NATIONAL INTERSTATE CORP – 10-Q – Management’s Discussion and Analysis of Financial Condition and Results of Operations
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Forward-Looking Statements
This document, including information incorporated by reference, contains "forward-looking statements" (within the meaning of the Private Securities Litigation Reform Act of 1995). All statements, trend analyses and other information contained in this Form 10-Q relative to markets for our products and trends in our operations or financial results, as well as other statements including words such as "may," "target," "anticipate," "believe," "plan," "estimate," "expect," "intend," "project," and other similar expressions, constitute forward-looking statements. We made these statements based on our plans and current analyses of our business and the insurance industry as a whole. We caution that these statements may and often do vary from actual results and the differences between these statements and actual results can be material. Factors that could contribute to these differences include, among other things:
• general economic conditions, weakness of the financial markets and other
factors, including prevailing interest rate levels and stock and credit market performance, which may affect or continue to affect (among other things) our ability to sell our products and to collect amounts due to us,
our ability to access capital resources and the costs associated with such
access to capital and the market value of our investments; • our ability to manage our growth strategy; • performance of securities markets; • our ability to attract and retain independent agents and brokers; • customer response to new products and marketing initiatives; • tax law and accounting changes;
• increasing competition in the sale of our insurance products and services
and the retention of existing customers; • changes in legal environment;
• regulatory changes or actions, including those relating to the regulation
of the sale, underwriting and pricing of insurance products and services
and capital requirements; • levels of natural catastrophes, terrorist events, incidents of war and other major losses; • adequacy of insurance reserves; and • availability of reinsurance and ability of reinsurers to pay their
obligations.
The forward-looking statements herein are made only as of the date of this report. We assume no obligation to publicly update any forward-looking statements.
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General
We underwrite and sell traditional and alternative risk transfer ("ART") property and casualty insurance products primarily to the passenger transportation industry, the trucking industry and moving and storage transportation companies, general commercial insurance to small businesses inHawaii andAlaska and personal insurance to owners of recreational vehicles and commercial vehicles throughoutthe United States . We have five property and casualty insurance subsidiaries:National Interstate Insurance Company ("NIIC"),Vanliner Insurance Company ("VIC" or "Vanliner"),National Interstate Insurance Company of Hawaii, Inc. ("NIIC-HI"),Triumphe Casualty Company ("TCC") andHudson Indemnity, Ltd. ("HIL") and five active agency and service subsidiaries. We write our insurance policies on a direct basis through NIIC, VIC, NIIC-HI and TCC. NIIC and VIC are licensed in all 50 states and theDistrict of Columbia . NIIC-HI is licensed inOhio ,Hawaii ,Michigan andNew Jersey . TCC holds licenses for multiple lines of authority, including auto-related lines, in 31 states and theDistrict of Columbia . HIL is domiciled in theCayman Islands and provides reinsurance for NIIC, VIC, NIIC-HI and TCC, primarily for the ART component. Insurance products are marketed through multiple distribution channels, including independent agents and brokers, program administrators, affiliated agencies and agent internet initiatives. We use our five active agency and service subsidiaries to sell and service our insurance business.
As of
Results of Operations
Overview
Through the operations of our subsidiaries, we are engaged in property and casualty insurance operations. We generate underwriting profits by providing what we view as specialized insurance products, services and programs not generally available in the marketplace. We focus on niche insurance markets where we offer insurance products designed to meet the unique needs of targeted insurance buyers that we believe are underserved by the insurance industry.
We derive our revenues primarily from premiums generated by our insurance policies and income from our investment portfolio. Our expenses consist primarily of losses and loss adjustment expenses ("LAE"), commissions and other underwriting expenses and other operating and general expenses.
Our net income, determined in accordance with GAAP, includes after-tax net realized gains from investments that may not be indicative of our ongoing operations. The following table reconciles net income to net income from operations, a non-GAAP financial measure that we believe is a useful tool for investors and analysts in analyzing ongoing operating trends.
Three Months Ended March 31, 2013 2012 Amount Per Share Amount Per Share (Dollars in thousands, except per share data) Net income from operations$ 7,012 $ 0.36$ 8,614 $ 0.44 After-tax net realized gains from investments 1,005 0.05 1,132 0.06 Net income$ 8,017 $ 0.41$ 9,746 $ 0.50 Our net income for the three months endedMarch 31, 2013 was$8.0 million ($0.41 per share diluted) compared to$9.7 million ($0.50 per share diluted) for the same period in 2012. This decrease was driven by the higher loss and LAE ratio of 76.1% for the three months endedMarch 31, 2013 as compared to 73.1% for the same period in 2012. This 3.0 percentage point increase was primarily attributable to elevated claim severity in certain of our ART products during the three months endedMarch 31, 2013 , partially offset by improvement in the loss and LAE results of two products which we have previously reported as having underperformed in recent periods, one of ourHawaii andAlaska products and our recreational vehicle product. Also contributing to the decline in net income for the first quarter of 2013 compared to the same period in 2012 was a decrease in net investment income, as yields available in the financial markets on fixed maturity securities have generally declined in recent years, placing downward pressure on our investment portfolio yield. Net investment income was also impacted by our average invested asset balances being slightly lower in the first quarter of 2013 as compared to the same period in 2012 due to our one-time special dividend payment inDecember 2012 . We recorded after-tax net realized gains from investments of$1.0 million ($0.05 per share diluted) for the first quarter of 2013, compared to$1.1 million ($0.06 per share diluted) for the comparative period in 2012. Our after-tax net realized gains for the three months endedMarch 31, 2013 were primarily generated by net gains associated with equity partnership investments and 20
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sales or redemptions of securities, while the after-tax net realized gains for the comparable period in 2012 related primarily to net gains associated with equity partnership investments. Our net income from operations for the three months endedMarch 31, 2013 was$7.0 million ($0.36 per share diluted) compared to$8.6 million ($0.44 per share diluted) for the same periods in 2012. The primary drivers for this period-over-period fluctuation are the same as those discussed above for the change in net income for the respective periods.
Gross Premiums Written
Three months endedMarch 31, 2013 compared toMarch 31, 2012 . We operate our business as one segment, property and casualty insurance. We manage this segment through a product management structure. The following table sets forth an analysis of gross premiums written by business component during the periods indicated: Three Months Ended March 31, 2013 2012 Amount Percent Amount Percent (Dollars in thousands) Alternative Risk Transfer$ 85,568 56.3 %$ 76,438 58.7 % Transportation 46,770 30.8 % 35,207 27.0 % Specialty Personal Lines 13,542 8.9 % 13,053 10.0 % Hawaii and Alaska 3,890 2.6 % 3,880 3.0 % Other 2,098 1.4 % 1,647 1.3 % Gross premiums written$ 151,868 100.0 %$ 130,225 100.0 % Gross premiums written includes both direct and assumed premium. During the first quarter of 2013, our gross premiums written increased$21.6 million , or 16.6%, compared to the same period in 2012, primarily attributable to the growth experienced in our transportation and ART components. Gross premiums written in our transportation component increased by$11.6 million , or 32.8%, in the first quarter of 2013 compared to the same period in 2012, primarily driven byVanliner's moving and storage products, which grew due to a combination of new customers, rate increases and growth in the exposure base among its existing customers. Also contributing to the transportation component's growth was the impact of premiums produced by the trucking product extension introduced in 2012, as well as rate increases on all transportation component products and high renewal retention in our traditional passenger transportation business. Our ART component's gross premiums written increased$9.1 million , or 11.9%, during the first quarter of 2013 compared to the same period in 2012 due to growth in existing ART programs including the addition of a new customer to our large account ART product, rate increases, growth in exposures on renewal business and the addition of new customers in many of our other ART programs. Additionally, we continued to experience high levels of member retention in group ART programs renewing during the period. The ART growth was partially offset by reductions in premium primarily associated with the impact of ending the business relationship with the agent for one of the products in the program business portion of our ART component. This product, which is in runoff, comprised 4.7% of our gross premiums written during the first quarter of 2012. The increase of$0.5 million , or 3.7%, in our specialty personal lines component was primarily related to the growth in our commercial vehicle product, which is mainly attributable to the impact of having appointed hundreds of new independent agents over the past several months and increased rates. This growth was partially offset by a decline in our recreational vehicle product primarily driven by the impact on quote volume and conversion rates associated with significantly increasing our premium rates. Our group ART programs, which focus on specialty or niche businesses, provide various services and coverages tailored to meet specific requirements of defined client groups and their members. These services include risk management consulting, claims administration and handling, loss control and prevention and reinsurance placement, along with providing various types of property and casualty insurance coverage. Insurance coverage is provided primarily to companies with similar risk profiles and to specified classes of business of our agent partners. As part of our ART programs, we have analyzed, on a quarterly basis, members' loss performance on a policy year basis to determine if there would be a premium assessment to participants or if there would be a return of premium to participants as a result of less-than-expected losses. Assessment premium and return of premium are recorded as adjustments to premiums written (assessments increase premiums written; returns of premium reduce premiums written). For the first quarter of 2013 and 2012, we recorded premium assessments of$3.2 and$1.5 million premium, respectively. 21
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Premiums Earned
Three months ended
Three Months Ended March 31, Change 2013 2012 Amount Percent (Dollars in thousands) Premiums earned: Alternative Risk Transfer$ 71,308 $ 58,210 $ 13,098 22.5 % Transportation 38,632 35,137 3,495 9.9 % Specialty Personal Lines 11,331 11,817 (486 ) (4.1 %) Hawaii and Alaska 3,561 3,384 177 5.2 % Other 2,075 1,577 498 31.6 % Total premiums earned$ 126,907 $ 110,125 $ 16,782 15.2 % Our premiums earned increased$16.8 million , or 15.2%, to$126.9 million during the three months endedMarch 31, 2013 compared to$110.1 million for the same period in 2012. The increase is primarily attributable to our ART component, which grew$13.1 million , or 22.5%, over 2012 mainly due to the gross premiums written growth from new and existing programs experienced throughout 2012. Our transportation component increased$3.5 million , or 9.9%, during the first quarter of 2013 compared to the same period in 2012 mainly due to the gross premiums written growth in 2012 amongVanliner's moving and storage products and our traditional trucking business. Partially offsetting these increases was a decrease in our specialty personal lines component of$0.5 million , or 4.1%, due to the decline in premiums written in our recreational vehicle product experienced throughout 2012.
Underwriting and Loss Ratio Analysis
Underwriting profitability, as opposed to overall profitability or net earnings, is measured by the combined ratio. The combined ratio is the sum of the loss and LAE ratio and the underwriting expense ratio. A combined ratio under 100% is indicative of an underwriting profit. Losses and LAE are a function of the amount and type of insurance contracts we write and of the loss experience of the underlying risks. We seek to establish case reserves at the maximum probable exposure based on our historical claims experience. Our ability to accurately estimate losses and LAE at the time of pricing our contracts is a critical factor in determining our profitability. The amount reported under losses and LAE in any period includes payments in the period net of the change in reserves for unpaid losses and LAE between the beginning and the end of the period. Our underwriting expense ratio includes commissions and other underwriting expenses and other operating and general expenses, offset by other income. Commissions and other underwriting expenses consist principally of brokerage and agent commissions reduced by ceding commissions received from assuming reinsurers, and vary depending upon the amount and types of contracts written and, to a lesser extent, premium taxes. Our underwriting approach is to price our products to achieve an underwriting profit even if we forgo volume as a result. After several years of modest single digit decreases in rate levels on our renewal business as a whole, since 2011 we have seen rate levels gradually stabilize on renewal business, with a number of our products experiencing single digit rate level increases on renewal business. This positive trend has continued into the first quarter of 2013, with many of our products taking rate increases of over 5% and, in some instances, exceeding 10%. 22
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The table below presents our net premiums earned and combined ratios for the periods indicated: Three Months Ended March 31, 2013 2012 (Dollars in thousands) Gross premiums written$ 151,868 $ 130,225 Ceded reinsurance (27,111 ) (23,510 ) Net premiums written 124,757 106,715 Change in unearned premiums, net of ceded 2,150 3,410 Total premiums earned$ 126,907 $ 110,125 Combined Ratios: Loss and LAE ratio (1) 76.1 % 73.1 % Underwriting expense ratio (2) 21.7 % 23.3 % Combined ratio 97.8 % 96.4 % (1) The ratio of losses and LAE to premiums earned.
(2) The ratio of the sum of commissions and other underwriting expenses, other
operating expenses less other income to premiums earned.
Three months endedMarch 31, 2013 compared toMarch 31, 2012 . Our loss and LAE ratio for the first quarter of 2013 increased 3.0 percentage points to 76.1% compared to 73.1% for the same period in 2012. This increase over the prior period is primarily attributable to higher claim severity in certain of our ART products during the three months endedMarch 31, 2013 . Accordingly, we have non-renewed certain underperforming accounts and have increased rate levels, as previously discussed. Partially offsetting this increased claim severity was improvement in the loss and LAE results of two products which we have previously reported as having underperformed in recent periods, one of ourHawaii andAlaska products and our recreational vehicle product. For the first quarter of 2013, we had unfavorable development from prior years' loss reserves of$2.4 million , or 1.9 percentage points compared to unfavorable development of$1.9 million , or 1.8 percentage points, in the first quarter of 2012. This unfavorable development was primarily related to settlements above the established case reserves and revisions to our estimated future settlements on an individual case by case basis. The prior years' loss reserve development is not considered to be unusual or significant to prior years' reserves based on the history of our business and the timing of events in the claims adjustment process. The underwriting expense ratio for the first quarter of 2013 decreased 1.6 percentage points to 21.7% compared to 23.3% for the same period in 2012, which was primarily attributable to leveraging our fixed operating costs while increasing our premium base in the first quarter of 2013 compared to the same period in the prior year. Specifically, operating costs associated with our insurance operations, such as product management, underwriting, sales and marketing costs, have remained flat during the first three months of 2013 as compared to the first three months of 2012.
Net Investment Income
Three months endedMarch 31, 2013 compared toMarch 31, 2012 . Net investment income decreased$1.2 million , or 13.3%, to$8.0 million in the first quarter of 2013 compared to the same period in 2012. Yields available in the financial markets on fixed maturity securities remain low, placing downward pressure on our net investment income. While we have normally had higher average invested assets period over period to help offset the declining yields, average fixed income holdings were slightly lower in the first quarter of 2013 as compared to the same period in 2012 primarily due to our one-time special shareholder dividend paid inDecember 2012 .
Net Realized Gains on Investments
Three months endedMarch 31, 2013 compared toMarch 31, 2012 . Net realized gains on investments were$1.5 million for the first quarter of 2013 compared to$1.7 million for the first quarter of 2012. The net realized gains for the three months endedMarch 31, 2013 were primarily generated from net realized gains associated with equity partnerships totaling$0.8 million and sales or redemptions of securities, which produced net gains of$0.7 million . The net realized gains for the first quarter of 2012 were primarily generated from net gains associated with equity partnership investments of$1.4 million and net realized gains associated with sales of securities totaling$0.4 million .
Commissions and Other Underwriting Expenses
Three months endedMarch 31, 2013 compared toMarch 31, 2012 . During the first quarter of 2013, commissions and other underwriting expenses of$22.9 million increased$1.4 million , or 6.2%, from$21.5 million in the comparable period in 2012. As a percentage of premiums earned, commissions and other underwriting expenses decreased to 18.0% for the three months ended 23
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Other Operating and General Expenses
Three months endedMarch 31, 2013 compared toMarch 31, 2012 . Other operating and general expenses increased$0.5 million , or 10.0%, to$5.4 million during the quarter endedMarch 31, 2013 compared to$4.9 million for the same period in 2012, primarily due to growth in our employee headcount and other expenses necessary to support the growth in our business. As a percentage of premiums earned, such expenses were relatively flat at 4.3% and 4.5% for the three months endedMarch 2013 and 2012, respectively.
Income Taxes
Three months endedMarch 31, 2013 compared toMarch 31, 2012 . The effective tax rate of 27.6% for the three month period endedMarch 31, 2013 decreased 1.6 percentage points, from 29.2%, as compared to the same period in 2012, primarily attributable to the impact of tax-exempt investment income. While our tax-exempt investment income was relatively flat in the first quarter of 2013 as compared to the same period in 2012, its impact on our effective tax rate was greater in the first quarter of 2013 due to having lower income before income taxes as compared to the prior period.
Financial Condition
Investments
AtMarch 31, 2013 , our investment portfolio contained$962.5 million in fixed maturity securities and$38.1 million in equity securities, all carried at fair value, with unrealized gains and losses reported as a separate component of shareholders' equity, and$38.4 million in other investments, which are limited partnership investments accounted for in accordance with the equity method. AtMarch 31, 2013 , we had pre-tax net unrealized gains of$45.8 million on fixed maturities and$6.9 million on equity securities. Our investment portfolio allocation is based on diversification among primarily high quality fixed maturity investments and guidelines in our investment policy. AtMarch 31, 2013 , 90.1% of the fixed maturities in our portfolio were rated "investment grade" (credit rating of AAA to BBB-) by nationally recognized rating agencies. Investment grade securities generally bear lower degrees of risk and corresponding lower yields than those that are unrated or non-investment grade. State and local government obligations represented approximately 37.1% of our fixed maturity portfolio atMarch 31, 2013 , with approximately$281.8 million , or 79.0%, of our state and local government obligations held in special revenue obligations, and the remaining amount held in general obligations. Our state and local government obligations portfolio is high quality, as 99.5% of such securities were rated investment grade atMarch 31, 2013 . We had no state and local government obligations for any state, municipality or political subdivision that comprised 10% or more of the total amortized cost or fair value of such obligations atMarch 31, 2013 . 24
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Summary information for securities with unrealized gains or losses atMarch 31, 2013 is shown in the following table. Approximately$1.0 million of fixed maturities and$27 thousand of equity securities had no unrealized gains or losses atMarch 31, 2013 . Securities with Securities with Unrealized Gains Unrealized Losses (Dollars in thousands) Fixed Maturities: Fair value of securities $ 885,680 $ 75,813 Amortized cost of securities 838,293 77,406 Gross unrealized gain or (loss) $ 47,387 $ (1,593 ) Fair value as a % of amortized cost 105.7 % 97.9 % Number of security positions held 714 50 Number individually exceeding$50,000 gain or (loss) 284 6 Concentration of gains or losses by type or industry: U.S. Government and government agencies $ 6,610 $ (7 ) Foreign governments 49 - State, municipalities and political subdivisions 16,186 (246 ) Residential mortgage-backed securities 9,646 (1,195 ) Commercial mortgage-backed securities 2,056 - Other debt obligations 281 (15 ) Financial institutions, insurance and real estate 4,133 (49 ) Industrial and other 8,426 (81 ) Percent rated investment grade (a) 90.7 % 83.1 % Equity Securities: Fair value of securities $ 34,553 $ 3,484 Cost of securities 27,553 3,610 Gross unrealized gain or (loss) $ 7,000 $ (126 ) Fair value as a % of cost 125.4 % 96.5 % Number individually exceeding$50,000 gain or (loss) 37 1
(a) Investment grade of AAA to BBB- by nationally recognized rating agencies.
The table below sets forth the scheduled maturities of available for sale fixed maturity securities atMarch 31, 2013 , based on their fair values. Other debt obligations, which are primarily comprised of asset-backed securities other than those related to mortgages, are categorized based on their average maturity. Actual maturities may differ from contractual maturities because certain securities may be called or prepaid by the issuers. Securities with Securities with Unrealized Gains Unrealized Losses Maturity: One year or less 2.4 % 1.3 % After one year through five years 31.0 %
15.2 %
After five years through ten years 30.6 % 20.2 % After ten years 12.2 % 16.0 % 76.2 % 52.7 % Mortgage-backed securities 23.8 % 47.3 % 100.0 % 100.0 % 25
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The table below summarizes the unrealized gains and losses on fixed maturities and equity securities by dollar amount.
At March 31, 2013 Aggregate Fair Value Aggregate Unrealized as % of Fair Value Gain (Loss) Cost Basis (Dollars in thousands) Fixed Maturities: Securities with unrealized gains: Exceeding$50,000 and for: Less than one year (95 issues)$ 169,397</money> $ 11,518 107.3 % More than one year (189 issues) 367,924 28,226 108.3 % Less than$50,000 (430 issues) 348,359 7,643 102.2 %$ 885,680 $ 47,387 Securities with unrealized losses: Exceeding$50,000 and for: Less than one year (1 issue)$ 2,595 $ (51 ) 98.1 % More than one year (5 issues) 4,907 (1,111 ) 81.5 % Less than$50,000 (44 issues) 68,311 (431 ) 99.4 %$ 75,813 $ (1,593 ) Equity Securities: Securities with unrealized gains: Exceeding$50,000 and for: Less than one year (30 issues)$ 14,892 $ 2,976 125.0 % More than one year (7 issues) 6,977 2,770 165.8 % Less than$50,000 (55 issues) 12,684 1,254 111.0 %$ 34,553 $ 7,000 Securities with unrealized losses: Exceeding$50,000 and for: Less than one year (1 issue)$ 664 $ (71 ) 90.3 % More than one year (0 issues) - - 0.0 % Less than$50,000 (10 issues) 2,820 (55 ) 98.1 %$ 3,484 $ (126 )
When a decline in the value of a specific investment is considered to be other-than-temporary, a provision for impairment is charged to earnings (accounted for as a realized loss) and the cost basis of that investment is reduced. The determination of whether unrealized losses are other-than-temporary requires judgment based on subjective as well as objective factors. Factors considered and resources used by management include those discussed in "Management's Discussion and Analysis of Financial Condition and Results of Operations - Other-Than-Temporary Impairment."
Liquidity and Capital Resources
The liquidity requirements of our insurance subsidiaries relate primarily to the liabilities associated with their products as well as operating costs and payments of dividends and taxes to us from insurance subsidiaries. Historically and during the first three months of 2013, cash flows from premiums and investment income have provided sufficient funds to meet these requirements, without requiring significant liquidation of investments. If our cash flows change dramatically from historical patterns, for example as a result of a decrease in premiums, an increase in claims paid or operating expenses, or financing an acquisition, we may be required to sell securities before their maturity and possibly at a loss. Our insurance subsidiaries generally hold a significant amount of highly liquid, short-term investments or cash and cash equivalents to meet their liquidity needs. Our historic pattern of using receipts from current premium writings for the payment of liabilities incurred in prior periods provides us with the option to extend the maturities of our investment portfolio beyond the estimated settlement date of our loss reserves. Funds received in excess of cash requirements are generally invested in additional marketable securities. We believe that our insurance subsidiaries maintain sufficient liquidity to pay claims and operating expenses, as well as meet commitments in the event of unforeseen events such as reserve deficiencies, inadequate premium rates or reinsurer insolvencies. Our principal sources of liquidity are our existing cash, cash equivalents and short-term investments. Cash and cash equivalents increased$1.8 million from$42.0 million atDecember 31, 2012 to$43.8 million atMarch 31, 2013 . We generated net cash from operations of$26.6 million for the three months endedMarch 31, 2013 , compared to$20.0 million during the comparable period in 2012. The growth we experienced in our gross premiums written in the first three months of 2013 compared to the same period 26
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in 2012 drove the
Net cash used in investing activities was$23.4 million and$14.1 million for the three months endedMarch 31, 2013 and 2012, respectively. Contributing to the$9.3 million increase in cash used in investing activities were increases of$11.1 million and$4.7 million from the purchases of fixed maturities and equity securities, respectively, as well as a$5.0 million decrease in the proceeds from the sale of fixed maturities, partially offset by a$9.7 million increase in the proceeds from maturities and redemptions of fixed maturity investments. The increase in the purchases of investment securities during the first quarter of 2013 was primarily attributable to reinvesting the proceeds from matured and redeemed fixed maturity securities. The increase in maturities and redemptions of fixed maturity investments in the first quarter of 2013 was due to an increase in scheduled maturities as compared to the first quarter of 2012. The net purchases of fixed maturities during the first three months of 2013 were primarily concentrated in other debt obligations, which are primarily comprised of asset-backed securities excluding those related to mortgages, while the net purchases of equity securities during the period were mainly concentrated in dividend yielding stocks. Net cash used in financing activities was$1.4 million and$2.0 million for the three months endedMarch 31, 2013 and 2012, respectively. Our financing activities include those related to stock option activity and dividends paid on our common shares. We have continuing cash needs for administrative expenses, the payment of principal and interest on borrowings, shareholder dividends and taxes. Funds to meet these obligations will come primarily from parent company cash, dividends and other payments from our insurance company subsidiaries. OnNovember 19, 2012 , we replaced our$50.0 million credit agreement with a$100.0 million unsecured credit agreement (the "Credit Agreement") that terminates inNovember 2017 , which includes a sublimit of$10.0 million for letters of credit. We have the ability to increase the line of credit to$125.0 million subject to the Credit Agreement's accordion feature. Amounts borrowed bear interest at either (1) a LIBOR rate plus an applicable margin ranging from 0.75% to 1.00% based on ourA.M. Best insurance group rating, or (2) a rate per annum equal to the greater of (a) the administrative agent's prime rate, (b) 0.50% in excess of the federal funds effective rate, or (c) 1.00% in excess of the one-month LIBOR rate. Based on ourA.M. Best insurance group rating of "A" atMarch 31, 2013 , we would pay interest at the LIBOR rate plus 0.875%. AtMarch 31, 2013 , we had$12.0 million outstanding under the Credit Agreement, with the interest rate on this debt equal to the six-month LIBOR (0.4649% atMarch 31, 2013 ) plus 87.5 basis points, with interest payments due throughout the year at each interest rate repricing date. The Credit Agreement requires us to maintain specified financial covenants measured on a quarterly basis, including minimum consolidated net worth and a maximum debt to capital ratio. In addition, the Credit Agreement contains certain affirmative and negative covenants customary for facilities of this type, including negative covenants that limit or restrict our ability to, among other things, pay dividends, incur additional indebtedness, effect mergers or consolidations, make investments, enter into asset sales, create liens, enter into transactions with affiliates and other restrictions customarily contained in such agreements. As ofMarch 31, 2013 , we were in compliance with all covenants. We believe that funds generated from operations, including dividends from insurance subsidiaries, parent company cash and funds available under our Credit Agreement, will provide sufficient resources to meet our liquidity requirements for at least the next 12 months. However, if these funds are insufficient to meet fixed charges in any period, we would be required to generate cash through sale of assets, sale of portfolio securities or similar transactions. If we were required to sell portfolio securities early for liquidity purposes rather than holding them to maturity, we would recognize gains or losses on those securities earlier than anticipated. Our ongoing corporate initiatives include actively evaluating potential acquisitions. At such time that we would execute an agreement to enter into an acquisition, such a transaction, depending upon the structure and size, could have an impact on our liquidity. If we were forced to borrow additional funds in order to meet liquidity needs, we would incur additional interest expense, which could have a negative impact on our earnings. Since our ability to meet our obligations in the long-term (beyond a 12-month period) is dependent upon factors such as market changes, insurance regulatory changes and economic conditions, no assurance can be given that the available net cash flow will be sufficient to meet our long-term operating needs. We are not aware of any trends or uncertainties affecting our liquidity, including any significant future reliance on short-term financing arrangements.
Critical Accounting Policies
The preparation of financial statements in conformity with U.S. generally accepted accounting principles ("GAAP") requires management to make estimates and assumptions that affect amounts reported in the financial statements. As more information becomes known, these estimates and assumptions could change and thus impact amounts reported in the future. Management believes that the establishment of losses and LAE reserves and the determination of "other-than-temporary" impairment on investments are the two areas where the degree of judgment required in determining amounts recorded in the financial statements 27
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make the accounting policies critical. For a more detailed discussion of these policies, see "Management's Discussion and Analysis of Financial Condition and Results of Operations - Critical Accounting Policies" in our Annual Report on Form 10-K for the year endedDecember 31, 2012 .
Losses and LAE Reserves
Significant periods of time can elapse between the occurrence of an insured loss, the reporting of that loss to us and our final payment of that loss and its related LAE. To recognize liabilities for unpaid losses, we establish reserves as balance sheet liabilities. AtMarch 31, 2013 andDecember 31, 2012 , we had$785.4 million and$775.3 million , respectively, of gross loss and LAE reserves, representing management's best estimate of the ultimate loss. Management records, on a monthly and quarterly basis, its best estimate of loss reserves. For purposes of computing the recorded reserves, management utilizes various data inputs, including analysis that is derived from a review of prior quarter results performed by actuaries employed by Great American. In addition, on an annual basis, actuaries from Great American review our recorded reserves for NIIC, VIC, NIIC-HI and TCC utilizing current period data and provide a Statement of Actuarial Opinion, required annually in accordance with state insurance regulations, on the statutory reserves recorded by these U.S. insurance subsidiaries. The actuarial analysis of NIIC's, VIC's, NIIC-HI's and TCC's combined net reserves for the year endingDecember 31, 2012 reflected point estimates that were within 2% of management's recorded net reserves as of such dates. Using this actuarial data along with its other data inputs, management concluded that the recorded reserves appropriately reflect management's best estimates of the liability as ofMarch 31, 2013 andDecember 31, 2012 .
The quarterly reviews of unpaid loss and LAE reserves by Great American actuaries are prepared using standard actuarial techniques. These may include (but may not be limited to):
• the Case Incurred Development Method; • the Paid Development Method; • the Bornhuetter-Ferguson Method; and • the Incremental Paid LAE to Paid Loss Methods. The period of time from the occurrence of a loss through the settlement of the liability is referred to as the "tail." Generally, the same actuarial methods are considered for both short-tail and long-tail lines of business because most of them work properly for both. The methods are designed to incorporate the effects of the differing length of time to settle particular claims. For short-tail lines, management tends to give more weight to the Case Incurred andPaid Development methods, although the various methods tend to produce similar results. For long-tail lines, more judgment is involved and more weight may be given to the Bornhuetter-Ferguson method. Liability claims for long-tail lines are more susceptible to litigation and can be significantly affected by changing contract interpretation and the legal environment. Therefore, the estimation of loss reserves for these classes is more complex and subject to a higher degree of variability. Supplementary statistical information is reviewed to determine which methods are most appropriate and whether adjustments are needed to particular methods. This information includes: • open and closed claim counts; • average case reserves and average incurred on open claims;
• closure rates and statistics related to closed and open claim percentages;
• average closed claim severity; • ultimate claim severity; • reported loss ratios; • projected ultimate loss ratios; and • loss payment patterns. 28
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Other-Than-Temporary Impairment
Our investments are exposed to at least one of three primary sources of investment risk: credit, interest rate and market valuation risks. The financial statement risks are those associated with the recognition of impairments and income, as well as the determination of fair values. We evaluate whether impairments have occurred on a case-by-case basis. Management considers a wide range of factors about the security issuer and uses its best judgment in evaluating the cause and amount of decline in the estimated fair value of the security and in assessing the prospects for near-term recovery. Inherent in management's evaluation of the security are assumptions and estimates about the operations of the issuer and its future earnings potential. Considerations we use in the impairment evaluation process include, but are not limited to:
• the length of time and the extent to which the market value has been below
amortized cost;
• whether the issuer is experiencing significant financial difficulties;
• economic stability of an entire industry sector or subsection;
• whether the issuer, series of issuers or industry has a catastrophic type
of loss;
• the extent to which the unrealized loss is credit-driven or a result of
changes in market interest rates; • historical operating, balance sheet and cash flow data; • internally and externally generated financial models and forecasts; • our ability and intent to hold the investment for a period of time sufficient to allow for any anticipated recovery in market value; and
• other subjective factors, including concentrations and information
obtained from regulators and rating agencies.
Under current other-than-temporary impairment accounting guidance, if management can assert that it does not intend to sell an impaired fixed maturity security and it is not more likely than not that it will have to sell the security before recovery of its amortized cost basis, then an entity may separate the other-than-temporary impairments into two components: 1) the amount related to credit losses (recorded in earnings) and 2) the amount related to all other factors (recorded in other comprehensive income (loss)). The credit related portion of an other-than-temporary impairment is measured by comparing a security's amortized cost to the present value of its current expected cash flows discounted at its effective yield prior to the impairment charge. Both components are required to be shown in the Consolidated Statements of Income. If management intends to sell an impaired security, or it is more likely than not that it will be required to sell the security before recovery, an impairment charge is required to reduce the amortized cost of that security to fair value. Additional disclosures required by this guidance are contained in Note 4 - "Investments." We closely monitor each investment that has a fair value that is below its amortized cost and make a determination each quarter for other-than-temporary impairment for each of those investments. There were no material other-than-temporary charges recorded during the three months endedMarch 31, 2013 and 2012. While it is not possible to accurately predict if or when a specific security will become impaired, given the inherent uncertainty in the market, charges for other-than-temporary impairment could be material to net income in subsequent quarters. Management believes it is not likely that future impairment charges will have a significant effect on our liquidity. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Financial Condition - Investments."
Contractual Obligations/Off-Balance Sheet Arrangements
During the first three months of 2013, our contractual obligations did not change materially from those discussed in our Annual Report on Form 10-K for the year ended
We do not have any relationships with unconsolidated entities of financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. 29
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NAVIGATORS GROUP INC – 10-Q – Management’s Discussion and Analysis of Financial Condition and Results of Operations
Commonwealth And First Allmerica Placed Under Review
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