As filed with the Securities and Exchange Commission on September 26, 2006

Registration No. 333-      

 

UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

 

 

 

Form S-1
REGISTRATION STATEMENT
UNDER
THE SECURITIES ACT OF 1933

 

 

 

AMERISAFE, Inc.
(Exact name of registrant as specified in its charter)

 

 

2301 Highway 190 West
DeRidder, Louisiana 70634
(337) 463-9052
(Address, including zip code, and telephone number, including area code, of registrant’s principal executive offices)

 

 

 

Todd Walker
Executive Vice President, General Counsel and Secretary
2301 Highway 190 West
DeRidder, Louisiana 70634
(337) 463-9052
(Name, address, including zip code, and telephone number, including area code, of agent for service)

 

 

 

Copies to:

 

 

 

Approximate date of commencement of proposed sale to the public:  As soon as practicable after the Registration Statement becomes effective.

 

If any of the securities being registered on this form are to be offered on a delayed or continuous basis pursuant to Rule 415 under the Securities Act of 1933, check the following box.  o

 

If this form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, please check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  o

 

If this form is a post-effective amendment filed pursuant to Rule 462(c) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  o

 

If this form is a post-effective amendment filed pursuant to Rule 462(d) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  o

 

CALCULATION OF REGISTRATION FEE

 

 

 

 

 

The Registrant hereby amends this Registration Statement on such date or dates as may be necessary to delay its effective date until the Registrant shall file a further amendment which specifically states that this Registration Statement shall thereafter become effective in accordance with Section 8(a) of the Securities Act of 1933 or until the Registration Statement shall become effective on the date as the Commission, acting pursuant to said Section 8(a), may determine.

 

 

SUBJECT TO COMPLETION, DATED SEPTEMBER 26, 2006

 

 

6,832,004 Shares

		AMERISAFE, Inc.

Common Stock

 

 

 

 

This prospectus covers the sale of 6,832,004 shares of our common stock by the selling shareholders named in this prospectus. We will not receive any proceeds from the sale of the shares by the selling shareholders.

 

Our common stock is listed on the NASDAQ Global Select Market under the symbol “AMSF.” On September 25, 2006, the last sale price of our common stock as reported by the NASDAQ Global Select Market was $9.98 per share.

 

Investing in our common stock involves risks. See “Risk Factors” beginning on page 9 to read about factors you should consider before buying our common stock.

 

 

 

 

*  See “Underwriting” on page 106 for a description of the underwriters’ compensation.

 

To the extent that the underwriters sell more than 6,832,004 shares of common stock, certain of the selling shareholders have granted the underwriters a 30-day option to purchase up to 1,024,801 additional shares of common stock at the public offering price, less the underwriting discount, to cover over-allotments, if any.

 

Neither the Securities and Exchange Commission nor any state securities commission or other regulatory body has approved or disapproved of these securities or passed upon the accuracy or adequacy of this prospectus. Any representation to the contrary is a criminal offense.

 

The underwriters expect to deliver the shares of common stock to purchasers on or about          , 2006.

 

 

 

 

 

The date of this prospectus is          , 2006.

 

TABLE OF CONTENTS

 

 

PROSPECTUS SUMMARY

	•	Construction. Includes a broad range of operations such as highway and bridge construction, building and maintenance of pipeline and powerline networks, excavation, commercial construction, roofing, iron and steel erection, tower erection and numerous other specialized construction operations. Our gross premiums written in 2005 for employers in the construction industry were $117.1 million, or 40.3% of total gross premiums written in 2005.
	•	Trucking. Includes a large spectrum of diverse operations including contract haulers, regional and local freight carriers, special equipment transporters and other trucking companies that conduct a variety of short- and long-haul operations. Our gross premiums written in 2005 for employers in the trucking industry were $59.3 million, or 20.4% of total gross premiums written in 2005.
	•	Logging. Includes tree harvesting operations ranging from labor intensive chainsaw felling and trimming to sophisticated mechanized operations using heavy equipment. Our gross premiums written in 2005 for employers in the logging industry were $26.3 million, or 9.0% of gross premiums written in 2005.

		As of and for the
		Three Months Ended
		June 30, 2006				March 31, 2006				December 31, 2005
		(Unaudited) (In thousands)
Gross premiums written		$	92,151			$	80,819			$	59,709
Net premiums written			87,427				76,368				53,098
Net premiums earned			72,107				67,874				67,198
Net investment income			5,843				5,973				4,897
Net income			7,818				7,236				5,404
Cash, cash equivalents and investments		$	616,755			$	600,767			$	582,904
Total shareholders’ equity			162,510				156,184				147,346
Net combined ratio(1)			95.2	%			95.0	%			96.7	%
Return on average equity(2)			19.6	%			19.1	%			18.3	%
Book value per share(3)		$	8.18			$	7.86			$	7.42

(1)		The net combined ratio is the sum of the net loss ratio, the net underwriting expense ratio and the net dividend ratio.
(2)		Return on average equity is calculated as annualized net income divided by average shareholders’ equity plus redeemable preferred stock.
(3)		Book value per share is calculated by dividing shareholders’ equity plus redeemable preferred stock at the date indicated by the number of shares of common stock outstanding (including 2,429,541 shares of common stock issuable upon conversion of our Series C and Series D convertible preferred stock at the current conversion price of $20.58 per share). As of September 30, 2005, the book value of our common stock, after giving effect to the completion of our initial public offering in November 2005, was $7.16 per share.

	•	Focus on Hazardous Industries. We have extensive experience insuring employers engaged in hazardous industries and have a history of profitable underwriting in these industries. Our specialized knowledge of these hazardous industries helps us better serve our policyholders, which leads to greater employer loyalty and policy retention. Our policy renewal rate on voluntary business that we elected to quote for renewal was 90.6% in 2005, 93.0% in 2004 and 91.4% in 2003.
	•	Focus on Small to Mid-Sized Employers. We believe large insurance companies generally do not target small to mid-sized employers in hazardous industries due to their smaller premium size, type of operations, mobile workforce and extensive service needs. We provide enhanced customer services to our policyholders. For example, unlike many of our competitors, our premium payment plans enable our policyholders to better match their premium payments with their payroll costs.
	•	Specialized Underwriting Expertise. Based on our 20-year underwriting history of insuring employers engaged in hazardous industries, we have developed industry specific risk analysis and rating tools to assist our underwriters in risk selection and pricing. Our 19 underwriting professionals average approximately 12 years of experience underwriting workers’ compensation insurance, most of which was focused on hazardous industries. We are highly disciplined when quoting and binding new business. In 2005, we offered quotes on approximately one out of four applications submitted. We do not delegate underwriting authority to agencies that sell our insurance or to any other third party.
	•	Comprehensive Safety Services. We provide proactive safety reviews of employers’ worksites, which are often located in rural areas. These safety reviews are a vital component of our underwriting process and also assist our policyholders in loss prevention and encourage the safest workplaces possible by deploying experienced field safety professionals, or FSPs, to our policyholders’ worksites. Our 52 FSPs have an average of approximately 13 years of workplace safety or related industry experience. In 2005, approximately 91.0% of our new voluntary business policyholders were subject to pre-quotation safety inspections. We perform periodic on-site safety surveys on all of our voluntary business policyholders.
	•	Proactive Claims Management. As of June 30, 2006, our employees managed more than 98% of our open claims in-house utilizing our intensive claims management practices that emphasize a personal approach and quality, cost-effective medical treatment. Our claims management staff includes 93 field case managers, or FCMs, who average approximately 17 years of experience in the workers’ compensation insurance industry. We currently average approximately 56 open indemnity claims per FCM, which we believe is significantly less than the industry. We believe our claims management practices allow us to achieve a more favorable claim outcome, accelerate an employee’s return to work and more rapidly close claims, all of which ultimately lead to lower overall costs. In addition, we believe our practices lessen the likelihood of litigation. Only 9.7% and 22.9% of all claims reported for accident years 2004 and 2005, respectively, were open as of June 30, 2006.

	•	Expand in our Existing Markets. Our market share in each of the nine states where we derived 5% or more of our gross premiums written in 2005 did not exceed 3% of the workers’ compensation market in that state based on data received from NCCI. Competition in our target markets is fragmented by state and employer industry focus. We believe that our specialized underwriting expertise and safety, claims and audit services position us to profitably increase our market share in our existing principal markets, with minimal increase in field service employees.
	•	Prudent and Opportunistic Geographic Expansion. We currently market our insurance in 26 states and the District of Columbia. At June 30, 2006, approximately 57.1% of our voluntary in-force premiums were generated in the nine states where we derived 5% or more of our gross premiums written in 2005. We are licensed in an additional 19 states and the U.S. Virgin Islands. Our existing licenses and rate filings will expedite our ability to write policies in these markets when we decide it is prudent to do so.
	•	Focus on Underwriting Profitability. We intend to maintain our underwriting discipline and profitability throughout market cycles. Our strategy is to focus on underwriting workers’ compensation insurance in hazardous industries and to maintain adequate rate levels commensurate with the risks we underwrite. We will also continue to strive for improved risk selection and pricing, as well as reduced frequency and severity of claims through comprehensive workplace safety reviews, rapid closing of claims through personal, direct contact with our policyholders and their employees, and effective medical cost containment measures.
	•	Leverage Existing Information Technology. We believe our customized information system, ICAMS, enhances our ability to select risk, write profitable business and cost-effectively administer our billing, claims and audit functions. We also believe our infrastructure is scalable and will enable us to accommodate our anticipated premium growth at current staffing levels and at minimal cost, which should have a positive effect on our expense ratio over time as we grow our premium base.
	•	Maintain Capital Strength. We completed our initial public offering in November 2005. Of the $53.0 million of net proceeds we retained from our initial public offering, we contributed $45.0 million to our insurance subsidiaries. The remaining $8.0 million will be used to make additional capital contributions to our insurance company subsidiaries as necessary to support our anticipated growth and for general corporate purposes. We plan to manage our capital to achieve our growth and profitability goals while maintaining a prudent operating leverage for our insurance company subsidiaries. To accomplish this objective, we intend to maintain underwriting profitability throughout market cycles, optimize our use of reinsurance and maximize an appropriate risk adjusted return on our growing investment portfolio. We presently expect that the net proceeds we retained from our initial public offering, combined with projected cash flow from operations, will provide us sufficient liquidity to fund our anticipated growth for at least the next 18 months.

	•	Adequacy of Premiums and Loss Reserves. Our loss reserves are based upon estimates that are inherently uncertain. These estimates may be inadequate to cover our actual losses, in which case we would need to increase our estimates and recognize a corresponding decrease in pre-tax net income for the period in which the change in our estimates occurs.
	•	Downgrade of our A.M. Best Rating. Our A.M. Best rating is subject to periodic review and, if it is downgraded, our business could be negatively affected by the loss of certain existing and potential policyholders and the loss of relationships with independent agencies.
	•	Cyclical Nature of the Workers’ Compensation Industry. The workers’ compensation insurance industry has historically fluctuated with periods of low premium rates and excess underwriting capacity resulting from increased competition followed by periods of high premium rates and shortages of underwriting capacity resulting from decreased competition. This cyclicality may cause our revenues and net income to fluctuate.
	•	Availability of Reinsurance. The availability, amount and cost of reinsurance are subject to market conditions and our experience with insured losses. If we are unable to obtain reinsurance on favorable terms, our ability to write new policies and renew existing policies could be adversely affected.
	•	Ability to Recover from Reinsurers. If any of our reinsurers is unable to meet any of its obligations to us, we would be responsible for all claims and claim settlement expenses that would otherwise be covered by our reinsurer. An inability to recover amounts due from our reinsurers would adversely affect our financial condition and results of operations.

Shares of common stock offered by selling shareholders		6,832,004 shares
Over-allotment shares of common stock offered by selling shareholders		1,024,801 shares
Shares of common stock to be outstanding after the offering		18,660,881 shares, including 1,214,771 shares issued immediately prior to the completion of this offering upon conversion of 250,000 shares of our convertible preferred stock held by certain of the selling shareholders.
Use of proceeds		All of the common stock offered hereby is being sold by the selling shareholders. We will not receive any proceeds from the sale of our common stock in this offering.
Dividend policy		We currently intend to retain any additional future earnings to finance our operations and growth. As a result, we do not expect to pay any cash dividends on our common stock for the foreseeable future.
		Our ability to pay dividends is subject to restrictions in our articles of incorporation that prohibit us from paying dividends on our common stock (other than in additional shares of common stock) without the consent of the holders of two-thirds of the outstanding shares of our convertible preferred stock. In addition, because AMERISAFE is a holding company and has no direct operations, our ability to pay dividends in the future may be limited by regulatory restrictions on the payment of dividends to AMERISAFE by our insurance company subsidiaries.
NASDAQ Global Select Market Symbol		“AMSF”

	•	1,214,770 shares issuable upon conversion of our then-outstanding Series C and Series D convertible preferred stock, subject to adjustment in certain circumstances;
	•	1,648,500 shares that may be issued pursuant to employee stock options outstanding as of the date of this prospectus, of which 1,548,500 were granted in November 2005 and 100,000 were granted in September 2006; all options vest 20% each year commencing on the first anniversary of the grant date; and
	•	276,112 additional shares available for future issuance under our equity incentive plans.

		Six Months Ended								Year Ended
		June 30,								December 31,
		2006				2005				2005				2004				2003				2002				2001
		(Unaudited)
		(In thousands, except share and per share data)
Income Statement Data
Gross premiums written		$	172,969			$	160,524			$	290,891			$	264,962			$	223,590			$	185,093			$	204,752
Ceded premiums written			(9,175	)			(9,697	)			(21,541	)			(21,951	)			(27,600	)			(26,563	)			(49,342	)
Net premiums written		$	163,794			$	150,827			$	269,350			$	243,011			$	195,990			$	158,530			$	155,410
Net premiums earned		$	139,981			$	125,032			$	256,568			$	234,733			$	179,847			$	163,257			$	170,782
Net investment income			11,816				7,650				16,882				12,217				10,106				9,419				9,935
Net realized gains (losses) on investments			2,235				774				2,272				1,421				316				(895	)			491
Fee and other income			355				306				561				589				462				2,082				1,367
Total revenues			154,387				133,762				276,283				248,960				190,731				173,863				182,575
Loss and loss adjustment expenses incurred			98,246				110,436	(2)			204,056	(2)			174,186				129,250				121,062				123,386
Underwriting and certain other operating costs(1)			17,435				14,697				33,008				28,987				23,062				22,674				23,364
Commissions			8,886				7,822				16,226				14,160				11,003				9,189				14,351
Salaries and benefits			8,209				7,048				14,150				15,034				15,037				16,541				17,148
Interest expense			1,656				1,326				2,844				1,799				203				498				735
Policyholder dividends			347				386				4				1,108				736				156				2,717
Total expenses			134,779				141,715				270,288				235,274				179,291				170,120				181,701
Income (loss) before taxes			19,608				(7,953	)			5,995				13,686				11,440				3,743				874
Income tax expense (benefit)			4,554				(3,669	)			65				3,129				2,846				(1,438	)			(395	)
Net income (loss)			15,054				(4,284	)			5,930				10,557				8,594				5,181				1,269
Payment-in-kind preferred dividends(3)			—				(4,720	)			(8,593	)			(9,781	)			(10,133	)			(9,453	)			(8,820	)
Net income (loss) available to common shareholders		$	15,054			$	(9,004	)		$	(2,663	)		$	776			$	(1,539	)		$	(4,272	)		$	(7,551	)
Portion allocable to common shareholders(4)			87.8	%			100.0	%			100.0	%			70.2	%			100.0	%			100.0	%			100.0	%
Net income (loss) allocable to common shareholders		$	13,212			$	(9,004	)		$	(2,663	)		$	545			$	(1,539	)		$	(4,272	)		$	(7,551	)
Diluted earnings per common share equivalent		$	0.76			$	(30.04	)		$	(1.25	)		$	2.14			$	(8.55	)		$	(23.72	)		$	(41.93	)
Diluted weighted average of common share equivalents outstanding			17,426,347				299,774				2,129,492				255,280				180,125				180,125				180,125
Selected Insurance Ratios
Current accident year loss ratio(5)			70.2	%			70.8	%			71.0	%			68.5	%			70.6	%			71.8	%			66.9	%
Prior accident year loss ratio(6)			0.0	%			17.5	%			8.5	%			5.7	%			1.3	%			2.4	%			5.3	%
Net loss ratio			70.2	%			88.3	%			79.5	%			74.2	%			71.9	%			74.2	%			72.2	%
Net underwriting expense ratio(7)			24.7	%			23.6	%			24.7	%			24.8	%			27.3	%			29.7	%			32.1	%
Net dividend ratio(8)			0.2	%			0.3	%			0.0	%			0.5	%			0.4	%			0.1	%			1.6	%
Net combined ratio(9)			95.1	%			112.2	%			104.2	%			99.5	%			99.6	%			104.0	%			105.9	%

		June 30,								December 31,
		2006				2005				2005				2004				2003				2002				2001
		(Unaudited)
		(In thousands)
Balance Sheet Data
Cash and cash equivalents		$	31,187			$	27,462			$	49,286			$	25,421			$	49,815			$	44,677			$	44,270
Investments			585,568				396,733				533,618				364,868				257,729				205,315				148,305
Amounts recoverable from reinsurers			118,899				174,556	(10)			122,562				198,977				211,774				214,342				298,451
Premiums receivable, net			143,839				144,953				123,934				114,141				108,380				95,291				104,907
Deferred income taxes			25,518				23,274				22,413				15,624				12,713				11,372				14,716
Deferred policy acquisition costs			19,630				18,496				16,973				12,044				11,820				9,505				11,077
Deferred charges			4,101				3,894				3,182				3,054				2,987				1,997				2,588
Total assets			956,145				811,530				892,320				754,187				678,608				603,801				645,474
Reserves for loss and loss adjustment expenses			505,060				457,827				484,485				432,880				377,559				346,542				383,032
Unearned premiums			148,337				137,536				124,524				111,741				103,462				87,319				92,047
Insurance-related assessments			39,739				34,487				35,135				29,876				26,133				23,743				25,964
Debt			36,090				36,090				36,090				36,090				16,310				8,000				9,000
Redeemable preferred stock(11)			50,000				134,808				50,000				131,916				126,424				121,300				116,520
Shareholders’ equity (deficit)(12)			112,510				(50,452	)			97,346				(42,862	)			(20,652	)			(25,100	)			(10,980	)

(1)		Includes policy acquisition expenses, such as assessments, premium taxes and other general and administrative expenses, excluding commissions and salaries and benefits, related to insurance operations and corporate operating expenses.
(2)		Includes (a) a pre-tax loss of $13.2 million in connection with a commutation agreement with Converium Reinsurance (North America), one of our reinsurers, pursuant to which Converium paid us $61.3 million in exchange for a termination and release of three of our five reinsurance agreements with Converium and (b) an $8.7 million pre-tax increase in our reserves for loss and loss adjustment expenses related to prior accident years.
(3)		Under the terms of our articles of incorporation, holders of our Series C and Series D convertible preferred stock are no longer entitled to receive pay-in-kind dividends as a result of the redemption and exchange of all of our outstanding shares of Series A preferred stock in connection with the initial public offering of our common stock in November 2005.
(4)		Reflects the participation rights of the Series C and Series D convertible preferred stock. See Note 15 to our audited financial statements.
(5)		The current accident year loss ratio is calculated by dividing loss and loss adjustment expenses incurred for the current accident year by the current year’s net premiums earned.
(6)		The prior accident year loss ratio is calculated by dividing the change in loss and loss adjustment expenses incurred for prior accident years by the current year’s net premiums earned.
(7)		The net underwriting expense ratio is calculated by dividing underwriting and certain other operating costs, commissions and salaries and benefits by the current year’s net premiums earned.
(8)		The net dividend ratio is calculated by dividing policyholder dividends by the current year’s net premiums earned.
(9)		The net combined ratio is the sum of the net loss ratio, the net underwriting expense ratio and the net dividend ratio.
(10)		Includes a $67.6 million recoverable from Converium, offset by a $1.3 million expense reimbursement that we owed to Converium. Subsequent to June 30, 2005, we received $61.3 million of this amount pursuant to a commutation agreement.
(11)		Includes our Series C and Series D convertible preferred stock, each of which is mandatorily redeemable upon the occurrence of certain events that are deemed to be outside our control. For periods presented prior to November 2005, also includes our Series A preferred stock, which was mandatorily redeemable upon the occurrence of certain events that were deemed to be outside our control. In connection with the initial public offering of our common stock in November 2005, all outstanding shares of our Series A preferred stock were redeemed and exchanged for shares of our common stock.
(12)		In 1997, we entered into a recapitalization transaction with Welsh, Carson, Anderson & Stowe VII, L.P. and WCAS Healthcare Partners, L.P., our principal shareholders, that resulted in a $164.2 million charge to retained earnings. For periods presented prior to November 2005, shareholders’ equity (deficit) included our Series E preferred stock. In connection with the initial public offering of our common stock in November 2005, all outstanding shares of our Series E preferred stock were redeemed for cash.

 

An investment in our common stock involves a number of risks. Before making a decision to purchase our common stock, you should carefully consider the following information about these risks, together with the other information contained in this prospectus. Any of the risks described below could result in a significant or material adverse effect on our business, financial condition or results of operations, and a decline in the market price of our common stock. You could lose all or part of your investment.

 

Risks Related to Our Business

 

Our loss reserves are based on estimates and may be inadequate to cover our actual losses.

 

We must establish and maintain reserves for our estimated liability for loss and loss adjustment expenses. We establish loss reserves that represent an estimate of amounts needed to pay and administer claims with respect to insured events that have occurred, including events that have occurred but have not yet been reported to us. Reserves are based on estimates of the ultimate cost of individual claims. These estimates are inherently uncertain. Judgment is required to determine the relevance of historical payment and claim settlement patterns under current facts and circumstances. The interpretation of this historical data can be impacted by external forces, principally legislative changes, economic fluctuations and legal trends. If there are unfavorable changes in our assumptions, our reserves may need to be increased.

 

Workers’ compensation claims often are paid over a long period of time. In addition, there are no policy limits on our liability for workers’ compensation claims as there are for other forms of insurance. Therefore, estimating reserves for workers’ compensation claims may be more uncertain than estimating reserves for other types of insurance claims with shorter or more definite periods between occurrence of the claim and final determination of the loss and with policy limits on liability for claim amounts. Accordingly, our reserves may prove to be inadequate to cover our actual losses. If we change our estimates, these changes would result in adjustments to our reserves and our loss and loss adjustment expenses incurred in the period in which the estimates are changed. If the estimate is increased, our pre-tax income for the period in which we make the change will decrease by a corresponding amount. In addition, increasing reserves results in a reduction in our surplus and could result in a downgrade in our A.M. Best rating. Such a downgrade could, in turn, adversely affect our ability to sell insurance policies.

 

If we do not accurately establish our premium rates, our results of operations will be adversely affected.

 

In general, the premium rates for our insurance policies are established when coverage is initiated and, therefore, before all of the underlying costs are known. Like other workers’ compensation insurance companies, we rely on estimates and assumptions in setting our premium rates. Establishing adequate rates is necessary, together with investment income, to generate sufficient revenue to offset losses, loss adjustment expenses and other underwriting expenses and to earn a profit. If we fail to accurately assess the risks that we assume, we may fail to charge adequate premium rates to cover our losses and expenses, which could reduce our net income and cause us to become unprofitable. For example, when initiating coverage on a policyholder, we estimate future claims expense based, in part, on prior claims information provided by the policyholder’s previous insurance carriers. If this prior claims information is not accurate, we may underprice our policy by using claims estimates that are too low. As a result, our actual costs for providing insurance coverage to our policyholders may be significantly higher than our premiums. In order to set premium rates accurately, we must:

 

 

We must also implement our pricing accurately in accordance with our assumptions. Our ability to undertake these efforts successfully, and as a result set premium rates accurately, is subject to a number of risks and uncertainties, principally:

 

 

Consequently, we could set our premium rates too low, which would negatively affect our results of operations and our profitability, or we could set our premium rates too high, which could reduce our competitiveness and lead to lower revenues.

 

A downgrade in our A.M. Best rating would likely reduce the amount of business we are able to write.

 

Rating agencies evaluate insurance companies based on their ability to pay claims. We are currently assigned a group letter rating of “A−” (Excellent) from A.M. Best, which is the rating agency that we believe has the most influence on our business. This rating is assigned to companies that, in the opinion of A.M. Best, have demonstrated an excellent overall performance when compared to industry standards. A.M. Best considers “A−” rated companies to have an excellent ability to meet their ongoing obligations to policyholders. The ratings of A.M. Best are subject to periodic review using, among other things, proprietary capital adequacy models, and are subject to revision or withdrawal at any time. A.M. Best ratings are directed toward the concerns of policyholders and insurance agencies and are not intended for the protection of investors or as a recommendation to buy, hold or sell securities. Our competitive position relative to other companies is determined in part by our A.M. Best rating. Any downgrade in our rating would likely adversely affect our business through the loss of certain existing and potential policyholders and the loss of relationships with certain independent agencies.

 

The workers’ compensation insurance industry is cyclical in nature, which may affect our overall financial performance.

 

The financial performance of the workers’ compensation insurance industry has historically fluctuated with periods of low premium rates and excess underwriting capacity resulting from increased competition followed by periods of high premium rates and shortages of underwriting capacity resulting from decreased competition. Although the financial performance of an individual insurance company is dependent on its own specific business characteristics, the profitability of most workers’ compensation insurance companies generally tends to follow this cyclical market pattern. Beginning in 2000 and accelerating in 2001, the workers’ compensation insurance industry experienced a market reflecting increasing premium rates, more restrictive policy coverage terms and more conservative risk selection. We believe these trends slowed beginning in 2004. We also believe the current workers’ compensation insurance market is slowly transitioning to a more competitive market environment in which underwriting capacity and price competition may increase. This additional underwriting capacity may result in increased competition from other insurance carriers expanding the kinds or amounts of business they write or seeking to maintain or increase market share at the expense of underwriting discipline. Because this cyclicality is due in large part to the actions of our competitors and general economic factors, we cannot predict the timing or duration of changes in the market cycle. While we have not experienced significant increased price competition in our target markets during 2005 and the first six months of 2006, these cyclical patterns could cause our revenues and net income to fluctuate, which may cause the price of our common stock to be volatile.

If we are unable to obtain reinsurance on favorable terms, our ability to write policies could be adversely affected.

 

We purchase reinsurance to protect us from the impact of large losses. Reinsurance is an arrangement in which an insurance company, called the ceding company, transfers insurance risk by sharing premiums with another insurance company, called the reinsurer. Conversely, the reinsurer receives or assumes reinsurance from the ceding company. Our 2006 reinsurance program provides us with reinsurance coverage for each loss occurrence up to $30.0 million, subject to applicable deductibles, retentions and aggregate limits. However, for any loss occurrence involving only one person, our reinsurance coverage is limited to $10.0 million, subject to applicable deductibles, retentions and aggregate limits. We retain the first $1.0 million of each loss and are subject to an annual aggregate deductible of approximately $10.8 million for losses between $1.0 million and $2.0 million before our reinsurers are obligated to reimburse us. After the deductible is satisfied, we retain 25.0% of each loss between $1.0 million and $2.0 million. The aggregate limit for all claims for losses between $1.0 million and $2.0 million is approximately $5.4 million. For losses between $2.0 million and $5.0 million, we are subject to an annual aggregate deductible of approximately $7.3 million before our reinsurers are obligated to reimburse us. The aggregate limit for all claims for losses between $2.0 million and $5.0 million is approximately $39.0 million. See “Business—Reinsurance.” The availability, amount and cost of reinsurance are subject to market conditions and our experience with insured losses.

 

Due to the increased cost of reinsurance, we have increased our levels of retention on a per occurrence basis each year since 2003. As a result, we are exposed to increased risk of loss resulting from volatility in the frequency and severity of claims, which could adversely affect our financial performance.

 

If any of our current reinsurers were to terminate participation in our 2006 reinsurance treaty program, we could be exposed to an increased risk of loss.

 

The agreements under our 2006 reinsurance treaty program may be terminated by us or our reinsurers upon 90 days prior notice effective on any January 1. If our reinsurance treaty program is terminated and we enter into a new program, any decrease in the amount of reinsurance at the time we enter into a new program, whether caused by the existence of more restrictive terms and conditions or decreased availability, will also increase our risk of loss and, as a result, could adversely affect our business, financial condition and results of operations. We currently have eleven reinsurers participating in our reinsurance treaty program, and we believe that this is a sufficient number of reinsurers to provide us with the reinsurance coverage we require. However, because our reinsurance treaty program may be terminated on any January 1, it is possible that one or more of our current reinsurers could terminate participation in our program. In addition, we may terminate the participation of one or more of our reinsurers under certain circumstances as permitted by the terms of our reinsurance agreements. In either of those events, if our reinsurance broker is unable to spread the terminated reinsurance among the remaining reinsurers in the program, it could take a significant amount of time to identify and negotiate agreements with a replacement reinsurer. During this time, we would be exposed to an increased risk of loss, the extent of which would depend on the volume of terminated reinsurance.

 

We may not be able to recover amounts due from our reinsurers, which would adversely affect our financial condition.

 

Reinsurance does not discharge our obligations under the insurance policies we write. We remain liable to our policyholders even if we are unable to make recoveries that we are entitled to receive under our reinsurance contracts. As a result, we are subject to credit risk with respect to our reinsurers. Losses are recovered from our reinsurers as claims are paid. In long-term workers’ compensation claims, the creditworthiness of our reinsurers may change before we recover amounts to which we are entitled. Therefore, if a reinsurer is unable to meet any of its obligations to us, we would be responsible for all claims and claim settlement expenses for which we would have otherwise received payment from the reinsurer.

 

In the past, we have been unable to recover amounts from our reinsurers. In 2001, Reliance Insurance Company, one of our former reinsurers, was placed under regulatory supervision by the Pennsylvania

Insurance Department and was subsequently placed into liquidation. As a result, between 2001 and June 30, 2006, we recognized losses related to uncollectible amounts due from Reliance aggregating $21.3 million.

 

As of June 30, 2006, we had $118.9 million of recoverables from reinsurers. Of this amount, $102.7 million was unsecured. As of June 30, 2006, our largest recoverables from reinsurers included $27.5 million from Munich Reinsurance America, Inc., $21.4 million from Odyssey America Reinsurance Company, $11.7 million from St. Paul Fire and Marine Insurance Company and $11.3 million from Clearwater Insurance Company. If we are unable to collect amounts recoverable from our reinsurers, our financial condition would be adversely affected.

 

A downgrade in the A.M. Best rating of one or more of our significant reinsurers could adversely affect our financial condition.

 

Our financial condition could be adversely affected if the A.M. Best rating of one or more of our significant reinsurers is downgraded. For example, our A.M. Best rating may be downgraded if our amounts recoverable from a reinsurer are significant and the A.M. Best rating of that reinsurer is downgraded. If one of our reinsurers suffers a rating downgrade, we may consider various options to lessen the impact on our financial condition, including commutation, novation and the use of letters of credit to secure amounts recoverable from reinsurers. However, these options may result in losses to our company, and there can be no assurance that we could implement any of these options.

 

In 2004, A.M. Best downgraded the financial strength rating of Converium Reinsurance (North America), our largest reinsurer at that time. Subsequently, in June 2005, A.M. Best placed our “A−” rating under review with negative implications, citing, among other things, concerns about credit risk associated with amounts recoverable from our reinsurers. Although Converium continued to reimburse us under the terms of our reinsurance agreements, we entered into a commutation agreement with Converium in June 2005 pursuant to which Converium paid us $61.3 million in exchange for a termination and release of three of our five reinsurance agreements with Converium. Under the commutation agreement, all liabilities reinsured with Converium under these three reinsurance agreements have reverted back to us. We recorded a pre-tax loss of $13.2 million in 2005 related to this commutation agreement. Converium remains obligated to us on the remaining two agreements. We cannot assure you that the cash payment we received from Converium, and any investment income we may earn on that amount, will be sufficient to cover all claims for which we would otherwise have been contractually entitled to recover from Converium under the three reinsurance agreements subject to the commutation agreement.

 

Negative developments in the workers’ compensation insurance industry would adversely affect our financial condition and results of operations.

 

We principally offer workers’ compensation insurance. We have no current plans to focus our efforts on offering other types of insurance. As a result, negative developments in the economic, competitive or regulatory conditions affecting the workers’ compensation insurance industry could have an adverse effect on our financial condition and results of operations. Negative developments in the workers’ compensation insurance industry could have a greater effect on us than on more diversified insurance companies that also sell other types of insurance.

 

A decline in the level of business activity of our policyholders, particularly those engaged in the construction, trucking and logging industries, could negatively affect our earnings and profitability.

 

In 2005, approximately 69.7% of our gross premiums written were derived from policyholders in the construction, trucking and logging industries. Because premium rates are calculated, in general, as a percentage of a policyholder’s payroll expense, premiums fluctuate depending upon the level of business activity and number of employees of our policyholders. As a result, our gross premiums written are primarily dependent upon the economic conditions in the construction, trucking and logging industries and upon economic conditions generally.

Unfavorable changes in economic conditions affecting the states in which we operate could adversely affect our financial condition or results of operations.

 

We market our insurance in 26 states and the District of Columbia. Although we have expanded our operations into new geographic areas and expect to continue to do so in the future, approximately 57.7% of our gross premiums written for the year ended December 31, 2005 were derived from the nine states in which we generated 5% or more of our gross premiums written in 2005. No other state accounted for more than 5.0% of gross premiums written in 2005. In the future, we may be exposed to economic and regulatory risks or risks from natural perils that are greater than the risks faced by insurance companies that have a larger percentage of their gross premiums written diversified over a broader geographic area. Unfavorable changes in economic conditions affecting the states in which we write business could adversely affect our financial condition or results of operations. See “Business—Policyholders.”

 

Our revenues and results of operations may fluctuate as a result of factors beyond our control, which fluctuation may cause the price of our common stock to be volatile.

 

The revenues and results of operations of insurance companies historically have been subject to significant fluctuations and uncertainties. Our profitability can be affected significantly by:

 

 

If our revenues and results of operations fluctuate as a result of one or more of these factors, the price of our common stock may be volatile.

 

We operate in a highly competitive industry and may lack the financial resources to compete effectively.

 

There is significant competition in the workers’ compensation insurance industry. We believe that our competition in the hazardous industries we target is fragmented and not dominated by one or more competitors. We compete with other insurance companies, individual self-insured companies, state insurance pools and self-insurance funds. Many of our existing and potential competitors are significantly larger and possess greater financial, marketing and management resources than we do. Moreover, a number of these competitors offer other types of insurance in addition to workers’ compensation and can provide insurance nationwide. We compete on the basis of many factors, including coverage availability, claims management, safety services, payment terms, premium rates, policy terms, types of insurance offered, overall financial strength, financial ratings and reputation. If any of our competitors offer premium rates, policy terms or types of insurance that are more competitive than ours, we could lose market share. No assurance can be given that we will maintain our current competitive position in the markets in which we currently operate or that we will establish a competitive position in new markets into which we may expand.

If we cannot sustain our relationships with independent agencies, we may be unable to operate profitably.

 

We market a substantial portion of our workers’ compensation insurance through independent agencies. As of June 30, 2006, independent agencies produced approximately 84% of our voluntary in-force premiums. No independent agency accounted for more than 1.2% of our voluntary in-force premiums at that date. Independent agencies are not obligated to promote our insurance and may sell insurance offered by our competitors. As a result, our continued profitability depends, in part, on the marketing efforts of our independent agencies and on our ability to offer workers’ compensation insurance and maintain financial strength ratings that meet the requirements of our independent agencies and their policyholders.

 

An inability to effectively manage the growth of our operations could make it difficult for us to compete and affect our ability to operate profitably.

 

Our continuing growth strategy includes expanding in our existing markets, entering new geographic markets and further developing our agency relationships. Our growth strategy is subject to various risks, including risks associated with our ability to:

 

 

Because we are subject to extensive state and federal regulation, legislative changes may negatively impact our business.

 

We are subject to extensive regulation by the Louisiana Department of Insurance and the insurance regulatory agencies of other states in which we are licensed and, to a lesser extent, federal regulation. State agencies have broad regulatory powers designed primarily to protect policyholders and their employees, and not our shareholders. Regulations vary from state to state, but typically address:

 

 

We may be unable to comply fully with the wide variety of applicable laws and regulations that are continually undergoing revision. In addition, we follow practices based on our interpretations of laws and regulations that we believe are generally followed by our industry. These practices may be different from interpretations of insurance regulatory agencies. As a result, insurance regulatory agencies could preclude us from conducting some or all of our activities or otherwise penalize us. For example, in order to enforce

applicable laws and regulations or to protect policyholders, insurance regulatory agencies have relatively broad discretion to impose a variety of sanctions, including examinations, corrective orders, suspension, revocation or denial of licenses and the takeover of one or more of our insurance subsidiaries. The extensive regulation of our business may increase the cost of our insurance and may limit our ability to obtain premium rate increases or to take other actions to increase our profitability.

 

The effects of emerging claim and coverage issues on our business are uncertain.

 

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 or size of claims. In some instances, these changes may not become apparent until after we have issued insurance policies that are affected by the changes. As a result, the full extent of our liability under an insurance policy may not be known until many years after the policy is issued. For example, medical costs associated with permanent and partial disabilities may increase more rapidly or be higher than we currently expect. Changes of this nature may expose us to higher claims than we anticipated when we wrote the underlying policy. As of June 30, 2006, approximately 9.7% of our 2004 reported claims and 1.1% of our pre-2004 reported claims were open.

 

Additional capital that we may require in the future may not be available to us or may be available to us only on unfavorable terms.

 

Our future capital requirements will depend on many factors, including state regulatory requirements, the financial stability of our reinsurers and our ability to write new business and establish premium rates sufficient to cover our estimated claims. We may need to raise additional capital or curtail our growth if the capital of our insurance subsidiaries is insufficient to support future operating requirements and/or cover claims. If we had to raise additional capital, equity or debt financing may not be available to us or may be available only on terms that are not favorable. In the case of equity financings, dilution to our shareholders could result and the securities sold may have rights, preferences and privileges senior to the common stock sold in this offering. In addition, under certain circumstances, the sale of our common stock, or securities convertible or exchangeable into shares of our common stock, at a price per share less than the market value of our common stock may result in an adjustment to the conversion price at which shares of our existing convertible preferred stock may be converted into shares of our common stock. If we cannot obtain adequate capital on favorable terms or at all, we may be unable to support future growth or operating requirements and, as a result, our business, financial condition or results of operations could be adversely affected.

 

If we are unable to realize our investment objectives, our financial condition and results of operations may be adversely affected.

 

Investment income is an important component of our net income. As of June 30, 2006, our investment portfolio, including cash and cash equivalents, had a carrying value of $616.8 million. For the year ended December 31, 2005, we had $16.9 million of net investment income. Our investment portfolio is managed by an independent asset manager that operates under investment guidelines approved by our board of directors. Although these guidelines stress diversification and capital preservation, our investments are subject to a variety of risks, including risks related to general economic conditions, interest rate fluctuations and market volatility. General economic conditions may be adversely affected by U.S. involvement in hostilities with other countries and large-scale acts of terrorism, or the threat of hostilities or terrorist acts.

 

Interest rates are highly sensitive to many factors, including governmental monetary policies and domestic and international economic and political conditions. Changes in interest rates could have an adverse effect on the value of our investment portfolio and future investment income. For example, changes in interest rates can expose us to prepayment risks on mortgage-backed securities included in our investment portfolio. When interest rates fall, mortgage-backed securities are prepaid more quickly than expected and the holder must reinvest the proceeds at lower interest rates. In periods of increasing interest rates, mortgage-backed securities

are prepaid more slowly, which may require us to receive interest payments that are below the interest rates then prevailing for longer than expected.

 

These and other factors affect the capital markets and, consequently, the value of our investment portfolio and our investment income. Any significant decline in our investment income would adversely affect our revenues and net income and, as a result, increase our shareholders’ deficit and decrease our surplus.

 

Our business is dependent on the efforts of our executive officers because of their industry expertise, knowledge of our markets and relationships with the independent agencies that sell our insurance.

 

Our success is dependent on the efforts of our executive officers because of their industry expertise, knowledge of our markets and relationships with our independent agencies. Our executive officers are C. Allen Bradley, Jr., Chairman, President and Chief Executive Officer; Geoffrey R. Banta, Executive Vice President and Chief Financial Officer; Arthur L. Hunt, Executive Vice President; Craig P. Leach, Executive Vice President, Sales and Marketing; David O. Narigon, Executive Vice President; and Todd Walker, Executive Vice President, General Counsel and Secretary. Mr. Hunt will retire from our company effective as of November 30, 2006. We have entered into employment agreements with each of our executive officers. The employment agreements with Messrs. Bradley, Banta, Hunt and Leach expire in January 2008, unless extended. The employment agreements with Messrs. Narigon and Walker expire in September 2009, unless extended. These employment agreements are more fully described under “Management—Employment and Consulting Agreements.” Should any of our executive officers cease working for us, we may be unable to find acceptable replacements with comparable skills and experience in the workers’ compensation insurance industry and the hazardous industries that we target. As a result, our operations may be disrupted and our business may be adversely affected. We do not currently maintain life insurance policies with respect to our executive officers.

 

AMERISAFE is an insurance holding company and does not have any direct operations.

 

AMERISAFE is a holding company that transacts business through its operating subsidiaries, including American Interstate. AMERISAFE’s primary assets are the capital stock of these operating subsidiaries. The ability of AMERISAFE to pay dividends to our shareholders depends upon the surplus and earnings of our subsidiaries and their ability to pay dividends to AMERISAFE. Payment of dividends by our insurance subsidiaries is restricted by state insurance laws, including laws establishing minimum solvency and liquidity thresholds, and could be subject to contractual restrictions in the future, including those imposed by indebtedness we may incur in the future. See “Business—Regulation—Dividend Limitations.” As a result, at times, AMERISAFE may not be able to receive dividends from its insurance subsidiaries and may not receive dividends in amounts necessary to pay dividends on our capital stock. Based on reported capital and surplus at December 31, 2005, American Interstate would have been permitted under Louisiana insurance law to pay dividends to AMERISAFE in 2006 in an amount up to $3.9 million without approval by the Louisiana Department of Insurance.

 

In addition, our ability to pay dividends is subject to restrictions in the articles of incorporation of AMERISAFE that prohibit us from paying dividends on our common stock (other than in additional shares of common stock) without the consent of the holders of two-thirds of the outstanding shares of our convertible preferred stock. If holders of our convertible preferred stock consent to the payment of a dividend, we must pay a dividend to the holders of our convertible preferred stock on an as-converted to common stock basis equal to the dividend we pay to holders of our common stock. Currently, we do not intend to pay dividends on our common stock.

 

Assessments and premium surcharges for state guaranty funds, second injury funds and other mandatory pooling arrangements may reduce our profitability.

 

Most states require insurance companies licensed to do business in their state to participate in guaranty funds, which require the insurance companies to bear a portion of the unfunded obligations of impaired, insolvent or failed insurance companies. These obligations are funded by assessments, which are expected to

continue in the future. State guaranty associations levy assessments, up to prescribed limits, on all member insurance companies in the state based on their proportionate share of premiums written in the lines of business in which the impaired, insolvent or failed insurance companies are engaged. See “Business—Regulation.” Accordingly, the assessments levied on us may increase as we increase our written premium. Some states also have laws that establish second injury funds to reimburse insurers and employers for claims paid to injured employees for aggravation of prior conditions or injuries. These funds are supported by either assessments or premium surcharges based on paid losses.

 

In addition, as a condition to conducting business in some states, insurance companies are required to participate in residual market programs to provide insurance to those employers who cannot procure coverage from an insurance carrier on a negotiated basis. Insurance companies generally can fulfill their residual market obligations by, among other things, participating in a reinsurance pool where the results of all policies provided through the pool are shared by the participating insurance companies. Although we price our insurance to account for obligations we may have under these pooling arrangements, we may not be successful in estimating our liability for these obligations. Accordingly, mandatory pooling arrangements may cause a decrease in our profits. At June 30, 2006 we participated in mandatory pooling arrangements in 17 states and the District of Columbia. As we write policies in new states that have mandatory pooling arrangements, we will be required to participate in additional pooling arrangements. Further, the impairment, insolvency or failure of other insurance companies in these pooling arrangements would likely increase the liability for other members in the pool. The effect of assessments and premium surcharges or changes in them could reduce our profitability in any given period or limit our ability to grow our business.

 

Being a public company has increased our expenses and administrative workload.

 

We completed our initial public offering in November 2005. As a public company, we must comply with various laws and regulations, including the Sarbanes-Oxley Act of 2002 and related rules of the Securities and Exchange Commission, or the SEC, and requirements of the NASDAQ Global Select Market. We were not required to comply with these laws and requirements as a private company. Complying with these laws and regulations requires the time and attention of our board of directors and management and increases our expenses. Among other things, we must:

 

 

In addition, being a public company has made it more expensive for us to obtain director and officer liability insurance. In the future, we may be required to accept reduced coverage or incur substantially higher costs to obtain this coverage. These factors could also make it more difficult for us to attract and retain qualified executives and members of our board of directors, particularly directors willing to serve on our audit committee.

 

We will be exposed to risks relating to evaluations of our internal controls over financial reporting required by Section 404 of the Sarbanes-Oxley Act of 2002.

 

We are in the process of evaluating our internal control systems to allow management to report on, and our independent auditors to assess, our internal controls over financial reporting. We will be performing the system and process evaluation and testing (and any necessary remediation) required to comply with the

management certification and auditor attestation requirements of Section 404 of the Sarbanes-Oxley Act. We are required to comply with Section 404 by no later than December 31, 2006. However, we cannot be certain as to the timing of completion of our evaluation, testing and remediation actions or the impact of the same on our operations. Furthermore, upon completion of this process, we may identify control deficiencies of varying degrees of severity under applicable SEC and Public Company Accounting Oversight Board rules and regulations that remain unremediated. As a public company, we will be required to report, among other things, control deficiencies that constitute a “material weakness” or changes in internal controls that materially affect, or are reasonably likely to materially affect, internal controls over financial reporting. A “material weakness” is a significant deficiency, or combination of significant deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. If we fail to implement the requirements of Section 404 in a timely manner, we might be subject to sanctions or investigation by regulatory agencies such as the SEC. In addition, failure to comply with Section 404 or the report by us of a material weakness may cause investors to lose confidence in our financial statements and the trading price of our common stock may decline. If we fail to remedy any material weakness, our financial statements may be inaccurate, our access to the capital markets may be restricted and the trading price of our common stock may decline.

 

We may have exposure to losses from terrorism for which we are required by law to provide coverage.

 

When writing workers’ compensation insurance policies, we are required by law to provide workers’ compensation benefits for losses arising from acts of terrorism. The impact of any terrorist act is unpredictable, and the ultimate impact on us would depend upon the nature, extent, location and timing of such an act. Our 2006 reinsurance treaty program affords coverage for up to $28.0 million for losses arising from terrorism, subject to applicable deductibles, retentions and aggregate limits. Notwithstanding the protection provided by reinsurance and the Terrorism Risk Insurance Extension Act of 2005, the risk of severe losses to us from acts of terrorism has not been eliminated because our reinsurance treaty program includes various sub-limits and exclusions limiting our reinsurers’ obligation to cover losses caused by acts of terrorism. Accordingly, events constituting acts of terrorism may not be covered by, or may exceed the capacity of, our reinsurance and could adversely affect our business and financial condition. In addition, the Terrorism Risk Insurance Extension Act of 2005 is set to expire on December 31, 2007. If this law is not extended or replaced by legislation affording a similar level of protection to the insurance industry against insured losses arising out of acts of terrorism, reinsurance for losses arising from terrorism may be unavailable or prohibitively expensive, and we may be further exposed to losses arising from acts of terrorism.

 

Risks Related to Our Common Stock and This Offering

 

The trading price of our common stock may decline after this offering.

 

The trading price of our common stock may decline after this offering for many reasons, some of which are beyond our control, including, among others:

 

 

In addition, the stock market in general has experienced significant volatility that often has been unrelated to the operating performance of companies whose shares are traded. These market fluctuations could adversely affect the trading price of our common stock, regardless of our actual operating performance. As a result, the trading price of our common stock may decrease and you may not be able to sell your shares at or above the price you pay to purchase them.

 

Securities analysts may not continue coverage of our common stock or may issue negative reports, which may adversely affect the trading price of our common stock.

 

There is no assurance that securities analysts will continue to cover our company. If securities analysts do not cover our company, this lack of coverage may adversely affect the trading price of our common stock. The trading market for our common stock relies in part on the research and reports that securities analysts publish about us or our business. If one or more of the analysts who cover our company downgrades our common stock, the trading price of our common stock may decline rapidly. If one or more of these analysts ceases to cover our company, we could lose visibility in the market, which, in turn, could also cause the trading price of our common stock to decline. Because of our small market capitalization, it may be difficult for us to attract securities analysts to cover our company, which could adversely affect the trading price of our common stock.

 

Our principal shareholders have the ability to significantly influence our business, which may be disadvantageous to other shareholders and adversely affect the trading price of our common stock.

 

As of June 30, 2006, Welsh, Carson, Anderson & Stowe VII, L.P. and WCAS Healthcare Partners, L.P., or Welsh Carson collectively, beneficially owned approximately 44.1% of our outstanding common stock and possess approximately 40.7% of the total voting power. As a result, these shareholders, acting together, have the ability to exert substantial influence over all matters requiring approval by our shareholders, including the election and removal of directors, any proposed merger, consolidation or sale of all or substantially all of our assets and other corporate transactions. Upon completion of this offering, Welsh Carson will beneficially own 2,215,721 shares, or 11.9%, of our common stock (1,214,771 shares, or 6.5%, of our common stock if the over-allotment option is exercised in full).

 

Future sales of our common stock may affect the trading price of our common stock and the future exercise of options or the exercise of the conversion rights of our convertible preferred stock may lower our stock price.

 

We cannot predict what effect, if any, future sales of our common stock, or the availability of shares for future sale, will have on the trading price of our common stock. Sales of a substantial number of shares of our common stock in the public market, or the perception that such sales could occur, may adversely affect the trading price of our common stock and may make it more difficult for you to sell your shares at a time and price that you determine appropriate. See “Shares Eligible for Future Sale” for further information regarding circumstances under which additional shares of our common stock may be sold. As of the date of this prospectus, there were 17,446,110 shares of our common stock outstanding. Immediately prior to the completion of this offering, we will issue 1,214,771 shares of common stock upon conversion of shares of our convertible preferred stock held by certain of the selling shareholders. After the completion of this offering, an additional 1,214,770 shares of our common stock will remain issuable upon the conversion of shares of our outstanding convertible preferred stock. Upon conversion, these shares of common stock will be freely tradable without restriction or further registration under the Securities Act. See “Description of Capital Stock.” We and our current directors, our officers and the selling shareholders have entered into 90-day lock-up agreements as described in “Shares Eligible for Future Sale—Lock-Up Agreements.” The lock-up agreement with Arthur L. Hunt will terminate on November 30, 2006 upon his retirement from the Company. Upon completion of this offering, an aggregate of 2,599,681 shares of our common stock, including shares issuable upon the exercise of options exercisable within 60 days of the date of this prospectus, will be subject to these lock-up agreements (1,574,880 shares if the over-allotment option is exercised in full). There are outstanding options exercisable to purchase 1,648,500 shares of our common stock, of which 1,548,500 were granted in

November 2005 and 100,000 were granted in September 2006. All options vest 20% each year commencing on the first anniversary of the date of grant.

 

The terms of our convertible preferred stock could adversely affect the value of our common stock.

 

The conversion price of our convertible preferred stock is currently $20.58 per share and our outstanding convertible preferred stock is presently convertible into 2,429,541 shares of common stock. After the completion of this offering, 1,214,770 shares will be issuable upon conversion of our convertible preferred stock. Subject to certain exceptions, the conversion price of our convertible preferred stock may decrease if we issue additional shares of our common stock for less than the market price of our common stock. No adjustment to the conversion price of our convertible preferred stock will result from this offering because we are not issuing additional shares of our common stock.

 

Holders of our convertible preferred stock have the right to cause us to file a registration statement with the SEC to sell the shares of common stock issuable upon conversion of the convertible preferred stock. See “Certain Relationships and Related Transactions—Registration Rights Agreement.” Sales of shares of common stock issuable upon conversion of our convertible preferred stock could adversely affect the trading price of our common stock.

 

We may not pay dividends on our common stock (other than in additional shares of common stock) without the consent of the holders of two-thirds of the outstanding shares of our convertible preferred stock. If holders of our convertible preferred stock consent to the payment of a dividend by us, we must pay a dividend to the holders of our convertible preferred stock on an as-converted to common stock basis equal to the dividend we pay to holders of our common stock.

 

The terms of our articles of incorporation relating to our convertible preferred stock could impede a change of control of our company. Following a change of control, holders of our convertible preferred stock have the right to require us to redeem their shares at a redemption price of $100 per share plus the cash value of any accrued and unpaid dividends. The redemption provisions of our convertible preferred stock could have the effect of discouraging a future change of control of our company. See “Description of Capital Stock—Authorized Capital Stock—Convertible Preferred Stock—Redemption.”

 

Provisions of our articles of incorporation and bylaws and under the laws of the states of Louisiana and Texas could impede an attempt to replace or remove our directors or otherwise effect a change of control of our company, which could diminish the value of our common stock.

 

Our articles of incorporation and bylaws contain provisions that may make it more difficult for shareholders to replace or remove directors even if the shareholders consider it beneficial to do so. In addition, these provisions could delay or prevent a change of control of our company that shareholders might consider favorable. Our articles of incorporation and bylaws contain the following provisions that could have an anti-takeover effect:

 

 

These provisions may make it difficult for shareholders to replace management and could have the effect of discouraging a future takeover attempt that is not approved by our board of directors, but which individual shareholders might consider favorable.

 

We are incorporated in Texas and are subject to Part 13 of the Texas Business Corporation Act. Under this statute, our ability to enter into a business combination with any affiliated shareholder is limited. See “Description of Capital Stock—Anti-Takeover Provisions.”

 

In addition, two of our three insurance company subsidiaries, American Interstate and Silver Oak Casualty, are incorporated in Louisiana and the other, American Interstate of Texas, is incorporated in Texas. Under Louisiana and Texas insurance law, advance approval by the state insurance department is required for any change of control of an insurer. “Control” is presumed to exist through the direct or indirect ownership of 10% or more of the voting securities of a domestic insurance company or any entity that controls a domestic insurance company. Obtaining these approvals may result in the material delay of, or deter, any such transaction.

 

You should rely only on the information contained in this prospectus. We have not, and the underwriters have not, authorized any other person to provide you with information that is different from that contained in this prospectus. If anyone provides you with different or inconsistent information, you should not rely on it. The selling shareholders and the underwriters are offering to sell and seeking offers to buy these securities only in jurisdictions where offers and sales are permitted. You should assume that the information contained in this prospectus is accurate only as of the date of this prospectus, regardless of the time of delivery of this prospectus or of any sale of common stock. Our business, financial condition, results of operations and prospects may have changed since that date.

 

In this prospectus:

 

 

Unless otherwise stated, all amounts in this prospectus assume no exercise of the underwriters’ over-allotment option.

 

This prospectus includes certain statements that we believe are, or may be considered to be, forward-looking statements within the meaning of various provisions of the Securities Act of 1933 and of the Securities Exchange Act of 1934. You should not place undue reliance on these statements. These forward-looking statements include statements that reflect the current views of our senior management with respect to our financial performance and future events with respect to our business and the insurance industry in general. Statements that include the words “expect,” “intend,” “plan,” “believe,” “project,” “forecast,” “estimate,” “may,” “should,” “anticipate” and similar statements of a future or forward-looking nature identify forward-looking statements. Forward-looking statements address matters that involve risks and uncertainties. Accordingly, there are or will be important factors that could cause our actual results to differ materially from those indicated in these statements. We believe that these factors include, but are not limited to, the following:

 

 

The foregoing factors should not be construed as exhaustive and should be read together with the other cautionary statements included in this prospectus, including under “Risk Factors.” If one or more events related to these or other risks or uncertainties materialize, or if our underlying assumptions prove to be incorrect, actual results may differ materially from what we anticipate. Any forward-looking statements you read in this prospectus reflect our views as of the date of this prospectus with respect to future events and are subject to these and other risks, uncertainties and assumptions relating to our operations, results of operations, growth strategy and liquidity. Before making a decision to purchase our common stock, you should carefully consider all of the factors identified in this prospectus that could cause actual results to differ.

 

All of our common stock offered hereby is being sold by the selling shareholders. We will not receive any proceeds from the sale of our common stock in this offering.

 

We have not paid cash dividends on our common stock in the prior two years. We currently intend to retain any future earnings to finance our operations and growth. As a result, we do not expect to pay any cash dividends on our common stock for the foreseeable future. Any future determination to pay cash dividends on our common stock will be at the discretion of our board of directors and will be dependent on our earnings, financial condition, operating results, capital requirements, any contractual, regulatory or other restrictions on the payment of dividends by our subsidiaries to AMERISAFE, and other factors that our board of directors deems relevant.

 

AMERISAFE is a holding company and has no direct operations. Our ability to pay dividends in the future depends on the ability of our operating subsidiaries to pay dividends to us. Our insurance company subsidiaries are regulated insurance companies and therefore are subject to significant regulatory restrictions limiting their ability to declare and pay dividends.

 

Our ability to pay dividends is also subject to restrictions set forth in our articles of incorporation, which prohibit us from paying dividends on our common stock (other than in additional shares of common stock) without the consent of the holders of two-thirds of the outstanding shares of our convertible preferred stock. If holders of our convertible preferred stock consent to the payment of a dividend by us, we must pay a dividend to the holders of our convertible preferred stock on an as-converted to common stock basis equal to the dividend we pay to holders of our common stock.

 

For additional information regarding restrictions on the payment of dividends by us and our insurance company subsidiaries, see “Business—Regulation—Dividend Limitations.”

 

Our common stock is traded on the NASDAQ Global Select Market under the symbol “AMSF” and has been traded on the NASDAQ since our initial public offering on November 18, 2005. The table below sets forth the reported high and low sales prices for our common stock, as reported on the NASDAQ for the periods indicated.

 

 

The table below sets forth our consolidated capitalization as of June 30, 2006 on an actual basis and on an as adjusted basis giving effect to the issuance of 1,214,771 shares of common stock upon conversion of 250,000 shares of our convertible preferred stock immediately prior to the completion of this offering.

 

We are not issuing additional shares of common stock in this offering and we will not receive any proceeds from the sale of the shares by the selling shareholders. Accordingly, our total capitalization will not change as a result of this offering, except for the expenses related to this offering to be paid by us.

 

 

The following income statement data for the years ended December 31, 2005, 2004 and 2003 and the balance sheet data as of December 31, 2005 and 2004 were derived from our consolidated financial statements included elsewhere in this prospectus. The income statement data for the years ended December 31, 2002 and 2001 and the balance sheet data as of December 31, 2003, 2002 and 2001 were derived from our audited consolidated financial statements, which are not included in this prospectus. The income statement data for the three- and six-month periods ended June 30, 2006 and 2005 and the balance sheet data as of June 30, 2006 and 2005 were derived from our unaudited condensed consolidated financial statements included elsewhere in this prospectus, which include all adjustments, consisting of normal recurring adjustments, that management considers necessary for a fair presentation of our financial position and results of operations for the periods presented. These historical results are not necessarily indicative of results to be expected from any future period. You should read the following selected financial information together with the other information contained in this prospectus, including “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the financial statements and related notes included elsewhere in this prospectus.

 

 

 

 

The following discussion of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and the notes thereto included elsewhere in this prospectus. This discussion includes forward-looking statements that are subject to risks, uncertainties and other factors described under the caption “Risk Factors.” These factors could cause our actual results in 2006 and beyond to differ materially from those expressed in, or implied by, those forward-looking statements. See “Forward-Looking Statements.”

 

Overview

 

AMERISAFE is a holding company that markets and underwrites workers’ compensation insurance through its subsidiaries. Workers’ compensation insurance covers statutorily prescribed benefits that employers are obligated to provide to their employees who are injured in the course and scope of their employment. Our business strategy is focused on providing this coverage to small to mid-sized employers engaged in hazardous industries, principally construction, trucking and logging. Employers engaged in hazardous industries pay substantially higher than average rates for workers’ compensation insurance compared to employers in other industries, as measured per payroll dollar. The higher premium rates are due to the nature of the work performed and the inherent workplace danger of our target employers. Hazardous industry employers also tend to have less frequent but more severe claims as compared to employers in other industries due to the nature of their businesses. We provide proactive safety reviews of employers’ workplaces. These safety reviews are a vital component of our underwriting process and also promote safer workplaces. We utilize intensive claims management practices that we believe permit us to reduce the overall cost of our claims. In addition, our audit services ensure that our policyholders pay the appropriate premiums required under the terms of their policies and enable us to monitor payroll patterns or aberrations that cause underwriting, safety or fraud concerns. We believe that the higher premiums typically paid by our policyholders, together with our disciplined underwriting and safety, claims and audit services, provide us with the opportunity to earn attractive returns on equity.

 

We market our insurance in 26 states and the District of Columbia through independent agencies, as well as through our wholly owned insurance agency subsidiary. We are also licensed in an additional 19 states and the U.S. Virgin Islands.

 

One of the key financial measures that we use to evaluate our operating performance is return on average equity. We calculate return on average equity by dividing net income by the average of shareholders’ equity plus redeemable preferred stock. Our return on average equity was 5.0% in 2005, 10.8% in 2004 and 8.5% in 2003. Our return on average equity was 19.6% and 19.4% for the three months and six months ended June 30, 2006, respectively. Our overall financial objective is to produce a return on equity of at least 15% over the long-term. We target producing a combined ratio of 96% or lower while maintaining optimal operating leverage in our insurance subsidiaries that is commensurate with our A.M. Best rating objective. Our combined ratio was 95.2% for the three months ended June 30, 2006, 95.1% for the six months ended June 30, 2006, 104.2% in 2005, 99.5% in 2004 and 99.6% in 2003. For 2006, we presently expect gross premiums written of between $317 million and $325 million, a combined ratio of less than 96%, and a return on average equity of approximately 15%.

 

Investment income is an important part of our business. Because the period of time between our receipt of premiums and the ultimate settlement of claims is often several years or longer, we are able to invest cash from premiums for significant periods of time. As a result, we are able to generate more investment income from our premiums as compared to insurance companies that operate in many other lines of business. From December 31, 2001 to June 30, 2006, our investment portfolio, including cash and cash equivalents, increased from $192.6 million to $616.8 million and produced net investment income of $5.8 million in the three months ended June 30, 2006, $11.8 million in the six months ended June 30, 2006, $16.9 million in 2005, $12.2 million in 2004 and $10.1 million in 2003. In the third quarter of 2005, we received a $61.3 million payment from one of our reinsurers pursuant to a commutation agreement. In the fourth quarter of 2005 we

completed our initial public offering, and we retained approximately $53.0 million of the net proceeds from the offering. Of the net proceeds we retained, we contributed $45.0 million to our insurance subsidiaries. The remaining $8.0 million will be used to make additional capital contributions to our insurance company subsidiaries as necessary to supplement our anticipated growth and for general corporate purposes.

 

The use of reinsurance is an important component of our business strategy. We purchase reinsurance to protect us from the impact of large losses. Our reinsurance program for 2006 includes eleven reinsurers that provide coverage to us in excess of a certain specified loss amount, or retention level. Under our reinsurance program, we pay our reinsurers a percentage of our gross premiums earned and, in turn, the reinsurers assume an allocated portion of losses for the accident year. Our 2006 reinsurance program provides us with reinsurance coverage for each loss occurrence up to $30.0 million, subject to applicable deductibles, retentions and aggregate limits. However, for any loss occurrence involving only one person, our reinsurance coverage is limited to $10.0 million, subject to applicable deductibles, retentions and aggregate limits. We retain the first $1.0 million of each loss and are subject to an annual aggregate deductible of approximately $10.8 million for losses between $1.0 million and $2.0 million before our reinsurers are obligated to reimburse us. After the deductible is satisfied, we retain 25.0% of each loss between $1.0 million and $2.0 million. The aggregate limit for all claims for losses between $1.0 million and $2.0 million is approximately $5.4 million. We are subject to an annual aggregate deductible of approximately $7.3 million for losses between $2.0 million and $5.0 million before our reinsurers are obligated to reimburse us. The aggregate limit for all claims for losses between $2.0 million and $5.0 million is approximately $39.0 million. See “Business—Reinsurance.” As losses are incurred and recorded, we record amounts recoverable from reinsurers for the portion of the losses ceded to our reinsurers.

 

With limited exceptions, we historically have retained a significant amount of losses under our reinsurance programs. From 1998 through 2000, we substantially lowered our retention to approximately $18,000 per loss occurrence, which means that we ceded a greater portion of our premiums to our reinsurers. The effect of these lower retention levels was a significant increase in the amount of estimated losses assumed by our reinsurers. In addition, our amounts recoverable from reinsurers increased, reaching a high of $360.9 million at April 30, 2001. In 2001 and 2002, we increased our retention level to $500,000. In 2003, we increased our retention to $500,000 plus 20% of each loss occurrence between $500,000 and $5.0 million. In 2004, we further increased our retention level to $1.0 million. In addition, for losses between $1.0 million and $2.0 million, we had an annual aggregate deductible of approximately $300,000 and, after we satisfied the deductible, retained 10% of each loss occurrence. For losses between $2.0 million and $5.0 million, we had an annual aggregate deductible of approximately $1.3 million and, after we satisfied the deductible, retained 20% of each loss occurrence. In 2005, we continued to retain the first $1.0 million of each loss occurrence. However, for losses between $1.0 million and $5.0 million, we increased our annual aggregate deductible to approximately $5.6 million and, after we satisfied the deductible, retained 10% of each loss occurrence. As described below under “—Liquidity and Capital Resources,” effective as of June 30, 2005, we entered into a commutation agreement with one of our reinsurers. Pursuant to this agreement, we released this reinsurer from all liabilities to us under certain reinsurance agreements in exchange for a cash payment of $61.3 million. As a result of increases in our retention levels, the commutation agreement and collections from our reinsurers in the normal course of business, our amounts recoverable from reinsurers have decreased from $199.0 million at December 31, 2004 to $118.9 million at June 30, 2006.

 

Our most significant balance sheet liability is our reserve for loss and loss adjustment expenses. We record reserves for estimated losses under insurance policies that we write and for loss adjustment expenses related to the investigation and settlement of policy claims. Our reserves for loss and loss adjustment expenses represent the estimated cost of all reported and unreported loss and loss adjustment expenses incurred and unpaid at any given point in time based on known facts and circumstances. Reserves are based on estimates of the most likely ultimate cost of individual claims. These estimates are inherently uncertain. Judgment is required to determine the relevance of our historical experience and industry information under current facts and circumstances. The interpretation of this historical and industry data can be impacted by external forces, principally frequency and severity of future claims, length of time to achieve ultimate settlement of claims, inflation of medical costs and wages, insurance policy coverage interpretations, jury determinations and

legislative changes. Accordingly, our reserves may prove to be inadequate to cover our actual losses. If we change our estimates, these changes would be reflected in our results of operations during the period in which they are made, with increases in our reserves resulting in decreases in our earnings. We increased our estimates for prior year loss reserves by $8.7 million in 2005, $13.4 million in 2004 and $2.3 million in 2003. We also recorded a $13.2 million loss in connection with our commutation with Converium in 2005. These increased estimates and the commutation decreased our net income approximately $14.2 million in 2005, $8.7 million in 2004 and $1.5 million in 2003. We have not increased our estimates for prior year loss reserves during the last four quarters.

 

The workers’ compensation insurance industry is cyclical in nature and influenced by many factors, including price competition, medical cost increases, natural and man-made disasters, changes in interest rates, changes in state laws and regulations and general economic conditions. A hard market cycle in our industry is characterized by decreased competition that results in higher premium rates, more restrictive policy coverage terms and lower commissions paid to agencies. In contrast, a soft market cycle is characterized by increased competition that results in lower premium rates, expanded policy coverage terms and higher commissions paid to agencies. We believe that the workers’ compensation insurance industry is slowly transitioning to a more competitive market environment. Our strategy across market cycles is to maintain premium rates, deploy capital judiciously, manage our expenses and focus on underserved markets within our target industries that we believe will provide opportunities for greater returns.

 

Principal Revenue and Expense Items

 

Our revenues consist primarily of the following:

 

Net Premiums Earned. Net premiums earned is the earned portion of our net premiums written. Net premiums written is equal to gross premiums written less premiums ceded to reinsurers. Gross premiums written includes the estimated annual premiums from each insurance policy we write in our voluntary and assigned risk businesses during a reporting period based on the policy effective date or the date the policy is bound, whichever is later, as well as premiums from mandatory pooling arrangements.

 

Premiums are earned on a daily pro rata basis over the term of the policy. At the end of each reporting period, premiums written that are not earned are classified as unearned premiums and are earned in subsequent periods over the remaining term of the policy. Our insurance policies typically have a term of one year. Thus, for a one-year policy written on July 1, 2005 for an employer with constant payroll during the term of the policy, we would earn half of the premiums in 2005 and the other half in 2006.

 

Net Investment Income and Net Realized Gains and Losses on Investments. We invest our statutory surplus funds and the funds supporting our insurance liabilities in fixed maturity and equity securities. In addition, a portion of these funds are held in cash and cash equivalents to pay current claims. Our net investment income includes interest and dividends earned on our invested assets. We assess the performance of our investment portfolio using a standard tax equivalent yield metric. Investment income that is tax-exempt is grossed up by our marginal federal tax rate of 35% to express yield on tax-exempt securities on the same basis as taxable securities. Net realized gains and losses on our investments are reported separately from our net investment income. Net realized gains occur when our investment securities are sold for more than their costs or amortized costs, as applicable. Net realized losses occur when our investment securities are sold for less than their costs or amortized costs, as applicable, or are written down as a result of an other-than-temporary impairment. We classify all of our fixed maturity securities, other than redeemable preferred stock, as held-to-maturity, and all of our equity securities and redeemable preferred stock as available-for-sale. Net unrealized gains (losses) on our equity securities and redeemable preferred stock are reported separately within accumulated other comprehensive income on our balance sheet.

 

Fee and Other Income. We recognize commission income earned on policies issued by other carriers that are sold by our wholly owned insurance agency subsidiary as the related services are performed. We also recognize a small portion of interest income from mandatory pooling arrangements in which we participate.

Our expenses consist primarily of the following:

 

Loss and Loss Adjustment Expenses Incurred. Loss and loss adjustment expenses incurred represents our largest expense item and, for any given reporting period, includes estimates of future claim payments, changes in those estimates from prior reporting periods and costs associated with investigating, defending and servicing claims. These expenses fluctuate based on the amount and types of risks we insure. We record loss and loss adjustment expenses related to estimates of future claim payments based on case-by-case valuations and statistical analyses. We seek to establish all reserves at the most likely ultimate exposure based on our historical claims experience. It is typical for our more serious claims to take several years to settle and we revise our estimates as we receive additional information about the condition of injured employees. Our ability to estimate loss and loss adjustment expenses accurately at the time of pricing our insurance policies is a critical factor in our profitability.

 

Underwriting and Certain Other Operating Costs. Underwriting and certain other operating costs are those expenses that we incur to underwrite and maintain the insurance policies we issue. These expenses include state and local premium taxes and fees and other operating costs, offset by commissions we receive from reinsurers under our reinsurance treaty program. We pay state and local taxes, licenses and fees, assessments and contributions to state workers’ compensation security funds based on premiums. In addition, other operating costs include general and administrative expenses, excluding commissions and salaries and benefits, incurred at both the insurance company and corporate levels.

 

Commissions. We pay commissions to our subsidiary insurance agency and to the independent agencies that sell our insurance based on premiums collected from policyholders.

 

Salaries and Benefits. We pay salaries and provide benefits to our employees.

 

Policyholder Dividends. In limited circumstances, we pay dividends to policyholders in particular states as an underwriting incentive.

 

Interest Expense. Interest expense represents amounts we incur on our outstanding indebtedness at the then-applicable interest rate.

 

Income Tax Expense. We incur federal, state and local income tax expense.

 

Critical Accounting Policies

 

It is important to understand our accounting policies in order to understand our financial statements. Management considers some of these policies to be very important to the presentation of our financial results because they require us to make estimates and assumptions. These estimates and assumptions affect the reported amounts of our assets, liabilities, revenues and expenses and the related disclosures. Some of the estimates result from judgments that can be subjective and complex and, consequently, actual results in future periods might differ from these estimates.

 

Management believes that the most critical accounting policies relate to the reporting of reserves for loss and loss adjustment expenses, including losses that have occurred but have not been reported prior to the reporting date, amounts recoverable from reinsurers, assessments, deferred policy acquisition costs, deferred income taxes and the impairment of investment securities.

 

The following is a description of our critical accounting policies.

 

Reserves for Loss and Loss Adjustment Expenses. We record reserves for estimated losses under insurance policies that we write and for loss adjustment expenses related to the investigation and settlement of policy claims. Our reserves for loss and loss adjustment expenses represent the estimated cost of all reported and unreported loss and loss adjustment expenses incurred and unpaid at any given point in time based on known facts and circumstances. Our reserves for loss and loss adjustment expenses are estimated using case-by-case valuations and statistical analyses.

 

In establishing these estimates, we make various assumptions regarding a number of factors, including frequency and severity of claims, length of time to achieve ultimate settlement of claims, projected inflation of

medical costs and wages, insurance policy coverage interpretations and judicial determinations. Due to the inherent uncertainty associated with these estimates, and the cost of incurred but unreported claims, our actual liabilities may be different from our original estimates. On a quarterly basis, we review our reserves for loss and loss adjustment expenses to determine whether further adjustments are required. Any resulting adjustments are included in the current period’s results. In establishing our reserves, we do not use loss discounting, which would involve recognizing the time value of money and offsetting estimates of future payments by future expected investment income. Additional information regarding our reserves for loss and loss adjustment expenses can be found in “Business—Loss Reserves.”

 

Amounts Recoverable from Reinsurers. Amounts recoverable from reinsurers represent the portion of our paid and unpaid loss and loss adjustment expenses that are assumed by reinsurers. These amounts are separately reported on our balance sheet as assets and do not reduce our reserves for loss and loss adjustment expenses because reinsurance does not relieve us of liability to our policyholders. We are required to pay claims even if a reinsurer fails to pay us under the terms of a reinsurance contract. We calculate amounts recoverable from reinsurers based on our estimates of the underlying loss and loss adjustment expenses, as well as the terms and conditions of our reinsurance contracts, which could be subject to interpretation. In addition, we bear credit risk with respect to our reinsurers, which can be significant because some of the unpaid loss and loss adjustment expenses for which we have reinsurance coverage remain outstanding for extended periods of time.

 

Assessments. We are subject to various assessments and premium surcharges related to our insurance activities, including assessments and premium surcharges for state guaranty funds and second injury funds. Assessments based on premiums are generally paid one year after the calendar year in which the policies are written. Assessments based on losses are generally paid within one year of when claims are paid by us. State guaranty fund assessments are used by state insurance oversight agencies to pay claims of policyholders of impaired, insolvent or failed insurance companies and the operating expenses of those agencies. Second injury funds are used by states to reimburse insurers and employers for claims paid to injured employees for aggravation of prior conditions or injuries. In some states, these assessments and premium surcharges may be partially recovered through a reduction in future premium taxes.

 

Deferred Policy Acquisition Costs. We defer commission expenses, premium taxes and certain marketing, sales, underwriting and safety costs that vary with and are primarily related to the acquisition of insurance policies. These acquisition costs are capitalized and charged to expense ratably as premiums are earned. In calculating deferred policy acquisition costs, these costs are limited to their estimated realizable value, which gives effect to the premiums to be earned, anticipated losses and settlement expenses and certain other costs we expect to incur as the premiums are earned, less related net investment income. Judgments as to the ultimate recoverability of these deferred policy acquisition costs are highly dependent upon estimated future profitability of unearned premiums. If the unearned premiums were less than our expected claims and expenses after considering investment income, we would reduce the deferred costs.

 

Deferred Income Taxes. We use the liability method of accounting for income taxes. Under this method, deferred income tax assets and liabilities are recognized for the future tax consequences attributed to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities resulting from a tax rate change impacts our net income or loss in the reporting period that includes the enactment date of the tax rate change.

 

In assessing whether our deferred tax assets will be realized, management considers whether it is more likely than not that we will generate future taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities, tax planning strategies and projected future taxable income in making this assessment. If necessary, we establish a valuation allowance to reduce the deferred tax assets to the amounts that are more likely than not to be realized.

Impairment of Investment Securities. Impairment of an investment security results in a reduction of the carrying value of the security and the realization of a loss when the fair value of the security declines below our cost or amortized cost, as applicable, for the security and the impairment is deemed to be other-than-temporary. We regularly review our investment portfolio to evaluate the necessity of recording impairment losses for other-than-temporary declines in the fair value of our investments. We consider various factors in determining if a decline in the fair value of an individual security is other-than-temporary. Some of these factors include:

 

 

Share-Based Compensation. As of January 1, 2005 we adopted Statement of Financial Accounting Standards (SFAS) No. 123(R)—Share-Based Payment. In accordance with SFAS No. 123(R) we are using the “modified prospective” method to record prospectively compensation costs for new and modified stock option awards over the applicable vesting periods.

Results of Operations

 

The table below summarizes certain operating results and key measures we use in monitoring and evaluating our operations.