Protective Insurance Corporation is a property-casualty insurer specializing in marketing and underwriting property, liability and workers' compensation coverage for trucking and commercial automobile fleets, as well
as coverage for trucking industry independent contractors. We operate as one reportable property and casualty insurance segment, offering a range of products and services, the most significant being commercial automobile and workers' compensation
insurance products.
The term “Protective,” as used throughout this Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”), refers to Protective Insurance Corporation, the parent company. The
terms the “Company,” “we,” “us” and “our,” as used throughout this MD&A, refer to Protective and all of its subsidiaries, unless the context clearly indicates otherwise. The term “Insurance Subsidiaries,” as used throughout this MD&A, refers
to Protective Insurance Company, Protective Specialty Insurance Company, Sagamore Insurance Company and B&L Insurance, Ltd.
Effective August 1, 2018, we changed our name to Protective Insurance Corporation to better align our holding company's and Insurance Subsidiaries' identities and to reflect our position within the insurance industry.
Effective January 1, 2018, we adopted Accounting Standards Update ("ASU") 2016-01, Financial Instruments - Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities, or ASU
2016-01, resulting in a cumulative-effect adjustment of $71.0 million ($46.2 million, net of tax). This adjustment moved our historical unrealized gains and losses, net of tax, on our equity portfolio from accumulated other comprehensive income
(loss) to retained earnings, but had no impact on overall shareholders' equity. In addition, for 2018 and forward, the change in fair value for equity securities is required to be recognized in net earnings rather than in other comprehensive income
(loss). The impact to our consolidated statements of operations will vary depending upon the level of volatility in the performance of the securities held in our equity portfolio and the overall market.
On December 22, 2017, the U.S. Tax Cuts and Jobs Act (the "U.S. Tax Act") was signed into law, which lowered the U.S. corporate income tax rate from 35% to 21% effective January 1, 2018. As a result, we recorded a tax
benefit of $9.6 million related to the remeasurement of our deferred tax assets and liabilities at December 31, 2017. As of December 31, 2017, the Internal Revenue Service ("IRS") had not yet published all of the detailed regulations resulting from
the enactment of the U.S. Tax Act; therefore, while we had not completed our accounting for the tax effects, we made a reasonable estimate of the tax effects on our existing deferred tax balances at December 31, 2017. We finalized our accounting for
the tax effects of the U.S. Tax Act during 2018. No material adjustments to income tax expense (benefit) were recorded during 2018.
On August 23, 2019, A.M. Best Company, Inc. ("A.M. Best") affirmed our financial strength rating of "A" (Excellent). A.M. Best continues to categorize our balance sheet as "very strong" and our operating performance as
"adequate," but its outlook remains negative.
Liquidity and Capital Resources
The primary sources of our liquidity are (1) funds generated from insurance operations, including net investment income, (2) proceeds from the sale of investments, and (3) proceeds from maturing investments.
We generally experience positive cash flow from operations. Premiums are collected on insurance policies in advance of the disbursement of funds for payment of claims. Operating costs of our property/casualty
Insurance Subsidiaries, other than loss and loss expense payments and commissions paid to related agency companies, average less than one-third of net premiums earned on a consolidated basis and the remaining amount is available for investment for
varying periods of time depending on the type of insurance coverage provided and the timing of the claim payments. Because losses are often settled in periods subsequent to when they are incurred, operating cash flows may, at times, become negative
as loss settlements on claim reserves established in prior years exceed current revenues. Our cash flow relating to premiums is significantly affected by reinsurance programs in effect, whereby we cede both premium and risk to other insurance and
reinsurance companies. These programs vary significantly among products and certain contracts call for reinsurance payment patterns, which do not coincide with the collection of premiums by us from our insureds.
On August 31, 2017, our Board of Directors authorized the reinstatement of our share repurchase program for up to 2,464,209 shares of our Class A or Class B Common Stock. On August 6, 2019, our Board of Directors
reaffirmed our share repurchase program, but also provided that the aggregate dollar amount of shares of our common stock that may be repurchased under the share repurchase program between August 6, 2019 and August 6, 2020 may not exceed $25.0
million and added a limit of no more than $6.25 million in repurchases per quarter. The repurchases may be made in the open market or through privately negotiated transactions, from time-to-time, and in accordance with applicable laws, rules and
regulations. On December 30, 2019, we entered into a stock repurchase plan for the purpose of repurchasing up to $0.6 million of shares of our common stock, at various pricing thresholds, in accordance with guidelines specified under Rule 10b5-1 of
the Securities Exchange Act of 1934, as amended (the "Rule 10b5-1 Plan"). The Rule 10b5-1 Plan was established pursuant to, and as part of, our share repurchase program and permits shares to be repurchased in accordance with pre-determined criteria
when repurchases would otherwise be prohibited, such as during self-imposed blackout periods, or under insider trading laws. The Rule 10b5-1 Plan expired on February 26, 2020. The share repurchase program may be amended, suspended or discontinued at
any time and does not commit us to repurchase any shares of our common stock. We have funded, and intend to continue to fund, the share repurchase program from cash on hand. The actual number and value of the shares to be purchased will depend on the
performance of our stock price, market volume and other market conditions. During the year ended December 31, 2019, we paid $11.5 million to repurchase 11,989 shares of Class A and 665,099 shares of Class B Common Stock under the share repurchase
program.
For several years, our investment philosophy has emphasized the purchase of short-term bonds with high quality and liquidity. Our fixed income investment portfolio continues to emphasize shorter-duration instruments.
If there was a hypothetical increase in interest rates of 100 basis points, the price of our fixed income portfolio, including cash, at December 31, 2019 would be expected to fall by approximately 2.6%. The credit quality of our fixed income
securities remains high with a weighted average rating of AA-, including cash. The average contractual life of our fixed income and short-term investment portfolio was 6.9 years at December 31, 2019 compared to 5.5 years at December 31, 2018. The
average duration of our fixed income portfolio remains shorter than the average duration of our liabilities. We also remain an active participant in the equity securities market, using capital in excess of amounts considered necessary to fund our
current operations. The long-term horizon for our equity investments allows us to invest in positions where ultimate value, and not short-term market fluctuation, is the primary focus. Investments made by our domestic property/casualty Insurance
Subsidiaries are regulated by guidelines promulgated by the National Association of Insurance Commissioners (the "NAIC"), which are designed to provide protection for both policyholders and shareholders.
Net cash flows from operations decreased $14.0 million to $86.7 million for 2019 compared to $100.7 million in 2018. The decrease in operating cash flows was primarily related to an increase in payments for losses and
loss adjustment expenses and operating expenses, partially offset by higher premium volume as well as higher investment income during 2019. Net cash flows from operations increased $3.0 million to $100.7 million for 2018 compared to $97.7 million in
2017, primarily due to higher premium volume in 2018 compared to 2017.
Net cash used in investing activities was $151.9 million for 2019 compared to net cash provided by investing activities of $23.7 million in 2018. The $175.6 million change was primarily the result of a decrease in
proceeds from sales of our fixed income and equity securities of $229.7 million compared to 2018. We also had higher purchases of fixed income and equity securities of $8.2 million during 2019 compared to 2018. These cash outflows were partially
offset by $33.4 million in distributions received from our limited partnership investments in 2019 compared to $6.9 million in 2018 and $20.4 million higher proceeds from maturities of fixed income securities during 2019 compared to 2018.
Additionally, during 2018, we purchased $10.0 million of company-owned life insurance, which did not recur in 2019. Net cash provided by investing activities was $23.7 million for 2018 compared to net cash used in investing activities of $74.3
million in 2017. The $98.0 million change was primarily related to higher proceeds from sales of fixed income and equity securities and lower purchases of fixed income and equity security investments. These increases were partially offset by lower
proceeds from maturities of our fixed income securities and lower distributions from out limited partnership investments during 2018, in addition to the purchase of $10.0 million of company-owned life insurance in the first quarter of 2018.
Net cash used in financing activities for 2019 consisted of regular cash dividend payments to shareholders of $5.9 million ($0.40 per share) and $11.5 million to repurchase 677,088 shares of our common stock.
Financing activities for 2018 consisted of regular cash dividend payments to shareholders of $16.8 million ($1.12 per share) and $4.6 million to repurchase 199,668 shares of our common stock. Financing activities for 2017 consisted of regular cash
dividend payments to shareholders of $16.3 million ($1.08 per share) and $1.9 million to repurchase 84,960 shares of our common stock.
Our assets at December 31, 2019 included $59.8 million of investments included within cash and cash equivalents on the consolidated balance sheet that are readily convertible to cash without market penalty and an
additional $86.4 million of fixed income investments maturing in less than one year. We believe these liquid investments, plus the expected cash flow from premium collections, are sufficient to provide for projected claim payments and operating cost
demands. In the event competitive conditions produce inadequate premium rates and we choose to further restrict volume, the liquidity of our investment portfolio would permit us to continue to pay claims as settlements are reached without requiring
the disposal of investments at a loss, regardless of interest rates in effect at the time. In addition, our reinsurance program is structured to avoid significant cash outlays that accompany large losses.
We maintain a revolving credit facility with a $40.0 million limit, with the option for up to an additional $35.0 million in incremental loans at the discretion of the lenders, which has an expiration date of August 9,
2022. Interest on this revolving credit facility is referenced to the London Interbank Offered Rate ("LIBOR") and can be fixed for periods of up to one year at our option. Outstanding drawings on this revolving credit facility were $20.0 million as
of December 31, 2019. At December 31, 2019, the effective interest rate was 2.88% and we had $20.0 million remaining under the revolving credit facility. The current outstanding borrowings were used to repay our previous line of credit. Our
revolving credit facility has two financial covenants, each of which were met as of December 31, 2019. These covenants require us to have a minimum U.S. generally accepted accounting principles ("GAAP") net worth and a maximum consolidated debt to
equity ratio of 0.35.
Annualized net premiums written by our Insurance Subsidiaries for 2019 equaled approximately 120.7% of the combined statutory surplus of these subsidiaries. According to the NAIC, acceptable ranges for the ratio of
net premiums written to statutory surplus include results of up to 300%. This ratio is designed to measure our ability to absorb above-average losses and our financial strength. Additionally, the
statutory capital of each of our Insurance Subsidiaries substantially exceeded minimum risk-based capital requirements set by the NAIC as of December 31, 2019. As a result, we have the ability to increase our business without seeking additional
capital to meet regulatory guidelines.
Consolidated shareholders' equity is composed largely of GAAP shareholders' equity of our Insurance Subsidiaries. As such, there are statutory restrictions on the transfer of substantial portions of this equity to
Protective. At December 31, 2019, $37.9 million may be transferred by dividend or loan to Protective without approval by, or prior notification to, regulatory authorities. An additional $201.0 million of shareholders' equity of our Insurance
Subsidiaries could be advanced or loaned to Protective with prior notification to, and approval from, regulatory authorities, although transfers of this size would not be practical. We believe these restrictions pose no material liquidity concerns
for us. We also believe the financial strength and stability of our Insurance Subsidiaries would permit access by Protective to short-term and long-term sources of credit when needed. Protective had cash and marketable securities valued at $7.1
million at December 31, 2019.
We believe investors’ understanding of our performance is enhanced by our disclosure of underwriting income (loss), which is a measure that is not calculated in accordance with GAAP. Underwriting income (loss)
represents the pre-tax profitability of our insurance operations and is derived by subtracting net realized and unrealized gains (losses) on investments and net investment income from income (loss) before federal income tax expense (benefit). For
2018, we also had a goodwill impairment charge, which was excluded from the calculation of 2018 underwriting income (loss). We use underwriting income (loss) as an internal performance measure in the management of our operations because we believe
it gives us and users of our financial information useful insight into our results of operations, our underlying business performance and our ongoing operating trends. Underwriting income (loss) should not be viewed as a substitute for income (loss)
before federal income tax expense (benefit) calculated in accordance with GAAP, and other companies may define underwriting income (loss) differently.
The ratio of consolidated other operating expenses, less commissions and other income, to net premiums earned, or our expense ratio, and the ratio of losses and loss expenses incurred, plus other operating expenses,
less commissions and other income, to net premiums earned, or our combined ratio, are measures of our profitability that we believe increase the period-to-period comparability of our operational results. For 2018, the goodwill impairment charge was
excluded from other operating expenses when calculating our expense ratio and our combined ratio, as these ratios are intended to depict our underlying business performance and ongoing operating trends. Our management uses these ratios to evaluate
performance, allocate resources and forecast future operating periods. While expense ratios and combined ratios are widely used within our industry, our use of such ratios may not be directly comparable to similarly titled measures reported by other
companies.
Results of Operations
2019 Compared to 2018
Gross premiums written for 2019 decreased $7.6 million (1.3%) due to the non-renewal of unprofitable business during the year, while net premiums earned increased $14.4 million (3.3%), as compared to 2018. The higher
net premiums earned in 2019 were primarily the result of lower premiums ceded when compared to 2018, as discussed below. The difference in the percentage change for premiums written compared to earned was reflective of the normal differences in the
financial statement recognition of earned premiums compared to written, as well as differences in reinsurance ceding rates on the mix of business in-force.
Premiums ceded to reinsurers on our insurance business averaged 21.3% of gross premiums written for 2019 compared to 23.7% for 2018. During 2018, we had reserve strengthening that resulted in ceding an additional
$17.3 million in premium from prior treaty years related to the variable premium adjustment provisions in our historical reinsurance treaties. In comparison the 2019 period reflected the ceding of only an additional $1.6 million in commercial
automobile premium from prior treaty years related to variable premium adjustment provisions in our historical reinsurance treaties. This was partially offset by higher gross premiums written in workers' compensation coverages, which carry a higher
reinsurance ceding rate in 2019 compared to 2018.
Losses and loss expenses incurred during 2019 increased $2.6 million (0.8%) to $348.5 million compared to $345.9 million in 2018, while the loss ratio decreased to 77.9% for 2019 compared to 79.9% for 2018. The loss
ratio is calculated as the percentage of losses and loss expenses incurred to net premiums earned. The increased losses and loss expenses incurred reflected an increase in current accident year losses driven by continued emergence of severity. This
current accident year development was partially offset by prior accident year net savings of $0.6 million that developed during 2019, primarily due to favorable loss development in workers' compensation coverages. Including the impact of the
additional $1.6 million of ceded premium discussed above, total prior accident years had an unfavorable impact of $1.0 million in 2019. Losses and loss expenses for 2018 reflected reserve adjustments of $16.8 million related to unfavorable prior
accident year loss development in commercial automobile coverages. Including the impact of the additional $17.3 million of ceded premium discussed above, total prior accident years had an unfavorable impact of $34.1 million in 2018.
Commercial automobile products covered by our reinsurance treaties from July 2013 through June 2019 are subject to an unlimited aggregate stop-loss provision. Currently each of these treaty years is reserved at or
above the attachment level of these treaties. For every $100 of additional loss, we are only responsible for our $25 retention. The following table illustrates the benefit of these reinsurance treaties based on select theoretical scenarios. For
these theoretical scenarios, the net financial loss to the Company is approximately 25% of the gross loss.
Commercial automobile products covered by our reinsurance treaty from July 2019 through June 2020 are also subject to an unlimited aggregate stop-loss provision. Once the aggregate stop-loss level is reached, for
every $100 of additional loss, we are responsible for our $65 retention. This increase in our retention compared to recent years, reflects the combination of 1) a decreased need for stop loss reinsurance protection resulting from a significant
decrease in our commercial automobile subject limits profile, 2) a higher cost for this cover and 3) our confidence in profitability improvements given the limits reductions and rate increases on our commercial automobile products.
Net investment income for 2019 increased 19.1% to $26.2 million compared to $22.0 million for 2018. The increase reflected an increase in average funds invested resulting from positive cash flow, as well as a
reallocation from equity investments held in limited partnerships into short-duration, high-quality bonds.
Net realized and unrealized gain on investments of $12.9 million during 2019 were primarily driven by $9.3 million in unrealized gains on equity securities during the period, net realized gains on sales of securities,
excluding impairment losses, of $2.5 million and a $1.6 million increase in the value of our limited partnership investments, partially offset by other-than-temporary impairments on our fixed income securities of $0.5 million recognized during the
period. Comparative 2018 net realized and unrealized losses on investments of $25.7 million were driven by $9.7 million in unrealized losses on equity securities during the period, a $9.3 million decrease in the value of our limited partnership
investments and net realized losses on sales of fixed income and equity securities of $6.6 million. Realized investment gains and losses result from decisions regarding overall portfolio realignment as well as the sale of individual securities,
including the change in the aggregate value of limited partnerships and, as such, should not be expected to be consistent from period to period.
Other operating expenses for 2019 increased $1.3 million (0.9%), to $138.5 million compared to 2018. The increase was driven primarily by higher commission expenses as a result of premium written mix and higher salary
and benefit expenses during 2019, partially offset by a non-cash goodwill impairment charge of $3.2 million recorded in 2018, which did not recur in 2019. The ratio of consolidated other operating expenses less commissions and other income to net
premiums earned (the "expense ratio") was 28.9% during 2019, compared to 28.7% for 2018.
Federal income tax expense was $1.3 million for 2019 compared to a federal income tax benefit of $9.8 million in 2018. The effective tax rate for 2019 was 15.3% compared to 22.3% in 2018. The effective federal income
tax rate in 2019 differed from the normal statutory rate primarily as a result of tax-exempt investment income and the dividends received deduction.
As a result of the factors discussed above, net income for 2019 was $7.3 million compared to net loss of $34.1 million in 2018, a change of $41.4 million.
2018 Compared to 2017
Gross premiums written for 2018 increased $77.8 million (15.4%), while net premiums earned increased $104.7 million (31.9%), as compared to 2017. The higher gross premiums written and net premiums earned were the
result of continued growth in our commercial automobile and workers' compensation products in both our retail and program distribution channels. The difference in the percentage change for premiums written compared to earned was reflective of the
normal differences in the financial statement recognition of earned premiums compared to written, as well as differences in reinsurance ceding rates on the mix of business in-force.
Premiums ceded to reinsurers on our insurance business averaged 23.7% of gross premiums written for 2018 compared to 30.0% for 2017. The percentage of premiums ceded to reinsurance decreased as a result of changes in
our reinsurance structure. In the third quarter of 2017, we lowered the quota share rate on our workers' compensation premiums to reflect growing profitability and confidence in this book of business. We also restructured our commercial automobile
reinsurance treaty, moving away from variable premium ceded rates (based on loss performance) to a flat ceding arrangement with no material changes to the economic risks taken for these products (i.e., ceded losses will decrease by a similar amount
as ceded premiums). The impact of these changes to our reinsurance structure was partially offset by reserve strengthening in 2018 that resulted in ceding an additional $17.3 million in premium from prior treaty years related to variable premium
adjustment provisions in our historical reinsurance treaties. Our historical commercial automobile reinsurance treaties cause an adjustment to premiums ceded when the ultimate loss estimate changes for a reinsurance treaty year. Reserve
strengthening in 2017 also resulted in ceding an additional $13.7 million in premium related to these variable premium adjustment provisions in 2017.
Losses and loss expenses incurred during 2018 increased $98.3 million (39.7%) to $345.9 million compared to $247.5 million in 2017. The loss ratio also increased to 79.9% for 2018 compared to a loss ratio of 75.4% for
2017. The loss ratio is calculated as the percentage of losses and loss expenses incurred to net premiums earned. The increased losses and loss expenses and loss ratio in 2018 reflected reserve adjustments of $16.8 million related to unfavorable
prior accident year loss development in commercial automobile coverages. These unfavorable loss developments were the result of increased claim severity due to a more challenging litigation environment, as well as an unexpected increase in the time
to settle claims leading to an unfavorable change in claim settlement patterns. The 2018 loss ratio also reflected an increase in current accident year losses driven by severe commercial automobile losses, including continued emergence of severity.
The 2017 loss ratio also reflected a $19.2 million reserve strengthening related to prior accident year deficiencies that developed as a result of unfavorable loss development from commercial automobile coverages, particularly from severe
transportation loss events that occurred primarily during the first six months of 2017 and higher than expected loss development for discontinued lines of business.
Commercial automobile products covered by our reinsurance treaties are subject to an aggregate stop-loss provision. Once this aggregate stop-loss level is reached, for every $100 of additional loss, we are responsible
only for our $25 retention. The following table illustrates the financial impact of a further 5% or 10% increase in ultimate losses for the 2013-2017 reinsurance treaty years covering these commercial automobile products:
Net investment income for 2018 increased 21.8% to $22.0 million compared to $18.1 million for 2017. The increase reflected an increase in average funds invested resulting from positive cash flow, as well as higher
interest rates, which led to higher reinvestment yields for our short-duration fixed income portfolio.
Net realized and unrealized losses on investments of $25.7 million during 2018 were driven by $9.7 million in unrealized losses on equity securities during the period, a $9.3 million decrease in the value of our
limited partnership investments and net realized losses on sales of fixed income and equity securities of $6.6 million. During 2018, we sold $149.2 million in equity securities resulting in a gain on sale of $51.9 million. The majority of this gain
was included in unrealized gains within other comprehensive income (loss) at December 31, 2017 and, as a result of the adoption of ASU 2016-01, was reclassified to retained earnings as of January 1, 2018 and not recognized in the consolidated
statements of operations for 2018. These equity sales further solidified the conservative nature of our high quality, short-duration investment portfolio; opportunistically utilized the new lower corporate tax rate of 21%, which was beneficial given
the low tax basis of many of these equity positions; and were accretive to income, given the increase in yields at the shorter end of the yield curve. Comparative 2017 net realized investment gains were $19.7 million, consisting primarily of $12.5
million in gains reported from our investments in limited partnerships and $7.4 million in net realized gains from sales of securities. Realized investment gains and losses result from decisions regarding overall portfolio realignment as well as the
sale of individual securities, including the change in aggregate value of limited partnerships and, as such, should not be expected to be consistent from period to period.
Other operating expenses for 2018 increased $23.6 million, or 20.8%, to $137.2 million compared to 2017. The increase in other operating expenses was primarily due to increased commission expenses as a result of
increased premiums written, higher salary and benefit expense and a non-cash impairment charge of $3.2 million recorded in the fourth quarter of 2018 to write off our entire goodwill balance. See Note M, "Acquisition and Related Goodwill and
Intangibles" to the consolidated financial statements in Part II, Item 8 of this Annual Report on form 10-K for further discussion. The expense ratio was 29.4% during 2018, or 28.7% excluding the impact of the goodwill impairment charge, compared to
33.0% for 2017. The decrease in the expense ratio was primarily related to the leveraging effect of higher net premiums earned in 2018 compared to 2017.
Federal income tax benefit was $9.8 million for 2018 compared to $8.2 million in 2017. The effective tax rate for 2018 was 22.3% compared to (81.0%) in 2017. The effective federal income tax rate in 2018 differed
only slightly from the normal statutory rate primarily as a result of tax-exempt investment income. In the fourth quarter of 2017, we recorded a benefit of $9.6 million related to the remeasurement of deferred tax assets and liabilities pursuant to
the U.S. Tax Act, which impacted our effective federal income tax rate for 2017.
As a result of the factors discussed above, the net loss for 2018 was $34.1 million compared to net income of $18.3 million in 2017, a change of $52.4 million.
Critical Accounting Policies
The Company's significant accounting policies that are material and/or subject to significant degrees of judgment are highlighted below.
Investment Valuation
All marketable securities are included in the Company's balance sheets at current fair market value.
Approximately 60% of the Company's assets are composed of investments at December 31, 2019. Approximately 90% of these investments are publicly-traded, owned directly and have readily-ascertainable market values. The
remaining 10% of investments are composed primarily of minority interests in several limited partnerships. These limited partnerships are engaged in long-short equities, private equity, country-focused funds and real estate development as an
alternative to direct equity investments. These partnerships do not have readily-determinable market values themselves. Rather, the values recorded are those provided to the Company by the respective partnerships based on the underlying assets of
the limited partnerships. While a substantial portion of the underlying assets are publicly-traded securities, those which are not publicly-traded have been valued by the respective limited partnerships using their experience and judgment.
Under Financial Accounting Standards Board ("FASB") guidance, if a fixed income security is in an unrealized loss position and the Company has the intent to sell the security, or it is more likely than not that the
Company will have to sell the security before recovery of its amortized cost basis, the decline in value is deemed to be other-than-temporary and is recorded to net realized gains (losses) on investments in the consolidated statements of operations.
For impaired fixed income securities that the Company does not intend to sell or it is more likely than not that the Company will not have to sell such securities, but the Company expects that it will not fully recover the amortized cost basis, the
credit component of the other-than-temporary impairment is recognized in net realized gains (losses) on investments in the consolidated statements of operations and the non-credit component of the other-than-temporary impairment is recognized
directly in shareholders' equity within accumulated other comprehensive income (loss).
In conjunction with the adoption of ASU 2016-01, unrealized gains or losses on equity securities are now recognized in the consolidated statements of operations and are no longer evaluated for other-than-temporary
declines.
It is important to note that all available-for-sale securities included in the Company's consolidated financial statements are valued at current fair market values. The evaluation process for determination of an
other-than-temporary decline in the value of investments, as described above, does not change these valuations but, rather, determines when a decline in value will be recognized in the consolidated statements of operations (other-than-temporary
decline), as opposed to a charge to shareholders' equity (temporary decline). This evaluation process is subject to risks and uncertainties because it is not always clear what has caused a decline in value of an individual security or because some
declines may be associated with market conditions or economic factors, which relate to an industry in general, but not necessarily to an individual issue. The Company has attempted to minimize many of these uncertainties by adopting a largely
objective evaluation process as described above. However, to the extent that certain declines in value are reported as unrealized at December 31, 2019, it is possible that future earnings charges will result should the declines in value increase or
persist or should the security actually be disposed of while market values are less than cost. At December 31, 2019, the total gross unrealized loss included in the Company's fixed income portfolio was approximately $3.6 million. No individual
issue constituted a material amount of this total. Had this entire amount been considered other-than-temporary at December 31, 2019, there would have been no impact on total shareholders' equity or book value since the decline in value of these
securities was previously recognized as a reduction to shareholders' equity.
Reinsurance Recoverable
Reinsurance ceded transactions were as follows for the years ended December 31 (dollars in thousands):
A discussion of the Company's reinsurance strategies is presented in Part I, Item 1, "Business", of this Annual Report on Form 10-K.
Amounts recoverable under the terms of reinsurance contracts comprised approximately 26% of total Company assets as of December 31, 2019. In order to be able to provide the high limits required by the Company's
insureds, the Company shares a significant amount of the insurance risk of the underlying contracts with various insurance entities through the use of reinsurance contracts. Some reinsurance contracts provide that a loss will be shared among the
Company and its reinsurers on a predetermined pro-rata basis ("quota share"), while other contracts provide that the Company will keep a fixed amount of the loss, similar to a deductible, with reinsurers taking all losses above this fixed amount
("excess of loss"). Some risks are covered by a combination of quota share and excess of loss contracts. The computation of amounts due from reinsurers is based upon the terms of the various contracts and follows the underlying estimation process
for loss and loss expense reserves, as described below. Accordingly, the uncertainties inherent in the loss and loss expense reserving process also affect the amounts recorded as recoverable from reinsurers. Estimation uncertainties are greatest
for claims which have occurred but which have not yet been reported to the Company. Further, the high limits provided by certain of the Company's insurance policies for commercial automobile liability, workers' compensation and professional
liability risks provide more variability in the estimation process than lines of business with lower coverage limits.
It should be noted, however, that a change in the estimate of amounts due from reinsurers on unpaid claims will not, in itself, result in charges or credits to losses incurred. This is because any change in estimated
recovery follows the estimate of the underlying loss. Thus, it is the computation of the gross underlying loss that is critical.
As with any receivable, credit risk exists in the recoverability of reinsurance. This may be even more pronounced than in normal receivable situations since recoverable amounts are not generally due until the loss is
settled which, in some cases, may be many years after the contract was written. If a reinsurer is unable, in the future, to meet its financial commitments under the terms of the contracts, the Company would be responsible to satisfy the reinsurer's
portion of the loss. The financial condition of each of the Company's reinsurers is vetted upon the execution of a given treaty, and only reinsurers with superior credit ratings are utilized. However, as noted above, reinsurers are often not called
upon to satisfy their obligations for several years and changes in credit worthiness can occur in the interim period. Reviews of the current financial strength of each reinsurer are made frequently and, should impairment in the ability of a
reinsurer be determined to exist, current year operations would be charged in amounts sufficient to provide for the Company's additional liability. Such charges are included in other operating expenses, rather than losses and loss expenses incurred,
since the inability of the Company to collect from reinsurers is a credit loss rather than a deficiency associated with the loss reserving process.
Loss and Loss Expense Reserves
The Company's reserves for losses and loss expenses ("reserves") are determined based on complex estimation processes using historical experience, current economic information and available industry statistics. The
Company's claims range from routine "fender benders" to the highly complex and costly third-party bodily injury claims involving large tractor-trailer rigs. Reserving for each class of claims requires a set of assumptions based upon historical
experience, knowledge of current industry trends and seasoned judgment. The high limits provided in many of the Company's policies provide for greater volatility in the reserving process for more serious claims. Court rulings, legislative actions
and trends in jury awards also play a significant role in the estimation process of larger claims. The Company continuously reviews and evaluates loss developments subsequent to each measurement date and adjusts its reserve estimation assumptions,
as necessary, in an effort to achieve the best possible estimate of the ultimate remaining loss costs at any point in time. Changes to previously established loss and loss expense reserve amounts are charged or credited to losses and loss expenses
incurred in the accounting periods in which they are determined. See Note C, "Loss and Loss Expense Reserves," to the Consolidated Financial Statements in Part II, Item 8 of this Annual Report on Form 10-K for additional information relating to loss
and loss expense reserve development.
The Company's methods for determining loss and loss expense reserves are essentially identical for interim and annual reporting periods.
A detailed analysis and discussion for each of the above basic reserve categories follows:
Reserves for known losses (Case reserves)
Each known claim, regardless of complexity, is handled by a claims adjuster experienced with claims of a similar nature, and a "case" reserve appropriate for the individual loss occurrence is established. For routine
"short-tail" claims, such as physical damage, the Company records an initial reserve that is based upon historical loss settlements adjusted for current trends. As information regarding the loss occurrence is gathered in the claim handling process,
the initial reserve is adjusted to reflect the anticipated ultimate cost to settle the claim. For more complex claims, which can tend toward being "long-tail" in nature, an experienced claims adjuster will review the facts and circumstances
surrounding the loss occurrence to make a determination of the reserve to be established. Many of the more complex claims involve litigation and necessitate an evaluation of potential jury awards, in addition to the factual information, to determine
the value of each claim. Each claim is frequently monitored and the recorded reserve is increased or decreased relative to information gathered during the settlement life cycle.
Reserves for incurred but not reported losses
The Company uses both standard actuarial techniques common to most insurance companies as well as proprietary techniques developed by the Company in connection with its specialty business products. For its short-tail
lines of business, the Company uses predominantly the incurred or paid loss development factor methods. The Company has found that the use of accident quarter loss development triangles, rather than those based upon accident year, are most
responsive to claim settlement trends and fluctuations in premium exposure for its short-tail lines. A minimum of 12 running accident quarters is used to project the reserve necessary for incurred but not reported ("IBNR") losses for its short-tail
lines.
The Company also uses the loss development factor approach for its long-tail lines of business. A minimum of 15 accident years is included in the loss development triangles used to calculate link ratios and the
selected loss development factors used to determine the reserves for IBNR losses. A minimum of 20 accident years is used for long-tail workers' compensation reserve projections. Significant emphasis is placed on the use of tail factors for the
Company's long-tail lines of business.
For the Company's commercial automobile risks, which are covered by regularly changing reinsurance agreements and which contain wide-ranging self-insured retentions ("SIR"), traditional actuarial methods are
supplemented by other methods, as described below, in consideration of the Company's exposures to loss. In situations where the Company's reinsurance structure, the insured's SIR selections, policy volume, and other factors are changing, current
accident period loss exposures may not be homogenous enough with historical loss data to allow for reliable projection of future developed losses. Therefore, the Company supplements the above-described actuarial methods with loss ratio reserving
techniques developed from the Company's proprietary databases to arrive at the reserve for IBNR losses for the calendar/accident period under review. As losses for a given calendar/accident period develop with the passage of time, management
evaluates such development on a monthly and quarterly basis and adjusts reserve factors, as necessary, to reflect current judgment with regard to the anticipated ultimate incurred losses. This process continues until all losses are settled for each
period subject to this method.
Reserves for loss adjustment expenses
While certain of the Company's products involve case basis reserving for allocated loss adjustment expenses, the majority of such reserves are determined on a bulk basis. The Company uses historical analysis of the
ratios of allocated loss adjustment expenses paid to losses paid on closed claims to arrive at the expected ultimate incurred loss adjustment expense factors applicable to each affected product. Once developed, the factors are applied to the
expected ultimate incurred losses, including IBNR, on all open claims. The resulting ultimate incurred allocated loss adjustment expense is then reduced by amounts paid to date on all open claims to arrive at the reserve for allocated loss
adjustment expenses to be incurred in the future for the handling of specific claims.
For those loss adjustment expenses not specific to individual claims (general claims handling expenses referred to as unallocated loss adjustment expenses), the Company uses a variation of the standard industry loss
adjustment expenses paid to losses paid (net of reinsurance) ratio analysis that equally weighs paid and incurred losses to establish the necessary reserves. The selected factors are applied to 100% of IBNR reserves and to case reserves, with
consideration given for that portion of loss adjustment expense already paid at the reserve measurement date. Such factors are monitored and revised, as necessary, on a quarterly basis.
Sensitivity Analysis - Potential impact on reserve volatility from changes in key assumptions
Management is aware of the potential for variation from the reserves established at any particular point in time. Savings or deficiencies could develop in future valuations of the currently established loss and loss
expense reserve estimates under a variety of reasonably possible scenarios. The Company's reserve selections are developed to be a "best estimate" of unpaid losses at a point in time and, due to the unique nature of its exposures, particularly in
the large commercial automobile excess product, ranges of reserve estimates are not established during the reserving process. However, basic assumptions that could potentially impact future volatility of the Company's valuations of current loss and
loss expense reserve estimates include, but are not limited to, the following:
Under reasonably possible scenarios, it is conceivable that the Company's selected loss estimates could be 10% or more redundant or deficient. The majority of the Company's reserves for losses and loss expenses, on a
net of reinsurance basis, relate to its commercial automobile products. Perhaps the most significant example of sensitivity to variation in the key assumptions is the loss ratio selection for the Company's commercial automobile products for policies
subject to certain major reinsurance treaties. The following table presents the approximate impacts on gross and net loss reserves of both a hypothetical 10 percentage point and a hypothetical 20 percentage point increase or decrease in the loss
factors actually utilized in the Company's reserve determination at December 31, 2019 for the prior seven treaty periods, which covers exposures earned on policies written between July 3, 2013 and December 31, 2019. The Company's selection of the
range of values presented should not be construed as the Company's prediction of future events, but rather simply an illustration of the impact of such events, should they occur.
The variation in impact from loss ratio increases and decreases is attributable to minimum and maximum premium rate factors included in the various reinsurance contracts. In between the minimum and maximum ceded
premium provisions within the treaty terms, net premiums earned can be increased or decreased based on a change in loss expectation. The total impact to profitability in the same scenarios is shown below ($ in millions):
Federal Income Tax Considerations
The liability method is used in accounting for federal income taxes. Using this method, deferred tax assets and liabilities are determined based on differences between financial reporting and tax bases of assets and
liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. The provision for deferred federal income tax is based on items of income and expense that are reported in
different years in the consolidated financial statements and tax returns and are measured at the tax rate in effect in the year the difference originated.
On December 22, 2017, the U.S. Tax Act was signed into law. The U.S. Tax Act lowered the U.S. corporate income tax rate from 35% to 21% effective January 1, 2018. GAAP requires the impact of tax legislation to be
recognized in the period in which the law was enacted. As a result of the U.S. Tax Act, the Company recorded a tax benefit of $9.6 million related to the remeasurement of its deferred tax assets and liabilities during the fourth quarter of 2017. As
of December 31, 2017, the IRS had not yet published all of the detailed regulations resulting from the enactment of the U.S. Tax Act; therefore, while the Company had not completed its accounting for the tax effects, it made a reasonable estimate of
the tax effects on its existing deferred tax balances at December 31, 2017. The Company finalized its accounting for the tax effects of the U.S. Tax Act during 2018. No material adjustments to income tax expense (benefit) were recorded in 2018.
Net deferred tax liabilities reported at December 31 are as follows (dollars in thousands):
Deferred tax assets at December 31, 2019 included approximately $11.5 million related to the timing of deductibility of loss and loss expense reserves, the majority of which relate to policy liability discounts
required by the Internal Revenue Code of 1986, as amended, which are perpetual in nature and, in the absence of the termination of the Company's business, will not, in the aggregate, reverse to a material degree in the foreseeable future. Unearned
premiums discount and deferred ceding commissions represent $2.5 million and $1.0 million of deferred tax assets, respectively. An additional $1.2 million relates to timing differences in the expensing of our stock compensation plans. The unrealized
gains in the Company's investment portfolios would allow for the recovery of this deferred tax at any time. The balance of deferred tax assets consists of various normal operating expense accruals and is not considered to be material. As a result of
its analysis, management has determined that no valuation allowance is necessary at December 31, 2019.
FASB provides guidance for recognizing and measuring uncertain tax positions and prescribes a threshold condition that a tax position must meet for any of the benefit of the uncertain tax position to be recognized in
the consolidated financial statements. Based on this guidance, management regularly analyzes tax positions taken or expected to be taken in a tax return based on the threshold condition prescribed. Tax positions that do not meet or exceed this
threshold condition are considered uncertain tax positions. Interest related to uncertain tax positions, if any, would be recognized in income tax expense. Penalties, if any, related to uncertain tax positions would be recorded in income tax
expense (benefit).
Impact of Inflation
To the extent possible, the Company attempts to recover the impact of inflation on loss costs and operating expenses by increasing the premiums it charges. Within the commercial automobile business, a majority of the
Company's accounts are charged as a percentage of an insured's gross revenue, mileage or payroll. As these charging bases increase with inflation, premium revenues are immediately increased. The remaining premium rates charged are adjustable only
at periodic intervals and often require state regulatory approval. Such periodic increases in premium rates may lag far behind cost increases.
To the extent inflation influences yields on investments, the Company is also affected. The Company's short-term and fixed investment portfolios are structured in direct response to available interest rates over the
yield curve. As available market interest rates fluctuate in response to the presence or absence of inflation, the yields on the Company's investments are impacted. Further, as inflation affects current market rates of return, previously committed
investments might increase or decline in value depending on the type and maturity of investment. For additional information, see Part II, Item 7A, "Quantitative and Qualitative Disclosures about Market Risk",
in this Annual Report on Form 10-K.
Inflation must also be considered by the Company in the creation and review of loss and loss adjustment expense reserves, as portions of these reserves are expected to be paid over extended periods of time. The
anticipated effect of inflation is implicitly considered when estimating liabilities for losses and loss adjustment expenses.
Contractual Obligations
The table below sets forth the amounts of the Company's contractual obligations at December 31, 2019.
The Company's loss and loss expense reserves do not have contractual maturity dates, and the exact timing of the payment of claims cannot be predicted with certainty. However, based upon historical payment patterns,
the above table presents an estimate of when the Company might expect its direct loss and loss expense reserves (without the benefit of reinsurance recoveries) to be paid. Timing of the collection of the related reinsurance recoverable, estimated to
be $432.1 million at December 31, 2019, or 44% of the loss and loss expense reserves presented in the above table, would approximate that of the above projected direct reserve payout but could lag behind such payments by several months in some
instances.
The investment commitment in the above table relates to a maximum unfunded capital obligation for a limited partnership investment at December 31, 2019. The actual call dates for such funding could vary from that
presented.
Borrowings made under the Company's line of credit can be called by the lender, under certain circumstances, with short notice. The Company entered into a new line of credit on August 9, 2018 with an expiration date
of August 9, 2022.
Off-Balance Sheet Arrangements
The Company has no off-balance sheet arrangements.