UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-K

 

OR

 

 

Commission File Number 2-39621

 

UNITED FIRE & CASUALTY COMPANY

(Exact name of registrant as specified in its charter)

 

 

Registrant’s telephone number, including area code: (319) 399-5700

 

Securities Registered Pursuant to Section 12(b) of the Act: None

 

Securities Registered Pursuant to Section 12(g) of the Act: None

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 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 [ ]

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [X ]

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

 

 

 

As of February 22, 2008, 27,116,490 shares of common stock were outstanding. The aggregate market value of voting stock held by nonaffiliates of the registrant as of June 30, 2007, was approximately $718.2 million. For purposes of this calculation, all directors and executive officers of the registrant are considered affiliates.

 

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FORM 10-K TABLE OF CONTENTS

 

 

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United Fire & Casualty Company and Subsidiaries

 

PART I.

ITEM 1. BUSINESS

It is important to note that our actual results could differ materially from those projected in forward-looking statements. Information concerning factors that could cause actual results to differ materially from those in forward-looking statements is contained in Part I, Item 1A, “Risk Factors” and Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

The terms “United Fire,” “we,” “us,” or “our” refer to United Fire & Casualty Company or United Fire & Casualty Company and its consolidated subsidiaries and affiliate, as the context requires. We are engaged in the business of writing property and casualty insurance and life insurance. We are an Iowa corporation incorporated in January 1946. Our principal executive office is located at 118 Second Avenue SE, P.O. Box 73909, Cedar Rapids, Iowa 52407-3909. Telephone: 319-399-5700.

We report our operations in two business segments: property and casualty insurance and life insurance. A table reflecting revenues, net income and assets attributable to our operating segments is included in Part II, Item 8, Note 11, “Segment Information.” All intercompany balances have been eliminated in consolidation.

Our property and casualty insurance segment includes United Fire & Casualty Company and the following companies, which United Fire & Casualty Company owns 100 percent, directly or indirectly: Addison Insurance Company, an Illinois property and casualty insurer; Lafayette Insurance Company, a Louisiana property and casualty insurer; American Indemnity Financial Corporation, a Delaware holding company; and Texas General Indemnity Company, a Colorado property and casualty insurer.

United Fire Lloyds, a Texas property and casualty insurer, is an affiliate of and operationally and financially controlled by United Fire & Indemnity Company.

Most of our property and casualty insurance subsidiaries are members of an intercompany reinsurance pooling arrangement. Pooling arrangements permit the participating companies to rely on the capacity of the entire pool’s capital and surplus, rather than being limited to policy exposures of a size commensurate with each participant’s own surplus level. Under such arrangements, the members share substantially all of the insurance business that is written, and allocate the combined premiums, losses and expenses based on percentages defined in the arrangement.

Our life insurance segment consists of United Life Insurance Company, an Iowa life insurer and wholly owned subsidiary of United Fire & Casualty Company.

As of December 31, 2007, we employed 667 full-time employees.

Available information

Our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as soon as reasonably practicable after we electronically file such materials with, or furnish them to, the Securities and Exchange Commission (“SEC”), are made available free of charge on our website at www.unitedfiregroup.com by selecting “Investor Relations” and then “SEC Filings.”

 

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Also available on our website is our Code of Ethics titled “Code of Ethics and Business Conduct,” which can be accessed at www.unitedfiregroup.com by selecting “Investor Relations,” then “Corporate Governance” and then “Code of Ethics.”

A free copy of our filings, as filed with the SEC, may also be obtained by writing to: Investor Relations, United Fire Group, PO Box 73909, Cedar Rapids, Iowa 52407-3909.

Any of the materials that we file with the SEC may also be read and copied at the SEC’s Public Reference Room at 100 F Street NE, Washington, D.C. 20549. Information on the operation of the SEC’s Public Reference Room may be obtained by calling the SEC at 1-800-SEC-0330. The SEC maintains a website that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC at www.sec.gov.

We market our products through our home office in Cedar Rapids, Iowa, and two regional locations: Westminster, Colorado, a suburb of Denver, and Galveston, Texas.

We are licensed as a property and casualty insurer in 42 states, primarily in the Midwest, West and South. We have 865 independent agencies representing us and our property and casualty insurance subsidiaries. Our life insurance subsidiary is licensed in 28 states, primarily in the Midwest and West and is represented by 927 independent agencies. The following table depicts the top five states for direct premiums written for our property and casualty insurance operations and life insurance operations for the year ended December 31, 2007.

(1) Please refer to the Non-GAAP financial measures section of this report for further explanation of this measure.

We staff our regional offices with underwriting, claims and marketing representatives and administrative technicians, all of whom provide support and assistance to the independent agencies. Also, home office staff technicians and specialists provide support to the subsidiaries, regional offices and independent agencies. We use management reports to monitor subsidiary and regional offices for overall results and conformity to our business policies.

The property and casualty and life insurance industries are highly competitive. We compete with numerous property and casualty insurance companies in the regional and national market, many of which are substantially larger and have considerably greater financial and other resources. In addition, because our products are marketed exclusively through independent insurance agencies, most of which represent more than one company, we face competition within each agency. Our competitors include companies that market their products through agents, as well as companies that sell insurance directly to their customers. Our competitive advantages include knowledgeable, experienced underwriters, appropriate pricing, quality service to our policyholders and our agents, and a competitive commissions program.

 

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Because we rely heavily on independent agencies, we utilize a profit-sharing plan as an incentive for agents to place high-quality property and casualty insurance business with us. We estimate property and casualty agencies will receive profit-sharing commissions of $12.4 million in 2008, based on business produced by the agencies in 2007.

We also encounter significant competition in all lines of life and annuity business from other life insurance companies and other providers of financial services. Our life insurance company utilizes competitive commission rates, other sales incentives and quality service to attract and maintain its relationship with independent agencies.

To enhance our ability to compete, we utilize technology in a variety of ways to assist our agents and improve the delivery of service to our policyholders. For example, our public website, which provides general company and product information, includes a section accessible exclusively to our agents where they can quote new business, submit applications, submit change requests, report new claims and process payments electronically. Our agents can access detailed information about their policyholders’ accounts, including policy declarations, coverage forms, billing transactions and claims information. Our agents can also use our website to access their experience reports, review detailed information about our products, order sales literature and download our applications, questionnaires and other forms. Our surety bond agents can issue and upload contract, license and permit bonds online, submit new bid bond requests and view detailed bond information. Our life agents can quote new life policies, view the status of customers’ applications and access detailed information on our annuity, universal life, term life and whole life policies. We electronically scan and store our documents, allowing multiple users to simultaneously retrieve and view them. Additionally, we provide our policyholders secure online access to their account information. We offer a variety of online payment options for our policyholders, including payment via credit card, debit card and electronic check. We believe our investment in technology allows us to provide enhanced service to our agents, policyholders and investors.

Property and casualty insurance segment

We write both commercial and personal lines of property and casualty insurance. We focus on our commercial lines, which represented 92.6 percent of our property and casualty insurance premiums earned for the year ended December 31, 2007. Our personal lines represented 7.4 percent of our property and casualty insurance premiums earned for the year ended December 31, 2007.

Products

Our primary commercial policies are tailored business packages that include the following coverages: fire and allied lines, other liability, automobile, workers’ compensation and surety. Our personal lines consist primarily of automobile and fire and allied lines coverages, including homeowners. For a more detailed discussion of our products, see the “Results of Operations” section of Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

Financial information

The following table shows loss ratios, expense ratios and combined ratios on a statutory basis for the periods indicated for us and for the property and casualty insurance industry. Industry ratios were obtained from A.M. Best Company.

(1) A.M. Best Company estimate

(2) Includes policyholder dividends

(3) Please refer to the Non-GAAP financial measures section of this report for further explanation of this measure.

 

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The following table shows our loss ratios, expense ratios and combined ratios for the periods indicated, presented in accordance with U.S. generally accepted accounting principles (“GAAP”). Industry ratios are unavailable because they are not normally calculated in accordance with GAAP.

 

The following table displays information for our property and casualty insurance segment presented in accordance with GAAP. Amounts shown are prior to intersegment eliminations.

Seasonality

Our property and casualty insurance segment experiences some seasonality with regard to premiums written, which are generally highest in January and July and lowest during the fourth quarter. Although we experience some seasonality in our premiums written, premiums are earned ratably over the period of coverage. Losses and loss settlement expenses incurred tend to remain consistent throughout the year, with the exception of when a catastrophe occurs. Catastrophes inherently are unpredictable and can occur at any time during the year from man-made or natural disaster events that include, but which are not limited to, hail, tornadoes, hurricanes and windstorms.

Life insurance segment

Products

United Life Insurance Company underwrites all of our life insurance business. Our principal life insurance products are single premium annuities, universal life products and traditional life (primarily single premium whole life insurance) products. Single premium annuities (approximately 83 percent), traditional life products (approximately 10 percent), and universal life products (approximately 7 percent) comprised our 2007 life insurance premium revenues, as determined on the basis of statutory accounting principles. We also underwrite and market other traditional products, including term life insurance and whole life insurance. Additionally, we offer an individual disability income rider that may be attached to our life insurance products. We do not write variable annuities or variable insurance products.

Statutory accounting principles require us to recognize deposits for policyholders on universal life and annuity products as premiums when they are collected. Under GAAP, we are required to recognize these deposits as policyholder liabilities.

Life insurance in force, before ceded reinsurance, totaled $4.5 billion and $4.3 billion as of December 31, 2007 and 2006, respectively. Traditional life insurance products represented 59 percent and 56 percent of our insurance in force at December 31, 2007 and 2006, respectively. Universal life insurance represented 38 percent and 40 percent of insurance in force at December 31, 2007 and 2006, respectively.

 

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Financial information

The following table displays information for our life insurance segment presented in accordance with GAAP. Amounts shown are prior to intersegment eliminations.

Seasonality

Our life insurance segment, as a whole, is generally not seasonal in nature.

Property and casualty insurance segment

Our property and casualty insurance companies follow the industry practice of reinsuring a portion of their exposure by ceding to reinsurers a portion of the premium received and a portion of the risk under the policies written. We purchase reinsurance to reduce the net liability on individual risks to predetermined limits and to protect us against catastrophic losses from a single catastrophe, such as a hurricane or tornado. We do not engage in any reinsurance transactions classified as finite risk reinsurance. In 2007, we ceded written premiums of $41.0 million, which was 8.0 percent of our direct and assumed written premium.

We use many reinsurers, both domestic and foreign, which helps us to avoid concentrations of credit risk associated with our reinsurance. Our principal reinsurers include QBE Reinsurance Corporation, Hannover Ruckversicherungs, Platinum Underwriters Re, AXA Corporate Solutions Insurance Company, Partner Reinsurance Company of the United States and Mutual Boiler Reinsurance.

We have several treaties that provide us with reinsurance coverage. Our reinsurance program limits the risk of loss that we retain by reinsuring direct risks in excess of our stated retention. For a more detailed discussion of our reinsurance program, see Part II, Item 8, Note 5, “Reinsurance.”

The ceding of insurance does not legally discharge us from primary liability under our policies, and we must pay the loss if the reinsurer fails to meet its obligation. We periodically monitor the financial condition of our reinsurers to confirm that they are financially stable. We believe that all of our reinsurers are in acceptable financial condition. At December 31, 2007, there were no reinsurance balances for which collection is at risk that would result in a material impact on our Consolidated Financial Statements. We account for premiums, written and earned, and losses incurred net of reinsurance ceded.

In the event that we incur catastrophe losses covered by our reinsurance program, our catastrophe reinsurance treaty would provide one guaranteed reinstatement at 100.0 percent of the original premium. We also purchase reinsurance from the Florida Hurricane Catastrophe Fund. The level of reinsurance protection obtained through this fund is immaterial to our operations.

The Terrorism Risk Insurance Program Reauthorization Act of 2007 (“TRIPRA”) was signed into law by President Bush on December 27, 2007. TRIPRA extended, with modifications, The Terrorism Risk Insurance Act of 2002 (“TRIA”) and The Terrorism Risk Insurance Extension Act of 2005 (“TRIA Extension Act”), previously set to expire on December 31, 2007. TRIA and TRIA Extension Act coverage included most direct commercial lines of business, including coverage for losses from nuclear, biological and chemical exposures if coverage was afforded by an insurer, with exclusions for commercial automobile insurance, burglary and theft insurance, surety insurance,

 

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professional liability insurance and farm owners multiple peril insurance. TRIPRA continues these TRIA and TRIA Extension Act coverages while eliminating the previous distinction between foreign (covered) and domestic (not covered) acts of terrorism. Under TRIPRA, each insurer has a deductible amount, which is 20.0 percent of the prior year’s direct commercial lines earned premiums for the applicable lines of business, and retention of 15.0 percent above the deductible. The percentages used in the TRIPRA deductible and retention calculations remained constant between 2007 and 2008. No insurer that has met its deductible shall be liable for the payment of any portion of that amount that exceeds the annual $100 billion aggregate loss cap specified in TRIPRA. TRIA has provided, and TRIPRA will continue to provide, marketplace stability. As a result, coverage for terrorist events in both the insurance and reinsurance markets is often available. The amount of aggregate losses necessary for an act of terrorism to be certified by the U.S. Secretary of Treasury, the Secretary of State and the Attorney General was $100 million for 2007 and remains the same for 2008. Our TRIA deductible was $65.4 million for 2007 and our TRIPRA deductible will approximate $66.8 million for 2008. Our catastrophe reinsurance treaty does not provide coverage for our terrorism exposure.

Historically, we have acted as a reinsurer, assuming both property and casualty reinsurance from other insurance or reinsurance companies. Most of the business we have assumed is property reinsurance, with an emphasis on catastrophe coverage. The majority of our assumed reinsurance business expired on or before December 31, 2000. We limit our exposure on our remaining assumed reinsurance contracts through selective renewal. However, we still have exposure related to the assumed reinsurance contracts that we have elected to continue writing and those that are in runoff status. In 2007, we assumed written premiums of $16.9 million.

Life insurance segment

Our life insurance company purchases reinsurance to limit the dollar amount of any one risk of loss. On standard individual life cases where the insured is age 65 or younger, our retention is $.2 million. On standard individual life cases where the insured is age 66 or older, our retention is $.1 million. Our accidental death benefit rider on an individual policy is reinsured at 100 percent, up to a maximum benefit of $.3 million. Our group coverage, both life and accidental death and dismemberment, is reinsured at 50 percent. Catastrophe excess reinsurance coverage applies when three or more insureds die in a catastrophic accident. For catastrophe excess claims, we retain the first $1.0 million of ultimate net loss and the reinsurer agrees to indemnify us for the excess up to a maximum of $5.0 million. We supplement this coverage when appropriate with “known concentration” coverage. Known concentration coverage is typically tied to a specific event and time period, with a threshold of a minimum number of lives involved in the event, minimum event deductible (company’s retention) and a maximum payout. In 2007, we ceded earned premiums of $1.7 million, which was 4.9 percent of our direct and assumed earned premiums.

The ceding of insurance does not legally discharge United Life Insurance Company from primary liability under its policies. United Life Insurance Company must pay the loss if the reinsurer fails to meet its obligations. United Life Insurance Company’s primary reinsurance companies are Generali USA Life Reassurance Company, American United Life Insurance Company, Hannover Life Reassurance Company of America and RGA Reinsurance Company. We periodically monitor the financial condition of our reinsurers to confirm that they are financially stable. We believe that all of our reinsurers are in acceptable financial condition. At December 31, 2007 and 2006, there were no reinsurance balances for which collection is at risk that would result in a material impact on our Consolidated Financial Statements.

The life insurance segment began assuming credit life and accident and health insurance in 2002. We discontinued this practice in 2004. We have an immaterial exposure related to our assumed reinsurance contracts that are in a runoff status.

 

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Property and casualty insurance segment

Reserves for losses and loss settlement expenses (“loss reserves”) are management’s best estimates at a given point in time of what we expect to pay for claims, based on facts, circumstances and historical trends then known.

The determination of reserves, particularly those relating to liability lines of insurance, reflects significant judgment factors. If, during the course of our regular monitoring of reserves, we determine that coverages previously written are incurring higher than expected losses, we would take action that could include increasing the related reserves. Any adjustments we make to reserves are reflected in operating results in the year in which we make those adjustments. As required by state law, we engage an independent actuary to render an opinion as to the adequacy of the statutory reserves we establish. The actuarial opinion is filed in those states where we are licensed. There are no material differences between our statutory reserves and those established under GAAP. Refer to the Critical Accounting Estimates section in Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” for a more detailed discussion of our loss reserves.

We do not discount loss reserves based on the time value of money. However, we consider inflation in the reserving process by reviewing cost trends, loss settlement expenses, historical reserving results and likely future economic conditions.

The table on the following page illustrates the change in our estimate of reserves for loss and loss settlement expenses for our property and casualty companies for the years 1998 through 2006. The first section shows the amount of the liability, as originally reported, at the end of each calendar year in our Consolidated Financial Statements. These reserves represent the estimated amount of losses and loss settlement expenses for losses arising in all prior years that are unpaid at the end of each year, including an estimate for our IBNR losses, net of applicable ceded reinsurance. The second section displays cumulative amount of net losses and loss settlement expenses paid for each year with respect to that liability. The third section shows the re-estimated amount of the previously recorded liability based on experience as of the end of each succeeding year. The estimate is increased or decreased as more information becomes known about the losses for individual years. The last section compares the latest re-estimate with the original estimate. Conditions and trends that have affected development of loss reserves in the past may not necessarily exist in the future. Accordingly, it would not be appropriate to extrapolate future redundancies or deficiencies based on this table.

 

 

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Over the course of the last 10 years, our original net loss reserves have exceeded our incurred losses and loss settlement expenses. Because establishing reserves is inherently uncertain, an analysis of factors affecting reserves can produce a range of reasonable estimates. Our philosophy is to establish loss reserves that are appropriate and reasonable, but assume a pessimistic view of potential outcomes. Generally, our best estimate of loss reserves is slightly above the midpoint of a range of reasonable estimates. We believe that it is appropriate and reasonable to establish a best estimate within a range of reasonable estimates for use in determining loss reserves, especially when we are reserving for claims for bodily injury, disabilities and similar claims, for which settlements and verdicts can vary widely. Our reserving philosophy may result in favorable development in succeeding years that will decrease loss and loss settlement expenses for prior year claims in the year of adjustment. While we realize that this philosophy, coupled with what we believe to be aggressive and successful claims management and loss settlement practices, has resulted in year-to-year net redundancies in reserves, we believe our approach is preferable to experiencing year-to-year uncertainty as to the adequacy of our reserves.

We believe the loss reserves for our property and casualty insurance segment at December 31, 2007, are appropriate. The increases over the last 10 years in loss reserves reflect our increased business. The higher level of loss reserves in 2005 resulted from net liabilities related to Hurricane Katrina and Hurricane Rita. In determining the appropriateness of our loss reserves, we rely upon the opinion of Regnier Consulting Group, an independent actuary, that our loss reserves meet the requirements of applicable insurance laws, are consistent with loss reserves that are computed in accordance with accepted loss reserving standards and principles, and make a reasonable provision in the aggregate for all unpaid loss and loss settlement expense obligations under the terms of our insurance policies and agreements. We also consider state regulatory reviews and examinations and our own experience. We have made no significant changes in our reserving methodology or philosophy over the past year.

Life insurance segment

The reserves reported in our Consolidated Financial Statements are calculated in accordance with GAAP. We calculate our reserve for annuity and universal life policy deposits in accordance with SFAS No. 97, “Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses on the Sale of Investments.” Under SFAS No. 97, we establish a benefit reserve at the time of policy issuance in an amount equal to the deposits received. Subsequently, we adjust the benefit reserve for any additional deposits, interest credited and partial or complete withdrawals. We determine reserves for statutory purposes based upon mortality rates and interest rates specified by Iowa state law. Our life insurance subsidiary’s reserves meet or exceed the minimum statutory requirements. Griffith, Ballard and Company, an independent actuary, assists us in developing and analyzing our reserves.

We comply with state insurance laws that prescribe the kind, quality and concentration of investments that may be made by insurance companies. We determine the mix of our investment portfolio based upon these state laws, our liquidity needs, our tax position and general market conditions. We also consider the timing of our obligations, as we must have cash available to pay obligations when due. We make modifications to our investment portfolio as these conditions change. We manage all but a small portion of our investment portfolio internally.

We invest the property and casualty insurance segment’s assets to meet liquidity needs and maximize after-tax returns with appropriate risk diversification. We invest the life insurance segment’s assets primarily in investment grade fixed maturities in order to meet liquidity needs, maximize the investment return and achieve a matching of assets and liabilities.

 

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Investment results presented in accordance with GAAP are summarized in the following table.

(1) Average based on invested assets (including money market accounts classified as cash equivalents) at beginning and end of year.

(2) Investment income after deduction of investment expenses, but before applicable income tax. Realized gains and losses are excluded.

 

We are subject to regulation and supervision in each of the states where our insurance companies are domiciled and licensed to conduct business. State insurance department commissioners regulate such matters as licenses, standards of solvency, premium rates, policy forms, investments, security deposits, accounting policy, form and content of financial statements, reserves for unpaid loss and loss settlement expenses, reinsurance, minimum capital and surplus requirements, dividends to shareholders, periodic examinations, and annual and other report filings. In general, such regulation is for the protection of policyholders rather than shareholders.

State regulators have the authority to approve or deny our premium rates to ensure that they are not excessive or discriminatory. For example, the Florida Office of Insurance Regulation rejected recent efforts by some insurers to increase rates for homeowners insurance within the state, in some cases by as much as 41 percent, and said that other rate reductions did not represent deep enough cuts. Because of this regulatory constraint, it is sometimes difficult to receive an adequate premium rate for our products, which can result in unsatisfactory underwriting results.

Despite strict oversight by state insurance regulators, insurance companies occasionally become insolvent. Each of our insurance companies is required to participate in state guaranty fund associations, whose purpose is to protect the policyholders of insolvent insurance companies. Guaranty fund associations assess solvent insurers to pay the claims of insolvent insurers. The assessments are based proportionately upon each solvent insurance company’s share of written premiums in the applicable state. Most state guaranty fund associations allow solvent insurers to recoup the assessments paid through rate increases, surcharges or premium tax credits. However, there is no assurance that we will ultimately recover these assessments. At December 31, 2007, we had no liability for state guaranty fund assessments.

State insurance regulators also establish insurance funds to provide insurance coverage to those insureds unable to obtain insurance through the voluntary insurance market. Occasionally these funds will issue assessments to insurance companies, including us, that write business within their states. The terms of some of these assessments allow for the amounts assessed to be recovered through surcharges to policyholders applied to insurance policies written in the state over a specific period. Therefore, we may be entitled to recoup part or all of any assessments through future surcharges to policyholders.

Our insurance companies are subject to state laws and regulations that require investment portfolio diversification and that limit the amount of investment in certain categories. Noncompliance may cause nonconforming investments to be nonadmitted in measuring statutory surplus and, in some instances, states may require us to sell the nonconforming securities. As of December 31, 2007, we were materially in compliance with the investment laws and regulations of all states in which our insurance companies are domiciled in.

The National Association of Insurance Commissioners annually calculates a number of financial ratios to assist state insurance regulators in monitoring the financial condition of insurance companies. A “usual range” of results for each ratio is used as a benchmark. Departure from the “usual range” on four or more of the ratios could lead to inquiries from individual state insurance departments as to certain aspects of a company’s business. None of our

 

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insurance companies had four or more ratios outside the “usual range” at December 31, 2007. In addition to the financial ratios, we are also required to calculate a minimum capital requirement for each of our insurance companies based on individual company insurance risk factors. These “risk-based capital” results are used to identify companies that require regulatory attention or the initiation of regulatory action. At December 31, 2007, all of our insurance companies had capital well in excess of the required levels.

We are not aware of any other current recommendations by the National Association of Insurance Commissioners, federal government, or other regulatory authorities in the states in which we conduct business that, if or when implemented, would have a material effect on our liquidity, capital resources or operations.

Our financial strength is regularly reviewed by an independent rating agency that assigns a rating based upon criteria such as results of operations, capital resources and minimum policyholders’ surplus requirements.

Our family of property and casualty insurers has received a group rating of “A” (Excellent) from A.M. Best Company. Within the group, all of our property and casualty insurers have an “A” (Excellent) rating, except one insurance subsidiary that is in a runoff status, which A.M. Best has designated as NR-3 (Rating Procedure Inapplicable). Our life insurance subsidiary has received an “A-” (Excellent) rating from A.M. Best Company. According to A.M. Best Company, companies rated “A” and “A-” have “an excellent ability to meet their ongoing obligations to policyholders.”

An insurer’s solvency rating is one of the primary factors evaluated by those in the market to purchase insurance. A poor rating indicates that there is an increased likelihood that the insurer could become insolvent and therefore not be able to fulfill its obligations under the insurance policies it issues. The level of an insurer’s solvency rating can affect its level of premium writings, the lines of business it can write and the market value of its shares of stock.

In recent years, A.M. Best has been reevaluating the methodology they utilize when rating an insurance company’s financial strength. The main focus of this reevaluation process has centered on whether or not solvency models currently utilized in determining an insurer’s financial strength contain enough flexibility and sophistication to accurately rate a specific insurer’s financial condition.

 

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ITEM 1A. RISK FACTORS

We provide the following discussion of risks and uncertainties relevant to our business. These are factors that we believe could cause our actual results to differ materially from expected and historical results. We could also be adversely affected by other factors in addition to those listed here. We have set forth additional information concerning factors that could cause actual results to differ materially from those in the forward-looking statements in Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

Risks relating to our business

Our property and casualty insurance operations expose us to claims arising from catastrophic events, which can be caused by various natural and man-made disasters, including, but not limited to, hurricanes, tornadoes, windstorms, hailstorms, fires, explosions, earthquakes, tropical storms and terrorist acts. Property damage resulting from catastrophes is the greatest risk of loss we face in the ordinary course of our business. We have exposure for catastrophe losses under both our commercial insurance policies and our personal insurance policies. In addition, our automobile and inland marine business exposes us to losses arising from floods and other perils.

 

Along with others in the industry, we use models developed by catastrophe modeling consultants in assessing our exposure to catastrophe losses. The catastrophe models that we employ have been evolving since the early 1990s and do not necessarily accurately predict future losses or accurately measure losses currently incurred. While we use information generated through catastrophe modeling in connection with our pricing and risk management activities, there are limitations with respect to any model’s usefulness in predicting losses in any reporting period. In 2006, and in response to the events surrounding Hurricanes Katrina, Rita and Wilma, the two prominent catastrophe modeling companies made significant changes to their catastrophe models. These changes resulted in widely divergent results for the same or similar scenarios run through each company’s catastrophe model. Divergent model results reached for the same or similar catastrophe scenarios lead to questionable predictive capability and post-event measurements that have not been well understood or proven to be sufficiently reliable. In addition, the models are not necessarily reflective of company- or state-specific policy language, demand surge for labor and materials and loss settlement expenses, which are subject to wide variation by catastrophe.

 

Because the occurrence and severity of catastrophes are inherently unpredictable and may vary significantly from year to year, historical results of operations may not be indicative of future results of operations. Catastrophes may also negatively affect our ability to write new business. Increases in the value and geographic concentration of insured property and the effects of inflation could increase the severity of claims from catastrophic events in the future.

Our reserves for claims and future policy benefits may prove to be inadequate, which may result in future charges to earnings and/or a downgrade of our financial strength rating or the financial strength ratings of our insurance company subsidiaries. We establish property and casualty loss reserves based on assumptions and estimates of damages and liabilities incurred. Griffith, Ballard and Company, our independent actuary, calculates reserves for our life insurance products based on many assumptions and estimates, including estimated premiums we will receive over the assumed life of the policy, the timing of the event covered by the insurance policy and the amount of benefits or claims to be paid.

Our property and casualty loss reserves are only estimates; we determine the amount of these loss reserves based on our best estimate and judgment of the losses and costs we will incur on existing insurance policies. Because of the uncertainties that surround estimating loss reserves, we cannot precisely determine the ultimate amounts of benefits

 

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and claims that we will pay or the timing of payment of benefits and claims. The following factors may have a substantial impact on our future loss reserve development:

Actual losses and loss settlement expenses paid might exceed our loss reserves. If our loss reserves are insufficient, or if we believe our loss reserves are insufficient to cover our actual loss and loss settlement expenses, we would have to increase our loss reserves and incur charges to our earnings. These charges could be material.

The financial results of companies in the property and casualty insurance industry historically have been cyclical in nature, characterized by periods of severe price competition and excess underwriting capacity, or soft markets, followed by periods of high premium rates and shortages of underwriting capacity, or hard markets. We expect these cycles to continue. Premium rates for property and casualty insurance are influenced by factors that are outside of our control, including market and competitive conditions and regulatory issues. Soft market conditions could require us to reduce premiums, limit premium increases, or discontinue offering certain of our insurance products in one or more states, resulting in a reduction in our premiums written and in our profit margins and revenues. The demand for property and casualty insurance can also vary significantly, rising as the overall level of economic activity increases and falling as that activity decreases. Fluctuations in demand and competition could produce underwriting results that would have a negative impact on the results of our operations and financial condition.

We are subject to the negative effects of interest rate fluctuations and other market changes, to declines in value due to market valuations and to declines in credit quality related to individual investments held in our investment portfolio. Some of our products, principally fixed annuities, expose us to the risk that changes in interest rates will reduce our “spread,” which is the difference between the amounts that we are required to pay under the contracts and the rate of return we are able to earn on our investments intended to support our obligations under the contracts.

In periods of increasing interest rates, we may not be able to replace our invested assets with higher-yielding assets to the extent needed to fund the higher rates we must pay with respect to our interest-sensitive products to keep them competitive. Consequently, we may have to accept a lower spread and thus lower profitability, or face a decline in sales and loss of existing contracts and related assets. In periods of declining interest rates, we have to reinvest the cash we receive as interest or return of principal on our investments in lower-yielding instruments than previously available. Moreover, borrowers may prepay fixed income securities, commercial mortgages, and mortgage-backed securities in which we have invested in order to borrow at lower market rates, exacerbating this risk. Because we are entitled to reset the interest rates on our annuities only at limited, pre-established intervals and because many of our policies have guaranteed interest rates, our spreads could decrease and potentially become negative.

Due to the reinvestment risk described above, a decline in market interest rates available on investments could also reduce our return from investments of capital that do not support particular policy obligations, which could also have a material adverse effect on our results of operations. The adverse effect on us from fluctuations in interest

 

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rates may be exacerbated because we currently maintain, and intend to continue to maintain, a large portion (85.7 percent at December 31, 2007) of our investment portfolio in fixed income securities, including our portfolio of preferred debt trading securities. The fair value of these investments generally increases or decreases in an inverse relationship with changes in interest rates. We classify the majority (98.5 percent, at December 31, 2007) of our fixed income securities as available-for-sale. We must report the value of those investments at their current fair value. Accordingly, fluctuations in interest rates may result in fluctuations in the valuation of our fixed income investments, which would affect our stockholders’ equity.

Fluctuations in interest rates may cause increased surrenders and withdrawals from our life insurance and annuity products. In periods of rising interest rates, policy loans and surrenders and withdrawals of life insurance policies and annuity contracts may increase as policyholders seek to buy products with perceived higher returns. For example, due to increasing interest rates on alternative investments, we experienced surrenders and withdrawals on our annuity products totaling $152.8 million in 2007 compared to $159.6 million in 2006. These withdrawals and terminations may require us to accelerate the amortization of deferred policy acquisition costs, which would increase our expenses in the current period.

The fair value of securities in our investment portfolio may fluctuate depending on general economic and market conditions or events relating to a particular issuer of securities. Changes in the fair value of securities in our investment portfolio could result in realized or unrealized investment losses, thereby affecting our stockholders’ equity.

We are exposed to the chance that issuers of bonds that we hold will not be able to pay principal or interest when it is due. Credit defaults and impairments may cause write-downs in the value of the bonds we hold. Pervasive deterioration in the credit quality of issuers, changes in interest rate levels and changes in interest rate spreads between types of investments could significantly affect the value of our invested assets and our earnings.

The insurance (and insurance brokerage) industry has become the focus of increased scrutiny by regulatory and law enforcement authorities, as well as class action attorneys and the general public, relating to allegations of improper special payments, price-fixing, bid-rigging, improper accounting practices, improper claims handling and other alleged misconduct, including the practices surrounding the placement of insurance business and misrepresentation in the scope of coverage. Formal and informal inquiries have been made of a large segment of the industry, and a large number of companies in the industry have received or may receive subpoenas, requests for information from regulatory authorities or other inquiries relating to these and similar matters. While we have no reason to believe that we will be targeted, these efforts are expected to result in both enforcement actions and proposals for new state and federal regulation, which may have a negative effect on our results of operations and financial condition.

As industry practices and legal, judicial, social and other environmental conditions change, unexpected and unintended issues related to claims and coverage may emerge. These issues may adversely affect our business by either extending coverage beyond our underwriting intent or by increasing the number and/or size of claims. Examples of these issues include:

 

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In addition, we have been the target of a number of class action lawsuits arising from Hurricane Katrina relating to allegations of improper claims settlement practices, misrepresentations in the scope of coverage and other matters. It is difficult to predict the outcome of these lawsuits, whether they will expand into other areas not yet contemplated, and whether activities and practices currently thought to be lawful will be characterized as unlawful. It is also difficult to predict the impact, if any, on our business and financial condition. However, rulings adverse to us in pending litigation arising from Hurricane Katrina would likely have a material adverse effect on our financial position, as well as on our results of operations.

Please refer to Part I, Item 3, “Legal Proceedings” for further discussion on our class action and individual lawsuits.

We are subject to extensive supervision and regulation by the states in which we operate. Our ability to comply with these laws and regulations and obtain necessary and timely regulatory action is and will continue to be critical to our success and ability to earn profits.

Examples of state regulations that pose particular risks to our ability to earn profits include the following:

 

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charge. In these markets, we may be compelled to underwrite significant amounts of business at lower than desired premium rates, possibly leading to an unacceptable return on equity. While these facilities are generally designed so that the ultimate cost is borne by policyholders, the exposure to assessments and our ability to recoup these assessments through adequate premium rate increases may not offset each other in our financial statements. Moreover, even if they do offset each other, they may not offset each other in our financial statements for the same fiscal period due to the ultimate timing of the assessments and recoupments or premium rate increases. Additionally, certain states require insurers to participate in guaranty funds for impaired or insolvent insurance companies. These state funds periodically assess losses against all insurance companies doing business in the state. Our operating results and financial condition could be adversely affected by any of these factors.

Compliance with these state laws and regulations requires us to incur administrative costs that decrease our profits. These laws and regulations may also prevent or limit our ability to underwrite and price risks accurately, obtain timely premium rate increases necessary to cover increased costs, discontinue unprofitable relationships or exit unprofitable markets, and otherwise continue to operate our business profitably. In addition, our failure to comply with these laws and regulations could result in actions by state or federal regulators, including the imposition of fines and penalties or, in an extreme case, revocation of our ability to do business in one or more states. Finally, we could face individual, group and class action lawsuits by our policyholders and others for alleged violations of certain state laws and regulations. Each of these regulatory risks could have a negative effect on our profitability.

Security breaches and other improper accessing of data in our facilities, networks or databases could result in loss or theft of data and information or systems’ interruptions that may expose us to liability and have an adverse impact on our business. Moreover, any compromise of the security of our data could harm our reputation and business. There can be no assurances that we will be able to implement security measures adequate to prevent every security breach.

Third-party rating agencies assess and rate the claims-paying ability of insurers and reinsurers based on criteria established by the agencies. Our property and casualty insurers have been assigned a financial strength rating of “A”

 

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(Excellent) from A.M. Best Company since 1994 (except for one insurance subsidiary that is in a runoff status, which A.M. Best has designated as NR-3 (Rating Procedure Inapplicable)). Our life insurance subsidiary has been assigned a financial strength rating of “A-” (Excellent) from A.M. Best since 1998. A.M. Best historically has rated our property and casualty companies on a pooled basis. However, beginning in 2006, our companies were rated on a group basis, consistent with rating guideline changes A.M. Best recently adopted. These financial strength ratings are used by policyholders, insurers, reinsurers and insurance and reinsurance intermediaries as an important means of assessing the financial strength and quality of insurers and reinsurers. These ratings are not evaluations directed to potential purchasers of our common stock and are not recommendations to buy, sell or hold our common stock. These ratings are subject to change at any time and could be revised downward or revoked at the sole discretion of the rating agency. Downgrades in our financial strength ratings could adversely affect our ability to access the capital markets or could lead to increased borrowing costs in the future. Perceptions of our company by investors, producers, other businesses and consumers could also be significantly impaired.

We believe that the rating assigned by A.M. Best is an important factor in marketing our products. Our ability to retain our existing business and to attract new business in our insurance operations depends largely on our ratings by this agency. Our failure to maintain our ratings, or any other adverse development with respect to our ratings, could cause our current and future independent agents and insureds to choose to transact their business with more highly rated competitors. If A.M. Best downgrades our ratings or publicly indicates that our ratings are under review, it is likely that we would not be able to compete as effectively with our competitors and our ability to sell insurance policies could decline. If that happens, our sales and earnings would decrease. For example, many of our agencies and insureds have guidelines that require us to have an A.M. Best financial strength rating of “A-” or higher. A reduction of our A.M. Best ratings below “A-” would prevent us from issuing policies to a majority of our insureds or other potential insureds with similar ratings requirements. In addition, a ratings downgrade for our property and casualty insurers by A.M. Best below “A” would constitute an event of default under our credit facility.

As part of our overall risk and capacity management strategy, we purchase reinsurance for significant amounts of risk that we and our insurance company subsidiaries and affiliate underwrite. The availability and cost of reinsurance is subject to market conditions that are beyond our control. The availability and cost of the reinsurance we purchase may affect the level of our business and profitability. Although we purposely work with several reinsurance intermediaries and reinsurers, we may be unable to maintain our current reinsurance facilities or obtain other reinsurance facilities in adequate amounts and at favorable premium rates. Moreover, there may be a situation in which we have more than two catastrophic events within one policy year. Because our current catastrophe reinsurance program only allows for one automatic reinstatement at an additional reinstatement premium, we would be required to obtain a new catastrophe reinsurance policy to maintain our current level of catastrophe reinsurance coverage. Such coverage may be difficult to obtain, particularly if it is necessary to do so during hurricane season following the second catastrophe. If we are unable to renew our expiring facilities or to obtain new reinsurance facilities, either our net exposure to risk would increase or, if we are unwilling to bear an increase in net risk exposures, we would have to reduce the amount of risk we underwrite.

Although reinsurance makes the reinsurer liable to us to the extent the risk is transferred, it does not relieve us of our liability to our policyholders. Our ability to collect reinsurance recoverables may be subject to uncertainty. Our losses must meet the qualifying conditions of the reinsurance contract. Reinsurers must also have the financial capacity and willingness to make payments under the terms of a reinsurance treaty or contract. Particularly, following a major catastrophic event, our inability to collect a material recovery from a reinsurer on a timely basis, or at all, could have a material adverse effect on our liquidity, operating results and financial condition.

The following states provided 54.4 percent of the direct premium volume in the property and casualty insurance segment in 2007: Texas (13.3 percent), Iowa (13.0 percent), Colorado (10.7 percent), Louisiana (8.8 percent) and Missouri (8.6 percent). The following states provided 74.8 percent of the direct statutory premium volume in the life insurance segment in 2007: Iowa (40.4 percent), Minnesota (10.4 percent), Wisconsin (8.9 percent), Nebraska (7.7 percent) and Illinois (7.4 percent). Our revenues and profitability are subject to the prevailing regulatory, legal,

 

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economic, political, demographic, competitive, weather and other conditions in the principal states in which we do business. Changes in any of these conditions could make it less attractive for us to do business in such states and would have a more pronounced effect on us compared to companies that are more geographically diversified. In addition, our exposure to severe losses from localized natural perils, such as hurricanes or hailstorms, is increased in those areas where we have written a significant amount of property and casualty insurance policies.

The insurance industry is highly competitive. In our property and casualty insurance business and in our life insurance business, we compete, and will continue to compete, with many major U.S. and non-U.S. insurers and smaller regional companies, as well as mutual companies, specialty insurance companies, underwriting agencies, and diversified financial services companies. Some of our competitors have far greater financial and marketing resources than we do. Our premium revenue and our profitability could decline if we lose business to competitors offering similar or better products at or below our prices. We price our insurance products based on estimated profit margins, and we would not be able to significantly reduce our current estimated profit margins in the near future. Some of our competitors, however, are better capitalized than we are and may be able to withstand significant reductions in their profit margins. If our competitors decide to target our policyholder base by offering lower-priced insurance, we may not be able to respond competitively, which could reduce our revenue and our profitability.

 

Risks relating to our common stock

We are an insurance company domiciled in the State of Iowa and, as a result, we are subject to Iowa insurance laws restricting our ability to pay dividends to our stockholders, including laws establishing minimum solvency and liquidity standards and laws that prohibit us from paying dividends except from the earned profits arising from our business. Our ability to pay dividends also depends upon the surplus and earnings of our subsidiary insurance companies and the ability of our subsidiary insurance companies to pay dividends to us. Payments of dividends by our subsidiary insurance companies are restricted by state insurance laws similar to those laws that restrict our payment of dividends. As a result of these restrictions, at times we may not be able to pay dividends on our common stock, or we may be required to seek prior approval from the applicable regulatory authority before we can pay any such dividends. In addition, the payment of dividends by us is within the discretion of our board of directors and will depend on numerous factors, including our financial condition, our capital requirements and other factors that our board of directors considers relevant.

The trading price of our common stock may fluctuate substantially due to a variety of factors, some of which are beyond our control and may not be related to our operating performance. These fluctuations could be significant and could cause a loss of part or the entire amount invested in our shares of common stock. Factors that could cause fluctuations include, but are not limited to, the following:

Our articles of incorporation and bylaws, as well as applicable laws governing corporations and insurance companies, contain provisions that could impede an attempt to replace or remove our management or prevent the sale of our company that, in either case, stockholders might consider being in their best interests. For example:

 

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directors. Consequently, it will take at least two annual stockholder meetings to effect a change in control of our board of directors.

Further, the insurance laws of Iowa and the states in which our subsidiary insurance companies are domiciled prohibit any person from acquiring direct or indirect control of us or our insurance company subsidiaries, generally defined as owning or having the power to vote 10.0 percent or more of our outstanding voting stock, without the prior written approval of state regulators.

These provisions of our articles of incorporation and bylaws, and these state laws governing corporations and insurance companies, may discourage potential acquisition proposals. These provisions and state laws may also delay, deter or prevent a change of control of our company, in particular through unsolicited transactions that some or all of our stockholders might consider to be desirable. As a result, efforts by our stockholders to change the direction or our company’s management may be unsuccessful, and the existence of such provisions may adversely affect market prices for our common stock if they are viewed as discouraging takeover attempts.

Based upon the number of shares of our common stock outstanding as of December 31, 2007, our largest stockholder will have a beneficial interest in, and the power to vote or control the disposition of, approximately 14.2 percent of our issued and outstanding common stock. He is in a position to strongly influence the outcome of substantially all corporate actions requiring stockholder approval, including mergers involving our company, sales of all, or substantially all, of our assets and the adoption of amendments to our articles of incorporation. Also, he may have interests different than, or adverse to, those of our other stockholders.

 

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ITEM 1B. UNRESOLVED STAFF COMMENTS

None.

ITEM 2. PROPERTIES

We own two buildings (a five-story office building and an eight-story office building in which part of the first floor is leased to tenants) and related parking facilities in Cedar Rapids, Iowa, that we use as our home office. The two buildings are connected by a skywalk. We also lease additional adjacent office space in Cedar Rapids. Our regional locations in Westminster, Colorado, and Galveston, Texas, conduct operations in leased office space. Our claims office in Metairie, Louisiana, also operates in leased office space. The table below shows a brief description of our owned and leased office space.

 

 

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ITEM 3. LEGAL PROCEEDINGS

We have been named as a defendant in various lawsuits, including actions seeking certification from the court to proceed as a class action suit and actions filed by individual policyholders, relating to disputes arising from damages that occurred as a result of Hurricane Katrina in 2005. As of December 31, 2007, there were in excess of 400 such cases pending, approximately 20 of which were styled as class actions. These cases have been filed in both Louisiana state courts and federal district courts. These cases involve, among other claims, disputes as to the amount of reimbursable claims in particular cases, as well as the scope of insurance coverage under homeowners and commercial property policies due to flooding, civil authority actions, loss of use and business interruption. Certain of these cases also claim a breach of duty of good faith or violations of Louisiana insurance claims-handling laws or regulations and involve claims for punitive or exemplary damages while other cases claim that under Louisiana’s so-called “Valued Policy Law”, the insurers must pay the total insured value of a home that is totally destroyed if any portion of such damage was caused by a covered peril, even if the principal cause of the loss was an excluded peril. Other cases challenge the scope or enforceability of the water damage exclusion in the policies.

Several actions pending against various insurers, including us, were consolidated for purposes of pretrial discovery and motion practice under the caption In re Katrina Canal Breaches Consolidated Litigation, Civil Action No. 05-4182 in the United States District Court, Eastern District of Louisiana. On November 27, 2006, the Federal District Court issued an Order in these consolidated cases denying our motion to dismiss. The Court held that the flood exclusions utilized in the forms of homeowners and commercial lines policies issued by us and a number of other insurance carriers were ambiguous because such exclusions did not specify that they applied to flooding caused by negligent acts or omissions as well as to flooding caused by natural incidents such as Acts of God. The plaintiffs in these cases claim, among other things, that the efficient proximate cause of their losses was the third-party negligence of Orleans Levee District. They claim that the Levee District was negligent in the maintenance of the canal walls or in its failure to warn the plaintiffs and others of the impending water intrusion. On August 2, 2007 the United States Court of Appeals, Fifth Circuit, issued an opinion reversing the District Court and finding the water damage exclusion to be unambiguous and enforceable. The plaintiffs in these cases have sought review in the United States Supreme Court.

Cases interpreting the water damage exclusion are also proceeding in the Louisiana state court system. A state trial court decision that adopted the legal reasoning of the (now reversed) Federal District Court was upheld by a divided Louisiana Court of Appeals. That court agreed with the trial court that the flood damage exclusion in a commercial property policy was ambiguous. The Louisiana Supreme Court has accepted this case for review. Activity in much of the hurricane-related litigation is at a standstill pending a decision by the Louisiana Supreme Court.

We intend to vigorously defend the flood exclusion matter and other cases related to losses incurred in connection with Hurricane Katrina. While we believe that the flood exclusion at issue is unambiguous and enforceable, the Louisiana Supreme Court could rule that our flood exclusions do not exclude losses from flooding caused by third-party negligence, that such negligence was the efficient proximate cause of such flooding, or that such an exclusion is inapplicable where any portion of a loss is attributable to a covered peril. Such a ruling would likely have a material adverse effect on our financial position, as well as on our results of operations. We have established our loss and loss settlement expense reserves on the assumption that the flood exclusion will be found to be enforceable and effective to exclude losses caused by third-party negligence, as well as by Acts of God, and that the application of the Valued Policy Law will not result in our having to pay damages for perils not otherwise covered. We believe that, in the aggregate, these reserves should be adequate. However, our evaluation of these claims and the adequacy of recorded reserves may change if we encounter adverse developments in the further defense of these claims.

We consider all of our other litigation pending at December 31, 2007, to be ordinary, routine, and incidental to our business.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

There were no matters submitted to a vote of the shareholders during the fourth quarter of 2007.

 

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PART II

ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

United Fire’s common stock is traded on the NASDAQ Stock Market under the symbol UFCS. On February 1, 2008, there were 929 holders of record of United Fire common stock. Such number of record holders does not reflect shareholders who beneficially own common stock in nominee or street name. The table below sets forth the high and low bid quotations for our common stock for the calendar periods indicated. These quotations reflect interdealer prices without retail markups, markdowns, or commissions and may not necessarily represent actual transactions.

Our policy has been to pay quarterly cash dividends, and we intend to continue that policy. The table below shows the quarterly cash dividends declared in 2007 and 2006. Payments of any future dividends and the amounts of such dividends, however, will depend upon factors such as net income, financial condition, capital requirements, and general business conditions. We have paid dividends every quarter since March 1968.

State law permits the payment of dividends only from statutory accumulated earned profits arising from business operations. Furthermore, under Iowa law we may pay dividends only if after giving effect to the payment we are either able to pay our debts as they become due in the usual course of business or our total assets would be equal to or more than the sum of our total liabilities. Our subsidiaries are also subject to similar state law restrictions on dividends.

Information about securities authorized for issuance under equity compensation plans is incorporated by reference from Part III, Item 12 “Security Ownership of Certain Beneficial Owners and Management.”

 

 

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In August 2007, our Board of Directors authorized us to repurchase an up to an additional 600,000 shares of our common stock, raising our total repurchase authorization to 687,167 shares. The following table shows the authorizations and stock repurchases made during the fourth quarter. For a more detailed discussion of our stock repurchase plan, refer to the “Financial Overview” section of Part II, Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

The following graph compares the cumulative total stockholder return on our common stock for the last five fiscal years with the cumulative total return of the Russell 2000 Index, the SNL Insurance Company Index and the SNL Property & Casualty Insurance Index, assuming an investment of $100 in each of the above at their closing prices on December 31, 2002, and reinvestment of dividends.

The following table shows the raw data used in the Total Return Performance graph above.

 

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ITEM 6. SELECTED FINANCIAL DATA

The selected financial data herein has been derived from the consolidated financial statements of United Fire and its subsidiaries and affiliate. The data should be read in conjunction with Part II, Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Part II, Item 8 “Consolidated Financial Statements and Related Notes.” The 2004 and prior amounts reflect the retroactive effects of our December 15, 2004, one-for-one stock dividend.

 

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ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Management’s Discussion and Analysis provides a narrative of our financial performance and condition that should be read in conjunction with the accompanying Consolidated Financial Statements. It includes the following sections:

 

This report may contain forward-looking statements about our operations, anticipated performance and other similar matters. The Private Securities Litigation Reform Act of 1995 provides a safe harbor under the Securities Act of 1933 and the Securities Exchange Act of 1934 for forward-looking statements. The forward-looking statements are not historical facts and involve risks and uncertainties that could cause actual results to differ materially from those expected and/or projected. Such forward-looking statements are based on current expectations, estimates, forecasts and projections about our company, the industry in which we operate, and beliefs and assumptions made by management. Words such as “expects,” “anticipates,” “intends,” “plans,” “believes,” “continues,” “seeks,” “estimates,” “predicts,” “should,” “could,” “may,” “will continue,” “might,” “hope” and variations of such words and similar expressions are intended to identify such forward-looking statements. These statements are not guarantees of future performance and involve risks, uncertainties and assumptions that are difficult to predict. Therefore, actual outcomes and results may differ materially from what is expressed in such forward-looking statements. Among the factors that could cause our actual outcomes and results to differ are:

 

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These are representative of the risks, uncertainties and assumptions that could cause actual outcomes and results to differ materially from what is expressed in forward-looking statements. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date of this report or as of the date they are made. Except as required under the federal securities laws and the rules and regulations of the Securities and Exchange Commission (the “SEC”), we do not have any intention or obligation to update publicly any forward-looking statements, whether as a result of new information, future events or otherwise.

Additional information concerning factors that could cause actual results to differ materially from those in the forward-looking statements is contained in Part I, Item 1A “Risk Factors” of this document.

Our business

We operate property and casualty and life insurance businesses, marketing our products through independent agents. Although we maintain a broad geographic presence that includes most of the United States, more than half of our property and casualty premiums are written in Iowa, Texas, Colorado, Louisiana and Missouri. Approximately three-fourths of our life insurance premiums are written in Iowa, Minnesota, Wisconsin, Nebraska and Illinois.

We conduct our operations through two distinct segments: property and casualty insurance and life insurance. We manage these segments separately because they generally do not share the same customer base, and they each have different pricing and expense structures. We evaluate segment profit based upon operating and investment results. Segment profit or loss described in the following sections of the Management’s Discussion and Analysis is reported on a pre-tax basis. Additional segment information is presented in Part II, Item 8, Note 11 “Segment Information” to the Consolidated Financial Statements.

Our revenue is primarily composed of premiums and investment income. Major categories of expenses include losses and loss settlement expenses, changes in reserves for future policy benefits, operating expenses and interest on policyholders’ accounts. Through disciplined underwriting and strong agency relationships, we have traditionally emphasized writing good business at an adequate price, preferring quality to volume. Our goal of consistent profitability is supported by these business strategies.

Our business is cyclical in nature and is influenced by many factors, including price competition, economic conditions, interest rates, weather-related events and other catastrophes including natural (for example hurricanes and tornados) and man-made disasters, state regulations, court decisions and changes in the law.

 

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Financial overview

In 2007, we attained record net income of $111.4 million, compared to $88.1 million in 2006 and $9.0 million in 2005. The strength of our underwriting and overall financial results in 2007 can be attributed to a relatively low level of claim activity related to catastrophes during the year. We also emphasized writing quality business – one of our company’s core objectives – and had favorable results in our non-catastrophe claim activity in each of the past three years. Our results in 2005 were significantly impacted by losses from Hurricane Katrina. Additional development on Hurricane Katrina losses continued to impact our results in 2006.

An additional measure of our results is the combined ratio. The property and casualty insurance industry uses the combined ratio as a measure of underwriting profitability. The combined ratio is the sum of the loss ratio (losses and loss settlement expenses incurred as a percent of net premiums earned) plus the expense ratio (underwriting expenses as a percent of net written premiums, if calculated on a statutory basis, or net earned premiums, if calculated on a GAAP basis). A combined ratio below 100 percent generally indicates a profitable book of business. Our GAAP combined ratio was 81.3 percent, 87.9 percent and 111.3 percent in 2007, 2006 and 2005, respectively. Our statutory combined ratio was 82.1 percent, 89.7 percent and 112.5 percent in 2007, 2006 and 2005, respectively. The statutory combined ratio for the property and casualty industry is projected by A.M. Best to be 95.6 percent for 2007. The industry statutory combined ratio was 92.4 percent in 2006 and 101.2 percent in 2005.

In the wake of record losses related to Hurricane Katrina and Hurricane Rita, we disclosed in 2006 that we intended to reduce our property exposures in the Gulf Coast region, particularly in Louisiana, as a way to mitigate the catastrophe risk associated with this business. During 2007 we took steps to reduce our exposure in the Gulf Coast, including the implementation of stricter underwriting guidelines and policy terms, as well as significant premium rate increases in catastrophe-prone areas. These steps have reduced our probable maximum loss due to catastrophe in the Gulf Coast area by over 40 percent from pre-Hurricane Katrina levels. With the exposure reduction in Louisiana and increased catastrophe reinsurance protection, we believe that we would not exceed our catastrophe reinsurance coverage limits for any future catastrophes similar in magnitude and intensity to Hurricane Katrina, which was the costliest catastrophe in the history of our company.

Beginning in 2005, the property and casualty industry entered into a soft market, characterized by increased price competition and excess underwriting capacity. During the three years ended 2007, we have experienced an increasing rate of competition, which has resulted in decreasing levels of premium pricing in many of our lines of insurance and in many of the geographic areas in which we write, with the exception of coastal areas. The significant losses that the insurance industry suffered due to Hurricane Katrina created hard market conditions in the Gulf Coast region in both personal and commercial lines. However, many insurers, ourselves included, also experienced an increase in prices for property catastrophe reinsurance coverage.

We anticipate that the soft market and more competitive pricing environment will continue through 2008 and beyond. In order to mitigate the effects of a soft insurance market, we will focus on retaining good business and writing quality new business. We intend to capitalize on the strength of our existing agency relationships by emphasizing our highly educated and experienced underwriting staff and our ability and willingness to underwrite and accept unique risks. To aid in policy retention, we provide our agents with superior customer service, which includes personally answering the telephone instead of forcing agents to wade through a series of automated telephone prompts. We will continue to foster personal relationships with our agents by offering cost effective loss control programs and computer systems automation that simplifies and speeds up the process of quoting and writing policies. In 2007, our top 500 agencies generated approximately 88 percent of our underwriting profits. Therefore, the majority of our efforts will be focused on these most profitable agents. In 2008, we will evaluate the potential benefits of entering into additional niche markets.

During 2007, we began writing workers’ compensation in states where we had previously not offered this line of insurance. Currently, workers’ compensation insurance premiums account for approximately 10.0 percent of our direct premiums. In 2008, we plan to increase our writing of workers’ compensation business as a companion line to our other commercial insurance policies. We are developing new underwriting tools and loss control services that will allow us to more effectively evaluate and mitigate risks, improving profitability in this line of business.

 

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A lingering challenge from Hurricane Katrina remains policyholder litigation. United Fire & Casualty Company and our Louisiana property and casualty insurance subsidiary, Lafayette Insurance Company, along with many other insurers in the Louisiana market, are named defendants in litigation generated by this catastrophe. Refer to Part I, Item 3 “Legal Proceedings” for a discussion of this litigation and its potential impact to our operations.

The strong results and steady income produced by our life insurance segment has historically helped offset the volatility of our property and casualty insurance earnings due to the cyclical nature of the property and casualty insurance business. In order to maintain profitability within our life insurance segment we will continue to diversify our product offerings in response to industry needs. In 2007 we introduced a new universal life product that combined the most popular features of and replaced our two existing universal life products. Our new universal life product includes a disability income rider with an increased monthly disability income benefit from $1,500 to $2,500. During 2007 we continued to see annuity withdrawals exceed new annuity deposits – although at a slower rate than experienced during 2006. The current interest rate environment presents a challenge to maintaining a profitable interest rate spread for our annuity business. We will continue monitoring annuity withdrawals closely to determine if interest rate adjustments become necessary in the future. Despite these challenges, we remain optimistic about the future of our life insurance business.

In August 2007, we announced that our Board of Directors authorized us to repurchase up to an additional 600,000 shares of our common stock, bringing our total repurchase authorization to 687,167 shares. Under this share repurchase program, we may purchase our common stock from time to time through open market or privately negotiated transactions. The amount and timing of stock repurchases is determined at the discretion of management and depends on a number of factors, including the price of our common stock, general market and economic conditions, and corporate and regulatory requirements. The share repurchase program will be in effect for two years, but may be modified or discontinued by us at any time.

We are faced with the challenge of balancing the capital adequacy requirements established by A.M. Best with market expectations regarding returns on equity investment. We currently consider our stock to be undervalued and, therefore, a good investment opportunity for our capital resources. During the last two quarters of 2007, we repurchased 497,500 shares of our common stock and returned them to the status of authorized but unissued shares. For a more detailed accounting of the shares repurchased under this program, refer to Part II, Item 5 “Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.”

On February 15, 2008, our Board of Directors authorized us to repurchase up to an additional 500,000 shares of common stock. As of February 15, 2008, our remaining repurchase authorization is 689,667 shares.

Enterprise risk management

Enterprise risk management (“ERM”) is a methodology that helps an organization assess and manage its overall exposure to risk. ERM has gained the attention of the insurance industry in recent years. ERM begins as a capital preservation process that helps insurers identify, quantify and manage risks from all sources that exist throughout the corporation, including risks arising from investments, underwriting, and operations. ERM considers the accumulation and diversification of risk and utilizes a company’s past experience to help evaluate future business plans and manage risk.

In 2007, we continued formalizing our ERM processes. We employ a multi-disciplinary approach to risk identification and evaluation – from claims to underwriting to financial to investments. Members of our ERM committee include our chief executive officer, chief financial officer, executive vice president, vice president of claims, vice president of corporate underwriting, chief investment officer and vice president/chief operating officer of our life insurance subsidiary (United Life Insurance Company), and United Life Insurance Company’s independent actuary. This committee met several times during the year to review the structure for our risk management process.

During its meetings, the ERM committee discussed the risks that our company faces, as well as the controls that are in place to mitigate those risks. These are not new ideas – management has actively and successfully managed risks

 

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throughout our company’s history. Collectively, the committee has identified two broad categories of risk faced by our company – insurance risk and operational risk. Types of insurance risks generally include, but are not limited to, those risks associated with geographical concentrations of property insured, business mix, catastrophe modeling, underwriting practices, loss reserving practices, policy pricing, and the actions of our competitors. Types of operational risks we face generally include, but are not limited to, those risks associated with business continuity planning, information technology, executive succession planning, regulatory and legal compliance, diversification of investments and the application of accounting policies and procedures.

ERM issues are discussed both during our quarterly Board of Directors meetings and at our semi-annual managers meetings. At these meetings, directors and managers are updated on ERM issues and the ongoing efforts of the ERM committee. The work of our ERM committee has led to the development of new tools designed to aid in the evaluation and mitigation of underwriting risks.

 

Our overall operating results have improved over the past three years. In 2007, we experienced a lower-than-normal level of catastrophe losses and continued to experience favorable results in most of our lines of business. Results in 2006 and 2005 were negatively impacted by Hurricane Katrina losses. The results in 2006 and 2005 without the impact of Hurricane Katrina were favorable, attesting to the quality of our core book of business. In addition, our life segment provided a steady stream of pre-tax income in each of the three years; $20.3 million in 2007, $21.9 million in 2006 and $21.4 million in 2005.

There has been slow growth in our net premiums earned over the past three years. Moderate increases in property and casualty premiums have been offset by moderate decreases in life insurance premiums. In the property and casualty segment, competitive market conditions have led to pricing reductions. Premium writings also decreased in 2007 as a result of our planned reduction of property exposures in Louisiana. However, some of this decrease was offset by pricing increases, specifically in hurricane-exposed regions.

 

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The commercial lines pricing environment continues to be competitive, with an average of mid-single digit percentage decreases in premium. In nearly every geographic location in which we do business, we are experiencing pricing pressure on renewal accounts, especially midsize and large accounts. The personal lines pricing environment also continues to be very competitive both in the auto and homeowners lines of business, with an average of mid-single digit percentage decreases in non-catastrophe exposed states.

Fortunately, we have been successful in retaining a high percentage of our quality accounts, so despite pricing reductions on these accounts they have continued to be profitable. In addition, we have been able to write new business, which has also been profitable.

Net investment income has increased moderately since 2005. In the life segment, our investment portfolio has decreased due to an outflow of annuity funds. Cash generated from operating results in the property and casualty segment has led to an increase in investable funds. During 2006 and 2007 we shortened the duration of our portfolio due to the interest rate environment. Over the past two years, short-term rates of return have generally exceeded long-term rates. Despite this recent short-term emphasis, we have actively managed the duration of our portfolio to attain an appropriate matching of assets to liabilities.

Property and casualty insurance segment

(1) Please refer to the Non-GAAP financial measures section of this report for further explanation of this measure.

 

(1) Please refer to the Non-GAAP financial measures section of this report for further explanation of this measure.

The property and casualty insurance segment reported pretax income of $139.0 million in 2007 and $103.6 million in 2006, compared with a pretax loss of $14.8 million in 2005. The improvement in the 2007 and 2006 results compared to 2005, was primarily due to the significant impact Hurricane Katrina and Hurricane Rita had on our loss experience during 2005. The financial impact from these hurricanes was realized largely on our homeowners, allied lines and commercial multiple peril lines of business.

 

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In the five years prior to 2005, our average catastrophe net losses incurred each year were approximately $21.0 million. In 2005, we incurred $197.1 million in catastrophes. Of this, $178.2 million was attributable to Hurricane Katrina. In 2006, our catastrophe losses totaled $59.8 million, with $31.7 million related to Hurricane Katrina development. In 2007, we incurred $14.1 million in catastrophe losses, with $6.3 million from Hurricane Katrina. In the months following Hurricane Katrina, we made the decision to reduce our property exposures along the Gulf Coast. Due to regulatory constraints, we were required to wait until 2007 to initiate our plan. In 2007, we exceeded our goal of reducing our property exposures in Louisiana, reducing the exposure by one-third. This planned reduction contributed to the flat growth in premium revenue between 2006 and 2007. In addition, premium growth was mitigated due to pricing declines, as a result of soft market conditions. Over the past two years, competitive pressure has led to pricing reductions in many of our lines of business, and in most areas in which we write, with the exception of catastrophe exposed areas. Since Hurricane Katrina, we have significantly increased our pricing in hurricane-exposed regions.

Without the impact of catastrophes, our results have been favorable. Over the past three years, there has been some deterioration in our combined ratio (without catastrophes), due primarily to pricing conditions. Also negatively impacting our non-catastrophe results in 2007 was an increase in claims frequency in the commercial auto line of business and an increase in claims severity in the other liability line of business. Further discussion about these lines as well as our other lines of business, are included in subsequent sections of this report.

Net investment income is discussed on a consolidated basis in a following section of this report.

Premiums

(1) Please refer to the Non-GAAP financial measures section of this report for further explanation of this measure.

During 2006 and 2007, despite the soft market conditions, our retention rates of quality accounts have remained high. We attribute this success to our relationships with our agents and a superior level of customer service. We also sought to increase our level of business through new policyholders. We initiated and increased writings in four southern states in 2007 and added many new accounts in some of our Midwestern states. The new business has been generated through our existing independent agency force. In 2007, we targeted the workers’ compensation line of business for growth and were able to increase revenues for this line. We are working on a program of new underwriting tools, to be implemented in 2008 that we anticipate will contribute to the profitability in the workers’ compensation line of business.

Over the past three years, our commercial lines of business has accounted for over 90 percent of premium revenue. We do not anticipate that our current mix of business (commercial lines/personal lines) will change materially.

Since 2000, we have had only five active accounts in our assumed business and a number of assumed contracts that are in run-off. Late in 2006, we made the decision to cancel one of the largest remaining assumed contracts. This decision was made in response to an exposure base that was in excess of our risk tolerance levels as compared to the premium we were able to collect. In 2007, premium writings were down by 11.0 percent as a result of this decision. During 2008, there will be additional reductions in assumed business as the cancelled contract expires.

Net premiums earned are decreased by ceded premiums that we pay to reinsurers. In 2005, we paid an $8.0 million reinstatement premium for our catastrophe reinsurance coverage, due to the fact that we had exceeded our reinsurance limits of $125.0 million on Hurricane Katrina. In 2006, premium rates for our catastrophe and excess of

 

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loss reinsurance increased substantially because of the significant losses incurred by reinsurers as a result of Hurricane Katrina and other catastrophes. Pricing of ceded reinsurance did not increase materially in 2007. Rather, the reduction in ceded premiums written in 2007, was due to the lower level of direct premiums written.

Losses and Loss Settlement Expenses

Each year, our results are impacted not only by losses that occur in the current year, but also by development on losses that have occurred in prior years. The development, which can have either a favorable or unfavorable impact on earnings, is due to paying losses at amounts different than what we reserved, or to changing loss reserve estimates based on new information that becomes available to us. For the past ten years, we have experienced a net redundancy due to losses that occurred in prior years. In 2007, we incurred losses of $245.8 million, of which $291.0 million were from losses that occurred in 2007. We had favorable development from prior years’ losses of $45.2 million. The redundancy was realized in each of our lines of business, with the exception of homeowners, which was attributable to Hurricane Katrina development.

In 2006, loss and loss settlement expenses incurred were $278.5 million, with $303.5 million of loss and loss settlement expenses that occurred in 2006 and a redundancy of $25.0 million ($62.2 million without the adverse development on Hurricane Katrina claims) on losses that occurred prior to 2006, which resulted from settling or re-estimating claims for less than reserved for at December 31, 2005. Due to Hurricane Katrina, our homeowners, allied lines and commercial multiple peril lines of business experienced a reserve deficiency, while our remaining lines of business experienced reserve redundancies for the year.

In 2005, loss and loss settlement expenses incurred were $375.9 million, which was comprised of $453.4 million that was attributable to losses that occurred in 2005 as offset by a $77.5 million redundancy on losses that occurred prior to 2005. This redundancy resulted from settling or re-estimating claims for less than reserved for at December 31, 2004. We experienced a reserve redundancy in each of our lines of business, with the exception of fidelity and surety.

Loss Reserves

We discuss our reserving process, which contributed to the favorable development of loss reserves in 2007, 2006 and 2005, under “Critical Accounting Estimates.” The majority of our business consists of short duration contracts. However, we consider our workers’ compensation and other liability lines of business to be long-tail lines of business due to the length of time that may elapse before claims are finally settled. Therefore, we may not know our final development on individual claims for many years. Our estimates for losses, particularly in these long-tail lines, are dependent upon many factors, such as the legal environment, inflation and medical costs. We consider all of these factors, as well as others, in estimating our loss reserves. As conditions or trends with respect to these factors change, we change our estimate for loss reserves accordingly.

The following table illustrates the primary components of the net loss redundancy we experienced in our reserves for 2007, 2006 and 2005.

 

 

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Salvage is the sale of damaged goods, for which the insured has been indemnified for and for which the insured has transferred title to the insurance company. Salvage reduces the cost incurred for property losses. Subrogation also reduces the costs incurred for a loss by seeking payment from other parties involved in the loss and/or from the other parties’ insurance company. Alternative dispute resolution facilitates settlements and reduces defense and legal costs through processes such as mediation and arbitration. Workers’ compensation medical bill review is a system designed to detect duplicate billings, unrelated and unauthorized charges and coding discrepancies, as well as it ensures that we are billed for medical services according to the fee schedule designated by each state in which we have claims.

Our “other” redundancy is attributable to both the payment of claims in amounts other than the amounts reserved and changes in loss reserves due to additional information on individual claims that we received after the reserves for those claims had been established. The additional information we consider is unique to each claim. Such information may include facts that reveal we have no coverage obligation for a particular claim, changes in applicable laws that reduce our liability or coverage exposure on a particular claim, facts that implicate other parties as being liable on a particular claim and favorable court rulings that decrease the likelihood that we would be liable for a particular claim. Also, additional information relating to severity is unique to each claim. For example, we may learn during the course of a claim that bodily injuries are less severe than originally believed or that damage to a structure is merely cosmetic instead of structural.

The table on the following page depicts our net loss ratio for 2007, 2006 and 2005.

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(1) “Other liability” is business insurance covering bodily injury and property damage arising from general business operations, accidents on the insured’s premises and products manufactured or sold.

(2) “Fire and allied lines” includes fire, allied lines, commercial multiple peril and inland marine.

(3) “Fire and allied lines” includes fire, allied lines, homeowners and inland marine.

 

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Commercial Lines

The net loss ratio in our commercial lines of business was 51.8 percent in 2007, 57.8 percent in 2006 and 71.7 percent in 2005. In our commercial property lines, the improvement was due primarily to the lower catastrophe losses experienced in 2007 and 2006 as compared to the losses experienced from Hurricane Katrina in 2005. The 2006 results in these lines were impacted by further development from Hurricane Katrina losses. Our commercial liability lines of business were not impacted materially by Hurricane Katrina. Across all of our commercial lines, pricing reductions impacted our results over the past three years, to varying degrees.

Commercial Fire and Allied Lines

Commercial fire and allied lines insurance covers losses to an insured’s property, including its contents, from weather, fire, theft or other causes. We provide this coverage through a variety of business policies. The net loss ratio for our commercial fire and allied lines was 56.0 percent in 2007, 85.6 percent in 2006 and 140.5 percent in 2005. The improvement in our 2007 results was due to a lower number of fires and storms occurring during the year as well as better catastrophe results than in prior years. The deterioration in the 2006 and 2005 results were a result of net catastrophe losses and loss settlement expenses from Hurricanes Katrina and Rita, which totaled $19.6 million and $126.1 million in this line of business during 2006 and 2005, respectively. Also, pricing in our commercial property lines of business decreased during 2007 and 2006, with the exception of catastrophe-prone areas along the Gulf Coast, primarily in Louisiana.

Other Liability

Our other liability line of insurance covers businesses for bodily injury liability and property damage arising from general business operations, accidents on their premises and products manufactured or sold. We reported a net loss ratio in this line of 40.5 percent in 2007, 29.7 percent in 2006 and 31.1 percent in 2005. The deterioration in the net loss ratio in 2007 was primarily related to increased severity. We had several large liability losses in 2007, but have detected no trends as to cause of loss or geographic location. We also experienced an increase in net premiums earned of 4.9 percent in 2007 over 2006, compared to an increase of 7.3 percent in 2006 over 2005, as a result of pricing initiatives in this particular line of business.

Commercial Automobile

Our commercial automobile insurance covers physical damage to an insured’s vehicle, as well as liabilities to third parties. Automobile physical damage insurance covers loss or damage to vehicles from collision, vandalism, fire, theft, flood or other causes. Automobile liability insurance covers bodily injury, damage to property resulting from automobile accidents caused by the insured, uninsured or underinsured motorists and the legal costs of defending the insured against lawsuits. Our company policy is to write only standard automobile insurance and we do not write coverage for large fleets of automobiles. Our net loss ratio in commercial automobile was 64.1 percent in 2007, 58.1 percent in 2006 and 45.1 percent in 2005. The deterioration in this line during 2007 was primarily due to a 3.8 percent increase in claim frequency as compared to 2006. The deterioration in this line during 2006 was primarily due to an increase in claim severity.

Workers’ Compensation

Our net loss ratio in the workers’ compensation line of business was 67.0 percent in 2007, 74.1 percent in 2006 and 62.9 percent in 2005. We consider our workers’ compensation business to be a companion product; we rarely write stand-alone workers’ compensation policies. Our workers’ compensation insurance covers primarily small- to mid-size accounts. The improvement in results in 2007 was due to lower severity, a slight decrease in our frequency and improvements in our medical review programs. The deterioration in workers’ compensation in 2006 was primarily due to an increase in claim severity.

During 2007, we introduced our workers’ compensation business into states where we had not previously written our workers’ compensation line and increased premium writings in states where we were already offering workers’

 

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compensation insurance. The challenges facing workers’ compensation insurance providers include the state regulatory climates in some states that make it difficult to obtain appropriate premium rate increases and inflationary medical costs. We believe that our underwriting expertise, loss control service and medical review programs will enable us to be profitable in the workers’ compensation line of business. Currently, we have a project underway to introduce predictive modeling analytics into our workers’ compensation underwriting process, which we anticipate will further enhance our profitability.

Fidelity and Surety

Our surety products guarantee performance and payment by our bonded principals. Our contract bonds protect owners from failure to perform on the part of our principals. In addition, our surety bonds protect material suppliers and subcontractors from nonpayment by our contractors. When surety losses occur, our loss is determined by estimating the cost to complete the remaining work and to pay the contractor’s unpaid bills, offset by contract funds due to the contractor, reinsurance and the value of any collateral to which we may have access. The net loss ratio in this line was 9.7 percent in 2007, 35.2 percent in 2006 and 46.3 percent in 2005. The improvement in 2007 as compared to 2006 was the result of stricter underwriting guidelines, as well as a decrease in frequency and severity. In 2007, there were no new claims that exceeded our $1.5 million reinsurance retention level, compared to three such claims in 2006 and four such claims in 2005. The 2006 and 2005 underwriting results were adversely impacted primarily by bonded principals that defaulted on their bonded obligations after a determination was made that they did not have the financial wherewithal to complete the bonded projects, which required us to pay the outstanding obligations associated with those projects. In response to the poor performance in the surety line of business, we continue to improve our underwriting discipline by, among other things, requiring principals to provide more frequent financial statements, requiring principals to maintain higher levels of capitalization, limiting bonding on those principals showing signs of inadequate cash flow and requiring additional indemnity and collateral. Our changes have resulted in a slight reduction in premium revenue in both 2007 and 2006.

Personal Lines

In our personal lines business, the net loss ratio was 60.7 percent in 2007, 81.2 percent in 2006 and 170.4 percent in 2005. The improvement in the 2007 results is due primarily to the effect that Hurricanes Katrina and Rita had on our 2006 and 2005 results. The competitive market conditions also impacted our results in each of these years. During 2007, premium pricing in our personal auto line of business decreased, while in 2006 and 2005, pricing decreased in each of our lines of personal insurance business. In both fire and allied lines (including homeowners) and automobile, our policy counts decreased in both 2007 and 2006. In our homeowners business, the premium reduction due to the loss of business was more than offset by the significant increases in premium pricing in hurricane-exposed regions.

In 2006, we introduced our Signature Premier Homeowners Program in Illinois, Iowa, Minnesota, Missouri, South Dakota, Wisconsin, Indiana, Nebraska and New Mexico. During 2007, we launched this product in North Dakota, Wyoming and Texas. In 2008, we plan to offer this insurance coverage in Colorado. While the product is still new, we have been pleased with the increase in the number of policies that we have issued and with the overall results.

Catastrophe Reinsurance

While we purchase catastrophe reinsurance to protect ourselves against severe hurricanes, Hurricane Katrina resulted in a level of damage that we did not foresee and did not consider when we evaluated our reinsurance coverage for 2005. This resulted in a level of reinsurance coverage that did not adequately protect us from the devastation of Hurricane Katrina. During 2007 and 2006, in addition to strengthening our underwriting guidelines in the Gulf Coast region and reducing our exposure in Louisiana, we also evaluated and modified our catastrophe reinsurance coverage to lessen the impact of future catastrophes in this region. Refer to Part I, Item 1, “Reinsurance,” and Part II, Item 8, Note 5, “Reinsurance” for a more detailed discussion of our reinsurance programs.

 

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Assumed Reinsurance

Our assumed reinsurance line of business improved in 2007 and 2006, reporting net loss ratios of 36.0 percent and 57.5 percent, respectively. The improvement in 2007 results was due to improved catastrophe loss development during the year. In 2005, the net loss ratio was 137.8 percent. The improvement in our net loss ratio from 2005 to 2006 was primarily due to the impact Hurricane Katrina and Hurricane Rita had on our assumed loss experience during 2005. In recent years, we have significantly reduced the level of our assumed reinsurance business. This decrease in assumed reinsurance business continued in 2007 with premium writing decreasing by 11.0 percent as the result of the cancellation of a large assumed contract. We anticipate more reductions in 2008 and in the future as the cancelled contract expires. We continue to have exposure, primarily with respect to catastrophe coverage related to the runoff business, as well as to the small number of assumed reinsurance contracts that we have continued to underwrite.

Other Underwriting Expenses

Our other underwriting expenses increased between 2007 and 2006, which was attributable to an increase in benefit expenses, an increase in accounts receivable charged off and a fixed level of operating expenses on flat premium revenue growth.

Life insurance segment

1. Please refer to the Non-GAAP financial measures section of this report for further explanation of this measure.

Our life insurance segment produced a steady stream of pre-tax income since 2005; however, revenues and expenses decreased in all three years. Net premium earned decreased in 2006 and 2007 due to a decrease in the sales of single premium whole life insurance and the run-off of credit life insurance. We intend to continue offering single premium whole life insurance and are developing a plan to give more focus to the marketing of this product. Net investment income also decreased in each of the three years presented, due to both declining invested assets and market interest rates. Investment results are discussed on a consolidated basis in a following section of this report.

 

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The fixed annuity deposits that we collect are not reported as net premiums earned under GAAP. Instead, we invest annuity deposits and record them as future policy benefits. The revenue that is generated from fixed annuity products consists of policy surrender charges and investment income earned. The difference between the yield we earn on our investment portfolio and the interest we credit on our fixed annuities is known as the investment spread. The investment spread is a major driver of the profitability for all of our annuity products.

Our annuity deposits grew by 11.1 percent in 2007 and by 122.4 percent in 2006.The increasing levels of annuity deposits since 2005 is primarily due to an increase in renewals of existing annuities during 2006 and 2007. Beginning in 2005, we began to experience an increase in the amount of annuity surrenders and withdrawals. This activity increased significantly in 2006, and then decreased slightly in 2007. We attribute the level of annuity surrenders and withdrawals to the perceived attractiveness of other interest rate products, primarily bank CDs. We have the ability to adjust the rates that we credit on fixed annuity products; however, we did not raise our crediting rates to a point where our investment spread was compromised.

The reduction in annuity balances was the primary contributor to the decrease in interest on policyholders’ accounts, each year since 2005, as well as a decline in credited interest rates on in force annuity contracts.

The increase in amortization of deferred policy acquisition costs in 2007 was due primarily to changes in our annuity assumptions, with the largest component attributable to a change in our policy lapse assumption. We increased our assumption in response to the increased level of annuity surrenders in recent years and our expectations about the interest rate environment. Amortization of deferred policy acquisition costs decreased in 2006 compared to 2005, due to a decrease of volume in our credit life and health insurance. We stopped writing new business in these lines of insurance in 2004. Refer to “Critical Accounting Estimates” in this section for a more detailed discussion of our life segment’s deferred policy acquisition costs.

Investment results

Over the past three years, our investment income has increased by 3.0 percent as a result of a 7.4 percent increase in the average invested assets which has offset the depressed market interest rates and the contraction of our annuity business during this period. More than 80.0 percent of our investment income originates from interest on fixed maturities. We derive our remaining investment income from dividends on equity securities, income from other long-term investments, interest on mortgage loans, interest on policy loans, interest on short-term investments and cash and cash equivalents and rent earned from tenants in our home office. The average investment yield, which is investment income divided by average invested assets, was 5.5 percent in 2007, 5.7 percent in 2006 and 5.8 percent in 2005.

Net realized investment gains in 2007 were primarily due to cash received as a result of transactions that impacted companies whose securities we held. The increase in net realized gains in 2006, compared to 2005, is primarily attributable to the sale of our property and casualty insurance subsidiary, American Indemnity Company, in 2006, which resulted in a realized gain of $3.4 million.

As of December 31, 2007, we recorded net unrealized gains, after tax, of $85.6 million, compared to $93.5 million in 2006 and $86.4 million in 2005. In each of the three years, our portfolio of equity securities was the largest contributor to net unrealized gains. In 2007, depressed stock prices resulted in the decrease in unrealized gains,

 

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