Net cash provided by financing activities in 2003 was $168.3 million, in 2004 was $64.4 million and in 2005 was $10.9 million.
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Float
Insurance companies receive premiums well before claims are paid to policyholders. This timing difference generates a float on which the Company has an opportunity to earn investment income. The float is calculated by subtracting amounts due from reinsurers and other insurers and deferred policy acquisition costs from unpaid claims, unearned premiums and funds withheld payable to reinsurers.
The table below shows the float, split between Canadian and U.S. operations at the end of each of the last six years:
| As at December 31, (In thousands of U.S. dollars) |
Canadian Operations |
U.S. Operations | Total | ||||
|---|---|---|---|---|---|---|---|
| 2005 | $820,823 | $1,300,813 | $2,121,636 | ||||
| 2004 | 667,906 | 1,332,040 | 1,999,946 | ||||
| 2003 | 510,601 | 1,139,289 | 1,649,890 | ||||
| 2002 | 262,035 | 779,777 | 1,041,812 | ||||
| 2001 | 188,225 | 305,441 | 493,666 | ||||
| 2000 | 172,875 | 186,572 | 359,447 | ||||
An underwriting profit reflects the benefit, in addition to investment income earned, of the float in that year. An underwriting loss reflects the cost of the float in that year, whereas and underwriting profit generates float at no cost. For the five year period to the end of 2005, the underwriting gain was $68.6 million and the float increased by $1.76 billion to $2.12 billion.
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The following is a description of our various financing arrangements, used to support our growth.
Bank Indebtedness
In February 1999, we entered into a $100 million five year fixed term unsecured credit facility at a fixed rate of LIBOR plus a spread which varied with our credit rating. We drew down the facility in full and entered into an interest rate swap transaction whereby we fixed our rate at 5.91% plus a spread based on our credit rating or the ratio of funded debt to total capitalization, whichever was higher, for the term of the facility. This facility matured and was fully repaid in March 2004. The interest rate swap contracts also matured in March 2004.
In May 2002, we entered into a C$66.5 million 364 day revolving credit facility at a floating interest rate determined based on the type of loan and our senior unsecured debt rating. The facility was renewed in May 2003 for one year and was not renewed in 2004.
In March 2004 we entered into a C$150 million revolving credit facility with a syndicate of three banks which replaced the $100 million and C$66.5 million facilities. The debt is guaranteed by Kingsway America and had a maturity date of March 4, 2005. In December 2004 the maturity of the facility was further extended to March 3, 2006. On February 15, 2006, the Company entered into a new C$150 million 364 day revolving credit facility that replaces the existing facility that had a maturity date of March 3, 2006. Depending on the type of loan, the facility bears interest that will be based on the Company’s unsecured debt rating. The credit facility contains numerous covenants that may limit our ability, among other things, to borrow money, make particular types of investments or other restricted payments, sell assets, merge or consolidate, pay dividends or redeem capital stock, and incur liens to secure indebtedness. The facility also requires us to maintain specified financial ratios. As of December 31, 2005, the effective interest rate was approximately 5%, we were in compliance with all of the covenants of this credit facility and we had approximately $11.2 million outstanding.
Canadian Senior Debenture Offering
On December 6, 2002, Kingsway Financial sold C$78 million aggregate principal amount of 8.25% senior unsecured debentures due December 31, 2007. The net proceeds of the offering amounted to approximately C$77.1 million, after the application of the underwriters’ discount and commission. The yield to maturity on the debentures is 8.298%. The debentures are unconditionally guaranteed by Kingsway America. Kingsway Financial’s obligations under, and Kingsway America’s guarantee of, the debentures will rank equally with the senior notes described below.
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U.S. Senior Note Offering
In January 2004 Kingsway America Inc. issued $100 million 7.50% senior notes due 2014. The notes are fully and unconditionally guaranteed by Kingsway Financial. The notes will be redeemable at Kingsway America’s option on or after February 1, 2009. Approximately $60 million was used to repay existing bank indebtedness and the remainder used for general corporate purposes. In March 2004 an additional $25 million of these senior notes were issued. The proceeds from this reopening were used to repay existing bank indebtedness.
Subordinated Debt
Between December 2002 and December 2003, Kingsway America issued $90.5 million in 30-year subordinated deferrable interest debentures in six private placement transactions. In each instance, a corresponding floating rate, junior subordinated, deferrable interest debenture was then issued by Kingsway America to a trust in exchange for the proceeds from the private sale.
The floating rate debentures bear interest at the rate of the London interbank offered interest rate for three-month U.S. dollar deposits, plus spreads ranging from 3.85% to 4.20%, but until dates ranging from December 4, 2007 to January 8, 2009, the interest rates will not exceed 12.45% to 12.75%. The Company has the right to call each of these securities at par anytime after five years from their issuance until their maturity. These debentures are unconditionally guaranteed by Kingsway Financial. The floating rate debenture issued by Kingsway America and Kingsway Financial’s guarantee of all debentures will rank junior to the senior notes issued by Kingsway America and the guarantee thereof by Kingsway Financial. The net proceeds to the Company were $95,613,000 in 2003 and $22,198,000 in 2002 after deducting expenses of $6,273,000 and $1,438,000, respectively. The proceeds were used to increase the capital of our U.S. insurance subsidiaries.
Loan Payable
On July 14, 2005 Kingsway Linked Return of Capital Trust completed its public offering of C$78 million of 5.00% Kingsway Linked Return of Capital Preferred Units due June 30, 2015 of which the Company was a promoter. The net proceeds of the offering were used for a series of investments that included the purchase of a C$74.1 million 7.12% senior note due June 30, 2015 issued by an affiliate.
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Contractual Obligations
Our provision for unpaid claims do not have contractual maturity dates. We have included an estimate of when we expect our unpaid claims to be paid, based on historical payment patterns, in the table below. The exact timing of the payment of claims cannot be predicted with certainty. We maintain an investment portfolio with varying maturities and a substantial amount in short-term investments to provide adequate cash flows for the payment of claims. The unpaid claims in the table below have not been reduced for amounts recoverable from reinsurers.
| Payments Due by Period | |||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| (In thousands of U.S. dollars) | 2006 | 2007 | 2008 | 2009 | 2010 | Thereafter | Total | ||||||||
| Contractual Obligations | |||||||||||||||
| Bank Indebtedness | $ 11,767 | $ -- | $ -- | $ -- | $ -- | $ -- | $ 11,767 | ||||||||
| Senior unsecured | |||||||||||||||
| debentures | -- | 67,068 | -- | -- | -- | 125,000 | 192,068 | ||||||||
| Subordinated | |||||||||||||||
| indebtedness | -- | -- | -- | -- | -- | 90,500 | 90,500 | ||||||||
| Loan Payable | -- | -- | -- | -- | -- | 66,222 | 66,222 | ||||||||
| Unpaid claims | 829,895 | 553,263 | 165,979 | 73,768 | 36,884 | 184,422 | 1,844,211 | ||||||||
| Total | $841,662 | $620,331 | $165,979 | $73,768 | $36,884 | $466,144 | $2,204,768 | ||||||||
As of December 31, 2005, we had approximately $360.6 million of total indebtedness. This compares with $340.3 million as at December 31, 2004 and $273.1 million as at December 31, 2003. The total amount of our debt service obligations in 2006 is expected to be approximately $28.1 million. Kingsway America’s payments under its debt obligations are funded through dividends from its U.S. subsidiaries and capital infusions by Kingsway Financial.
Capital Requirements
In Canada, property and casualty insurance companies are regulated by the Office of the Superintendent of Financial Institutions (OSFI) and the Financial Services Commission of Ontario (FSCO) and are required to maintain a level of capital sufficient to achieve a target of 150% of a minimum capital test (MCT) formula. As at December 31, 2005, each of the Canadian subsidiaries had capital in excess of the MCT. See the table below for a company by company analysis.
In the United States, a risk based capital (RBC) formula is used by the National Association of Insurance Commissioners (NAIC) to identify property and casualty insurance companies that may not be adequately capitalized. As a minimum, the NAIC requires that capital and surplus not fall below 200% of the authorized control level. As at December 31, 2005, the average statutory capital and surplus was 3.9 times the authorized control level for our U.S. subsidiaries. See the table below for a company by company analysis.
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| Capital Requirements As at December 31 |
2005 | 2004 | |||||||
|---|---|---|---|---|---|---|---|---|---|
| MCT (%) | Excess over Minimum(1) |
MCT (%) | Excess over Minimum(1) |
||||||
| Canadian Insurance Subsidiaries | |||||||||
| Kingsway General | 239 | $ 37.4 | 200 | $ 21.4 | |||||
| York Fire | 269 | 13.4 | 362 | 18.6 | |||||
| Jevco | 189 | 17.0 | 223 | 25.1 | |||||
| Kingsway Reinsurance (Bermuda) Ltd. | 19.1 | 10.2 | |||||||
| Total Canadian Operations | $ 86.9 | $ 75.3 | |||||||
| U.S. Insurance Subsidiaries | RBC (%) | RBC (%) | |||||||
| Lincoln General | 288 | $ 44.4 | 350 | $ 68.8 | |||||
| Universal Casualty | 567 | 22.0 | 480 | 17.3 | |||||
| American Service | 636 | 20.7 | 410 | 11.6 | |||||
| American Country | 381 | 12.6 | 250 | 4.7 | |||||
| Hamilton Group | 449 | 13.5 | 330 | 11.1 | |||||
| Southern United | 1,840 | 18.4 | 1,310 | 18.2 | |||||
| Zephyr | 1,297 | 16.1 | 2,015 | 14.8 | |||||
| Kingsway Reinsurance Corporation (Barbados) | 305.2 | 228.8 | |||||||
| Total U.S. Operations | $ 452.9 | $ 375.3 | |||||||
| Total Consolidated | $ 539.8 | $ 450.6 | |||||||
| (1) | Excess over regulatory minimum expressed in millions of U.S. dollars. |
Our reinsurance subsidiaries, which are domiciled in Barbados and Bermuda, are required by the regulator in the jurisdictions in which they operate to maintain minimum capital levels. As of December 31, 2005, the capital maintained by Kingsway Reinsurance Corporation was 458% or $305.2 million in excess of the regulatory requirements in Barbados. As of December 31, 2005, the capital maintained by Kingsway Reinsurance (Bermuda) Limited was 151% or $19.1 million in excess of the regulatory requirements in Bermuda.
Based on the various regulatory restrictions, our insurance and reinsurance subsidiaries would have aggregate dividend capacity of $377.0 million. In most jurisdictions the payment of dividends is subject to regulatory approval.
Off-Balance Sheet Financing
The Company entered into an off-balance sheet transaction through the Kingsway Linked Return of Capital Trust transaction that was completed on July 14, 2005 which is more fully described in notes 13(d) and 14 of the audited consolidated financial statements. The net proceeds from this offering were invested into a Kingsway controlled entity which is not consolidated based on accounting standards. The effect of this transaction is to show additional debt on the Company’s financial statements and an offsetting equity investment of C$8.3 million into the non-consolidated affiliated entity. The Company does not have any other off-balance sheet financing arrangements.
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Standard & Poor’s Rating of Kingsway Financial’s Counterparty Credit and Senior Unsecured Debt
On January 29, 2004, Standard & Poor’s issued its rating of “BBB-” on the $100 million of our senior notes due 2014 issued in January 2004. On March 8, 2004, Standard & Poor’s issued its rating of “BBB-” on an additional $25 million of our senior notes due 2014 issued in March 2004.
On March 17, 2005 Standard and Poor’s Rating services reaffirmed its counterparty and senior unsecured debt credit ratings on Kingsway Financial of “BBB-” with a stable outlook.
On August 3, 2005, Standard & Poor’s issued its rating of “BBB-” on the Kingsway Return of Capital Trust.
According to Standard & Poor’s, a BBB- rating (fourth out of nine rating levels) indicates that the obligation has adequate protection parameters; however, adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity of the obligor to meet its financial commitments under the obligation. A plus or minus designation within a ratings category indicates relative standing within the category.
DBRS’s Rating of our Senior Debentures and Senior Notes
On January 31, 2006, Dominion Bond Rating Service Limited (“DBRS”) confirmed its previous rating of “BBB”with a stable outlook on the Senior Debentures. According to DBRS, a “BBB”rating (fourth out of nine rating levels) indicates that protection of interest and principal is considered adequate, but that the entity is more susceptible to adverse changes in financial and economic conditions, or there may be other adversities present which reduce the strength of the entity and its rated securities. DBRS also assigned a rating trend of “stable” to our Senior Debentures. According to DBRS, a rating trend gives an indication of what direction the rating in question is headed should the given conditions and tendencies continue.
On July 22, 2005, DBRS issued its rating of Pdf-3 (high) with a stable outlook on the Kingsway Return of Capital Trust. According to DBRS, a Pdf-3 rating (third out of six rating levels) indicates adequate credit quality.
On January 31, 2006, DBRS confirmed its previous rating of “BBB” with a stable outlook on $125 million of our senior notes issued in January 2004.
On January 31, 2006, DBRS reaffirmed the Company’s financial strength rating of “BBB” with a stable outlook.
Impact of Ratings Changes
We would expect that a downgrade in our rating by either Standard & Poor’s or DBRS would have a negative impact on our business, such as causing an increase in the interest rate on our bank credit facility.
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Shareholders’ Equity
As a result of our profitability, shareholders’ equity increased 21% to $804.7 million at December 31, 2005 compared to $666.5 million at December 31, 2004. During 2005, our shareholders’ equity was increased by $8.2 million as a result of the currency translation adjustment of our Canadian dollar denominated assets into U.S. dollars. Book value per share outstanding was $14.25 per share at December 31, 2005, an increase of 20% compared to $11.86 per share at December 31, 2004. Book value per share outstanding increased 9% in 2000, 29% in 2001, 16% in 2002, 24% in 2003, 25% in 2004 and 20% in 2005.
Evaluation of Disclosure Controls and Procedures
Disclosure controls and procedures are designed to provide reasonable assurance that all relevant information is gathered and reported to senior management, including the President and CEO (CEO) and Executive Vice President and CFO (CFO), on a timely basis so that appropriate decisions can be made regarding public disclosure.
An evaluation of the effectiveness of the design and operation of the Company’s disclosure controls and procedures was conducted as of December 31, 2005 by and under the supervision of the Company’s management, including the CEO and CFO. Based on this evaluation, the CEO and CFO have concluded that such disclosure controls and procedures, as defined in Multilateral Instrument 52-109, Certification of Disclosure in Issuers’ Annual and Interim Filings, and in Rule 13a-15(e) under the Securities Exchange Act of 1934 (the Exchange Act) were adequate and effective and designed to provide reasonable assurance that material information relating to the Company required to be disclosed in reports that are filed or submitted under Canadian securities legislation and the Exchange Act are recorded, processed, summarized and reported within the time periods specified by those laws.
Legal Proceedings
In the ordinary course of business, we are, from time to time, involved in various claims and legal proceedings, including class actions. While it is not possible to estimate the final outcome of these various proceedings at this time, we do not believe the outcome of such proceedings will have a material impact on our financial condition or results of operations.
Systems and Technology
Information systems and technology are significant contributors to operational efficiency, customer service and the effective management of our business. On-going investments in information technology will introduce new capabilities and enhance current systems to support electronic commerce and electronic data interchange with our independent agents, brokers, program managers and other business partners. We are creating secure Internet access to information, documents, premium payments, and policy quoting, issue, and maintenance. Duplicate entry of information will be reduced by moving transactions electronically between our systems and our partners’ systems. Back office system for claims management, billing, and reinsurance are being enhanced. Workflow and document management technology will help us achieve greater efficiency and better customer service. Management information and business intelligence applications will help us to manage our growing business.
Employees
As of December 31, 2005, we employed approximately 2,300 personnel, of whom approximately 865 are located in Canada and approximately 1,435 are located in the United States. None of our employees are represented by a labour union and we have never experienced a work stoppage. We believe our relationship with our employees is good.
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Quarterly Results
(In thousands of U.S. dollars, except earnings per share amounts)
| 2005 | 2004 | ||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Q4 | Q3 | Q2 | Q1 | Q4 | Q3 | Q2 | Q1 | ||||||||||
| Gross premiums written | $439,267 | $452,341 | $478,446 | $524,606 | $473,951 | $472,971 | $516,493 | $538,391 | |||||||||
| Net premiums earned | 445,372 | 461,446 | 469,300 | 415,825 | 451,332 | 453,329 | 430,851 | 442,862 | |||||||||
| Net income | 35,901 | 31,339 | 29,647 | 38,121 | 29,828 | 23,353 | 24,464 | 23,369 | |||||||||
| Earning per share | |||||||||||||||||
| Basic | $ 0.64 | $ 0.55 | $ 0.52 | $ 0.68 | $ 0.53 | $ 0.42 | $ 0.44 | $ 0.42 | |||||||||
| Diluted | 0.63 | 0.55 | 0.52 | 0.67 | 0.53 | 0.41 | 0.43 | 0.41 | |||||||||
Summary of Quarterly Results
Kingsway’s quarterly earnings, revenue and expenses are modestly affected by seasonal factors. In 2004 and 2005 the most significant factors contributing to the trend of quarterly earnings were the increases in estimates for unpaid claims from prior accident years, the realized net gains from the investment portfolio, currency fluctuations and positive cash flow generated from operating activities which has enabled the Company to increase its investment portfolio. In 2005 gross premiums written have mainly been affected by the softening market conditions in the U.S., partially offset by an increase in the premiums written in the Canadian market driven by premium rate increases.
Quarterly net premiums earned have been impacted by the softening U.S. market described above, offset by the non-renewal in the first quarter of 2005 of the quota-share reinsurance arrangement entered into in the second quarter of 2004.
Fourth Quarter Results
Gross premiums written in the fourth quarter of 2005 declined 7% to $439.3 million compared to $474.0 million reported in the fourth quarter of 2004. This decrease reflects the softening conditions in certain U.S. markets.
Net premiums earned were $445.4 million in the fourth quarter of 2005 a decline of 1% compared to $451.3 million for the fourth quarter of 2004. The quota share decreased the net premium earned in the fourth quarter of 2004 by $48.2 million. After adjusting for this, the net premiums earned declined 11% in the fourth quarter of 2005, primarily due to the softening U.S. market.
Total revenue for the fourth quarter of 2005 includes net realized investment gains of $8.2 million compared to $7.0 million of gains reported in the fourth quarter of 2004. Investment income increased 21% to $24.9 million in the fourth quarter of 2005 compared to $20.6 million for the fourth quarter of 2004.
Net income in the fourth quarter of 2005 increased 20% to $35.9 million compared to $29.8 million reported in the fourth quarter of 2004. The increase is a result of the improved underwriting results recorded by the Company in
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2005 with the combined ratio improving to 97.7% for the fourth quarter of 2005 compared to 98.2% reported for the fourth quarter of 2004. As a result of the increased net income, basic earnings per share and diluted earnings per share for the fourth quarter of 2005 increased to 64 cents and 63 cents, or a 21% and 19% increase, respectively, over the 53 cents reported in the fourth quarter of 2004.
Risk Factors
You should carefully consider the risks described below and all other information contained in this annual report, including the financial statements and accompanying notes. The risks and uncertainties described below are those we currently believe to be material, but they may not be the only ones we face. If any of the following risks, or any other risks and uncertainties that we have not yet identified or that we currently consider not to be material, actually occur or become material risks, our business, prospects, financial condition, results of operations and cash flows could be materially and adversely affected.
Our insurance subsidiaries’provisions for unpaid claims may be inadequate, which would result in a reduction in our net income and might adversely affect our financial condition.
Our insurance subsidiaries’provisions for unpaid claims do not represent an exact calculation of our actual liability, but are estimates involving actuarial and statistical projections at a given point in time of what we expect to be the cost of the ultimate settlement and administration of known and unknown claims. The process for establishing the provision for unpaid claims reflects the uncertainties and significant judgemental factors inherent in estimating future results of both known and unknown claims and as such, the process is inherently complex and imprecise. These estimates are based upon various factors, including:
| • | Actuarial projections of the cost of settlement and administration of claims reflecting facts and circumstances then known; |
| • | Estimates of future trends in claims severity and frequency; |
| • | Judicial theories of liability; |
| • | Variability in claims handling procedures; |
| • | Economic factors such as inflation; |
| • | Judicial and legislative trends, and actions such as class action lawsuits and judicial interpretation of coverages or policy exclusions; and |
| • | The level of insurance fraud. |
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Most or all of these factors are not directly quantifiable, particularly on a prospective basis, and the effects of these and unforeseen factors could negatively impact our ability to accurately assess the risks of the policies that we write. In addition, there may be 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.
We continually refine our estimates in an ongoing process as claims are reported and settled. The following factors may have a substantial impact on our future claims incurred:
| • | The amounts of claims payments; |
| • | The expenses that we incur in resolving claims; |
| • | Legislative and judicial developments; and |
| • | Changes in economic conditions, including inflation. |
As time passes and more information about the claims becomes known, the estimates are appropriately adjusted upward or downward to reflect this additional information. Because of the elements of uncertainty encompassed in this estimation process, and the extended time it can take to settle many of the more substantial claims, several years of experience may be required before a meaningful comparison can be made between actual losses and the original provision for unpaid claims.
The development of the provision for unpaid claims is shown by the difference between estimates of claims as of the initial year end and the re-estimated liability at each subsequent year end. Favourable development (reserve redundancy) means that the original claims estimates were higher than subsequently determined or re-estimated. Unfavourable development (reserve deficiency) means that the original claims estimates were lower than subsequently determined or re-estimated. In recent years, we have experienced reserve deficiencies on prior periods. Although we have made adjustments in our reserving practices and have seen a substantial improvement in our development experienced in 2004 and 2005, we cannot assure you that we will not have additional reserve development in the future. In addition, we have in the past, and may in the future, acquire other insurance companies. We cannot assure you that the provisions for unpaid claims of the companies that we acquire are or will be adequate.
Actual claims and claim adjustment expenses we incur under insurance policies that we write may deviate, perhaps substantially, from the amounts of provisions reflected in our financial statements. To the extent that actual claims incurred exceed our expectations and the provision for unpaid claims reflected on our financial statements, we will be required to reflect those changes by increasing our provision for unpaid claims. In addition, government
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regulators could require that we increase our provisions if they determine that our provision for unpaid claims were understated in the past. When we increase the provision for unpaid claims, our pre-tax “strengthening” of the provision for unpaid claims causes a reduction in our insurance subsidiaries’ surplus which could cause a downgrading of the ratings of our insurance subsidiaries. Any such downgrade could, in turn, adversely affect our ability to sell insurance policies. See the Risk Factors section for a more detailed discussion of the impact of a ratings downgrade.
We may experience difficulty in managing our growth, which could adversely affect our results of operations and financial condition.
Growth may place a strain on our management systems and operational and financial resources. We plan to continue to expand our specialty focus into selected regional markets in the United States and Canada and to increase the distribution of our core products in our existing markets. Our future growth and the successful integration and management of new program manager relationships, acquired businesses and other new business involve numerous risks that could adversely affect our profitability, and are contingent on many factors, including:
| • | expanding our financial, operational and management information systems; |
| • | managing our relationships with independent agents, program managers and brokers, including maintaining adequate controls; |
| • | expanding our executive management and the infrastructure required to effectively control our growth; |
| • | maintaining ratings for certain of our insurance subsidiaries; |
| • | increasing the statutory capital of our insurance subsidiaries to support growth in written premiums; |
| • | accurately setting provisions for claims for new business where historical underwriting experience may not be available; |
| • | obtaining regulatory approval for appropriate premium rates; and |
| • | obtaining the required regulatory approvals to offer additional insurance products or to expand into additional states or provinces. |
We cannot assure you that we will be able to manage our growth effectively or that we will be successful in expanding our business, that our existing infrastructure will be able to support additional expansion or that any new business will be profitable. If we are unable to manage our growth, our results of operations and financial condition may be adversely affected.
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Our business is subject to risks related to litigation and regulatory actions.
In addition to the occasional employment-related litigation, we are a defendant in a number of claims relating to our insurance and other related business operations. We may from time to time be subject to a variety of legal and regulatory actions relating to our current and past business operations, including, but not limited to:
| • | Disputes over coverage or claims adjudication; |
| • | Disputes regarding sales practices, disclosure, premium refunds, licensing, regulatory compliance and compensation arrangements; |
| • | Disputes with our agents, producers or network providers over compensation and termination of contracts and related claims; |
| • | Disputes relating to customers regarding the ratio of premiums to benefits in our various business lines; |
| • | Disputes with taxing authorities regarding our tax liabilities; and |
| • | Disputes relating to certain businesses acquired or disposed of by us. |
In addition, plaintiffs continue to bring new types of legal claims against insurance and related companies. Current and future court decisions and legislative activity may increase our exposure to these types of claims. Multiparty or class action claims may present additional exposure to substantial economic, non-economic or punitive damage awards. The loss of even one of these claims, if it resulted in a significant damage award or a judicial ruling that was otherwise detrimental, could create a precedent in our industry that could have a material adverse effect on our results of operations and financial condition. This risk of potential liability may make reasonable settlements of claims more difficult to obtain. We cannot determine with any certainty what new theories of recovery may evolve or what their impact may be on our business.
We may be subject to governmental or administrative investigations and proceedings in the context of our highly regulated sectors of activity. We cannot predict the outcome of these investigations, proceedings and reviews, and cannot assure you that such investigations, proceedings or reviews or related litigation or changes in operating policies and practices would not materially adversely affect our results of operations and financial condition. In addition, if we were to experience difficulties with our relationship with a regulatory body in a given jurisdiction, it could have a material adverse effect on our ability to do business in that jurisdiction.
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The insurance and related businesses in which we operate may be subject to periodic negative publicity which may negatively impact our financial results.
Our products and services are ultimately distributed to individual consumers. From time to time, consumer advocacy groups or the media may focus attention on insurance products and services, thereby subjecting our industry to periodic negative publicity. We also may be negatively impacted if participants in one or more of our markets engages in practices resulting in increased public attention to our businesses. Negative publicity may also result in increased regulation and legislative scrutiny of practices in the P&C insurance industry as well as increased litigation, which may further increase our costs of doing business and adversely affect our profitability by impeding our ability to market our products and services, requiring us to change our products or services or increasing the regulatory burdens under which we operate.
We rely on independent agents, program managers and brokers and are exposed to risks.
We market and distribute our automobile insurance products through a network of over 2,900 independent agents and approximately 22 program managers in the United States and over 3,000 independent brokers across Canada. In 2005, approximately 65% of our gross written premiums in the United States were sourced through program managers and approximately 35% were sourced through independent agents. Our insurance products are marketed through a large number of independent agents, program managers and brokers and we rely heavily on their ability to attract new business. These independent agencies and program managers typically represent more than one insurance company, which may expose us to competition within the agencies and, therefore, we cannot rely on their commitment to our insurance products. In some markets, we operate pursuant to “open market” arrangements in which we have no formal relationships with the brokers who place our risk in these markets. Loss of all or a substantial portion of the business provided by these intermediaries could have a material adverse effect on our business, results of operations and financial condition.
Our independent agents, program managers and brokers generally have the ability to bind insurance policies and a few program managers may settle claims on our behalf, actions over which we have only a limited ability to exercise control. In the event that an independent agent, program manager or broker exceeds its authority by binding us on a risk that does not comply with our underwriting guidelines, we may be at risk for that policy until we effect a cancellation. Although to date we have not experienced a material loss from improper use of binding authority by our agents, program managers or brokers, any improper use of such authority may result in losses that could have a material adverse effect on our business, results of operations and financial condition.
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In accordance with industry practice, our customers often pay the premiums for their policies to agents, program managers or brokers for payment over to us. These premiums are considered paid when received by the agent, program manager or broker and thereafter the customer is no longer liable to us for those amounts, whether or not we have actually received the premiums from the agent, program manager or broker. Consequently, we assume a degree of risk associated with our reliance on independent agents, program managers and brokers in connection with the settlement of insurance balances.
In addition, program managers are subject to regulation as insurance producers, including licensing requirements, and, to the extent that the program manager has the ability to bind insurance policies and to settle claims, the program manager is subject to regulation of these functions. Noncompliance by any of our program managers with applicable regulatory requirements could have adverse regulatory implications on us.
Engaging in acquisitions involves risks and, if we are unable to effectively manage these risks, our business may be materially harmed.
From time to time we engage in discussions concerning acquisition opportunities and, as a result of such discussions, may enter into acquisition transactions. Acquisitions entail numerous risks, including the following:
| • | difficulties in the integration of the acquired business; |
| • | assumption of unknown material liabilities, including deficient provisions for unpaid claims; |
| • | diversion of management’s attention from other business concerns; |
| • | failure to achieve financial or operating objectives; and |
| • | potential loss of policyholders or key employees of acquired companies. |
We may not be able to integrate successfully any business, operations, personnel, services or products that we may acquire in the future.
The highly competitive environment in which we operate could have an adverse effect on our business, results of operations and financial condition.
The P&C markets in which we operate are highly competitive. We compete, and will continue to compete, with major North American and other insurers, many of which have greater financial, marketing and management resources than we do. There may also be other companies that may be planning to enter the insurance industry of which we are not aware. Insurers in our markets generally compete on the basis of price, consumer recognition,
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coverages offered, claims handling, financial stability, customer service and geographic coverage. Although our pricing is influenced to some degree by that of our competitors, we generally believe that it is not in our best interest to compete solely on price, and may from time to time experience a loss of market share during periods of intense price competition. Our business could be adversely impacted by the loss of business to competitors offering competitive insurance products at lower prices. This competition could affect our ability to attract and retain profitable business.
In our non-standard automobile business, we compete with both large national underwriters and smaller regional companies. Our competitors include other companies that, like us, serve the independent agency market, as well as companies that sell insurance directly to customers. Direct underwriters may have certain competitive advantages over agency underwriters, including increased name recognition, loyalty of the customer base to the insurer rather than to an independent agency and reduced costs to acquire policies. Any new, proposed or potential legislative or industry developments could further increase competition in our markets. New competition from these developments could cause the demand for our products to decrease, which would adversely affect our profitability.
Additionally, in certain provinces or states, government operated risk plans may provide non-standard automobile insurance products at a lower price than those we provide.
From time to time, our markets may also attract competition from new or temporary entrants. In some cases, such entrants may, because of inexperience, the desire for new business or for other reasons, price their insurance below the rates that we believe offer an acceptable premium for the related risk. Further, a number of our competitors, including new entrants to our markets, are developing e-business capabilities which may impact the level of business transacted through our more traditional distribution channels or which may affect pricing in the market as a whole.
Our operating results may fluctuate as a result of many factors, including cyclical patterns in the P&C insurance industry and in the automobile insurance market.
The results of companies in the P&C insurance industry have historically been subject to significant fluctuations and uncertainties. The industry’s profitability can be affected significantly by many factors, including:
| • | rising costs that are not known by companies at the time they price their products, such as unforeseen case law developments; |
| • | unpredictable developments, including weather-related and other natural catastrophes; |
| • | changes in insurance and tax laws and regulation, as well as new legislative initiatives; and |
| • | general economic conditions, such as fluctuations in interest rates, inflationary pressures and other changes in the investment environment, which affect returns on invested capital and may impact the ultimate payout of loss amounts. |
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In addition, the profitability of automobile insurers can be affected significantly by many factors, including:
| • | regulatory regimes which limit the ability of insurers to detect and defend against fraudulent claims and fraud rings; |
| • | developing trends in tort and class action litigation which may encourage frivolous litigation or expose automobile insurers to allegations of bad faith; |
| • | changes in consumer protection laws which could limit the use of used or like kind and quality after-market parts or to compel compensation for alleged diminution in value notwithstanding repair of the vehicle; and |
| • | changes in laws or regulations, including the adoption of consumer initiatives regarding rates charged for automobile or other insurance coverage or claims handling procedures. |
The financial performance of the P&C insurance industry has historically tended to fluctuate in cyclical patterns of “soft” markets characterized generally by increased competition resulting in lower premium rates followed by “hard”markets characterized generally by lessening competition and increasing premium rates. Although an individual insurance company’s financial performance depends on its own specific business characteristics, the profitability of most property and casualty insurance companies tends to follow this cyclical market pattern with profitability generally increasing in hard markets and decreasing in soft markets.
Our operations are restricted by the terms of our credit agreements and debt indentures, which could limit our ability to plan for or to react to market conditions or meet our capital needs.
Our credit agreements and debt indentures contain numerous covenants that limit our ability, among other things, to borrow money, make particular types of investments or other restricted payments, sell assets, merge or consolidate, pay dividends or redeem capital stock, and incur liens to secure indebtedness. These agreements also require us to maintain specified financial ratios. The covenants under our debt agreements could limit our ability to plan for or react to market conditions or to meet our capital needs. Our ability to comply with the capital surplus ratios and other financial covenants in these agreements may be affected by events beyond our control and we may have to curtail some of our operations and growth plans to maintain compliance.
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If we are not able to comply with the covenants and other requirements contained in our credit agreements and debt indentures, an event of default under the relevant debt instrument could occur. If an event of default does occur, it could trigger a default under our other debt instruments, we could be prohibited from accessing additional borrowings, and the holders of the defaulted debt instrument could declare amounts outstanding with respect to such debt to become immediately due and payable. Upon such an event, our assets and cash flow may not be sufficient to fully repay borrowings under our outstanding debt instruments. In addition, such a repayment under an event of default could adversely affect our liquidity and force us to cease or substantially slow our growth.
If we are unable to maintain our current claims-paying ratings, our ability to write insurance and to compete with other insurance companies may be adversely impacted.
Third party rating agencies assess and rate the claims-paying ability of insurers and reinsurers based upon criteria that they have established. Periodically these rating agencies evaluate us to confirm that we continue to meet the criteria of the ratings previously assigned to us. Financial strength ratings are an important factor in establishing the competitive position of insurance companies and may be expected to have an effect on an insurance company’s premiums.
All of our insurance companies with the exception of Zephyr are rated by A.M. Best, which issues independent opinions of an insurer’s financial strength and its ability to meet policyholder obligations. Of our Canadian subsidiaries, Jevco Insurance Company possesses an “A-” (Excellent) rating (fourth highest of 15 rating levels) and Kingsway General Insurance Company and York Fire & Casualty Insurance Company, possess a “B++” (Very Good) group rating from A.M. Best (fifth highest of 15 rating levels). Of our U.S. subsidiaries, Lincoln General Insurance Company and Universal Casualty Company have an “A-” (Excellent) rating (fourth highest of 15 rating levels), American Service Insurance Company, Inc. has a “B++” (Very Good) rating (fifth highest of 15 rating levels), American Country Insurance Company and Southern United Fire Insurance Company have a “B+” (Very Good) rating (sixth highest of 15 rating levels), and U.S. Security Insurance Company has a “B” (Fair) rating (seventh highest of 15 rating levels). According to A.M. Best, companies rated as A and A- (Excellent) are deemed “secure”. These ratings are assigned to insurers which have, on balance, excellent balance sheet strength, operating performance and business profile when compared to the standards established by A.M. Best and, in A.M. Best’s opinion, have a strong ability to meet their ongoing obligations to policyholders. According to A.M. Best, insurers rated as B++ and B+ (Very Good) are deemed “secure” and have, on balance, very good balance sheet strength, operating performance and business profile when compared to the standards established by A.M. Best and, in A.M. Best’s opinion, have a good ability to meet their ongoing obligations to policyholders. According to A.M. Best, companies rated as B (Fair) are deemed “vulnerable” and this rating is assigned to insurers that have, on balance,
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fair balance sheet strength, operating performance and business profile when compared to the standards established by A.M. Best and, in A.M. Best’s opinion, have an ability to meet their ongoing obligations to policyholders.
We cannot assure you that A.M. Best will not downgrade our ratings or place them under review with negative implications in the future. If we are unable to maintain our current ratings, our ability to write insurance business and compete with other insurance companies may be adversely affected. Rating agencies evaluate insurance companies based on financial strength and the ability to pay claims, factors which are more relevant to policyholders than to investors. Financial strength ratings by rating agencies are not ratings of securities or recommendations to buy, hold or sell any security and should not be relied upon as such.
The majority of our gross premiums written are derived from the non-standard automobile and trucking insurance markets. If the demand for insurance in these markets declines, our results of operations could decline significantly.
For the year ended December 31, 2005, approximately 31% of our gross premiums written were attributable to trucking insurance and 29% were attributable to non-standard auto insurance. The size of both the trucking insurance and non-standard automobile markets can be affected significantly by many factors outside of our control, such as the underwriting capacity and underwriting criteria of standard automobile insurance carriers and trucking insurers, and we may be specifically affected by these factors. Additionally, an economic downturn in one or more of our principal markets could result in fewer automobile sales and a lower volume of goods shipped by truck, resulting in less demand for these insurance products. To the extent that these insurance markets are affected adversely for any reason, our gross premiums written will be disproportionately affected due to our substantial reliance on these insurance markets.
If we fail to comply with applicable insurance laws or regulatory requirements, our business, results of operations and financial condition could be adversely affected.
As an insurance company, we are subject to numerous laws and regulations. These laws and regulations delegate regulatory, supervisory and administrative powers to federal, provincial or state insurance commissioners and agencies. Such regulation generally is designed to protect policyholders rather than shareholders, and is related to matters including:
| • | rate setting; |
| • | risk-based capital and solvency standards; |
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| • | restrictions on the amount, type, nature, quality and quantity of investments; |
| • | the maintenance of adequate reserves for unearned premiums and unpaid claims; |
| • | restrictions on the types of terms that can be included in insurance policies; |
| • | standards for accounting; |
| • | marketing practices; |
| • | claims settlement practices; |
| • | the examination of insurance companies by regulatory authorities, including periodic financial and market conduct examinations; |
| • | the licensing of insurers and their agents; |
| • | limitations on dividends and transactions with affiliates; |
| • | approval of certain reinsurance transactions; and |
| • | insolvency proceedings. |
In addition, these statutes typically require us to periodically file financial statements and annual reports, prepared on a statutory accounting basis, and other information with insurance regulatory authorities, including information concerning our capital structure, ownership, financial condition and general business operations. We allocate considerable time and resources to comply with these requirements.
Any failure to comply with applicable laws or regulations could result in the imposition of fines or significant restrictions on our ability to do business, which could adversely affect our results of operations or financial condition. In addition, any changes in laws or regulations, including the adoption of consumer initiatives regarding rates charged for automobile or other insurance coverage or claims handling procedures, could materially adversely affect our business, results of operations and financial condition.
In order to enhance the regulation of insurer solvency, a risk based capital, or RBC, formula was adopted by the U.S. National Association of Insurance Commissioners, or NAIC, for U.S. insurance companies. State insurance regulators monitor the financial status of an insurer by reviewing the insurer’s compliance with RBC requirements. The provinces in which we operate in Canada also have solvency requirements. If our insurance subsidiaries do not comply with these minimum capital requirements, they may be restricted or prohibited from operating. If our insurance subsidiaries are required to increase their reserves in the future, as a result of unexpectedly poor claims experience or otherwise, they may violate these minimum capital requirements unless we are able to take actions to improve the solvency of those subsidiaries. As a result, our business, results of operations, and financial condition may be materially adversely affected.
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We believe that our insurance and reinsurance subsidiaries are in compliance with applicable regulatory requirements in all material respects. It is not possible to predict the future impact of changing federal, state and provincial regulation on our operations, and there can be no assurance that laws and regulations enacted in the future will not be more restrictive than existing laws and regulations.
Our business could be adversely affected as a result of changing political, regulatory, economic or other influences.
The insurance industry is subject to changing political, economic and regulatory influences. These factors affect the practices and operation of insurance and reinsurance organizations. Legislatures in Canada, the United States, Barbados, Bermuda and local jurisdictions in which we operate have periodically considered programs to reform or amend their respective insurance and reinsurance systems. Recently, the insurance and reinsurance regulatory framework has been subject to increased scrutiny in many jurisdictions.
Changes in current insurance regulation may include increased governmental involvement in the insurance industry and initiatives aimed at premium controls, or may otherwise change the business and economic environment in which insurance industry participants operate. Historically, the automobile insurance industry has been under pressure from time to time from regulators, legislators or special interest groups to reduce, freeze or set rates at levels that are not necessarily related to underlying costs or risks, including initiatives to roll back automobile and other personal line rates. These changes may limit our ability to price automobile insurance adequately and could require us to discontinue unprofitable product lines, make unplanned modifications of our products and services, or may result in delays or cancellations of sales of our products and services. For example, a rate freeze in late 2003 and premium roll-back in 2004 were instituted in Alberta. As a result, we have purposely reduced our business in Alberta until market conditions improve. We cannot predict the future impact of changing laws or regulations on our operations and any changes could have a material adverse effect on our results of operations or financial condition.
Our business may be materially adversely affected if the tax laws of the United States or Canada change or relevant tax authorities successfully challenge our interpretations of these laws.
We operate wholly owned subsidiary reinsurance companies in Barbados and Bermuda for the sole purpose of reinsuring risks from our own subsidiaries. Legislation was proposed in 2002 which would have disallowed a deduction for U.S. income tax purposes for premiums paid to certain specified related reinsurers. If this or similar legislation were to be enacted, this could have the effect of increasing the taxes payable by us or certain of our subsidiaries. We cannot assure you that any such legislation or similar legislation will not be enacted.
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Due to our corporate structure and to differences in the tax laws of the United States and Canada, we deduct interest paid on certain debt in the United States as well as in Canada. Such deductions are based on our interpretation of applicable tax laws. There is no guarantee that the Internal Revenue Service or any other tax authority will not challenge our interpretation, and if such a challenge were made and were successful, the taxes payable by us or certain of our subsidiaries could be increased. In addition, amendments or changes in applicable income tax laws or regulations, including those arising from judicial decisions or administrative pronouncements, could deny a deduction for interest to taxpayers with a structure similar to ours.
We may not be able to realize our investment objectives, which could significantly reduce our net income.
We depend on income from our investment portfolio for a substantial portion of our earnings. In 2003, 2004, and 2005, net investment income and net realized capital gains accounted for approximately 5.4%, 5.1% and 6.8%, respectively, of our consolidated revenue. A significant decline in investment yields in our investment portfolio or an impairment of securities that we own could have a material adverse effect on our business, results of operations and financial condition. We currently maintain and intend to continue to maintain an investment portfolio comprising primarily fixed income securities. As of December 31, 2005, the fair value of our investment portfolio included $2.37 billion of fixed income securities. For 2003, 2004 and 2005, the change in net unrealized gains in our portfolio reflected an increase of $20.5 million, an increase of $20.1 million and a decrease of $43.1 million, respectively. Due to fluctuations in the yields on fixed income securities, we face reinvestment risk as these securities mature because the funds may be reinvested at rates lower than that of the maturing security.
Our 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. In addition, changing economic conditions can result in increased defaults by the issuers of securities that we own. Interest rates are highly sensitive to many factors, including 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 securities markets and, consequently, the value of the securities we own. We may not be able to realize our investment objectives, which could reduce our net income significantly.
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We derive the majority of our premiums from a few geographic areas, which may cause our business to be affected by catastrophic losses or business conditions in these areas.
Despite our wide North American market span, some jurisdictions including Illinois, Florida, Ontario and California generate a significant percentage of premiums. Our results of operations may, therefore, be adversely affected by any catastrophic losses in these areas. Catastrophic losses can be caused by a wide variety of events, including earthquakes, hurricanes, tropical storms, tornadoes, wind, ice storms, hail, fires, terrorism, riots and explosions, and their incidence and severity are inherently unpredictable. Catastrophic losses are characterized by low frequency but high severity due to aggregation of losses, and could result in adverse effects on our results of operations or financial condition. Our results of operations may also be adversely affected by general economic conditions, competition, regulatory actions or other business conditions that affect losses or business conditions in the areas in which we do business.
If reinsurance rates rise significantly or reinsurance becomes unavailable or reinsurers are unable to pay our claims, we may be adversely affected.
We purchase reinsurance from third parties in order to reduce our liability on individual risks. Reinsurance does not relieve us of our primary liability to our insureds. A third party reinsurer’s insolvency or inability or unwillingness to make payments under the terms of a reinsurance treaty could have a material adverse effect on our financial condition or results of operations. As of December 31, 2005, we had $223.0 million recoverable from third party reinsurers and other insurers. The majority of these recoverables are unsecured. The losses reported by the reinsurance industry since 2001, including losses resulting from the World Trade Center terrorist attacks and recent hurricanes in the southern U.S., have adversely affected the financial resources of some reinsurers and their ability to pay claims. Also, the material decline in the worldwide equity markets and the defaults and credit downgrades on bonds of many companies have contributed to a significant decline in the net equity of some reinsurers.
The amount and cost of reinsurance available to our insurance companies are subject, in large part, to prevailing market conditions beyond our control. Our ability to provide insurance at competitive premium rates and coverage limits on a continuing basis depends in part upon the extent to which we can obtain adequate reinsurance in amounts and at rates that will not adversely affect our competitive position. We cannot assure you that we will be able to maintain our current reinsurance facilities, which generally are subject to annual renewal. If we are unable to renew any of these facilities upon their expiration or to obtain other reinsurance facilities in adequate amounts and at favourable rates, we may need to modify our underwriting practices or reduce our underwriting commitments.
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Kingsway Financial is a holding company and its operating subsidiaries are subject to dividend restrictions.
Kingsway Financial is an insurance holding company with assets consisting primarily of the capital stock of its subsidiaries. Our operations are and will continue to be limited by the earnings of our subsidiaries and the distribution or other payment of such earnings to us in the form of dividends, loans, advances or the reimbursement of expenses. The payment of dividends, the making of loans and advances or the reimbursement of expenses to us by our subsidiaries is contingent upon the earnings of those subsidiaries and is subject to various business considerations. In addition, payments of dividends to us by our insurance and reinsurance subsidiaries are subject to various statutory and regulatory restrictions imposed by the insurance laws of the domiciliary jurisdiction of such subsidiaries, including Barbados and Bermuda. For the year 2006, under these insurance regulatory restrictions, based on our December 31, 2005 financial statements, our insurance and reinsurance subsidiaries would have aggregate dividend capacity of $377.0 million. In most jurisdictions payment of dividends is subject to prior regulatory approval. The inability of our subsidiaries to pay dividends to us could have a material adverse effect on our business and financial condition.
Our business depends upon key employees, and if we are unable to retain the services of these key employees or to attract and retain additional qualified personnel, our business may suffer.
We are dependent on a number of key employees. 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. The loss of the services of any of our key employees, or the inability to identify, hire and retain other highly qualified personnel in the future, could adversely affect the quality and profitability of our business operations. There are no employment contracts in place for any of our executives.
Various factors may inhibit potential acquisition bids that could be beneficial to our shareholders.
Regulatory provisions may delay, defer or prevent a takeover attempt that shareholders may consider in their best interest. For example, under the terms of applicable U.S. state statutes, any person or entity desiring to purchase more than a specified percentage (commonly 10%) of our outstanding voting securities is required to obtain regulatory approval prior to its purchase of our shares. These requirements would generally require a potential bidder to obtain the prior approval by the insurance departments of the states in which our U.S. subsidiaries are domiciled and may require pre-acquisition notification in states that have adopted pre-acquisition notification provisions. Obtaining these approvals could result in material delays or deter any such transaction.
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Regulatory requirements could make a potential acquisition of our company more difficult and may prevent shareholders from receiving the benefit from any premium over the market price of our common shares offered by a bidder in a takeover context. Even in the absence of a takeover attempt, the existence of these provisions may adversely affect the prevailing market price of our common shares if they are viewed as discouraging takeover attempts in the future.
In addition, the Shareholder Rights Plan approved by our shareholders may also have anti-takeover effects. Our Shareholders Rights Plan is designed to protect our shareholders in the event of unsolicited offers to acquire us, and other coercive takeover tactics which, in the opinion of our board of directors, could impair its ability to represent shareholder interests. The provisions of our Shareholder Rights Plan may render an unsolicited takeover more difficult or less likely to occur or might prevent such a takeover, even though such takeover may offer our shareholders the opportunity to sell their shares at a price above the prevailing market price.
Fluctuations in currency exchange rates could negatively affect our results.
Effective December 31, 2005 we prepared our consolidated financial statements in U.S. dollars. In 2005, 32% of our premiums came from our Canadian operations and are currently denominated in Canadian dollars. Therefore, fluctuations in the U.S. to Canadian dollar exchange rate will impact our results of operations and financial condition from period to period. However, the reporting volatility has been reduced due to the larger portion of our operations conducting its business in our reporting currency, U.S. dollars.
Our Canadian insurance operations generally write policies denominated in Canadian dollars and invest in Canadian dollars. Our U.S. operations generally write policies denominated in U.S. dollars and invest in U.S. dollars. Although investing in local currencies limits the effect of currency exchange rate fluctuations on local operating results, fluctuations in such rates could affect our operations or results, and do affect the translation of these results into U.S. dollars in our consolidated financial statements. During 2005, our shareholders’ equity was increased by $8.2 million as a result of the currency translation adjustment of our Canadian dollar denominated assets into U.S. dollars.
Beginning in the first quarter of 2006, we will commence reporting of our financial results in U.S. dollars. Our results have been influenced by fluctuations in the U.S. to Canadian dollar foreign exchange rate.
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| A. | Evaluation of Disclosure Controls and Procedures |
Our management, including our Chief Executive Officer and Chief Financial Officer, as of the end of the period covered by this annual report have conducted an evaluation of the effectiveness of disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e)) pursuant to Rule 13a-15 promulgated under the Securities Exchange Act of 1934. Based on that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that the disclosure controls and procedures were effective and designed to ensure that all material information required to be filed in this annual report has been made known to them in a timely fashion.
| B. | Changes in Internal Controls |
There have been no significant changes in internal controls, or in factors that could significantly affect internal controls, that occurred during the period covered by the annual report that has materially affected, or is reasonably likely to materially affect, the Company’s internal controls over financial reporting.
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The Registrant’s Audit Committee is composed of the following directors: Mr. David H. Atkins (Chair), Mr. Thomas A. Di Giacomo, Mr. F. Michael Walsh and Mr. Walter E. Farnam. The Registrant’s board of directors has determined that Mr. David H. Atkins is an audit committee financial expert and independent, as that term is defined by the New York Stock Exchange’s listing standards applicable to the Registrant. The Commission has indicated that the designation of Mr. Atkins as the audit committee financial expert does not deem him an “expert” for any purpose, impose any duties, obligations or liability on Mr. Atkins that are greater than those imposed on members of the audit committee and board of directors who do not carry this designation or identification, or affect the duties, obligations or liability of any other member of the audit committee or board of directors.
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The Registrant has adopted a code of ethics and business conduct for all employees and officers. The Registrant has also adopted a code of ethics that applies to Kingsway’s principal executive officer, principal financial officer, principal accounting officer and other senior financial personnel. These codes of ethics are available at the Registrant’s website, www.kingsway-financial.com/investor.htm.
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KPMG LLP has served as the Registrant’s independent registered public accounting firm since 1989. In 2005 and 2004, fees for audit, audit-related, tax and other services provided to the Registrant by KPMG LLP were as follows:
| Year Ended December 31, | |||||
| In Canadian dollars | 2005 | 2004 | |||
| Audit fees | $2,121,000 | $2,064,000 | |||
| Audit-related fees | $ 169,000 | $ 467,000 | |||
| Tax fees | $ 245,000 | $ 57,000 | |||
| Other fees | $ 2,000 | $ 2,000 | |||
| Total | $2,437,000 | $2,590,000 | |||
Pursuant to the terms of its charter, the Audit Committee establishes the independent registered public accounting firm's fees. Such fees are based upon the complexity of the matters in question and the time incurred by the independent registered public accounting firm. The Audit Committee reviews and considers whether the provision of services other than audit services is compatible with maintaining the independent registered public accounting firm's independence. In 2003, the Audit Committee considered and pre-approved expenditure limits for the Registrant’s independent registered public accounting firm and established a system to review and pre-approve the provision of non-audit services by the Registrant’s independent registered public accounting firm to ensure they are consistent with maintaining the independent registered public accounting firm's independence. The audit committee pre-approved 100% of the services performed by the Registrant’s independent registered public accounting firm for audit-related and non-audited related services for the years ended December 31, 2005 and 2004.
A discussion of the nature of the services provided under each category is provided below.
Audit Fees
These are services rendered for the audit of the financial statements or services that are provided for statutory and regulatory filings or engagements and include reporting in connection with the various securities offerings of the Registrant.
Audit-Related Fees
These are fees for assurance and related services that are related to the performance of the audit or review of financial statements and are not reported in the “Audit Fee” category. This work primarily included advisory services on internal controls and French translation services in 2005, and in 2004 primarily appointed actuary services.
Tax Fees
These services included analyses of various tax matters affecting the Registrant and its subsidiaries. These services are primarily composed of advice on international tax planning and tax review services for the Registrant and its subsidiaries.
All Other Fees
These services were related to a subscription for online accounting research.
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See page 51 of Item 3 of this report. The off-balance sheet arrangement provided C$8.3 million of additional working capital for our U.S. operations which was sourced from Kingsway Financial. The off-balance sheet arrangements did not materially effect the liquidity of the Company.
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See page 50 of Item 3 of this report.
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| A. | Undertaking |
Registrant undertakes to make available, in person or by telephone, representatives to respond to inquiries made by the Commission staff, and to furnish promptly, when requested to do so by the Commission staff, information relating to: the securities registered pursuant to Form 40-F; the securities in relation to which the obligation to file an annual report on Form 40-F; or transactions in said securities.
| B. | Consent to Service of Process |
Registrant has previously filed with the Commission a Form F-X in connection with the registration of Common Shares.
The following exhibits are filed as part of this report:
| Exhibit Number | Title | |
| 31.1 | Certification of William G. Star, Chief Executive Officer, pursuant to Rule 13a-14(a) or 15d-14(a) of the Securities Exchange Act | |
| 31.2 | Certification of W. Shaun Jackson, Chief Financial Officer, pursuant to Rule 13a-14(a) or 15d-14(a) of the Securities Exchange Act | |
| 32.1 | Certification of William G. Star, Chief Executive Officer, pursuant to Rule 13a-14(b) or 15d-14(b) and Section 1350 of Chapter 63 of Title 18 of the United States Code (18 U.S.C. 1350) | |
| 32.2 | Certification of W. Shaun Jackson, Chief Financial Officer, pursuant to Rule 13a-14(b) or 15d-14(b) and Section 1350 of Chapter 63 of Title 18 of the United States Code (18 U.S.C. 1350) |
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Pursuant to the requirements of the Exchange Act, the Registrant certifies that it meets all of the requirements for filing on Form 40-F/A and has duly caused this registration statement to be signed on its behalf by the undersigned, thereto duly authorized.
| KINGSWAY FINANCIAL SERVICES INC. | ||
| August 30, 2006 | By: /s/ W. Shaun Jackson ________________________________ | |
| W. Shaun Jackson Executive Vice President and Chief Financial Officer |
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EXHIBIT INDEX
| Number | Document | Sequential Sequential Page Number |
|---|---|---|
| 31.1 | Certification of William G. Star, Chief Executive Officer, pursuant to Rule 13a-14(a) or 15d-14(a) of the Securities Exchange Act | 80 |
| 31.2 | Certification of W. Shaun Jackson, Chief Financial Officer, pursuant to Rule 13a-14(a) or 15d-14(a) of the Securities Exchange Act | 81 |
| 32.1 | Certification of William G. Star, Chief Executive Officer, pursuant to Rule 13a-14(b) or 15d-14(b) and Section 1350 of Chapter 63 of Title 18 of the United States Code (18 U.S.C. 1350) | 82 |
| 32.2 | Certification of W. Shaun Jackson, Chief Financial Officer, pursuant to Rule 13a-14(b) or 15d-14(b) and Section 1350 of Chapter 63 of Title 18 of the United States Code (18 U.S.C. 1350) | 83 |