| National Interstate CORP ITEM 1A Risk Factors Please refer to “Forward-Looking Statements” following the Index in the front of this Form 10-K All material risks and uncertainties currently known regarding our business operations are included in this section |
| If any of the following risks, or other risks and uncertainties that we have not yet identified or that we currently consider not to be material, actually occur, our business, prospects, financial condition, results of operations and cash flows could be materially and adversely affected |
| If we expand our operations too rapidly and do not manage that expansion effectively, our financial performance could be adversely affected |
| We have experienced rapid growth since our incorporation in January of 1989 |
| We intend to continue to grow by developing new products, expanding into new product lines, expanding our insurance distribution network and, possibly, making strategic acquisitions (including the recently completed acquisition of TCC effective January 1, 2006) |
| Continued growth will impose significant demands on our management, including the need to identify, recruit, maintain and integrate additional employees |
| We may experience higher than anticipated indemnity losses arising from new and expanded insurance products |
| In addition, our systems, procedures and internal controls may not be adequate to support our operations as they expand |
| Any failure by us to manage our growth effectively could have a material adverse effect on our business, financial condition or results of operations |
| In addition, our historical growth rates may not accurately reflect our future growth rates or our growth potential |
| Because we are primarily a transportation insurer, conditions in that industry could adversely affect our business |
| Approximately 72dtta0prca of our gross written premiums for the year ended December 31, 2005 and 71dtta9prca for the year ended December 31, 2004 were generated from transportation insurance policies including captive programs for transportation companies |
| Adverse developments in the market for transportation insurance could cause our results of operations to suffer |
| The transportation insurance industry is cyclical |
| Historically, the industry has been characterized by periods of price competition and excess capacity followed by periods of high premium rates and shortages of underwriting capacity |
| We believe we are currently in the part of the cycle marked by increased price competition, as compared to the peak of the hard market in 2002 and 2003 |
| These fluctuations in the business cycle could negatively impact our revenues |
| Additionally, our results may be affected by risks that impact the transportation industry related to severe weather conditions, such as rainstorms, snowstorms, hail and ice storms, floods, hurricanes, tornadoes and earthquakes, as well as explosions, terrorist attacks and riots |
| Our transportation insurance business also may be affected by cost trends that negatively impact profitability such as inflation in vehicle repair costs, vehicle replacement parts costs, used vehicle prices, fuel costs and medical care costs |
| Increased litigation of claims may also negatively impact our profitability |
| Our growth strategy includes expanding into product lines in which we have limited experience |
| We are continually evaluating new lines of business to add to our product mix |
| In some instances we have limited experience with marketing and managing these new product lines and insuring the types of risks involved |
| Our failure to effectively analyze new underwriting risks, set adequate premium rates and establish reserves for these new products, or efficiently adjust claims arising from these new products, could have a material adverse effect on our business, financial condition or results of operations |
| During the start up period for new products, we generally set more conservative loss reserves, which could adversely affect our statutory capital, net income and dividends |
| 18 _________________________________________________________________ [76]Table of Contents We face competition from companies with greater financial resources, broader product lines, higher ratings and stronger financial performance than us, which may impair our ability to retain existing customers, attract new customers and maintain our profitability and financial strength |
| The commercial transportation insurance business is highly competitive and, except for regulatory considerations, there are relatively few barriers to entry |
| Many of our competitors are substantially larger and may enjoy better name recognition, substantially greater financial resources, higher ratings by rating agencies, broader and more diversified product lines and more widespread agency relationships than we do |
| We compete with large national underwriters and smaller niche insurance companies |
| In particular, in the specialty insurance market we compete against, among others, Lancer Insurance Company, Lincoln General Insurance Company (a subsidiary of Kingsway Financial Services, Inc |
| Our underwriting profits could be adversely impacted if new entrants or existing competitors try to compete with our products, services and programs or offer similar or better products at or below our prices |
| We have continued to develop alternative risk transfer programs (often known as captive insurance), attracting new customers as well as transitioning existing traditional customers into the alternative risk transfer programs which constituted approximately 38dtta4prca of our gross premiums written as of December 31, 2005 |
| We believe these programs help solidify the customer relationship and the retention of our customer base |
| A departure of an entire captive program due to competition could adversely affect our results |
| If we are not able to attract and retain independent agents and brokers, our revenues could be negatively affected |
| We compete with other insurance carriers to attract and retain business from independent agents and brokers |
| Some of our competitors offer a larger variety of products, lower prices for insurance coverage or higher commissions than we offer |
| Our top ten independent agents/brokers accounted for an aggregate of 27dtta1prca of our direct premiums written during the year ended December 31, 2005, and our top two independent agents/brokers accounted for an aggregate of 11dtta2prca of our direct premiums written during the year ended December 31, 2005 |
| If we are unable to attract and retain independent agents/brokers to sell our products, our ability to compete and attract new customers and our revenues would suffer |
| We are subject to comprehensive regulation, and our ability to earn profits may be restricted by these regulations |
| We are subject to comprehensive regulation by government agencies in the states and foreign jurisdictions where our insurance company subsidiaries are domiciled (Ohio, Hawaii, Pennsylvania and the Cayman Islands) and, to a lesser degree, where these subsidiaries issue policies and handle claims |
| Failure by one of our insurance company subsidiaries to meet regulatory requirements could subject us to regulatory action |
| The regulations and associated examinations may have the effect of limiting our liquidity and may adversely affect results of operations |
| We must comply with statutes and regulations relating to, among other things: • statutory capital and surplus and reserve requirements; • standards of solvency that must be met and maintained; • payment of dividends; • changes of control of insurance companies; • transactions between an insurance company and any of its affiliates; • licensing of insurers and their agents; • types of insurance that may be written; • market conduct, including underwriting and claims practices; 19 _________________________________________________________________ [77]Table of Contents • provisions for unearned premiums, losses and other obligations; • ability to enter and exit certain insurance markets; • nature of and limitations on investments, premium rates, or restrictions on the size of risks that may be insured under a single policy; • privacy practices; • deposits of securities for the benefit of policyholders; • prior approval of certain corporate transactions; • payment of sales compensation to third parties; • approval of policy forms; and • guaranty fund and voluntary market regulations and assessments |
| In addition, state insurance department examiners perform periodic financial, market conduct and other examinations of insurance companies |
| Compliance with applicable laws and regulations is time consuming and personnel-intensive |
| The Company’s last financial examination was completed by the Ohio Department of Insurance on June 18, 2003 for the period ending December 31, 2001 |
| We were notified in 2005 that Departments of Insurance from Ohio, Pennsylvania and Hawaii will be examining the Company’s insurance subsidiaries in 2006 for the period ending December 31, 2005 |
| We expect the state of Ohio to coordinate this examination |
| Any adverse findings by these insurance departments, or any others that conduct examinations, can result in significant fines and penalties, negatively affecting our profitability |
| We have not been notified by any regulatory agency that we are in violation of any of the applicable laws and regulations referred to above nor are we aware of any such violation |
| In addition, insurance-related laws and regulations may become more restrictive in the future, and new restrictive laws may be enacted |
| New or more restrictive regulation in the future, including changes in current tax or other regulatory interpretations affecting the alternative risk transfer insurance model, could make it more expensive for us to conduct our business, restrict the premiums we are able to charge or otherwise change the way we do business |
| For a further discussion of the regulatory framework in which we operate, see the subsection of “Business” entitled “Regulation |
| ” As a holding company, we are dependent on the results of operations of our insurance company subsidiaries to meet our obligations and pay future dividends |
| The Company is a holding company and a legal entity separate and distinct from its insurance company subsidiaries |
| As a holding company without significant operations of its own, one of the Company’s sources of funds are dividends and other distributions from its insurance company subsidiaries |
| As discussed under the subsection of “Business” entitled “Regulation,” statutory and regulatory restrictions limit the aggregate amount of dividends or other distributions that our insurance subsidiaries may declare or pay within any twelve-month period without advance regulatory approval, and require insurance companies to maintain specified levels of statutory capital and surplus |
| Insurance regulators have broad powers to prevent reduction of statutory surplus to inadequate levels and could refuse to permit the payment of dividends calculated under any applicable formula |
| As a result, we may not be able to receive dividends from our insurance subsidiaries at times and in amounts necessary to meet our operating needs, to pay dividends to our shareholders or to pay corporate expenses |
| We are currently rated “A” (Excellent) by AM Best, their third highest rating out of 16 rating categories |
| A decline in our rating below “A−” could adversely affect our position in the insurance market, make it more difficult to market our insurance products and cause our premiums and earnings to decrease |
| Financial ratings are an important factor influencing the competitive position of insurance companies |
| AM Best ratings, which are commonly used in the insurance industry, currently range from “A++” (Superior) to “F” (In Liquidation), with a total of 16 separate ratings categories |
| AM Best currently assigns us a financial strength rating of “A” (Excellent) |
| This is a recent upgrade from our previous rating of “A−” prior to June 2004 |
| The objective of AM Best’s rating system is to provide potential policyholders and other interested parties an opinion 20 _________________________________________________________________ [78]Table of Contents of an insurer’s financial strength and ability to meet ongoing obligations, including paying claims |
| This rating reflects AM Best’s analysis of our balance sheet, financial position, capitalization and management |
| It is not an evaluation of an investment in our common shares, nor is it directed to investors in our common shares and is not a recommendation to buy, sell or hold our common shares |
| This rating is subject to periodic review and may be revised downward, upward, or revoked at the sole discretion of AM Best |
| If our rating is reduced by AM Best below our previous rating of “A−”, we believe that our competitive position in the insurance industry could suffer, and it could be more difficult for us to market our insurance products |
| A downgrade could result in a significant reduction in the number of insurance contracts we write and in a substantial loss of business, as such business could move to other competitors with higher ratings, causing premiums and earnings to decrease |
| New claim and coverage issues are continually emerging in the insurance industry, and these new issues could negatively impact our revenues, our business operations or our reputation |
| As insurance industry practices and regulatory, judicial, and industry conditions change, unexpected and unintended issues related to pricing, claims, coverage and business practices may emerge |
| Plaintiffs often target property and casualty insurers in purported class action litigation relating to claims handling and insurance sales practices |
| A recent example of emerging class action litigation relates to the use of an applicant’s credit rating as a factor in making risk selection and pricing decisions |
| The resolution and implications of new underwriting, claims and coverage issues could have a negative effect on our insurance business by extending coverage beyond our underwriting intent, increasing the size of claims or otherwise requiring us to change our business practices |
| The effects of unforeseen emerging claim and coverage issues could negatively impact our revenues, results of operations and our reputation |
| If our claims payments and related expenses exceed our reserves, our financial condition and results of operations could be adversely affected |
| Our success depends upon our ability to accurately assess and price the risks covered by the insurance policies that we write |
| We establish reserves to cover our estimated liability for the payment of all losses and loss adjustment expenses incurred with respect to premiums earned on the insurance policies that we write |
| Reserves do not represent an exact calculation of liability |
| Rather, reserves are estimates of our expectations regarding the ultimate cost of resolution and administration of claims under the insurance policies that we write |
| These estimates are based upon actuarial and statistical projections, assessments of currently available data, historical claims information, as well as estimates and assumptions regarding future trends in claims severity and frequency, judicial theories of liability and other factors |
| We continually refine our reserve estimates in an ongoing process as experience develops and claims are reported and settled |
| Each year, our reserves are certified by an accredited actuary from Great American |
| Establishing an appropriate level of reserves is an inherently uncertain process |
| The following factors may have a substantial impact on our future actual losses and loss adjustment expense experience: • the amount of claims payments; • the expenses that we incur in resolving claims; • legislative and judicial developments; and • changes in economic conditions, including the effect of inflation |
| Such developments could cause our level of reserves to be inadequate |
| To the extent that actual losses and loss adjustment expenses exceed expectations and the reserves reflected on our financial statements, we will be required to immediately reflect those changes by increasing reserves |
| When we increase reserves, the pre-tax income for the period in which we do so will decrease by a corresponding amount |
| In addition to having a negative effect on reserves and pre-tax income, increasing or “strengthening” reserves causes a reduction in our insurance companies’ surplus and could cause a downgrading of the rating of our insurance company subsidiaries |
| Such a downgrade could, in turn, adversely affect our ability to sell insurance policies |
| 21 _________________________________________________________________ [79]Table of Contents Our inability to retain our senior executives and other key personnel could adversely affect our business |
| Our success depends in part upon the ability of our executive management and other key personnel to implement our business strategy and on our ability to attract and retain qualified employees |
| The Company’s loss of certain senior executives and other key personnel or the failure to attract and develop talented new executives and managers could adversely affect our business |
| We currently have an employee retention agreement with only one member of our executive management |
| Market fluctuations, changes in interest rates or a need to generate liquidity can have significant and negative effects on our investment portfolio |
| Our results of operations depend in part on the performance of our invested assets |
| As of December 31, 2005, 87dtta2prca of our investment portfolio (excluding cash and cash equivalents) was invested in fixed maturities and 10dtta3prca was invested in equity securities |
| As of December 31, 2005, approximately 68dtta7prca of our fixed maturity portfolio was invested in US Government and government agency fixed income securities and approximately 97dtta0prca was invested in fixed maturities rated “AAA”, “AA” and “A” by Standard & Poor’s Corporation |
| Certain risks are inherent in investing in fixed maturities including loss upon default and price volatility in reaction to changes in interest rates and general market factors |
| The fair value of our fixed maturities will fluctuate as interest rates change |
| The current environment of increasing interest rates may cause the market value of our fixed maturities to decrease |
| At December 31, 2005, we had pretax net unrealized losses of dlra4dtta4 million on fixed maturities |
| Changes in interest rates may result in fluctuations in the income from, and the valuation of, our fixed income investments |
| Large investment losses would significantly decrease our asset base, and affect our ability to underwrite new business |
| Historically, and during the most recent extended low interest rate period, we have not had the need to sell our investments to generate liquidity |
| If we were forced to sell portfolio securities early for liquidity purposes rather than holding them to maturity, we would recognize gains or losses on those securities earlier than anticipated |
| We may not be successful in reducing our risk and increasing our underwriting capacity through reinsurance arrangements, which could adversely affect our business, financial condition and results of operations |
| In order to reduce our underwriting risk and increase our underwriting capacity, we transfer portions of our insurance risk to other insurers through reinsurance contracts |
| Ceded premiums written amounted to 21dtta8prca and 26dtta0prca, respectively, of our gross premiums written for the year ended December 31, 2005 and 2004 |
| The availability, cost and structure of reinsurance protection are subject to prevailing market conditions that are outside of our control and which may affect our level of business and profitability |
| We have recently increased our participation in the risk retention for certain products in part because we believe the current price increases in the reinsurance market are excessive for the reinsurance exposure assumed |
| In order for these contracts to qualify for reinsurance accounting and to provide the additional underwriting capacity that we desire, the reinsurer generally must assume significant risk and have a reasonable possibility of a significant loss |
| Our reinsurance facilities are generally subject to annual renewal |
| We may be unable to maintain our current reinsurance facilities or obtain other reinsurance facilities in adequate amounts and at favorable rates |
| If we are unable to renew our expiring facilities or 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 which could adversely impact our results of operations |
| We are subject to credit risk with respect to the obligations of our reinsurers and certain of our insureds |
| The inability of our risk sharing partners to meet their obligations could adversely affect our profitability |
| Although the reinsurer is liable to us to the extent of risk ceded by us, we remain ultimately liable to the policyholder on all risks, even those reinsured |
| As a result, ceded reinsurance arrangements do not limit our ultimate obligations to policyholders to pay claims |
| We are subject to credit risks with respect to the financial strength of our reinsurers |
| We are also subject to the risk that our reinsurers may dispute their obligations to pay our claims |
| As a result, we may not recover sufficient amounts for claims that we submit to our reinsurers in a timely manner, if at all |
| 22 _________________________________________________________________ [80]Table of Contents As of December 31, 2005, we had a total of dlra68dtta7 million of unsecured reinsurance recoverables and our largest unsecured recoverable from a single reinsurer, Platinum Underwriters Reinsurance, was dlra32dtta2 million |
| In addition, our reinsurance agreements are subject to specified limits and we would not have reinsurance coverage to the extent that we exceed those limits |
| With respect to our insurance programs, we are subject to credit risk with respect to the payment of claims and on the portion of risk exposure either ceded to the captives or retained by our clients |
| The credit worthiness of prospective risk sharing partners is a factor we consider when entering into or renewing these alternative risk transfer programs |
| We typically collateralize balances due through funds withheld or letters of credit |
| To date, we have not, in the aggregate, experienced material difficulties in collecting balances from our risk sharing partners |
| No assurance can be given, however, regarding the future ability of these entities to meet their obligations |
| The inability of our risk sharing partners to meet their obligations could adversely affect our profitability |
| We may not be successful in executing our business plan for our US Virgin Islands servicing operations |
| Hudson Management Group, Ltd |
| was formed on July 29, 2004 and received approval of its application to the US Virgin Islands Economic Development Commission for a grant of certain tax abatements and other benefits in June, 2005 |
| We have hired an initial staff of professionals, but in order to execute our business plan, we will need to hire additional qualified professionals and possibly obtain additional regulatory approvals |
| We also need to establish critical market relationships with our insurance customers and adopt procedures and controls necessary to operate effectively and profitably |
| Finally, we have developed a business strategy for our US Virgin Islands servicing operations based on professional advice and available guidance from the Internal Revenue Service |
| Our failure to effectively implement our business plan could prevent us from realizing our US Virgin Islands operating efficiencies |
| Your interests as a holder of our common shares may be different than the interests of our majority shareholder, Great American Insurance Company |
| As of December 31, 2005, American Financial Group, Inc, through its wholly-owned subsidiary Great American, owns 53dtta5prca of our outstanding common shares |
| The interests of American Financial Group, Inc |
| may differ from the interests of our other shareholders |
| American Financial Group, Inc |
| ’s representatives hold four out of eight seats of our Board of Directors |
| As a result, American Financial Group, Inc |
| has the ability to exert significant influence over our policies and affairs including the power to affect the election of our Directors, appointment of our management and the approval of any action requiring a shareholder vote, such as amendments to our Articles of Incorporation or Code of Regulations, transactions with affiliates, mergers or asset sales |
| Subject to the terms of our right of first refusal to purchase its shares in certain circumstances, American Financial Group, Inc |
| may be able to prevent or cause a change of control of the Company by either voting its shares against or for a change of control or selling its shares and causing a change of control |
| The ability of our majority shareholder to prevent or cause a change of control could delay or prevent a change of control, or cause a change of control to occur at a time when it is not favored by other shareholders |
| As a result, the trading price of our common shares could be adversely affected |
| We may have conflicts of interest with our majority shareholder, Great American Insurance Company, that we are unable to resolve in our favor |
| From time to time, Great American and its affiliated companies engage in underwriting activities and enter into transactions or agreements with us or in competition with us, which may give rise to conflicts of interest |
| We do not have any agreement or understanding with any of these parties regarding the resolution of potential conflicts of interest |
| In addition, we may not be in a position to influence any party’s decision not to engage in activities that would give rise to a conflict of interest |
| These parties may take actions that are not in the best interests of our other shareholders |
| We rely on Great American to provide certain services to us including internal audit, actuarial, legal, and other support services |
| If Great American no longer controlled a majority of our shares, it is possible that many of these 23 _________________________________________________________________ [81]Table of Contents services would cease or, alternatively be provided at an increased cost to us |
| This could impact our personnel resources, require us to hire additional professional staff and generally increase our operating expenses |
| Provisions in our organizational documents, Ohio corporate law and the insurance laws of Ohio, Pennsylvania and Hawaii could impede an attempt to replace or remove our management or Directors or prevent or delay a merger or sale, which could diminish the value of our common shares |
| Our Amended and Restated Articles of Incorporation and Code of Regulations, the corporate laws of Ohio and the insurance laws of various states contain provisions that could impede an attempt to replace or remove our management or Directors or prevent the sale of our Company that shareholders might consider to be in their best interests |
| These provisions include, among others: • a classified Board of Directors consisting of eight Directors divided into two classes; • the inability of our shareholders to remove a Director from the Board without “cause;” • requiring a vote of holders of 50prca of the common shares to call a special meeting of the shareholders; • requiring a two-thirds vote to amend the shareholder protection provisions of our Code of Regulations and to amend the Articles of Incorporation; • requiring the affirmative vote of a majority of the voting power of our shares represented at a special meeting of shareholders; • excluding the voting power of interested shares to approve a “control share acquisition” under Ohio law; and • prohibiting a merger, consolidation, combination or majority share acquisition between us and an interested shareholder or an affiliate of an interested shareholder for a period of three years from the date on which the shareholder first became an interested shareholder, unless previously approved by our Board |
| These provisions may prevent shareholders from receiving the benefit of any premium over the market price of our common shares offered by a bidder in a potential takeover |
| In addition, the existence of these provisions may adversely affect the prevailing market price of our common shares if they are viewed as discouraging takeover attempts |
| The insurance laws of most states require prior notice or regulatory approval of changes in control of an insurance company or its holding company |
| The insurance laws of the States of Ohio, Hawaii and Pennsylvania, where our US insurance companies are domiciled, provide that no corporation or other person may acquire control of a domestic insurance or reinsurance company unless it has given notice to such insurance or reinsurance company and obtained prior written approval of the relevant insurance regulatory authorities |
| Any purchaser of 10prca or more of our aggregate outstanding voting power could become subject to these regulations and could be required to file notices and reports with the applicable regulatory authorities prior to such acquisition |
| In addition, the existence of these provisions may adversely affect the prevailing market price of our common shares if they are viewed as discouraging takeover attempts |
| See the subsection of “Business” entitled “Regulation |
| ” Future sales of our common shares may affect the trading price of our common shares |
| We cannot predict what effect, if any, future sales of our common shares, or the availability of common shares for future sale, will have on the trading price of our common shares |
| Sales of substantial amounts of our common shares in the public market by Great American Insurance Company or our other shareholders, or the possibility or perception that such sales could occur, could adversely affect prevailing market prices for our common shares |
| If such sales reduce the market price of our common shares, our ability to raise additional capital in the equity markets may be adversely affected |
| Great American and Alan Spachman, our Chairman and President, currently have the right to require us to register all of their common shares, subject to restrictions |
| Great American and Alan Spachman own 10cmam200cmam000 and 3cmam080cmam000, respectively, of the Company’s issued and outstanding shares |
| We are now obligated to register the shares of Great American (and those of our President and Chairman Alan Spachman) and intend to file a registration statement on Form S-3, covering all such shares, immediately following the release of this Annual Report on 24 _________________________________________________________________ [82]Table of Contents Form 10-K Upon the effectiveness of any such registration statement, all shares covered by that registration statement could be sold into the public markets |
| In addition, we filed a registration statement on Form S-8 under the Securities Act to register 1cmam338cmam800 of the common shares issued or reserved for issuance for awards granted under our Long Term Incentive Plan |
| Shares registered under the registration statement on Form S-8 also could be sold into the public markets, subject to applicable vesting provisions and any volume limitations and other restrictions applicable to our officers and Directors selling shares under Rule 144 |
| The sale of the shares under these registration statements in the public market, or the possibility or perception that such sales could occur, could adversely affect prevailing market prices for our common shares |
| We completed our initial public offering in February 2005, and we do not have a significant presence in the market |
| You may have difficulty selling your common shares because of the limited trading volume for such shares |
| As a new public company whose common shares recently began trading on the Nasdaq National Market, there may be less coverage by security analysts, the trading price may be lower, and it may be more difficult for our shareholders to dispose of their common shares due to the lower trading volume in our common shares |
| Our lack of a significant presence in the market could serve to limit the distribution of news relating to National Interstate and limit investor interest in our common shares |
| In addition, the Company does not manage analysts’ or investors’ earnings expectations |
| One or more of these factors could result in price volatility and serve to depress the liquidity and market prices of our common shares |
| We face ongoing challenges as a result of being a public company and our financial results could be adversely affected |
| As a public company, we incur significant legal, accounting and other expenses that result from corporate governance requirements, including requirements under the Sarbanes-Oxley Act of 2002, as well as rules implemented by the Securities and Exchange Commission and the National Association of Securities Dealers |
| We expect these rules and regulations to increase our legal and finance compliance costs and to make some activities more time-consuming and costly |
| We continue to evaluate and monitor developments with respect to compliance with public company requirements, and we cannot predict or estimate the amount or timing of additional costs we may incur |
| Once we become an accelerated filer, as defined by Securities and Exchange Commission rules and regulations, we will be required to comply with Section 404 of the Sarbanes-Oxley Act relating to internal controls over financial reporting |
| This will occur for the year ending December 31, 2006 |
| We have committed a significant amount of resources to cure any internal control deficiencies in advance of that deadline |
| Any failure to do so could adversely impact our operating results |