Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following discussion and analysis of our financial condition and results of
operations should be read in conjunction with the consolidated financial
statements and accompanying notes of United America Indemnity included elsewhere
in this report. Some of the information contained in this discussion and
analysis or set forth elsewhere in this report, including information with
respect to our plans and strategy, constitutes forward-looking statements that
involve risks and uncertainties. Please see "Cautionary Note Regarding
Forward-Looking Statements" at the end of this Item 2 for a discussion of
important factors that could cause actual results to differ materially from the
results described in or implied by the forward-looking statements contained
herein. For more information regarding our business and operations, please see
our Annual Report on Form 10-K for the year ended December 31, 2008.
Recent Developments
On May 5, 2009, we completed the Rights Offering in which a total of 17,178,421
Class A common shares and 11,435,244 Class B common shares were issued. The
issuance of the Class A common shares included 41,588 Class A common shares
issued to an affiliate of Fox Paine & Company in a private placement pursuant to
Section 4(2) of the Securities Act, as amended. The affiliate of Fox Paine &
Company purchased the 41,588 Class A common shares for $3.50 per share, which
was the subscription price at which all Class A common shareholders and Class B
common shareholders were entitled to purchase additional shares.
At the Annual General Shareholders' meeting held on October 27, 2009, our
shareholders voted to approve the payment to Fox Paine & Company of the
arrangement fee of $2.0 million and backstop fee of $5.0 million related to the
Rights Offering, in which a total of 17,178,421 Class A common shares and
11,435,244 Class B common shares were issued. The fees were paid on October 27,
2009. See Note 8 in Item 1 of Part I of this report for more details concerning
the Rights Offering.
Overview
Our Insurance Operations distribute property and casualty insurance products
through a group of approximately 110 professional general agencies that have
limited quoting and binding authority, as well as a number of wholesale
insurance brokers who in turn sell our insurance products to insureds through
retail insurance brokers. We operate predominantly in the excess and surplus
lines marketplace. To manage our operations, we differentiate them by product
classification. These product classifications are: 1) Penn-America, which
includes property and general liability products for small commercial businesses
distributed through a select network of wholesale general agents with specific
binding authority; 2) United National, which includes property, general
liability, and professional lines products distributed through program
administrators with specific binding authority; and 3) Diamond State, which
includes property, casualty, and professional lines products distributed through
wholesale brokers and program administrators with specific binding authority.
Our Reinsurance Operations are comprised of the operations of Wind River
Reinsurance, a Bermuda based treaty and facultative reinsurer of excess and
surplus lines and specialty property and casualty insurance.
We derive our revenues primarily from premiums paid on insurance policies that
we write and from income generated by our investment portfolio, net of fees paid
for investment management services. The amount of insurance premiums that we
receive is a function of the amount and type of policies we write, as well as of
prevailing market prices.
Our expenses include losses and loss adjustment expenses, acquisition costs and
other underwriting expenses, corporate and other operating expenses, interest,
other investment expenses, and income taxes. Losses and loss adjustment expenses
are estimated by management and reflect our best estimate of ultimate losses and
costs arising during the reporting period and revisions of prior period
estimates. We record losses and loss adjustment expenses based on an actuarial
analysis of the estimated losses we expect to incur on the insurance policies we
write. The ultimate losses and loss adjustment expenses will depend on the
actual costs to resolve claims. Acquisition costs consist principally of
commissions that are typically a percentage of the premiums on the insurance
policies we write, net of ceding commissions earned from reinsurers and
allocated internal costs. Other underwriting expenses consist primarily of
personnel expenses and general operating expenses. Corporate and other operating
expenses are comprised primarily of outside legal fees, other professional fees,
including accounting fees, directors' fees, management fees, salaries and
benefits for company personnel whose services relate to the support of corporate
activities, and taxes incurred. Interest expense consists primarily of interest
on senior notes payable, junior subordinated debentures, and funds held on
behalf of others.
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Critical Accounting Estimates and Policies
Our consolidated financial statements are prepared in conformity with GAAP,
which requires us to make estimates and assumptions that affect the reported
amounts of assets and liabilities at the date of the financial statements and
the reported amounts of revenues and expenses during the reporting periods.
Actual results could differ from those estimates and assumptions. We believe
that of our significant accounting policies, the following may involve a higher
degree of judgment and estimation.
Liability For Unpaid Losses And Loss Adjustment Expenses
Although variability is inherent in estimates, we believe that the liability for
unpaid losses and loss adjustment expenses reflects our best estimate for future
amounts needed to pay losses and related loss adjustment expenses and the impact
of our reinsurance coverages with respect to insured events.
In developing loss and loss adjustment expense ("loss" or "losses") reserve
estimates, our actuaries perform detailed reserve analyses each quarter. To
perform the analysis, the data is organized at a "reserve category" level. A
reserve category can be a line of business such as commercial automobile
liability, or it can be a particular type of claim such as construction defect.
The reserves within a reserve category level are characterized as either
short-tail or long-tail. Most of our business can be characterized as medium to
long-tail. For long-tail business, it will generally be several years between
the time the business is written and the time when all claims are settled. Our
long-tail exposures include general liability, professional liability, products
liability, commercial automobile liability, and excess and umbrella. Short-tail
exposures include property, commercial automobile physical damage, and equine
mortality. To manage our insurance operations, we differentiate them by product
classifications, which are Penn-America, United National, and Diamond State. For
further discussion about our product classifications, see "General - Our
Insurance Operations" in Item 1 of Part I of our Annual Report on Form 10-K for
the year ended December 31, 2008. Each of our product classifications contain
both long-tail and short-tail exposures. Every reserve category is analyzed by
our actuaries each quarter. The analyses generally include reviews of losses
gross of reinsurance and net of reinsurance.
A full review of the loss reserves of our Reinsurance Operations was performed
by an independent actuary in the third quarter of 2009. For our Insurance
Operations, an independent actuary performed a peer review of our internal
actuary recommended reserves.
The methods that we use to project ultimate losses for both long-tail and
short-tail exposures include, but are not limited to, the following:
• Paid Development method;
• Incurred Development method;
• Expected Loss Ratio method;
• Bornhuetter-Ferguson method using premiums and paid loss;
• Bornhuetter-Ferguson method using premiums and incurred loss; and
• Average Loss method.
The Paid Development method estimates ultimate losses by reviewing paid loss
patterns and applying them to accident years with further expected changes in
paid loss. Selection of the paid loss pattern requires analysis of several
factors including the impact of inflation on claims costs, the rate at which
claims professionals make claim payments and close claims, the impact of
judicial decisions, the impact of underwriting changes, the impact of large
claim payments and other factors. Claim cost inflation itself requires
evaluation of changes in the cost of repairing or replacing property, changes in
the cost of medical care, changes in the cost of wage replacement, judicial
decisions, legislative changes and other factors. Because this method assumes
that losses are paid at a consistent rate, changes in any of these factors can
impact the results. Since the method does not rely on case reserves, it is not
directly influenced by changes in the adequacy of case reserves.
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For many reserve categories, paid loss data for recent periods may be too
immature or erratic for accurate predictions. This situation often exists for
long-tail exposures. In addition, changes in the factors described above may
result in inconsistent payment patterns. Finally, estimating the paid loss
pattern subsequent to the most mature point available in the data analyzed often
involves considerable uncertainty for long-tail reserve categories.
The Incurred Development method is similar to the Paid Development method, but
it uses case incurred losses instead of paid losses. Since this method uses more
data (case reserves in addition to paid losses) than the Paid Development
method, the incurred development patterns may be less variable than paid
development patterns. However, selection of the incurred loss pattern requires
analysis of all of the factors listed in the description of the Paid Development
method. In addition, the inclusion of case reserves can lead to distortions if
changes in case reserving practices have taken place and the use of case
incurred losses may not eliminate the issues associated with estimating the
incurred loss pattern subsequent to the most mature point available.
The Expected Loss Ratio method multiplies premiums by an expected loss ratio to
produce ultimate loss estimates for each accident year. This method may be
useful if loss development patterns are inconsistent, losses emerge very slowly,
or there is relatively little loss history from which to estimate future losses.
The selection of the expected loss ratio requires analysis of loss ratios from
earlier accident years or pricing studies and analysis of inflationary trends,
frequency trends, rate changes, underwriting changes, and other applicable
factors.
The Bornhuetter-Ferguson method using premiums and paid losses is a combination
of the Paid Development method and the Expected Loss Ratio method. This method
normally determines expected loss ratios similar to the method used for the
Expected Loss Ratio method and requires analysis of the same factors described
above. The method assumes that only future losses will develop at the expected
loss ratio level. The percent of paid loss to ultimate loss implied from the
Paid Development method is used to determine what percentage of ultimate loss is
yet to be paid. The use of the pattern from the Paid Development method requires
consideration of all factors listed in the description of the Paid Development
method. The estimate of losses yet to be paid is added to current paid losses to
estimate the ultimate loss for each year. This method will react very slowly if
actual ultimate loss ratios are different from expectations due to changes not
accounted for by the expected loss ratio calculation.
The Bornhuetter-Ferguson method using premiums and incurred losses is similar to
the Bornhuetter-Ferguson method using premiums and paid losses except that it
uses case incurred losses. The use of case incurred losses instead of paid
losses can result in development patterns that are less variable than paid
development patterns. However, the inclusion of case reserves can lead to
distortions if changes in case reserving practices have taken place, and the
method requires analysis of all the factors that need to be reviewed for the
Expected Loss Ratio and Incurred Development methods.
The Average Loss method multiplies a projected number of ultimate claims by an
estimated ultimate average loss for each accident year to produce ultimate loss
estimates. Since projections of the ultimate number of claims are often less
variable than projections of ultimate loss, this method can provide more
reliable results for reserve categories where loss development patterns are
inconsistent or too variable to be relied on exclusively. In addition, this
method can more directly account for changes in coverage that impact the number
and size of claims. However, this method can be difficult to apply to situations
where very large claims or a substantial number of unusual claims result in
volatile average claim sizes. Projecting the ultimate number of claims requires
analysis of several factors including the rate at which policyholders report
claims to us, the impact of judicial decisions, the impact of underwriting
changes and other factors. Estimating the ultimate average loss requires
analysis of the impact of large losses and claim cost trends based on changes in
the cost of repairing or replacing property, changes in the cost of medical
care, changes in the cost of wage replacement, judicial decisions, legislative
changes and other factors.
For many exposures, especially those that can be considered long-tail, a
particular accident year may not have a sufficient volume of paid losses to
produce a statistically reliable estimate of ultimate losses. In such a case,
our actuaries typically assign more weight to the Incurred Development method
than to the Paid Development method.
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As claims continue to settle and the volume of paid losses increases, the
actuaries may assign additional weight to the Paid Development method. For most
of our reserve categories, even the incurred losses for accident years that are
early in the claim settlement process will not be of sufficient volume to
produce a reliable estimate of ultimate losses. In these cases, we will not
assign any weight to the Paid and Incurred Development methods and will use the
Bornhuetter-Ferguson and Expected Loss Ratio methods. For short-tail exposures,
the Paid and Incurred Development methods can often be relied on sooner
primarily because our history includes a sufficient number of years to cover the
entire period over which paid and incurred losses are expected to change.
However, we may also use the Expected Loss Ratio, Bornhuetter-Ferguson and
Average Loss methods for short-tail exposures.
Generally, reserves for long-tail lines use the Expected Loss Ratio method for
the most recent accident year, shift to the Bornhuetter-Ferguson methods for the
next two years, and then shift to the Incurred and/or Paid Development method.
Claims related to umbrella business are usually reported later than claims for
other long-tail lines. For umbrella business, the Expected Loss Ratio and
Bornhuetter-Ferguson methods are used for as many as six years before shifting
to the Incurred Development method. Reserves for short-tail lines use the
Bornhuetter-Ferguson methods for the most recent accident year and shift to the
Incurred and/or Paid Development method in subsequent years.
For other more complex reserve categories where the above methods may not
produce reliable indications, we use additional methods tailored to the
characteristics of the specific situation. Such reserve categories include
losses from construction defects and A&E.
For construction defect losses, our actuaries organize losses by the year in
which they were reported. To estimate losses from claims that have not been
reported, various extrapolation techniques are applied to the pattern of claims
that have been reported to estimate the number of claims yet to be reported.
This process requires analysis of several factors including the rate at which
policyholders report claims to us, the impact of judicial decisions, the impact
of underwriting changes and other factors. An average claim size is determined
from past experience and applied to the number of unreported claims to estimate
reserves for these claims.
Establishing reserves for A&E and other mass tort claims involves considerably
more judgment than other types of claims due to, among other things,
inconsistent court decisions, an increase in bankruptcy filings as a result of
asbestos-related liabilities, and judicial interpretations that often expand
theories of recovery and broaden the scope of coverage. The insurance industry
continues to receive a substantial number of asbestos-related bodily injury
claims, with an increasing focus being directed toward other parties, including
installers of products containing asbestos rather than against asbestos
manufacturers. This shift has resulted in significant insurance coverage
litigation implicating applicable coverage defenses or determinations, if any,
including but not limited to, determinations as to whether or not an asbestos
related bodily injury claim is subject to aggregate limits of liability found in
most comprehensive general liability policies. In response to these continuing
developments, management increased gross and net A&E reserves during the second
quarter of 2008 to reflect its best estimate of A&E exposures. In 2008, one of
our insurance companies was dismissed from a lawsuit seeking coverage from it
and other unrelated insurance companies. The suit involved issues related to
approximately 3,900 existing asbestos related bodily injury claims and future
claims. The dismissal was the result of a settlement of a disputed claim related
to accident year 1984. The settlement is conditioned upon certain legal events
occurring which will trigger financial obligations by the insurance company.
Management will continue to monitor the developments of the litigation to
determine if any additional financial exposure is present.
Reserve analyses performed by our actuaries result in actuarial point estimates.
The results of the detailed reserve reviews were summarized and discussed with
our senior management to determine the best estimate of reserves. This group
considered many factors in making this decision. The factors included, but were
not limited to, the historical pattern and volatility of the actuarial
indications, the sensitivity of the actuarial indications to changes in paid and
incurred loss patterns, the consistency of claims handling processes, the
consistency of case reserving practices, changes in our pricing and
underwriting, and overall pricing and underwriting trends in the insurance
market.
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Management's best estimate at September 30, 2009 was recorded as the loss
reserve. Management's best estimate is as of a particular point in time and is
based upon known facts, our actuarial analyses, current law, and our judgment.
This resulted in carried gross and net reserves of $1,340.6 million and
$764.2 million, respectively, as of September 30, 2009. A breakout of our gross
and net reserves, excluding the effects of our intercompany pooling arrangements
and intercompany quota share reinsurance agreement, as of September 30, 2009 is
as follows:
Gross Reserves
(Dollars in thousands) Case IBNR (1) Total
Insurance Operations:
Penn-America $ 179,127 $ 323,760 $ 502,887
United National 204,505 448,855 653,360
Diamond State 52,314 92,576 144,890
Total Insurance Operations 435,946 865,191 1,301,137
Reinsurance Operations:
Wind River Reinsurance 12,987 26,470 39,457
Total $ 448,933 $ 891,661 $ 1,340,594
Net Reserves (2)
(Dollars in thousands) Case IBNR (1) Total
Insurance Operations:
Penn-America $ 153,770 $ 266,444 $ 420,214
United National 69,854 143,271 213,125
Diamond State 37,656 64,427 102,083
Total Insurance Operations 261,280 474,142 735,422
Reinsurance Operations:
Wind River Reinsurance 5,426 23,360 28,786
Total $ 266,706 $ 497,502 $ 764,208
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(1) Losses
incurred but
not reported,
including the
expected
future
emergence of
case
reserves.
(2) Does not
include
reinsurance
receivable on
paid losses
or reserve
for
uncollectible
reinsurance.
We continually review these estimates and, based on new developments and
information, we include adjustments of the estimated ultimate liability in the
operating results for the periods in which the adjustments are made. The
establishment of loss and loss adjustment expense reserves makes no provision
for the possible broadening of coverage by legislative action or judicial
interpretation, or the emergence of new types of losses not sufficiently
represented in our historical experience or that cannot yet be quantified or
estimated. We regularly analyze our reserves and review pricing and reserving
methodologies so that future adjustments to prior year reserves can be
minimized. However, given the complexity of this process, reserves require
continual updates and the ultimate liability may be higher or lower than
previously indicated. Changes in estimates for loss and loss adjustment expense
reserves are recorded in the period that the change in these estimates is made.
See Note 6 to the consolidated financial statements in Item 1 of Part I of this
report for details concerning the changes in the estimate for incurred loss and
loss adjustment expenses related to prior accident years.
The detailed reserve analyses that our actuaries complete use a variety of
generally accepted actuarial methods and techniques to produce a number of
estimates of ultimate loss. We determine our best estimate of ultimate loss by
reviewing the various estimates and assigning weight to each estimate given the
characteristics of the reserve category being reviewed. The reserve estimate is
the difference between the estimated ultimate loss and the losses paid to date.
The difference between the estimated ultimate loss and the case incurred loss
(paid loss plus case reserve) is considered to be IBNR. IBNR calculated as such
includes a provision for development on known cases (supplemental development)
as well as a provision for claims that have occurred but have not yet been
reported (pure IBNR).
In light of the many uncertainties associated with establishing the estimates
and making the assumptions necessary to establish reserve levels, we review our
reserve estimates on a regular basis and make adjustments in the period that the
need for such adjustments is determined. The anticipated future loss emergence
continues to be reflective of historical patterns, and the selected development
patterns have not changed significantly from those underlying our most recent
analyses.
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The key assumptions fundamental to the reserving process are often different for
various reserve categories and accident years. Some of these assumptions are
explicit assumptions that are required of a particular method, but most of the
assumptions are implicit and cannot be precisely quantified. An example of an
explicit assumption is the pattern employed in the Paid Development method.
However, the assumed pattern is itself based on several implicit assumptions
such as the impact of inflation on medical costs and the rate at which claim
professionals close claims. Loss frequency is a measure of the number of claims
per unit of insured exposure, and loss severity is a measure of the average size
of claims. Each reserve segment has an implicit frequency and severity for each
accident year as a result of the various assumptions made.
Previous reserve analyses have resulted in our identification of information and
trends that have caused us to increase or decrease our frequency and severity
assumptions in prior periods and could lead to the identification of a need for
additional material changes in loss and loss adjustment expense reserves, which
could materially affect our results of operations, equity, business and insurer
financial strength and debt ratings. Factors affecting loss frequency include,
among other things, the effectiveness of loss controls and safety programs and
changes in economic activity or weather patterns. Factors affecting loss
severity include, among other things, changes in policy limits and deductibles,
rate of inflation and judicial interpretations. Another factor affecting
estimates of loss frequency and severity is the loss reporting lag, which is the
period of time between the occurrence of a loss and the date the loss is
reported to us. The length of the loss reporting lag affects our ability to
accurately predict loss frequency (loss frequencies are more predictable for
short-tail lines) as well as the amount of reserves needed for IBNR.
If the actual levels of loss frequency and severity are higher or lower than
expected, the ultimate losses will be different than management's best estimate.
For most of our reserving classes, we believe that frequency can be predicted
with greater accuracy than severity. Therefore, we believe management's best
estimate is more sensitive to changes in severity than frequency. The following
table, which we believe reflects a reasonable range of variability around our
best estimate based on our historical loss experience and management's judgment,
reflects the impact of changes (which could be favorable or unfavorable) in
frequency and severity on our current accident year gross loss estimate of
$135.2 million for claims occurring during the nine months ended September 30,
2009:
Severity Change
(Dollars in thousands) -10% -5% 0% 5% 10%
Frequency Change -5 % $ (19,607 ) $ (13,184 ) $ (6,761 ) $ (338 ) $ 6,085
-3 % (17,173 ) (10,615 ) (4,057 ) 2,502 9,060
-2 % (15,956 ) (9,330 ) (2,704 ) 3,921 10,547
-1 % (14,739 ) (8,046 ) (1,352 ) 5,341 12,035
0 % (13,522 ) (6,761 ) - 6,761 13,522
1 % (12,305 ) (5,477 ) 1,352 8,181 15,010
2 % (11,088 ) (4,192 ) 2,704 9,601 16,497
3 % (9,871 ) (2,907 ) 4,057 11,021 17,985
5 % (7,437 ) (338 ) 6,761 13,860 20,960
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