Attached files

file filename
EX-10.65 - EX-10.65 - PATRIOT RISK MANAGEMENT, INC.c54053a8exv10w65.htm
EX-23.2 - EX-23.2 - PATRIOT RISK MANAGEMENT, INC.c54053a8exv23w2.htm
EX-10.64 - EX-10.64 - PATRIOT RISK MANAGEMENT, INC.c54053a8exv10w64.htm
Table of Contents

As filed with the Securities and Exchange Commission on January 8, 2010
Registration No. 333-150864
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
 
 
 
Amendment No. 8
to
Form S-1
 
REGISTRATION STATEMENT
UNDER
THE SECURITIES ACT OF 1933
 
 
 
 
Patriot Risk Management, Inc.
(Exact name of registrant as specified in its charter)
 
         
Delaware   6331   73-1665495
(State or other jurisdiction of
incorporation or organization)
  (Primary Standard Industrial
Classification Code Number)
  (I.R.S. Employer
Identification No.)
401 East Las Olas Boulevard, Suite 1540
Fort Lauderdale, Florida 33301
(954) 670-2900
(Address, including zip code, and telephone number, including area code, of registrant’s principal executive offices)
 
 
 
 
Steven M. Mariano
Chairman, President and Chief Executive Officer
401 East Las Olas Boulevard, Suite 1540
Fort Lauderdale, Florida 33301
(954) 670-2900
(Name, address, including zip code, and telephone number, including area code, of agent for service)
 
 
 
 
Copies to:
 
     
J. Brett Pritchard
Christopher A. Pesch
Locke Lord Bissell & Liddell LLP
111 South Wacker Drive
Chicago, Illinois 60606
(312) 443-0700
  John J. Sabl
Beth Flaming
Sidley Austin LLP
One South Dearborn Street
Chicago, Illinois 60603
(312) 853-7000
 
 
 
 
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
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer o Accelerated filer o Non-accelerated filer þ Smaller reporting company o
(Do not check if a smaller reporting company)
 
CALCULATION OF REGISTRATION FEE
 
             
      Proposed Maximum
    Amount of
Title of Each Class of
    Aggregate
    Registration
Securities to be Registered     Offering Price(1)(2)     Fee(3)
Common Stock, par value $0.001 per share
    $207,000,000     $11,550.60
             
 
(1) Includes amount attributable to shares of common stock issuable upon the exercise of the underwriters’ over-allotment option.
 
(2) Estimated solely for the purpose of calculating the amount of the registration fee in accordance with Rule 457(o) under the Securities Act of 1933, as amended.
 
(3) Previously paid.
 
 
 
 
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 such date as the Commission, acting pursuant to said Section 8(a), may determine.
 


Table of Contents

The information in this prospectus is not complete and may be changed. These securities may not be sold until the registration statement filed with the Securities and Exchange Commission is effective. This prospectus is not an offer to sell these securities and is not soliciting an offer to buy these securities in any jurisdiction where the offer or sale is not permitted.
 
SUBJECT TO COMPLETION, DATED JANUARY 8, 2010
 
PRELIMINARY PROSPECTUS
 
[          ] Shares
 
(PATRIOT LOGO)
 
Common Stock
 
 
 
 
We are offering [          ] shares of our common stock in this firm commitment underwritten public offering. This is our initial public offering. We anticipate that the initial public offering price of our common stock will be between $ [     ] and $ [     ] per share.
 
Prior to this offering, there has been no public market for our common stock, and our common stock is not currently listed on any national exchange or market system. We have applied to have shares of our common stock approved for listing on the New York Stock Exchange under the symbol “PMG.”
 
Investing in our common stock involves risks. See “Risk Factors” beginning on page 14 of this prospectus to read about the risks you should consider before buying our common stock.
 
 
 
 
                 
    Per Share     Total  
 
Price to public
  $                $             
Discounts and commissions to underwriters(1)
  $       $    
Net proceeds (before expenses) to us
  $       $  
 
 
(1) No discounts will be paid to underwriters with respect to shares purchased by our directors, officers and employees or persons having business relationships with us in the directed share program. See “Underwriting” on page 186 of this prospectus for a description of the underwriters’ compensation.
 
We have granted the underwriters the right to purchase up to [     ] additional shares of our common stock at the public offering price, less the underwriting discounts, solely to cover over-allotments, if any. The underwriters can exercise this right at any time within 30 days after the date of our underwriting agreement with them.
 
Neither the Securities and Exchange Commission nor any state securities commission or other regulatory body has approved or disapproved of these securities or determined if this prospectus is truthful or complete. Any representation to the contrary is a criminal offense.
 
The underwriters expect to deliver the shares of our common stock to purchasers against payment on or about [          , 2010].
 
FBR Capital Markets  
  Macquarie Capital  
  Oppenheimer & Co.
 
The date of this prospectus is          , 2010.


 

 
TABLE OF CONTENTS
 
         
    Page
 
    ii  
    1  
    14  
    37  
    38  
    39  
    40  
    42  
    43  
    46  
    97  
    154  
    160  
    175  
    178  
    181  
    183  
    186  
    190  
    190  
    190  
    F-1  
 EX-10.64
 EX-10.65
 EX-23.2


Table of Contents

 
CERTAIN IMPORTANT INFORMATION
 
For your convenience we have included below definitions of terms used in this prospectus.
 
In this prospectus:
 
  •  references to “Patriot,” “our company,” “we,” “us” or “our” refer to Patriot Risk Management, Inc. and its direct and indirect wholly-owned subsidiaries, including Patriot National Group, Inc., Guarantee Insurance Company, PRS Group, Inc. and its subsidiaries and Patriot Underwriters, Inc. and its subsidiary, unless the context suggests otherwise;
 
  •  references to “Patriot Risk Management” refer solely to Patriot Risk Management, Inc., unless the context suggests otherwise;
 
  •  references to “Guarantee Insurance” refer solely to Guarantee Insurance Company, our wholly-owned insurance company;
 
  •  references to “PUI” refer collectively to Patriot Underwriters, Inc. and its direct wholly-owned subsidiary, Patriot General Agency, Inc.;
 
  •  references to “PRS” refer collectively to PRS Group, Inc. and its direct and indirect wholly-owned subsidiaries, including Patriot Risk Services, Inc., Patriot Risk Management of Florida, Inc., Patriot Insurance Management Company, Inc., Patriot Re International, Inc. and Patriot Recovery, Inc., unless the context suggests otherwise;
 
  •  references to “PF&C” and “Argonaut-Southwest” refer solely to Argonaut-Southwest Insurance Company, a shell property and casualty insurance company domiciled in Illinois that is not currently writing new business and that, subject to receiving regulatory approvals, we plan to acquire on or prior to March 4, 2010 and rename as Patriot Fire & Casualty Insurance Company;
 
  •  references to “alternative market business” refer to arrangements in which workers’ compensation insurance policies are written by Guarantee Insurance and the policyholder or another party bears a substantial portion of the underwriting risk, primarily through the reinsurance of the risk by a segregated portfolio captive (as described below). This business also includes other arrangements through which we share underwriting risk with our policyholders, such as pursuant to a large deductible policy or a retrospectively rated policy;
 
  •  references to “traditional business” refer to guaranteed cost workers’ compensation insurance policies written by Guarantee Insurance in which Guarantee Insurance bears substantially all of the underwriting risk, subject to reinsurance arrangements. Workers’ compensation insurance is a system established under state and federal laws under which employers provide insurance for benefit payments to their employees for work-related injuries, deaths and diseases, regardless of fault, in exchange for mandatory relinquishment of the employee’s right to sue his or her employer for the tort of negligence; and
 
  •  references to “segregated portfolio captive” refer to a captive reinsurance company that operates as a single legal entity with segregated pools of assets, or segregated portfolio cells. The pool of assets and associated liabilities of each segregated portfolio cell within a segregated portfolio captive are solely for the benefit of the segregated portfolio cell participants, and the pool of assets of one segregated portfolio cell is statutorily protected from the creditors of the others. In this prospectus, we sometimes refer to the segregated portfolio cell participants as the owners of the cell.
 
Unless otherwise stated, in this prospectus:
 
  •  all amounts assume no exercise of the underwriters’ over-allotment option;
 
  •  all share numbers assume the automatic conversion of our Series A convertible preferred stock, stated value $1,000 per share, into [          ] shares of our common stock and the automatic conversion of our Series B common stock, par value $.001 per share, into [          ] shares of our common stock upon completion of this offering; and


ii


Table of Contents

 
  •  all share amounts (other than the stock options and warrants to be issued upon completion of this offering) have been adjusted to reflect a [          ] to 1 stock split to be effected immediately prior to completion of this offering.
 
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. We 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.


iii


Table of Contents

 
PROSPECTUS SUMMARY
 
This summary highlights information contained elsewhere in this prospectus. Before making a decision to purchase our common stock, you should read the entire prospectus carefully, including the “Risk Factors” and “Forward-Looking Statements” sections and our consolidated financial statements and the notes to those financial statements. Except as otherwise noted, all information in this prospectus assumes that all of the [          ] shares of common stock offered hereby will be sold and that the underwriters will not exercise their over-allotment option.
 
Overview
 
We produce, underwrite and administer alternative market and traditional workers’ compensation insurance plans and provide claims services for insurance companies, segregated portfolio captives and reinsurers. Through our wholly owned insurance company subsidiary, Guarantee Insurance Company (Guarantee Insurance), we generally participate in a portion of the insurance underwriting risk. Our business model has two components:
 
  •  In our insurance services segment, we generate fee income by providing workers’ compensation claims services as well as agency and underwriting services almost entirely for the benefit of Guarantee Insurance, segregated portfolio captives and Guarantee Insurance’s traditional business quota share reinsurers under the Patriot Risk Services brand, and have recently begun providing these services for another insurance company under the Patriot Underwriters’ brand, a practice which we refer to as business process outsourcing, or BPO.
 
  •  In our insurance segment, we generate underwriting income and investment income by providing alternative market workers’ compensation risk transfer solutions and traditional workers’ compensation insurance coverage in Florida and 22 other jurisdictions.
 
We believe that our insurance services capabilities, specialized alternative market product knowledge and our hybrid business model allow us to achieve attractive returns through a range of industry pricing cycles and provide a substantial competitive advantage in areas that are underserved by competitors, which are generally insurance service providers or insurance carriers.
 
In 2009, we began producing business and performing insurance services for ULLICO Casualty Company, which we refer to as our BPO client. ULLICO Casualty Company is licensed to write workers’ compensation insurance in 47 states plus the District of Columbia and is rated “B+” (Good) by A.M Best. We earn commissions for producing business and insurance services income for providing underwriting, policy and claims administration, nurse case management and cost containment services and, in certain cases, services to segregated portfolio cell captives on the business we produce for our BPO client. Additionally, we assume a portion of the premium and associated losses and loss adjustment expenses on the business we produce for our BPO client, as mutually determined on a policy-by-policy basis.
 
Our Services and Products
 
Through our subsidiary, PRS Group, Inc. and its subsidiaries, which we collectively refer to as PRS, and our subsidiary, Patriot Underwriters, Inc. and its subsidiary, which we collectively refer to as PUI, we earn income for workers’ compensation claims services as well as agency and underwriting services. Workers’ compensation claims services include nurse case management, cost containment services and claims administration and adjudication services. Cost containment services refer to workers’ compensation bill review and re-pricing services. Workers’ compensation agency and underwriting services include general agency services and specialty underwriting, policy administration and captive management services. We currently provide these services principally to Guarantee Insurance for its benefit, for the benefit of segregated portfolio captives and for the benefit of Guarantee Insurance’s traditional business quota share reinsurers. We also provide these services to our BPO client.
 
Through Guarantee Insurance, we provide alternative market workers’ compensation risk transfer solutions, including workers’ compensation policies or arrangements where the policyholder, an agent or


1


Table of Contents

another party generally bears a substantial portion of the underwriting risk. For example, the policyholder, an agent or another party may bear a substantial portion of the underwriting risk through the reinsurance of the risk by a segregated portfolio captive that is controlled by the policyholder, an agent or another party. A segregated portfolio captive refers to a captive reinsurance company that operates as a single legal entity with segregated pools of assets, or segregated portfolio cells, the assets and associated liabilities of which are solely for the benefit of the segregated portfolio cell participants. Through our segregated portfolio captive arrangements, we generally retain between 10% and 90% of the underwriting risk and earn a ceding commission from the segregated portfolio captive, which is payment to Guarantee Insurance by the captive of a commission as compensation for providing underwriting, policy and claims administration, captive management and investment portfolio management services. For the nine months ended September 30, 2009, we retained approximately 14% of the underwriting risk under our segregated portfolio captive arrangements.
 
Our alternative market business also includes other arrangements through which we share underwriting risk with our policyholders, such as large deductible policies or policies for which the final premium is based on the insured’s actual loss experience during the policy term, which we refer to as retrospectively rated policies. Unlike our traditional workers’ compensation policies, these arrangements align our interests with those of the policyholders or other parties participating in the risk-sharing arrangements, allowing them to share in the underwriting profit or loss. In addition, our alternative market business includes guaranteed cost policies issued to certain professional employer organizations and professional temporary staffing organizations on which we retain the risk. The excess of loss reinsurance on these policies is provided by the same reinsurer that covers our segregated portfolio captive insurance plans, retrospectively rated plans and large deductible plans, and these plans may be converted to risk sharing arrangements in the future.
 
We provide alternative market risk transfer solutions to companies in a broad array of industries, including employers such as hospitality companies, construction companies, professional employer organizations, clerical and professional temporary staffing companies, industrial companies, car dealerships, food services and retail and wholesale operations.
 
Through Guarantee Insurance, we also provide traditional workers’ compensation insurance coverage. We manage risk through the use of quota share and excess of loss reinsurance. Quota share reinsurance is a form of proportional reinsurance in which the reinsurer assumes an agreed upon percentage of each risk being insured and shares all premiums and losses with us in that proportion. Excess of loss reinsurance covers all or a specified portion of losses on underlying insurance policies in excess of a specified amount, or retention. We typically provide traditional workers’ compensation insurance coverage to:
 
  •  small to medium-sized employers in a broad array of industries, including clerical and professional services, food services, retail and wholesale operations and industrial services;
 
  •  low to medium hazard classes; and
 
  •  accounts with annual premiums below $250,000.
 
Our Competitive Strengths
 
We believe we have the following competitive strengths:
 
  •  Exclusive Focus on Workers’ Compensation Services and Products.  Our operations are focused exclusively on workers’ compensation insurance services, workers’ compensation alternative market risk management solutions and traditional workers’ compensation insurance coverage. We believe this focus allows us to provide superior services and products to our customers relative to multiline insurance service providers and multiline insurance carriers. Furthermore, a significant portion of our services and products are provided in Florida, and we believe that certain of our multiline competitors that offer workers’ compensation coverage as part of a package policy including commercial property coverage tend to compete less for Florida workers’ compensation business because of property-related loss experience.


2


Table of Contents

 
  •  Hybrid Business Model.  In addition to the fee income we earn for nurse case management, cost containment and other insurance services, we also earn ceding commissions on our alternative market business involving segregated portfolio cell captives, and we earn underwriting and investment income on our alternative market and traditional workers’ compensation business. Because our nurse case management and cost containment service income is principally related to workers’ compensation claim frequency and medical costs, the operating results of our insurance services segment are not materially dependent on fluctuations or trends in prevailing workers’ compensation insurance premium rates. We believe that by changing the emphasis we place on our insurance services segment and ceding commission-based alternative market business relative to our traditional workers’ compensation business, we will be better able to achieve attractive returns and growth through a range of market cycles.
 
  •  Targeted Market for Alternative Market Risk Transfer Solutions.  Although other insurers generally only offer alternative market products to large corporate customers, we offer alternative market workers’ compensation solutions to small, medium and larger-sized employers, enabling them and others to share in the claims experience and benefit from favorable loss experience.
 
  •  Enhanced Traditional Business Product Offerings.  In our traditional business, we offer a number of flexible payment plans, including pay-as-you-go plans in which we partner with payroll service companies and our independent agents and their small employer clients to collect premiums and payroll information on a monthly or bi-weekly basis. Pay-as-you-go plans provide us with current payroll data and allow employers to remit premiums through their payroll service provider in an automated fashion. Flexible payment plans give employers a way to purchase workers’ compensation insurance without having to make a large upfront premium deposit payment. We believe that flexible payment plans, including pay-as-you-go plans, for small employers provide us with the opportunity to earn more favorable underwriting margins due to several factors:
 
  i.  favorable cash flows afforded under this plan can be more important to smaller employers than a price differential;
 
  ii.  smaller employers are generally less able to obtain premium rate credits and discounts; and
 
  iii.  the premium remittance mechanism results in a more streamlined renewal process and a lower frequency of business being re-marketed at renewal, leading to more favorable retention rates.
 
  •  Specialized Underwriting Expertise.  We select and price our alternative market and traditional business products based on the specific risk associated with each potential policyholder rather than solely on the policyholder’s industry class. We utilize state-specific actuarial models on accounts with annual premiums over $100,000. In our alternative market business, we seek to align our interests with those of our policyholders or other parties participating in the risk-sharing arrangements by having them share in the underwriting profits and losses. We believe that we can compete effectively for alternative market and traditional insurance business based on our specialized underwriting focus and our accessibility to our clients. We generally compete on these attributes more so than on price, which we believe is generally not a differentiating factor in the states in which we write most of our business. For the nine months ended September 30, 2009 and year ended December 31, 2008, we reported consolidated net loss ratios of 55.9% and 58.3%, respectively. The net loss ratio is the ratio between losses and loss adjustment expenses incurred and net premiums earned, and is a measure of the effectiveness of our underwriting efforts.
 
  •  Effective Claims Management, Nurse Case Management and Cost Containment Services.  Guarantee Insurance began writing business as a subsidiary of Patriot Risk Management, in the first quarter of 2004. As our business has grown, we have been successful in reasonably estimating our total liabilities for losses and loss adjustment expenses, establishing and maintaining adequate case reserves and rapidly closing claims. We provide our customers with an active claims management program. Our claims department employees average more than 12 years of workers’ compensation insurance industry experience, and members of our claims management team average more than 24 years of workers’


3


Table of Contents

  compensation experience. In addition, our nurse case management and bill review professionals have extensive training and expertise in assisting injured workers to return to work quickly. As of December 31, 2008, approximately 6%, 2%, 1% and 0.4% of total reported claims for accident years 2007, 2006, 2005 and 2004, respectively, remained open. Final net paid losses and loss adjustment expenses associated with closed claims are approximately 5% less than the initial reserves established for them.
 
  •  Strong Distribution Relationships.  We maintain relationships with our network of more than 570 independent, non-exclusive agencies in 23 jurisdictions by emphasizing personal interaction and superior service and maintaining an exclusive focus on alternative market workers’ compensation solutions and traditional workers’ compensation insurance coverage. Our experienced underwriters work closely with our independent agents to market our products and serve the needs of prospective policyholders.
 
  •  Proven Leadership and Experienced Management.  The members of our senior management team average over 20 years of insurance industry experience and over 15 years of workers’ compensation insurance experience. Their authority and areas of responsibility are consistent with their functional and state-specific experience.
 
Our Strategy
 
We believe that the net proceeds from this offering will provide us with the additional capital necessary to increase the amount of insurance that we write and to make strategic acquisitions of insurance services operations and insurance companies. We plan to continue pursuing profitable growth and favorable returns on equity and believe that our competitive strengths will help us achieve our goal of delivering attractive returns to our investors. Our strategy to achieve these goals is to:
 
  •  Expand in Our Existing Markets.  In all of the states in which we operate, we believe that a significant portion of total workers’ compensation insurance premium is written by numerous companies that individually have a small market share. We believe that our market share in each of the states in which we currently write business does not exceed 2%. We plan to continue to take advantage of our competitive position to expand in our existing markets. We believe that our risk selection, claims management, nurse case management and cost containment capabilities position us to profitably increase market share in our existing markets.
 
  •  Expand into Additional Markets.  We are licensed to write workers’ compensation insurance in 27 jurisdictions, and we also hold 4 inactive workers’ compensation licenses. For the nine months ended September 30, 2009, we wrote traditional and alternative market business in 23 jurisdictions, principally in those jurisdictions that we believe provide the greatest opportunity for near-term profitable growth. For the nine months ended September 30, 2009, approximately 74% of our traditional and alternative market business was written in Florida, New Jersey, Missouri, Georgia and New York. We wrote approximately 28% of our direct premiums written in Florida for the nine months ended September 30, 2009. We plan to expand our business in states where we believe we can profitably write business. To do this, we plan to continue to leverage our talented pool of personnel, some of whom have prior expertise operating in states in which we do not currently operate. In addition, we may seek to acquire other insurance companies, books of business or other workers’ compensation policy and claims administration providers, general agencies or general underwriting organizations as we expand in our existing markets and into additional markets.
 
  •  Expand our BPO Business.  In 2009, we entered into an agreement to produce business and perform insurance services for our BPO client to gain access to workers’ compensation insurance business in certain additional states. For the nine months ended September 30, 2009, approximately 34% of the business we produced and serviced for our BPO client was in California, and approximately 31% of such business was in either Texas, Michigan, Illinois or South Carolina. In the fourth quarter of 2009, we entered into BPO relationships with two other companies, and we are seeking to enter into additional BPO relationships.


4


Table of Contents

 
  •  Expand Nurse Case Management, Cost Containment and Other Insurance Services Operations.  We plan to continue to generate fee income through our insurance services segment by offering workers’ compensation nurse case management and cost containment services to segregated portfolio captives and our quota share reinsurers. We plan to offer these services, together with general agency, general underwriting and policy and claims administration services, to other regional and national insurance companies and self-insured employers. We also plan to increase our insurance services income by expanding both organically and through strategic acquisitions of workers’ compensation policy and claims administration service providers, general agencies or general underwriting organizations. Taking advantage of our hybrid business model, we plan to identify and acquire insurance services operations that will create synergies with our alternative market and traditional workers’ compensation business.
 
  •  Obtain a Favorable Rating from A.M. Best.  We have been informed by A.M. Best that after completion of this offering, we may expect Guarantee Insurance to receive a financial strength rating of “A−” (Excellent), which is the fourth highest of fifteen A.M. Best rating levels. This indicative rating assignment is subject to the capitalization of Guarantee Insurance (and PF&C if we acquire it) at a level that A.M. Best requires to support the assignment of the “A−” rating through 2012. We expect that the contribution of $155 million of the net proceeds of this offering to Guarantee Insurance (and PF&C if we acquire it) on or prior to March 4, 2010 will be sufficient to satisfy this requirement. If we acquire PF&C as described elsewhere in this prospectus, this rating assignment is also conditioned upon regulatory approval of a pooling agreement between Guarantee Insurance and PF&C. Pooling is a risk-sharing arrangement under which premiums and losses are shared between the pool members. We expect to make the contemplated capital contributions when we purchase PF&C or conclude not to proceed with that transaction, in either event prior to March 4, 2010. The prospective rating indication we received from A.M. Best is not a guarantee of final rating outcome. In addition, in order to maintain this rating, Guarantee Insurance (as well as PF&C if it is acquired) must maintain capitalization at a level that A.M. Best requires to support the assignment of the “A−” rating, and any material negative developments in our operations, including in terms of management, earnings, capitalization or risk profile could result in negative rating pressure and possibly a rating downgrade. While we have expanded our business profitably without an A.M. Best rating and we believe that we can continue to do so with the net proceeds from this offering, we believe that an “A−” rating from A.M. Best would increase our ability to market to large employers and create new opportunities for our products and services in rating sensitive markets. A.M. Best’s ratings reflect its opinion of an insurance company’s financial strength and ability to meet ongoing obligations to policyholders and are not intended for the protection of investors.
 
  •  Leverage Existing Infrastructure.  We service our insurance services customers and policyholders through regional offices in three states, each of which we believe has been staffed to accommodate a certain level of insurance services business and premium growth. We plan to realize economies of scale in our workforce and leverage other scalable infrastructure costs.
 
Our Challenges and Risks
 
Our company and our business are subject to numerous risks as more fully described in the section of this prospectus entitled “Risk Factors.” As part of your evaluation of our business, you should consider the challenges and risks we face in implementing our business strategies, including the following:
 
  •  Adequacy of Loss Reserves.  Our loss reserves are based upon estimates that are uncertain. These estimates may be inadequate to cover our actual losses, in which case we would need to increase our reserves, which would result in a decrease in our net income. In addition, Guarantee Insurance has legacy asbestos and environmental claims arising out of the sale of general liability insurance and participations in reinsurance assumed through underwriting management organizations prior to 1984. There are significant additional uncertainties in estimating the amount of potential losses from asbestos and environmental claims. As a result, it is more difficult to estimate what the ultimate loss costs will be for these claims than for other types of claims.


5


Table of Contents

 
  •  Pricing Our Premiums.  We underwrite and price our insurance policies at their inception before all of the underlying costs are known. If we price our premiums too low, we will have insufficient income to cover our losses and expenses. In addition, we do business in several administered pricing states, including Florida, where insurance rates are set by the state insurance regulatory authorities and are adjusted periodically. There can be no assurance that state-mandated insurance rates in administered pricing states will enable us to generate appropriate underwriting margins. For the nine months ended September 30, 2009 and the year ended December 31, 2008, we wrote approximately 52% and 67% of our direct premiums written, respectively, in administered pricing states.
 
  •  Geographic Concentration.  Our business is concentrated in Florida and a few other states. Our financial performance is tied to the business, economic and regulatory conditions in these states. If the environment in these states worsens, there could be an adverse effect on our business, financial condition and results of operations.
 
  •  Cyclical Nature of the Workers’ Compensation Industry and Economic Downturn.  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 is beyond our control and may adversely affect our overall financial performance. In addition, the prevailing macroeconomic conditions in the fourth quarter of 2008 and in 2009 have led to a decrease in payrolls and a corresponding decrease in workers’ compensation direct premiums written.
 
  •  Limited Operating History.  We commenced operations in 2004 after acquiring Guarantee Insurance, and we formed PRS in 2005. An investor in our common stock should consider that, as a relatively new company, we have a limited operating history on which you can evaluate our performance and base an estimate of our future earning prospects. Accordingly, our future results of operations or financial condition may vary significantly from expectations.
 
Recent Developments
 
New BPO Relationships
 
In December 2009, we entered into a new BPO relationship with Advantage Workers Compensation Insurance Company (Advantage WC), an insurer rated “A−” (Excellent) by A.M. Best, pursuant to which we will produce business and perform insurance services for Advantage WC in certain Midwestern states. In November 2009, we entered into an agreement with Advantage Specialty, Inc. and its affiliate, Scibal Associates, Inc., to produce business for SPARTA Insurance Holdings, Inc. in certain states. We do not expect to assume any risk related to the business we produce for Advantage WC or SPARTA. Because we established these relationships in the fourth quarter of 2009, references in this prospectus to “our BPO client” refer only to Ullico Casualty Company.
 
Warrant Issuance
 
Prior to the completion of this offering, we expect that our board of directors will declare a dividend of warrants to purchase a total of [          ] shares of our common stock, payable to our stockholders at the effective time of this offering. Each warrant would represent the right to purchase one share of our common stock at the same price as the common stock sold in this offering. The right to purchase common stock under the warrants would begin upon the expiration of the lock-up agreements as described in “Shares Eligible for Future Sale — Lock-Up Agreements.” The warrants would expire 10 years after the date of issuance. The warrants also would contain a cashless exercise provision. These warrants would be subject to the restrictions contained in the lock-up agreements.
 
Acquisition of Shell Insurance Company
 
On December 18, 2009, we entered into a stock purchase agreement with Argonaut Insurance Company to acquire Argonaut-Southwest Insurance Company, a shell property and casualty insurance company


6


Table of Contents

domiciled in Illinois that is licensed to write workers’ compensation insurance in Arizona, Arkansas, California, Illinois, Louisiana, Mississippi, New Jersey, New Mexico, Oklahoma, Oregon, and Texas. Guarantee Insurance is licensed in each of these jurisdictions except for Arizona, California, Illinois, Oregon, and Texas. We plan to rename Argonaut-Southwest as Patriot Fire & Casualty Insurance Company (PF&C) when we acquire it, and as a condition to the acquisition we will seek to have it redomesticated to Florida. The redomestication and acquisition are subject to regulatory approvals by both the Illinois and Florida insurance departments. In addition, if we acquire PF&C, our prospective rating assignment from A.M. Best is conditioned upon Florida regulatory approval of a pooling agreement between PF&C and Guarantee Insurance that is satisfactory to A.M. Best. If we receive all regulatory approvals for this transaction, we plan to acquire PF&C on or prior to March 4, 2010. There can be no assurance that we will obtain the necessary regulatory approvals to complete this acquisition. We do not believe that our failure to acquire PF&C will adversely affect our business plan or prevent us from obtaining the “A−” rating from A.M. Best that we expect to receive upon completion of this offering.
 
We intend to contribute a substantial portion of the net proceeds of this offering to Guarantee Insurance and PF&C (if we acquire it) in order to support their premium writings.
 
Our Organization
 
Patriot Risk Management, Inc. was incorporated in Delaware in April 2003 by Steven M. Mariano, our Chairman, President and Chief Executive Officer. In September 2003, our wholly owned subsidiary, Patriot National Insurance Group, Inc., acquired Guarantee Insurance, a shell property and casualty insurance company that was not writing new business at the time we acquired it. At that time, Guarantee Insurance had approximately $3.2 million in loss and loss adjustment expense reserves relating to commercial general liability claims that had been in run-off since 1983, and was licensed to write insurance business in 41 states and the District of Columbia. Guarantee Insurance is domiciled in Florida and began writing business as a subsidiary of Patriot Risk Management in the first quarter of 2004. Guarantee Insurance is currently licensed to write workers’ compensation insurance in 27 jurisdictions, and also holds 4 inactive workers’ compensation licenses.
 
In 2005, we formed PRS Group, Inc. as a wholly owned subsidiary and incorporated Patriot Risk Services, Inc. PRS provides nurse case management and cost containment services for the benefit of Guarantee Insurance, segregated portfolio captives, our quota share reinsurers and our BPO client.
 
In 2008, we formed Patriot Recovery, Inc. to assist us in investigation and subrogation activities.
 
In 2009, we established Patriot Underwriters, Inc. and its subsidiary, Patriot General Agency, Inc., to provide general agency and general underwriting services to third parties. Through PUI and PRS, we are currently licensed as an insurance agent or producer in 46 jurisdictions, and currently have several pending agency licenses.
 
Prior to November 2009, Patriot National Insurance Group, Inc. was named Guarantee Insurance Group, Inc.


7


Table of Contents

Patriot’s current corporate structure is as follows:
 
(CHART)
 
 
* Subject to obtaining regulatory approvals, we plan to acquire PF&C on or prior to March 4, 2010. See “— Recent Developments — Acquisition of Shell Insurance Company.”
 
Patriot Risk Management, Inc. is an insurance holding company that was incorporated in Delaware in 2003. Our principal subsidiaries are Guarantee Insurance Company, Patriot Underwriters, Inc. and Patriot Risk Services, Inc. Our executive offices are located at 401 East Las Olas Boulevard, Suite 1540, Fort Lauderdale, Florida 33301, and our telephone number at that location is (954) 670-2900.


8


Table of Contents

The Offering
 
Shares of common stock offered by us [          ] shares
 
Over-allotment shares of common stock offered by us
[          ] shares
 
Shares of common stock to be outstanding after the offering
[          ] shares
 
Use of proceeds We estimate that our net proceeds from this offering will be approximately $[     ] million, based on an assumed initial public offering price of $[     ] per share, which is the mid-point of the price range set forth on the cover page of this prospectus, and after deducting the estimated underwriting discounts and commissions and our estimated offering expenses. We estimate that our net proceeds will be approximately $[     ] million if the underwriters exercise their over-allotment option in full. We intend to contribute approximately $[     ] million to Guarantee Insurance to support its premium writings. As described elsewhere in this prospectus, we have entered into a stock purchase agreement to acquire PF&C, a shell property and casualty insurance company. The acquisition of PF&C is subject to various regulatory approvals. If we obtain these regulatory approvals and consummate the acquisition on or prior to March 4, 2010, we plan instead to use approximately $16.7 million of the net proceeds of this offering to pay the purchase price for PF&C (of which approximately $15.5 million represents the capital and surplus of PF&C), to contribute approximately $[     ] million to PF&C to support its premium writings, and to contribute approximately $[     ] million to Guarantee Insurance to support its premium writings. We expect that the remaining $[     ] million, or $[     ] million if we acquire PF&C, will be used to support our anticipated growth and general corporate purposes and to fund other holding company operations, including the repayment of all or a portion of our existing indebtedness and potential acquisitions although we have no current understandings or agreements regarding any such acquisitions (other than PF&C). If the underwriters exercise all or any portion of their over-allotment option, we intend to use all or a substantial portion of the net proceeds therefrom to pay down the balance of our credit facilities as described elsewhere in this prospectus. See “Use of Proceeds.”
 
Dividend policy We do not expect to pay any cash dividends on our common stock for the foreseeable future. We currently intend to retain any additional future earnings to finance our operations and growth. 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 and other restrictions on the payment of dividends by us or by our subsidiaries to us, and other factors that our board of directors deems relevant.
 
Proposed New York Stock Exchange symbol
“PMG”


9


Table of Contents

 
The number of shares of common stock shown to be outstanding upon completion of the offering excludes:
 
  •  up to [          ] shares of common stock that may be issued pursuant to the underwriters’ over-allotment option;
 
  •  163,500 shares of common stock issuable upon the exercise of options outstanding as of December 31, 2009;
 
  •  [          ] shares of common stock issuable upon the exercise of stock options we intend to grant to our directors, executive officers and other employees upon completion of this offering, at an exercise price equal to the initial public offering price;
 
  •  [          ] shares of common stock issuable upon the exercise of warrants we intend to issue to our existing stockholders upon completion of this offering, at an exercise price equal to the initial public offering price; and
 
  •  [          ] additional shares of common stock available for future issuance under our 2010 Stock Incentive Plan.


10


Table of Contents

SUMMARY HISTORICAL CONSOLIDATED FINANCIAL INFORMATION
 
The following income statement data for the nine months ended September 30, 2009 and 2008 and balance sheet data as of September 30, 2009 were derived from our unaudited consolidated financial statements included elsewhere in this prospectus. The income statement data for the years ended December 31, 2008, 2007 and 2006 were derived from our audited consolidated financial statements included elsewhere in this prospectus. The income statement data for the years ended December 31, 2005 and 2004 were derived from our audited consolidated financial statements that are not included in this prospectus. These historical results are not necessarily indicative of results to be expected in any future period. You should read the following summary 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.
 
                                                         
    Nine Months
       
    Ended September 30,     Years Ended December 31,  
    2009     2008     2008     2007     2006     2005     2004  
    (Unaudited)     In thousands, except per share data and percentages  
 
Income Statement Data
                                                       
Gross premiums written
  $ 95,972     $ 94,878     $ 117,563     $ 85,810     $ 62,372     $ 47,576     $ 30,911  
Ceded premiums written
    56,573       52,926       71,725       54,894       42,986       23,617       22,702  
                                                         
Net premiums written
    39,399       41,952       45,838       30,961       19,386       23,959       8,209  
                                                         
Revenues
                                                       
Net premiums earned
    28,369       32,276       49,220       24,613       21,053       21,336       2,948  
Insurance services income
    9,753       4,706       5,657       7,027       7,175       4,369       6,429  
Net investment income
    1,354       1,487       2,028       1,326       1,321       1,077       233  
Net realized gains (losses) on investments
    903       (253 )     (1,037 )     (5 )     (1,346 )     (2,298 )     (4,632 )
                                                         
Total revenues
    40,379       38,216       55,868       32,961       28,203       24,484       4,978  
                                                         
Expenses
                                                       
Net losses and loss adjustment expenses
    15,864       20,719       28,716       15,182       17,839       12,022       2,616  
Net policy acquisition and underwriting expenses
    8,498       8,176       13,535       6,023       3,834       3,168       2,016  
Other operating expenses
    11,100       8,055       10,930       8,519       9,704       6,378       4,989  
Interest expense
    1,119       1,102       1,437       1,290       1,109       1,129       555  
                                                         
Total expenses
    36,581       38,052       54,618       31,014       32,486       22,697       10,176  
                                                         
Other income
          219       1,469             796             110  
Loss from write-off of deferred equity offering costs(1)
                (3,486 )                        
Gain on early extinguishment of debt(2)
                            6,586              
                                                         
Income (loss) before income tax expense benefit
    3,798       383       (767 )     1,947       3,099       1,787       (5,088 )
Income tax expense (benefit)
    1,422       (217 )     (643 )     (432 )     1,489       687       (751 )
                                                         
Net income (loss)
  $ 2,376     $ 600     $ (124 )   $ 2,379     $ 1,610     $ 1,100     $ (4,337 )
                                                         
Earnings Per Share
                                                       
Basic
  $ 1.95     $ 0.44     $ (0.09 )   $ 1.77     $ 1.16     $ 0.88       NM (3)
Diluted
    1.94       0.44       (0.09 )     1.76       1.15       0.87       NM (3)
Weighted Average Common Shares Outstanding:
                                                       
Basic
    1,216       1,361       1,361       1,342       1,392       1,251       NM (3)
Diluted
    1,225       1,370       1,361       1,351       1,398       1,258       NM (3)
Return on average equity(4)
    36.7 %     15.1 %     NM (6)     58.5 %     107.0 %     NM (7)     NM (8)
Selected Insurance Ratios(5)
                                                       
Net loss ratio
    55.9 %     64.2 %     58.3 %     61.7 %     84.7 %     56.3 %     NM (3)
Net expense ratio
    30.0 %     25.3 %     27.5 %     24.5 %     18.2 %     14.8 %     NM (3)
                                                         
Net combined ratio
    85.9 %     89.5 %     85.8 %     86.2 %     102.9 %     71.1 %     NM (3)
                                                         
 


11


Table of Contents

                 
    September 30, 2009  
    Actual     As Adjusted(9)  
    (Unaudited)
 
    In thousands  
 
Balance Sheet Data
               
Investments
  $ 47,051       47,051  
Cash and cash equivalents
    7,452       [     ]  
Amounts recoverable from reinsurers
    58,328       58,328  
Premiums receivable, net
    83,040       83,040  
Prepaid reinsurance premiums
    42,010       42,010  
Other assets
    19,910       21,110  
                 
Total assets
  $ 257,791       [     ]  
                 
Reserves for losses and loss adjustment expenses
  $ 83,210       83,210  
Unearned and advanced premium reserves
    63,702       63,702  
Reinsurance funds withheld and balances payable
    56,458       56,458  
Debt and accrued interest
    20,089       20,089  
Other liabilities
    24,203       24,203  
                 
Total liabilities
    247,662       247,662  
Stockholders’ equity
    10,129       [     ]  
                 
Total liabilities and stockholders’ equity
  $ 257,791       [     ]  
                 
 
 
(1) In 2008, we wrote off approximately $3.5 million of deferred equity offering costs incurred in connection with our prior efforts to consummate an initial public offering during 2007 and 2008.
 
(2) In 2006, Guarantee Insurance entered into a settlement and termination agreement with the former owner of Guarantee Insurance that allowed for an early extinguishment of debt in the amount of $8.8 million in exchange for $2.2 million in cash and release of the indemnification agreement previously entered into by the parties. As a result, we recognized a gain on the early extinguishment of debt on a pre-tax basis of approximately $6.6 million. We also recognized other income in connection with the forgiveness of accrued interest associated with the early extinguishment of debt on a pre-tax basis of $796,000.
 
(3) We do not believe this metric is meaningful for the period indicated.
 
(4) Return on average equity for a given period (annualized in the case of periods less than one year) is calculated by dividing net income for that period by average stockholders’ equity as of the beginning and end of the period.
 
(5) The net loss ratio is calculated by dividing net losses and loss adjustment expenses by net premiums earned. The net expense ratio is calculated by dividing net policy acquisition and underwriting expenses (which are comprised of gross policy acquisition costs and other gross expenses incurred in our insurance operations, net of ceding commissions earned from our reinsurers) by net premiums earned. The net combined ratio is the sum of the net loss ratio and the net expense ratio.
 
(6) In 2008, we reported a net loss of $124,000, principally as a result of a non-recurring loss from the write-off of deferred equity offering costs of approximately $3.5 million as described above. Due to this non-recurring charge, our return on average equity for 2008 was (2.0)%, which we do not believe is meaningful.
 
(7) In 2005, we reported net income of $1.1 million. However, our average stockholders’ equity for 2005 was only approximately $180,000, which results in a return on average equity of 609.4%, which we do not believe is meaningful.
 
(8) In 2004, we reported a net loss of $4.3 million, principally as a result of a loss from the write-off of an investment in Foundation Insurance Company, a subsidiary of Tarheel Group, Inc., as described below

12


Table of Contents

under “Certain Relationships and Related Transactions.” Due to this change, our return on average equity for 2004 was (19,275.6)%, which we do not believe is meaningful.
 
(9) The As Adjusted balance sheet data as of September 30, 2009 reflects the issuance of [          ] shares of our common stock at the assumed initial public offering price of $[     ] per share, which is the mid-point of the price range set forth on the cover page of this prospectus, and the application of the net proceeds therefrom after deducting estimated underwriting discounts and commissions and our estimated offering expenses.


13


Table of Contents

 
RISK FACTORS
 
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. Many factors, including the risks described below, could result in a significant or material adverse effect on our business, financial condition and results of operations. If this were to happen, the price of our shares could decline significantly and you could lose all or part of your investment.
 
Risks Related to Our Business
 
Our business, financial condition and results of operations may be adversely affected if our actual losses and loss adjustment expenses exceed our estimated loss and loss adjustment expense reserves.
 
We maintain reserves for estimated losses and loss adjustment expenses. Loss and loss adjustment expense reserves 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. Such reserves are estimates and are therefore inherently uncertain. Judgment is required to determine the degree to which historical payment and claim settlement patterns should be considered in establishing loss and loss adjustment expense reserves. The interpretation of historical data can be impacted by external forces, such as legislative changes, economic fluctuations and legal trends.
 
Our net reserves for losses and loss adjustment expenses at December 31, 2008, 2007, 2006, 2005 and 2004 were $37.1 million, $26.6 million, $24.8 million, $17.4 million and $11.8 million, respectively. At December 31, 2008, our re-estimated reserves for the years ended December 31, 2007, 2006, 2005 and 2004 were $27.9 million, $21.3 million, $16.7 million and $11.4 million, respectively. Accordingly, at December 31, 2008, our reserves for the years ended December 31, 2007, 2006, 2005 and 2004 showed a net cumulative redundancy (deficiency) of approximately ($1.3 million), $3.6 million, $697,000 and $429,000, respectively. Our historical claims data is not fully developed, and, accordingly, in addition to our own historical claims data, we currently utilize industry data in establishing our reserves. Key assumptions that we utilize to estimate our reserves include industry frequency and severity trends and health care cost and utilization patterns. There can be no assurance that our reserves will be adequate in the future. If there are unfavorable changes in our assumptions, our reserves may need to be increased.
 
It is difficult to estimate reserves for workers’ compensation claims, because workers’ compensation claims are often paid over a long period of time, and there are no policy limits on liability for claim amounts. Accordingly, our reserves may prove to be inadequate to cover our actual losses. We review our loss reserves each quarter. We may adjust our loss reserves based on the results of these reviews, and these adjustments could be significant. If we change our estimates, these changes would result in adjustments to our loss reserves and losses 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.
 
Additionally, we have certain exposures related to legacy commercial general liability claims, including asbestos and environmental liability claims, and there can be no assurance that our loss and loss adjustment expense reserves for these claims are adequate. See “— Guarantee Insurance has legacy commercial general liability claims, including asbestos and environmental liability claims.”
 
If we do not properly price our insurance policies, our business, financial condition and results of operations will be adversely affected; we do not set prices for our policies in Florida or the other administered pricing states where we write premiums.
 
If our premium rates are too low, our results of operations and our profitability will be adversely affected, and if our premium rates are too high, our competitiveness may be reduced and we may generate lower revenues.


14


Table of Contents

In general, the premium rates for our insurance policies are established by us (in states other than administered pricing states, as discussed below) when coverage is initiated and, therefore, before all of the underlying costs are known. Like other workers’ compensation insurance companies and insurance holding companies, we rely on estimates and assumptions in setting our premium rates. Establishing adequate rates is necessary to generate sufficient revenue, together with investment income, to operate profitably. If we fail to accurately assess the risks that we assume, we may fail to charge adequate premium rates. For example, when underwriting coverage on a new policy, 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 or not indicative of future claims experience, we may under-price our policies 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:
 
  •  collect and properly analyze a substantial volume of data;
 
  •  develop, test and apply appropriate rating formulae;
 
  •  closely monitor and timely recognize changes in trends; and
 
  •  make assumptions regarding both the frequency and severity of losses with reasonable accuracy.
 
We must also price our insurance policies appropriately for each jurisdiction. The assumptions we make regarding our premium rates in states in which we currently write policies may not be appropriate for new geographic markets into which we may expand. Our ability to establish appropriate premium rates in new markets is subject to a number of risks and uncertainties, principally:
 
  •  insufficient reliable data;
 
  •  incorrect or incomplete analysis of available data;
 
  •  uncertainties generally inherent in estimates and assumptions, especially in markets in which we have less experience;
 
  •  our inability to implement appropriate rating formulae or other pricing methodologies;
 
  •  regulatory constraints on rate increases;
 
  •  costs of ongoing medical treatment;
 
  •  our inability to accurately estimate retention, investment yields and the duration of our liability for losses and loss adjustment expenses; and
 
  •  unanticipated court decisions, legislation or regulatory action.
 
For the nine months ended September 30, 2009 and the years ended December 31, 2008 and 2007, we wrote approximately 52%, 67% and 70% of our direct premiums written, respectively, in administered pricing states — Florida, Indiana, New Jersey, and, prior to October 1, 2008, New York. Effective October 1, 2008, New York is no longer an administered pricing state. In 2008, we wrote approximately 46% of our direct premiums written in Florida. In administered pricing states, insurance rates are set by the state insurance regulators and are adjusted periodically. Rate competition generally is not permitted in these states. Therefore, rather than setting rates for the policies, our underwriting efforts in these states for our traditional business relate primarily to the selection of the policies we choose to write at the premium rates that have been set.
 
The Florida Office of Insurance Regulation, or the Florida OIR, has approved overall workers’ compensation rate decreases of 6.8%, 18.6%, 18.4% and 15.7%, effective as of January 1, 2010, 2009, 2008 and 2007, respectively. If a state insurance regulator lowers premium rates, we may be less profitable, and we may choose not to write policies in that state. We have responded to Florida rate decreases by expanding our alternative market business in Florida and strengthening our collateral on that business where appropriate. In addition, we have the ability to offer different kinds of policies in administered pricing states, including retrospectively rated policies and dividend policies, for which an insured can receive a return of a portion of the premium paid if the insured’s claims experience is favorable. We expect an increase in Florida experience


15


Table of Contents

rate modifications, which permit us to increase the premium charged based on a policyholder’s loss history. We anticipate that our ability to adjust to these market changes will create opportunities as our competitors find the Florida market less desirable. However, there can be no assurance that state mandated insurance rates in administered pricing states will enable us to generate appropriate underwriting margins. Furthermore, there can be no assurance that alternative kinds of policies in administered pricing states will continue to be permitted or will enable us to generate appropriate underwriting margins.
 
Our geographic concentration ties our performance to business, economic and regulatory conditions in Florida and certain other states.
 
In 2008, we wrote insurance in 22 states and the District of Columbia. For the nine months ended September 30, 2009 and the years ended December 31, 2008 and 2007, approximately 28%, 46% and 59% of our total direct premiums written, respectively, were concentrated in our largest state, Florida.
 
For the nine months ended September 30, 2009, approximately 34% of our alternative market business direct premiums written were concentrated in Florida, and approximately 20%, 12% and 10% were concentrated in New Jersey, Georgia and New York, respectively. No other state accounted for more than 5% of our alternative market business direct premiums written for the nine months ended September 30, 2009.
 
For the nine months ended September 30, 2009, approximately 22% and 21% of our traditional business direct premiums written were concentrated in Florida and New Jersey, respectively, and between 5% and 10% were concentrated in each of Georgia, Indiana, Arkansas, New York and Missouri. No other state accounted for more than 5% of our traditional business direct premiums written for the nine months ended September 30, 2009.
 
Unfavorable business, economic or regulatory conditions in the states where we conduct the majority of our traditional and alternative market business could have a significant adverse impact on our business, financial condition and results of operations. In Florida, the state in which we write the majority of our premium, and also in Indiana and New Jersey, insurance regulators establish the premium rates we charge. In these states, insurance regulators may set rates below those that we require to maintain profitability.
 
Because our business is concentrated in Florida and certain other states, we may be exposed to economic and regulatory risks that are greater than the risks we would face if our business were spread more evenly by state. Our workers’ compensation insurance operations are affected by the economic health of the states in which we operate. Premium growth is dependent upon payroll growth, which, in turn, is affected by economic conditions. Furthermore, losses and loss adjustment expenses can increase in weak economic conditions because it is more difficult to return injured workers to work when employers are otherwise reducing payrolls. Florida is exposed to severe natural perils, such as hurricanes. If Florida were to experience a natural peril of the magnitude of Hurricane Katrina or other catastrophic event, the result could be a disruption of the entire local economy and the loss of jobs, which could have a material adverse effect on our business, financial condition and results of operations. We could also be adversely affected by any material change in Florida law or regulation or any Florida court decision affecting workers’ compensation carriers generally. Unfavorable changes in economic conditions affecting the states in which we write business could adversely affect our business, financial condition and results of operations.
 
The workers’ compensation insurance industry is cyclical in nature, which may affect our overall financial performance.
 
Historically, the workers’ compensation insurance market has undergone cyclical periods of price competition and excess underwriting capacity (known as a soft market), followed by periods of high premium rates and shortages of underwriting capacity (known as a hard market). Although an individual insurance company’s financial performance is dependent on its own specific business characteristics, the profitability of most workers’ compensation insurance companies tends to follow this cyclical market pattern. Additional underwriting capacity, and the resulting increased competition for premium, is the result of insurance companies expanding the types or amounts of business they write, or of companies seeking to maintain or increase market share at the expense of underwriting discipline. In our traditional workers’ compensation


16


Table of Contents

business, we have been experiencing increased price competition since 2007 in certain markets, and these cyclical patterns, the actions of our competitors and general economic factors could cause our revenue and net income to fluctuate, which may cause the price of our common stock to be volatile. Because this cyclicality is due in large part to the actions of our competitors and general economic factors beyond our control, we cannot predict with certainty the timing or duration of changes in the market cycle.
 
Because we have a limited operating history, our future operating results and financial condition are more likely to vary from expectations.
 
We commenced operations in 2004 after acquiring Guarantee Insurance, and we formed PRS Group, Inc. in 2005. As a relatively new company, we have a limited operating history on which you can evaluate our performance and base an estimate of our future earning prospects. In addition, our business plan contemplates that we will expand into new geographic areas and provide claims administration, general agency and general underwriting services to other insurance companies and self-insured employers through additional business process outsourcing relationships. We cannot assure you that we will obtain the regulatory approvals necessary for us to conduct business as planned or that any approval granted will not be subject to conditions that restrict our operations. In addition, we cannot assure you that we will have, or be able to raise, the funds necessary to capitalize our subsidiaries in order to further grow our business. Accordingly, our future results of operations or financial condition may vary significantly from expectations.
 
Our insurance services fee income and insurance services net income is currently substantially dependent on Guarantee Insurance’s premium levels.
 
Our insurance services fee income and insurance services net income is generated primarily from Guarantee Insurance, segregated portfolio captives and our quota share reinsurers. If Guarantee Insurance premium levels decrease, we would experience a corresponding decrease in insurance services fee income and insurance services net income. There can be no assurance that Guarantee Insurance premium levels will not decrease.
 
Our insurance services fee income is currently substantially dependent on Guarantee Insurance’s risk retention levels.
 
Because insurance services fee income earned by PRS from Guarantee Insurance attributable to the portion of the insurance risk that Guarantee Insurance retains and assumes from other insurance companies is eliminated upon consolidation, our insurance services income, on a consolidated basis, is currently substantially dependent on Guarantee Insurance’s risk retention levels. If Guarantee Insurance increases its risk retention levels, our insurance services fee income will decrease, in which case we would also experience a corresponding decrease in our losses and loss adjustment expenses and net policy acquisition and underwriting expenses. Guarantee Insurance’s risk retention levels, measured by the ratio of net premiums earned to gross premiums earned, were 49% and 33% for the years ended December 31, 2008 and 2007, respectively. Guarantee Insurance entered into additional quota share agreements effective December 31, 2008 and January 1, 2009 which reduced our risk retention levels in 2009. Our risk retention rate for the nine months ended September 30, 2009 was 37%. There can be no assurance as to our overall risk retention levels in the future.
 
We need to obtain additional licenses to allow us to provide insurance services to third parties.
 
As part of our business plan, we expect to expand our fee-generating insurance services by offering policy and claims administration, general agency and general underwriting services to other regional and national insurance companies and self-insured employers. We also plan to explore strategic acquisitions of policy and claims administrators, general agencies or general underwriters. In order to expand these services, we will need to obtain additional licenses to allow us to provide certain of these services to third parties. However, there can be no assurance that we will be successful in expanding these fee-generating services or obtaining the necessary licenses. Our failure to expand these services would have a material adverse effect on our business plan.


17


Table of Contents

Guarantee Insurance has legacy commercial general liability claims, including asbestos and environmental liability claims.
 
Guarantee Insurance has legacy commercial general liability claims, including asbestos and environmental liability claims, arising out of the sale of general liability insurance and participations in reinsurance assumed through underwriting management organizations, commonly referred to as pools. Guarantee Insurance ceased offering direct liability coverage in 1983 and ceased participations in reinsurance pools after 1982. In addition to the general uncertainties encountered in estimating workers’ compensation loss and loss adjustment expense reserves described above, there are significant additional uncertainties in estimating the amount of our potential losses from asbestos and environmental claims. Generally, reserves for asbestos and environmental claims cannot be estimated with traditional loss reserving techniques that rely on historical accident year development factors due to the uncertainties surrounding asbestos and environmental liability claims. Among the uncertainties impacting the estimation of such losses are:
 
  •  potentially long waiting periods between exposure and emergence of any bodily injury or property damage;
 
  •  difficulty in identifying sources of environmental or asbestos contamination;
 
  •  difficulty in properly allocating responsibility and liability for environmental or asbestos damage;
 
  •  changes in underlying laws and judicial interpretation of those laws;
 
  •  potential for an environmental or asbestos claim to involve many insurance providers over many policy periods;
 
  •  long reporting delays from insureds to insurance companies;
 
  •  historical data concerning asbestos and environmental losses being more limited than historical information on other types of claims;
 
  •  questions concerning interpretation and application of insurance coverage; and
 
  •  uncertainty regarding the number and identity of insureds with potential asbestos or environmental exposure.
 
These factors generally render traditional actuarial methods less effective at estimating reserves for asbestos and environmental losses than reserves on other types of losses. As of December 31, 2008, we had established gross reserves of approximately $6.8 million and net reserves, net of reinsurance recoverable on unpaid losses and loss adjustment expenses, of approximately $3.0 million for legacy asbestos and environmental claims, which include 22 direct claims and Guarantee Insurance’s participation in two reinsurance pools and our estimate for the impact of unreported claims. As of December 31, 2008, one of the pools in which we are a participant (which accounted for approximately 80% of these net reserves at December 31, 2008) had approximately 1,600 open claims. Of these, one claim carries reserves of more than $100,000. In this pool, Guarantee Insurance reinsured the risks of other insurers and then ceded a portion (generally 80%) of these reinsurance risks to other reinsurers, which we refer to as participating pool reinsurers. Under this structure, Guarantee Insurance remains obligated for the total liability under each reinsurance contract to the extent any of the participating pool reinsurers fails to pay its share. Over time, Guarantee Insurance’s net liabilities under these reinsurance contracts have increased from approximately 20% to approximately 50% of the pooled risks due to the insolvency of some participating pool reinsurers. In the second pool (which accounted for approximately 20% of our net reserves for legacy asbestos and environmental claims at December 31, 2008), Guarantee Insurance is one of a number of participating pool reinsurers, and Guarantee Insurance’s liability is based on the percentage share of the pool obligations it reinsures. We review our loss and loss adjustment expense reserves for asbestos and environmental claims based on historical experience, current developments and actuarial reports for the pools, and this review entails a detailed analysis of our direct and assumed exposure.


18


Table of Contents

In addition, as of December 31, 2008, we had established gross reserves of approximately $3.6 million and net reserves, net of reinsurance recoverable on unpaid losses and loss adjustment expenses, of approximately $1.5 million for legacy commercial general liability claims.
 
For the year ended December 31, 2008, incurred losses and loss adjustment expenses associated with adverse development of reserves for legacy claims were approximately $709,000. For the year ended December 31, 2007, we recognized a reduction of incurred losses and loss adjustment expenses attributable to favorable development of reserves for legacy claims of approximately $1.3 million. For the year ended December 31, 2006, incurred losses and loss adjustment expenses associated with adverse development of reserves for legacy asbestos and environmental and commercial general liability claims were approximately $516,000.
 
We plan to continue to monitor industry trends and our own experience in order to determine the adequacy of our environmental and asbestos reserves. However, there can be no assurance that the reserves we have established are adequate. In addition, we are reviewing whether to adopt the survival ratio reserve methodology for our asbestos and environmental exposures, an asbestos and environmental exposure reserving methodology commonly utilized by our publicly held insurance company peers. If we had adopted the survival ratio reserve methodology as of December 31, 2008, our net reserve for asbestos and environmental exposures would have been approximately $5.1 million, representing an increase in net losses and net loss adjustment expenses of approximately $2.1 million. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Outlook — Reserving Methodology for Legacy Asbestos and Environmental Exposures.”
 
If we cannot sustain our relationships with independent agencies, we may be unable to operate profitably.
 
We market and sell our insurance products and services primarily through direct contracts with more than 570 independent, non-exclusive agencies. Our products are marketed by independent wholesale and retail agencies, some of which account for a large portion of our revenues. Other insurance companies compete with us for the services and allegiance of these agents. These agents may choose to direct business to our competitors, or may direct less desirable business to us. Our business relationships are generally governed by agreements with agents that may be terminated on short notice. For the nine months ended September 30, 2009, approximately 11.2% and 6.5% of our total new and renewal direct premiums written were derived from various offices of Appalachian Underwriters, Inc. and the Insurance Office of America, Inc., respectively, and no other agent accounted for more than 5% of our new and renewal direct premiums written. For the year ended December 31, 2008, approximately 14% of our total new and renewal direct premiums written were derived from the agent whose single account with us in 2008 was Progressive Employer Services, Inc., or PES, our then largest policyholder. The policy with PES was cancelled in October 2008. For the year ended December 31, 2008, approximately 9% and 7% of our total new and renewal direct premiums written were derived from various offices of Appalachian Underwriters, Inc. and the Insurance Office of America, Inc., respectively, and no other agent accounted for more than 5% of our new and renewal direct premiums written. 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 that meets the requirements and preferences of our independent agencies and their customers. A significant decrease in business from, or the entire loss of, our largest agency or several of our other large agencies would have a material adverse effect on our business, financial condition and results of operations.
 
We have filed a lawsuit against our former largest customer regarding amounts we contend are due and owing and are in dispute. This customer is controlled by an individual who was one of our stockholders as of December 31, 2008. We may never receive any of the disputed amounts that we contend are due and owing.
 
For the years ended December 31, 2008 and 2007, approximately 14% and 15% of our direct premiums written, respectively, were attributable to one customer, PES. The policy was cancelled in October 2008 for non-payment of premium and duplicate coverage. PES is a company controlled by Steven Herrig, an individual who, as of December 31, 2008, beneficially owned shares of our common stock through Westwind Holding


19


Table of Contents

Company, LLC, or Westwind, a company controlled by Mr. Herrig. Westwind’s stock ownership represented approximately 15.8% of our outstanding common stock as of December 31, 2008. Most of PES’s employees are located in Florida, where workers’ compensation insurance premium rates are established by the state. Premiums receivable from PES totaled approximately $8.3 million as of September 30, 2009 and December 31, 2008. This amount is comprised of approximately $1.1 million for billed but unpaid premium audits for the 2006 policy year, approximately $2.0 million for a billed but unpaid experience rate modification as determined by NCCI, approximately $300,000 for billed but unpaid premium installments for the 2008 policy year and approximately $4.9 million of estimated but unbilled premium audits for the 2007 and 2008 policy years.
 
We have filed a lawsuit against PES to collect these and additional amounts we believe are due and owing. See “Business — Legal Proceedings — Actions Involving Progressive Employer Services, et al.” We have the right to access certain collateral pledged by Westwind to offset against premium and other amounts owed by PES and Westwind to Guarantee Insurance, including funds held under reinsurance treaties, which totaled approximately $3.3 million as of September 30, 2009 and December 31, 2008. Additionally, in March 2009, we exercised a call option on all 215,263 shares of our common stock owned by Westwind to partially satisfy the amounts we contend are due and owing. On May 11, 2009, Westwind filed a complaint in Florida State Court related to the exercise of the call option, claiming breach of contract and conversion, seeking damages of $2.2 million and other damages as determined by the court. There can be no assurance that we will prevail in the lawsuit or that, if we prevail, we ultimately will be able to collect any amounts awarded. PES has contended that we have failed to arrange for the issuance of a dividend from Guarantee Insurance to PES from the segregated portfolio cell controlled by it in the amount of $3.9 million and that we have failed to provide PES with certain information. Moreover, PES may bring claims against us alleging that our conduct has damaged it. As the litigation continues, we and PES may identify additional amounts in dispute. If we are unable to recover from PES any of the $8.3 million premiums receivable plus the $2.2 million that we have offset against the premiums receivable through the exercise of our call option, we would recognize a pre-tax charge in the amount of such unrecovered amount.
 
If we do not obtain reinsurance from traditional reinsurers or segregated portfolio captives on favorable terms, our business, financial condition and results of operations could be adversely affected.
 
We purchase reinsurance to manage our risk and exposure to losses. Reinsurance is a transaction between insurance companies in which an original insurer, or ceding company, remits a portion of its premiums to a reinsurer, or assuming company, as payment for the reinsurer’s commitment to indemnify the original insurer for a portion of its insurance liability. In return, the reinsurer assumes insurance risk from the ceding company. We participate in quota share and excess of loss reinsurance arrangements. Our quota share reinsurers include Swiss Reinsurance America Corporation, one of the largest reinsurers in the United States and rated “A+” by A.M. Best Company, ULLICO Casualty Company, rated “B+” (Good) by A.M Best and Harco National Insurance Company rated “A−” (Very Good) by A.M. Best. Under our traditional business quota share reinsurance agreement effective July 1, 2008, we ceded 50% of all net retained liabilities arising from all traditional business premiums written, excluding certain states, for all losses up to $500,000 per occurrence, subject to various restrictions and exclusions. Effective January 1, 2009, coverage from one of the reinsurers under this quota share agreement, which comprised 37.5% of the total 50.0% coverage, expired, the participation of the other quota share reinsurer was increased from 12.5% to 25.0% and previously excluded states were added to the coverage. We entered into an additional traditional business quota share agreement pursuant to which we ceded 37.83% of our gross unearned premium reserves as of December 31, 2008. Additionally, effective January 1, 2009, we entered into a traditional business quota share agreement pursuant to which we cede 68% of all traditional business written in Florida, Georgia and New Jersey during calendar year 2009 for all losses up to $1.0 million per occurrence, subject to various restrictions, exclusions and limitations. We do not have any other quota share reinsurance arrangements for our traditional business.
 
We reinsure, on a quota share basis, a substantial portion of our underwriting risk on our alternative market business to segregated portfolio captives in which our policyholders or other parties have an economic interest. Generally, we cede between 50% and 90% of the premium and losses under such alternative market


20


Table of Contents

policies to segregated portfolio captives, up to $1 million per occurrence subject to various restrictions and exclusions, including an aggregate limit on the captive’s reinsurance obligations. For the year ended December 31, 2008, we ceded approximately 88% of our segregated portfolio captive alternative market gross premiums written under quota share reinsurance agreements with segregated portfolio captives. For the years ended December 31, 2007 and 2006, we ceded 82% and 87% of our segregated portfolio captive alternative market gross premiums written under quota share reinsurance agreements with segregated portfolio captives, respectively. On our segregated portfolio captive alternative market business, any losses in excess of the aggregate limit are borne by us. Thus, if we set this aggregate limit too low, our business, financial condition and results of operations would be adversely affected.
 
The excess of loss reinsurance for both our traditional and alternative market business under our 2009/2010 reinsurance program covers, subject to certain restrictions and exclusions, losses that exceed $1.0 million per occurrence up to $29.0 million per occurrence per life, with coverage of up to an additional $20.0 million per occurrence for certain losses involving injuries to several employees. Since Guarantee Insurance’s quota share reinsurance is included within its retention for purposes of its excess of loss reinsurance, its effective retention for a $1.0 million claim arising out of its traditional business covered by quota share reinsurance would be $875,000 in all states except Georgia, Florida and New Jersey where the effective retention is $195,000.
 
The excess of loss reinsurance for both our traditional and alternative market business under our 2008/2009 reinsurance program covers, subject to certain restrictions and exclusions, losses that exceed $1.0 million per occurrence up to $9.0 million per occurrence, with coverage of up to an additional $10.0 million per occurrence for certain losses involving injuries to several employees. However, effective July 1, 2008, the first layer of this excess of loss reinsurance for our traditional business ($4.0 million excess of a $1.0 million retention) is subject to an annual deductible of $1.0 million such that this reinsurance only applies to losses in excess of $1.0 million per occurrence after July 1, 2008 to the extent that such losses exceed $1.0 million in the aggregate. See “Business — Reinsurance.”
 
The availability, amount and cost of reinsurance are subject to market conditions and our experience with insured losses. There can be no assurance that our reinsurance agreements can be renewed or replaced prior to expiration upon terms as satisfactory to us as those currently in effect. If we are unable to renew or replace any of our quota share or excess of loss reinsurance agreements, our net liability on individual risks would increase, we would have greater exposure to catastrophic losses, our underwriting results would be subject to greater variability, and our underwriting capacity would be reduced. Any reduction or other changes in our reinsurance arrangements could materially adversely affect our business, financial condition and results of operations.
 
If we are not able to recover amounts due from our reinsurers, our business, financial condition and results of operations would be adversely affected.
 
Reinsurance does not discharge us of our obligations under our insurance policies. We remain liable to our policyholders even if we are unable to make recoveries that we believe 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. With respect to long-term workers’ compensation claims, the creditworthiness of our reinsurers may change before we recover amounts to which we are entitled. 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. For example, we have experienced an increase in certain liabilities relating to some of our legacy exposures as a result of the insolvency of some participating pool reinsurers. See — “Guarantee Insurance has legacy commercial general liability claims, including asbestos and environmental liability claims.”
 
As of December 31, 2008, we had $42.1 million of gross exposures to reinsurers, comprised of reinsurance recoverables on paid and unpaid losses and loss adjustment expenses. Furthermore, as of December 31, 2008, we had $26.1 million of net exposure to reinsurers — $23.5 million from reinsurers licensed in Florida, which we refer to as authorized reinsurers, and $2.6 million from reinsurers not licensed in


21


Table of Contents

Florida, which we refer to as unauthorized reinsurers. If we are unable to collect amounts recoverable from our reinsurers, our business, financial condition and results of operations would be adversely affected.
 
We are subject to extensive state regulation; regulatory and legislative changes may adversely impact our business.
 
We are subject to extensive regulation by the Florida OIR, 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 stockholders. Regulations vary from state to state, but typically address:
 
  •  standards of solvency, including risk-based capital measurements;
 
  •  restrictions on the nature, quality and concentration of investments;
 
  •  restrictions on the terms of insurance policies;
 
  •  restrictions on the way premium rates are established and the premium rates are charged;
 
  •  procedures for adjusting claims, which can affect the ultimate amount for which a claim is settled;
 
  •  standards for appointing general agencies;
 
  •  limitations on transactions with affiliates;
 
  •  restrictions on mergers and acquisitions;
 
  •  medical privacy standards;
 
  •  restrictions on the ability of insurance companies to pay dividends;
 
  •  establishment of reserves for unearned premiums, losses and other purposes;
 
  •  licensing requirements and approvals that affect our ability to do business;
 
  •  certain required methods of accounting; and
 
  •  potential assessments for state guaranty funds, second injury funds and other mandatory pooling arrangements.
 
We may be unable to comply fully with the wide variety of applicable laws and regulations that are frequently undergoing revision. In addition, we follow practices based on our interpretations of laws and regulations that we believe are generally followed by the insurance 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 or fine us. Moreover, 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 insurance companies. As a result, if we fail to comply with applicable laws or regulations, insurance regulatory agencies could preclude us from conducting some or all of our activities or otherwise penalize us. 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. For example, as a result of a financial examination by the Florida OIR in 2006 for the year ended December 31, 2004, Guarantee Insurance was fined $40,000 for various violations including failure to maintain a minimum statutory policyholders’ surplus. Also, as a result of writing premiums in South Carolina in an inadvertent breach of our agreement with the South Carolina Department of Insurance not to write any new business in South Carolina without the Department’s consent, we may be required to pay a fine or face other disciplinary action.
 
Guarantee Insurance is subject to periodic examinations by state insurance departments in the states in which it is licensed. In March 2008, the Florida OIR completed its financial examination of Guarantee Insurance as of and for the year ended December 31, 2006. In its examination report, the Florida OIR made a


22


Table of Contents

number of findings relating to Guarantee Insurance’s failure to comply with corrective comments made in earlier examination reports by the Florida OIR for the year ended December 31, 2004 and by the South Carolina Department of Insurance for the year ended December 31, 2005. The Florida OIR also made a number of proposed adjustments to the statutory financial statements of Guarantee Insurance for the year ended December 31, 2006, attributable to, among other things, corrections of accounting errors and an upward adjustment in Guarantee Insurance’s reserves for unpaid losses and loss adjustment expenses. These proposed adjustments resulted in a $119,000 net decrease in Guarantee Insurance’s reported policyholders surplus but did not cause Guarantee Insurance to be in violation of a consent order issued by the Florida OIR in 2006 in connection with the redomestication of Guarantee Insurance from South Carolina to Florida that requires Guarantee Insurance to maintain a minimum statutory policyholders surplus of the greater of $9.0 million or 10% of total liabilities excluding taxes, expenses and other obligations due or accrued, and Guarantee Insurance was not required to file an amended 2006 annual statement with the Florida OIR reflecting these adjustments.
 
In connection with the Florida OIR examination report for the year ended December 31, 2006, the Florida OIR issued a consent order requiring Guarantee Insurance to pay a penalty of $50,000, pay $25,000 to cover administrative costs and undergo an examination prior to June 1, 2008 to verify that it has addressed all of the matters raised in the examination report. In addition, the consent order required Guarantee Insurance to hold annual stockholder meetings, maintain complete and accurate minutes of all stockholder and board of director meetings, implement additional controls and review procedures for its reinsurance accounting, perform accurate and timely reconciliations for certain accounts, establish additional procedures in accordance with Florida OIR information technology specialist recommendations, correctly report all annual statement amounts, continue to maintain adequate loss and loss adjustment reserves and continue to maintain a minimum statutory policyholders surplus of the greater of $9.0 million or 10% of total liabilities excluding taxes, expenses and other obligations due or accrued. The consent order required Guarantee Insurance to provide documentation of compliance with these requirements. In 2008, the Florida OIR engaged a consultant to perform a target examination of Guarantee Insurance to assess its compliance with these requirements. In August 2008, the consultant’s target examination fieldwork was completed, and the Florida OIR issued its report on the target examination, concluding that, with certain immaterial exceptions, Guarantee Insurance was in compliance with all of the findings from the examination report for the year ended December 31, 2006.
 
State laws require insurance companies to maintain minimum surplus balances and place limits on the amount of insurance a company may write based on the amount of that company’s surplus. These limitations may restrict the rate at which our insurance operations can grow.
 
In May 2009 in connection with a Florida OIR targeted examination, we advised the Florida OIR that all intercompany receivables would be settled within 30 days. As of September 30, 2009, Guarantee Insurance had approximately $2.1 million in intercompany receivables that have been outstanding for more than 30 days, and approximately $975,000 that had been outstanding for more than 90 days (although subsequent to September 30, 2009, these balances were repaid). Because some of the intercompany receivables were outstanding for more than 30 days, the Florida OIR may object to these transactions or take other regulatory action against us. In addition, under statutory accounting rules, Guarantee Insurance is required to record the amount of any intercompany receivables that have been outstanding for more than 90 days as a nonadmitted asset. Therefore, to the extent that any intercompany receivables have been outstanding for more than 90 days, Guarantee Insurance will be required to nonadmit the amount of such receivables, which will result in a corresponding decrease in the surplus of Guarantee Insurance. If the decrease in Guarantee Insurance’s surplus were to cause Guarantee Insurance to be out of compliance with certain ratios or minimum surplus levels as required by the Florida OIR, we could face possible regulatory action and would be required to obtain additional reinsurance, reduce our insurance writings or add capital to Guarantee Insurance.
 
State laws also require insurance companies to establish reserves for payments of policyholder liabilities and impose restrictions on the kinds of assets in which insurance companies may invest. These restrictions may require Guarantee Insurance to invest in assets more conservatively than it would if we were not subject to state law restrictions and may prevent it from obtaining as high a return on its assets as it might otherwise be able to realize.


23


Table of Contents

State regulation of insurance company financial transactions and financial condition are based on statutory accounting principles, or SAP. State insurance regulators closely monitor the financial condition of insurance companies reflected in SAP financial statements and can impose significant operating restrictions on an insurance company that becomes financially impaired. Regulators generally have the power to impose restrictions or conditions on the following kinds of activities of a financially impaired insurance company: transfer or disposition of assets, withdrawal of funds from bank accounts, extension of credit or advancement of loans and investment of funds.
 
Many states have laws and regulations that limit an insurer’s ability to withdraw from a particular market. For example, states may limit an insurer’s ability to cancel or not renew policies. Furthermore, certain states prohibit an insurer from withdrawing from one or more lines of business in the state, except pursuant to a plan that is approved by the state insurance department. The state insurance department may disapprove a plan that may lead to market disruption. Laws and regulations that limit cancellation and non-renewal and that subject program withdrawals to prior approval requirements may restrict our ability to exit unprofitable markets.
 
Licensing laws and regulations vary from state to state. In all states, the applicable licensing laws and regulations are subject to amendment or interpretation by regulatory authorities. Generally such authorities are vested with relatively broad and general discretion as to the granting, renewing and revoking of licenses and approvals. Licenses may be denied or revoked for various reasons, including the violation of regulations and conviction of crimes. Possible sanctions which may be imposed by regulatory authorities include the suspension of individual employees, limitations on engaging in a particular business for specified periods of time, revocation of licenses, censures, redress to clients and fines.
 
In some instances, we follow practices based on interpretations of laws and regulations generally followed by the industry, which may prove to be different from the interpretations of regulatory authorities.
 
We currently are not rated by A.M. Best or any other insurance rating agency, and if we do not receive a favorable rating from A.M. Best after the offering, or if we do obtain such a rating and then fail to maintain it, our business, financial condition and results of operations may be adversely affected.
 
Rating agencies rate insurance companies based on their financial strength and their ability to pay claims, factors that are relevant to agents and policyholders. We have never been rated by any nationally recognized independent rating agency. The ratings assigned by nationally recognized independent rating agencies, particularly A.M. Best, may become material to our ability to maintain and expand our business. Ratings from A.M. Best and other rating agencies are used by some insurance buyers, agents and brokers as an indicator of financial strength and security.
 
We have been informed by A.M. Best that after completion of this offering, we may expect Guarantee Insurance to receive a financial strength rating of “A−” (Excellent), which is the fourth highest of fifteen A.M. Best rating levels. This indicative rating assignment is subject to the capitalization of Guarantee Insurance (and PF&C if we acquire it) at a level that A.M. Best requires to support the assignment of the “A−” rating through 2012 . We expect that the contribution of $155 million of the net proceeds of this offering to Guarantee Insurance (and PF&C if we acquire it) on or prior to March 4, 2010 will be sufficient to satisfy this requirement. If we acquire PF&C as described elsewhere in this prospectus, this rating assignment is also conditioned upon regulatory approval of a pooling agreement between Guarantee Insurance and PF&C. Pooling is a risk-sharing arrangement under which premiums and losses are shared between the pool members. We expect to make the contemplated capital contributions when we purchase PF&C or conclude not to proceed with that transaction, in either event prior to March 4, 2010. The prospective rating indication we received from A.M. Best is not a guarantee of final rating outcome. In addition, in order to maintain this rating, Guarantee Insurance (as well as PF&C if it is acquired) must maintain capitalization at a level that A.M. Best requires to support the assignment of the “A−” rating, and any material negative developments in our operations, including in terms of management, earnings, capitalization or risk profile could result in negative rating pressure and possibly a rating downgrade. While we have expanded our business profitably without an A.M. Best rating and we believe that we can continue to do so with the net proceeds from this offering, we believe that an “A−” rating from A.M. Best would increase our ability to market to large


24


Table of Contents

employers and create new opportunities for our products and services in rating sensitive markets. A.M. Best’s ratings reflect its opinion of an insurance company’s financial strength and ability to meet ongoing obligations to policyholders and are not intended for the protection of investors.
 
A.M. Best ratings tend to be more important to our alternative market customers than our traditional business customers. A favorable A.M. Best rating would increase our ability to sell our alternative market products to larger employers. We believe that a favorable rating would also open significant new markets for our products and services. Our failure to obtain or maintain a favorable rating may have a material adverse affect on our business plan.
 
We expect to apply to A.M. Best for a rating as soon as practicable. We may not be given a favorable rating or if we are given a favorable rating such rating may be downgraded, which may adversely affect our ability to obtain business and may adversely affect the price we can charge for the insurance policies we write. 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. Other companies in our industry that have been rated and have had their rating downgraded have experienced negative effects. 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. Although we are not currently rated by A.M. Best, if we obtain an A.M. Best rating after the offering, our competitive position relative to other companies will be determined in part by our A.M. Best rating.
 
If we are unable to realize our investment objectives, our business, financial condition and results of operations may be adversely affected.
 
Investment income is an important component of our net income. As of September 30, 2009 and December 31, 2008, our investment portfolio, including cash and cash equivalents, had a carrying value of $54.5 million and $63.4 million, respectively. For the nine months ended September 30, 2009 and the year ended December 31, 2008, we had net investment income of $1.4 million and $2.0 million, respectively. Our investment portfolio is managed by Gen Re — New England Asset Management (a subsidiary of Berkshire Hathaway, Inc.), an independent asset manager, pursuant to investment guidelines approved by Guarantee Insurance’s 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. For example, in 2008 and 2007, credit markets were significantly impacted by sub-prime mortgage losses, increased mortgage defaults and worldwide market dislocations. Furthermore, financial markets experienced substantial and unprecedented volatility as a result of further dislocations in the credit markets, including the bankruptcy of Lehman Brothers Holdings Inc. In 2008, we recognized an other-than-temporary-impairment charge of approximately $350,000 related to investments in certain bonds issued by Lehman Brothers Holdings, Inc., which filed a voluntary petition for relief under Chapter 11 of Title 11 of the United States Code in the United States Bankruptcy Court, and approximately $875,000 related to investments in certain common stocks purchased in 2005.
 
In addition, our investment portfolio includes asset-backed and mortgage-backed securities. As of September 30, 2009 and December 31, 2008, asset-backed and mortgage-backed securities constituted approximately 25% and 26% of our invested assets, respectively, including cash and cash equivalents. As with other fixed income investments, the fair market value of these securities fluctuates depending on market and other general economic conditions and the interest rate environment. 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 asset-backed and mortgage-backed securities included in our investment portfolio. When interest rates fall, asset-backed and 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, asset-backed and 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.


25


Table of Contents

We also seek to manage our investment portfolio such that the security maturities provide adequate liquidity relative to our expected claims payout pattern. However, the duration of our insurance liabilities may differ from our expectations. If we need to liquidate invested assets prematurely in order to satisfy our claim obligations and the fair value of such assets is below our original cost, we may recognize losses on investments, which could have a material adverse effect on our business, financial condition and results of operations.
 
Additionally, our fixed maturity securities were reclassified as available for sale at December 31, 2008 and, accordingly, are carried at market value. Decreases in the value of our fixed securities may have a material adverse effect on our business, financial condition and results of operations.
 
General economic conditions may be adversely affected by a variety of factors, including U.S. involvement in hostilities with other countries, large-scale acts of terrorism and the threat of hostilities or terrorist acts. 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 business, financial condition and results of operations.
 
We are more vulnerable to negative developments in the workers’ compensation insurance industry than companies that also write other lines of insurance.
 
Our business involves providing insurance services related to underwriting, workers’ compensation insurance policies, and we have no current plans to focus our efforts on offering other lines of insurance. As a result, negative developments in the economic, competitive or regulatory conditions affecting the workers’ compensation insurance industry could have a material adverse effect on our business, 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 lines of insurance.
 
We derive a significant portion of our insurance services income from our BPO client.
 
For the nine months ended September 30, 2009, approximately 35% of our insurance services income was derived from our BPO client. Our BPO client may terminate its service arrangement with us at anytime without cause, upon 180 days’ notice, so there is no assurance that our arrangement with our BPO client will continue. The loss of our BPO client would, and the loss of any additional BPO client that we may develop may have a material adverse effect on our business, financial condition and results of operations.
 
New agreements involving fronting arrangements or distribution and insurance services relationships with other carriers or acquisitions could result in operating difficulties and other harmful consequences.
 
In 2009, we started producing business and performing insurance services for our BPO client and entered into BPO relationships with two other companies. We are seeking to enter into additional BPO relationships. Developing the technology infrastructure necessary to service or facilitate new relationships will require substantial time and effort on our part, and the integration and management of these relationships may divert management time and focus from operating our current business.
 
We have limited experience in acquiring other companies, and we may have difficulty integrating the operations of companies that we may acquire and may incur substantial costs in connection therewith.
 
Our business plan includes growing our revenues through the acquisition of other insurance services operations and insurance companies. However, our experience acquiring companies has been limited to our acquisition of Guarantee Insurance and our proposed acquisition of PF&C. See “Summary — Recent Developments — Acquisition of Shell Insurance Company.” We have evaluated, and expect to continue to evaluate, a wide array of potential strategic transactions. From time to time, we may engage in discussions regarding potential acquisitions. The costs and benefits of future acquisitions are uncertain. Any of these transactions could be material to our business, financial condition and results of operations. In addition, the


26


Table of Contents

process of integrating the operations of an acquired company may create unforeseen operating difficulties and expenditures and is risky. The areas where we may face risks include:
 
  •  the need to implement or remediate controls, procedures and policies appropriate for a public company at companies that, prior to the acquisition, lacked these controls, procedures and policies;
 
  •  diversion of management time and focus from operating our business to acquisition integration challenges;
 
  •  cultural challenges associated with integrating employees from the acquired company into our organization;
 
  •  retaining employees from the businesses we acquire; and
 
  •  the need to integrate each company’s accounting, management information, human resource and other administrative systems to permit effective management.
 
We operate in a highly competitive industry, and others may have greater financial resources to compete effectively.
 
The market for workers’ compensation insurance products and risk management services is highly competitive. Competition in our business is based on many factors, including pricing (with respect to insurance products, either through premiums charged or policyholder dividends), services provided, underwriting practices, financial ratings assigned by independent rating agencies, capitalization levels, quality of care management services, speed of claims payments, reputation, perceived financial strength, effective loss prevention, ability to reduce claims expenses and general experience. In some cases, our competitors offer lower priced products and services than we do. If our competitors offer more competitive prices, payment plans, services or commissions to independent agencies, we could lose market share or have to reduce our prices in order to maintain market share, which would adversely affect our profitability. Our competitors are insurance companies, self-insurance funds, state insurance pools and workers’ compensation insurance service providers, many of which are significantly larger and possess considerably greater financial, marketing, management and other resources than we do. Consequently, they can offer a broader range of products, provide their services nationwide and capitalize on lower expenses to offer more competitive pricing.
 
With respect to our insurance services business, we believe PRS’s principal competitors in the nurse case management and cost containment services market are CorVel Corporation, GENEX Services, Inc. and various other smaller providers. In the general agency market, we believe we compete with numerous national wholesale agents and brokers.
 
With respect to our insurance business, we believe our principal competitors are American International Group, Inc., Liberty Mutual Insurance Company and Hartford Insurance Company, as well as smaller regional carriers. Many of our competitors are substantially larger and have substantially greater market share and capital resources than we have.
 
State insurance regulations require maintenance of minimum levels of surplus and of ratios of net premiums written to surplus. Accordingly, competitors with more surplus than us have the potential to expand in our markets more quickly and to a greater extent than we can. Additionally, greater financial resources permit a carrier to gain market share through more competitive pricing, even if that pricing results in reduced underwriting margins or an underwriting loss. Many of our competitors are multi-line carriers that can price the workers’ compensation insurance that they offer at a loss in order to obtain other lines of business at a profit. If we are unable to compete effectively, our business, financial condition and results of operations could be materially adversely affected.


27


Table of Contents

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, acquiring insurance services companies, 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:
 
  •  identify profitable new geographic markets for entry;
 
  •  attract and retain qualified personnel for expanded operations;
 
  •  identify potential acquisition targets and successfully acquire them;
 
  •  expand existing and develop new agency relationships;
 
  •  identify, recruit and integrate new independent agencies; and
 
  •  augment our internal monitoring and control systems as we expand our business.
 
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 December 31, 2008, approximately 0.4%, 1%, 2% and 6% of our total reported claims for accident years 2004, 2005, 2006 and 2007, respectively, remained open.
 
As more fully described under “Business — Legal Proceedings,” we are involved in certain litigation matters. Litigation is subject to inherent uncertainties, and if there were an outcome unfavorable to us, our business, financial condition and results of operations could be materially adversely affected.
 
Our business is dependent on the efforts of our senior management and other key employees because of their industry expertise, knowledge of our markets and relationships with the independent agencies that sell our insurance.
 
We believe our success will depend in substantial part upon our ability to attract and retain qualified executive officers, experienced underwriting talent and other skilled employees who are knowledgeable about our business. We rely substantially on the services of our executive management team and other key employees. The key executive officers and employees upon whom we rely are Steven M. Mariano, Chairman of the Board, President and Chief Executive Officer; Michael W. Grandstaff, Senior Vice President and Chief Financial Officer; Charles K. Schuver, Senior Vice President and Chief Underwriting Officer of Guarantee Insurance; Timothy J. Ermatinger, Chief Executive Officer of PRS Group, Inc.; Richard G. Turner, Senior Vice President and Executive Vice President of Alternative Markets and Theodore G. Bryant, Senior Vice President, Counsel and Secretary. We entered into employment agreements with each of these officers in 2008. Although we are not aware of any planned departures or retirements, if we were to lose the services of members of our senior management team, our business, financial condition and results of operations could be adversely affected. We do not currently maintain key man life insurance policies with respect to our employees.
 
Our ability to attract and retain new key employees may be adversely impacted by the limited number of shares available for future grants ([     ] shares) under our 2010 Stock Plan after option grants are made at the time this offering is completed. In addition, our compensation for our independent directors includes an equity component, which will utilize a portion of available shares. While we would not expect new grants to be made to current officers in the near term, we may need to offer equity compensation as a component of


28


Table of Contents

compensation for hiring new members of senior management as we grow. In the absence of our ability to do this, we may need to pay higher levels of cash compensation in the near term to attract desired candidates and may be unable to hire some candidates.
 
Our status as an insurance holding company with no direct operations could adversely affect our ability to pay dividends in the future.
 
Patriot Risk Management is a holding company that transacts business through its operating subsidiaries. Patriot Risk Management’s primary assets are the capital stock of these operating subsidiaries. Thus, the ability of Patriot Risk Management to pay dividends to our stockholders depends upon the surplus and earnings of our subsidiaries and their ability to pay dividends to Patriot Risk Management. Payment of dividends by our insurance subsidiary 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, Patriot Risk Management may not be able to receive dividends from Guarantee Insurance, its insurance company subsidiary or may not receive dividends in amounts necessary to pay dividends on our capital stock.
 
Neither PRS nor PUI is statutorily restricted from paying dividends to Patriot Risk Management, although our credit facilities prohibit us and our operating subsidiaries from paying any dividends on our and their respective capital stock without the consent of our lenders. In addition, future debt agreements may contain certain prohibitions or limitations on the payment of dividends. Because Guarantee Insurance is, and if we acquire it, PF&C will be, regulated by the Florida OIR, both companies will be subject to significant regulatory restrictions limiting their ability to declare and pay dividends.
 
At the time we acquired Guarantee Insurance, it had a large statutory unassigned deficit. See Note 13 to our audited consolidated financial statements as of December 31, 2008 and for the year then ended, which financial statements are included elsewhere in this prospectus (our “Consolidated Financial Statements”). As of September 30, 2009, Guarantee Insurance’s statutory unassigned deficit was $95.5 million. Under Florida law, insurance companies may only pay dividends out of available and accumulated surplus funds derived from realized net operating profits on their business and net realized capital gains, except under limited circumstances with the prior approval of the Florida OIR. Moreover, Florida law has several different tests that limit the payment of dividends, without the prior approval of the Florida OIR, to an amount generally equal to 10% of the surplus or gain from operations, with additional restrictions. However, pursuant to a consent order issued by the Florida OIR on December 29, 2006 in connection with the redomestication of Guarantee Insurance from South Carolina to Florida, Guarantee Insurance is prohibited from paying dividends, without approval of the Florida OIR, until December 29, 2009. Therefore, it is unlikely that Guarantee Insurance will be able to pay dividends for the foreseeable future without prior approval of the Florida OIR. Currently, we do not intend to pay cash dividends on our common stock.
 
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, future acquisitions 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 portion of our net proceeds of this offering to be contributed to the capital of our insurance subsidiaries is insufficient to support future operating requirements or cover claims.
 
If we need 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 to us. In the case of equity financings, dilution to our stockholders 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, we may sell 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. In the case of debt financings, we may be subject to unfavorable interest


29


Table of Contents

rates and covenants that restrict our ability to operate our business freely. We may need to finance our expansion or future acquisitions with borrowings under one or more financing facilities. As of the date of this prospectus, we do not have any commitment for any such facility. If we cannot obtain financing on commercially reasonable terms, we may be required to modify our expansion plans, delay acquisitions or incur higher than anticipated financing costs, any of which could have an adverse impact on the execution of our growth strategy and business. 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 and results of operations could be adversely affected.
 
Assessments for state guaranty funds and 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 Guarantee Insurance may increase as it increases its premiums written. 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 assessments based on premiums or paid losses. For the years ended December 31, 2008 and 2007, gross expenses incurred in connection with assessments for state guaranty funds and second injury funds were $4.1 million and $3.4 million, respectively. Our alternative market customers reimburse us for their pro rata share of any such amounts that we are assessed with respect to premiums written for such customers.
 
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. It is possible that losses from our participation in these pools may exceed the premiums we receive from the pools. Accordingly, mandatory pooling arrangements may cause a decrease in our profits. Guarantee Insurance currently participates in the NCCI national workers’ compensation insurance pool. Net underwriting income (losses) associated with this mandatory pooling arrangement for the years ended December 31, 2008 and 2007 were approximately ($98,000) and $159,000, respectively. As we write policies in new states that have mandatory pooling arrangements, we will be required to participate in additional pooling arrangements. Furthermore, the impairment, insolvency or failure of other insurance companies in these pooling arrangements would likely increase our liability under these pooling arrangements. The effect of assessments or changes in assessments could reduce our profitability in any given period or limit our ability to grow our business.
 
The outcome of insurance industry investigations and regulatory proposals could adversely affect our business, financial condition and results of operations.
 
The United States insurance industry has in recent years become the focus of investigations and increased scrutiny by regulatory and law enforcement authorities, as well as class action attorneys and the general public, relating to allegations of improper special payments, price-fixing, bid-rigging, improper accounting practices and other alleged misconduct, including payments made by insurers to brokers and the practices surrounding the placement of insurance business. Formal and informal inquiries have been made of a large segment of the industry, and a number of companies in the insurance industry have received or may receive subpoenas, requests for information from regulatory agencies or other inquiries relating to these and similar matters. For example, on September 28, 2007, we received a Subpoena from the New Jersey Office of the


30


Table of Contents

Insurance Fraud Prosecutor regarding insurance policies issued to one of our policyholders. We have responded to the subpoena and expect no further action. These efforts have resulted and are expected to result in both enforcement actions and proposals for new state and federal regulation. Some states have adopted new disclosure requirements in connection with the placement of insurance business. It is difficult to predict the outcome of these investigations, whether they will expand into other areas not yet contemplated, whether activities and practices currently thought to be lawful will be characterized as unlawful, what form any additional laws or regulations will have when finally adopted and the impact, if any, of increased regulatory and law enforcement action and litigation on our business, financial condition and results of operations.
 
Recently, Congress has examined a possible repeal of the McCarran-Ferguson Act, which exempts the insurance industry from federal anti-trust laws. There can be no assurance that the McCarran-Ferguson Act will not be repealed, or that any such repeal, if enacted, would not have a material adverse effect on our business, financial condition and results of operations.
 
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 our business would depend upon the nature, extent, location and timing of such an act as well as the availability of any reinsurance that we purchase for terrorism losses and of any assistance for the payment of such losses provided by the Federal government pursuant to the Terrorism Risk Insurance Act of 2002, or TRIA.
 
TRIA provides co-assistance to commercial property and casualty insurers for payment of losses from an act of terrorism which is declared by the U.S. Secretary of Treasury to be a “certified act of terrorism.” Assistance under the TRIA program is subject to other limitations and restrictions. Such assistance is only available for losses from a certified act of terrorism if aggregate insurance industry losses from the act exceed $100 million. As originally enacted, TRIA only applied to acts of terrorism committed on behalf of foreign persons or interests. However, legislation extending the program through December 31, 2014 removed this restriction so that TRIA now applies to both domestic and foreign terrorism occurring in the U.S. Under the TRIA program, the federal government covers 85% of the losses from covered certified acts of terrorism in excess of a deductible amount. This deductible is calculated as 20% of an affiliated insurance group’s prior year premiums on commercial lines policies (with certain exceptions, such as commercial auto insurance policies) covering risks in the United States. We estimate that our deductible would be approximately $23.5 million for 2009. Because TRIA does not cover 100% of our exposure to terrorism losses and there are substantial limitations and restrictions on the protection against terrorism losses provided to us by our reinsurance, the risk of severe losses to us from acts of terrorism remains. Accordingly, events constituting acts of terrorism may not be covered by, or may exceed the capacity of, our reinsurance and TRIA protections and could adversely affect our business, financial condition and results of operations.
 
The federal terrorism risk assistance provided by TRIA will expire at the end of 2014 and may not be renewed. Any renewal may be on substantially less favorable terms.
 
Risks Related to Our Common Stock and This Offering
 
There has been no prior public market for our common stock, and, therefore, you cannot be certain that an active trading market or a specific share price will be established.
 
Currently, there is no public trading market for our common stock, and it is possible that an active trading market will not develop upon completion of this offering or that the market price of our common stock will decline below the initial public offering price. We have applied to have our shares of common stock approved for listing on the New York Stock Exchange under the symbol “PMG.” The initial public offering price per share will be determined by negotiation among us and the underwriters and may not be indicative of the market price of our common stock after completion of this offering.


31


Table of Contents

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:
 
  •  our results of operations;
 
  •  changes in expectations as to our future results of operations, including financial estimates and projections by securities analysts and investors;
 
  •  results of operations that vary from those expected by securities analysts and investors;
 
  •  developments in the healthcare or insurance industry;
 
  •  changes in laws and regulations;
 
  •  announcements of claims against us by third parties;
 
  •  future sales of our common stock;
 
  •  rising levels of claims costs, including medical and prescription drug costs, that we cannot anticipate at the time we establish our premium rates;
 
  •  fluctuations in interest rates, inflationary pressures and other changes in the investment environment that affect returns on invested assets;
 
  •  changes in the frequency or severity of claims;
 
  •  the financial stability of our reinsurers and changes in the level of reinsurance capacity and our capital and surplus;
 
  •  new types of claims and new or changing judicial interpretations relating to the scope of liabilities of insurance companies;
 
  •  volatile and unpredictable developments, including man-made, weather-related and other natural catastrophes or terrorist attacks; and
 
  •  price competition.
 
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 be less than the initial public offering price, and you may not be able to sell your shares at or above the price you pay to purchase them.
 
Public investors will suffer immediate and substantial dilution as a result of this offering.
 
The initial public offering price per share is significantly higher than our net tangible book value per share of our common stock. Accordingly, if you purchase shares in this offering, you will suffer immediate and substantial dilution of your investment. Based upon the issuance and sale of [          ] shares of our common stock at an assumed initial offering price of $[     ] per share, which is the midpoint of the price range set forth on the cover page of this prospectus, you will incur immediate dilution of approximately $[     ] in the net tangible book value per share if you purchase common stock in this offering. See “Dilution.” In addition, investors in this offering will:
 
  •  pay a price per share that substantially exceeds the book value of our assets after subtracting liabilities; and
 
  •  contribute [     ]% of the total amount invested to date to fund our company based on an assumed initial offering price to the public of $[     ] per share, which is the midpoint of the price range set forth on the cover page of this prospectus, but will own only [     ]% of the shares of common stock outstanding after completion of this offering.


32


Table of Contents

 
Future sales of our common stock may affect the trading price of our common stock and the future exercise of options may lower the price of our common stock.
 
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 after completion of this offering, 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. Upon completion of this offering, there will be [          ] shares of our common stock outstanding. An additional [          ] shares of common stock will be issuable upon the exercise of warrants we intend to issue to our existing stockholders upon completion of this offering, at an exercise price equal to the initial public offering price. Moreover, [          ] additional shares of our common stock are issuable upon the exercise of options granted under our equity compensation plans and [          ] shares will be issuable upon the exercise of outstanding options that we intend to grant to our directors, executive officers and other employees upon the completion of this offering, at an exercise price equal to the initial public offering price. Following completion of this offering, we intend to register all [          ] of these shares and also the [          ] shares reserved for issuance under the 2010 Stock Incentive Plan. See “Description of Capital Stock” and “Executive Compensation.” We and our current directors, executive officers and stockholders have entered into 180-day lock-up agreements. The lock-up agreements are described in “Shares Eligible for Future Sale — Lock-Up Agreements.” An aggregate of [          ] shares of our common stock will be subject to these lock-up agreements upon completion of this offering.
 
Being a public company will increase our expenses and administrative workload and will expose us to risks relating to evaluation of our internal controls over financial reporting required by Section 404 of the Sarbanes-Oxley Act of 2002.
 
As a public company, we will need to comply with additional 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 New York Stock Exchange. We were not required to comply with these laws and requirements as a private company. Complying with these laws and regulations will require the time and attention of our board of directors and management and will increase our expenses. Among other things, we will need to: design, establish, evaluate and maintain a system of internal controls over financial reporting in compliance with the requirements of Section 404 of the Sarbanes-Oxley Act and the related rules and regulations of the SEC and the Public Company Accounting Oversight Board; prepare and distribute periodic reports in compliance with our obligations under the federal securities laws; establish new internal policies, principally those relating to disclosure controls and procedures and corporate governance; institute a more comprehensive compliance function; and involve to a greater degree our outside legal counsel and accountants in the above activities. We anticipate that our annual expenses in complying with these requirements will be approximately $500,000 to $1,500,000.
 
In addition, we also expect that being a public company will make it more expensive for us to obtain director and officer liability insurance. 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 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 plan to perform 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 in our annual report for the year ending December 31, 2010. 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.


33


Table of Contents

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 or the trading price of our common stock to decline. If we fail to remediate 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.
 
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 “control deficiency” exists when the design or operation of a control does not allow management or employees, in the normal course of performing their assigned functions, to prevent or detect misstatements on a timely basis. A “significant deficiency” is a control deficiency, or combination of control deficiencies, that adversely affects the ability to initiate, authorize, record, process or report financial data reliably in accordance with generally accepted accounting principles that results in more than a remote likelihood that a misstatement of financial statements that is more than inconsequential will not be prevented or detected. A “material weakness” is a significant deficiency, or a 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.
 
Our independent registered public accounting firm has in the past identified certain deficiencies in internal controls that it considered to be control deficiencies and material weaknesses. If we fail to remediate these internal control deficiencies and material weaknesses and maintain an effective system of internal controls over financial reporting, we may not be able to accurately report our financial results.
 
During their audit of our financial statements for the year ended December 31, 2006, BDO Seidman, LLP, our independent registered public accounting firm (independent auditors), identified certain deficiencies in internal controls that they considered to be control deficiencies and material weaknesses. Specifically, our independent auditors identified material weaknesses relating to: (1) a lack of independent reconciliation regarding the schedule of premiums receivable, and (2) problems regarding the files maintained for reinsurance agreements, making it difficult to determine which agreement was in force and which versions of the various agreements are in force.
 
In response, we initiated corrective actions to remediate these control deficiencies and material weaknesses, including the implementation of timely account reconciliations, formal purchasing policies, accurate premium tax accruals, the appropriate segregation of accounting duties, a formal impairment analysis for intangible assets, proper accounting for equity-based compensation in accordance with Financial Accounting Standards Board (FASB) guidance and enhanced reinsurance documentation and risk transfer analysis.
 
Our independent auditors did not identify any material weaknesses during their audit of our 2007 and 2008 financial statements. However, during their audit of our financial statements for the year ended December 31, 2008, our independent auditors identified certain deficiencies in internal controls that they considered to be significant control deficiencies, but not material weaknesses. The significant control deficiencies identified by our independent auditors related to insufficient internal controls in our financial reporting process, specifically due to a lack of segregation of duties in the financial statement preparation process, and the insufficient assessment and documentation of management’s consideration of significant accounting issues, including the appropriate accounting literature cited, conclusions reached and an appropriate level of review and approval for such decisions. In connection with their review of our financial statements for the nine months ended September 30, 2009, our independent auditors noted that certain of these significant deficiencies had not yet been remediated. In response, we have taken the following actions to address these deficiencies: improving our financial statement review process by adding an independent review of the financial statements by qualified management, actively seeking to hire a corporate controller who is a certified public accountant with significant public-company accounting and reporting experience, identifying other accounting personnel requirements, and initiating the process to engage a qualified independent consulting firm to evaluate our internal controls and identify areas for improvement, including areas related to the deficiencies identified by our independent auditors. However, we have not yet completed the process of


34


Table of Contents

identifying and implementing enhanced controls that we believe will be necessary to remediate these deficiencies.
 
It is possible that we or our independent auditors may identify additional significant deficiencies or material weaknesses in our internal control over financial reporting in the future. Any failure or difficulties in implementing and maintaining these controls could cause us to fail to meet the periodic reporting obligations that we will become subject to after this offering or result in material misstatements in our financial statements. The existence of a material weakness could result in errors to our financial statements requiring a restatement of our financial statements, cause us to fail to meet our reporting obligations and cause investors to lose confidence in our reported financial information, which could lead to a decline in our stock price.
 
Due to the concentration of our capital stock ownership with our founder, Chairman, President and Chief Executive Officer, Steven M. Mariano, he may be able to influence stockholder decisions, which may conflict with your interests as a stockholder.
 
Immediately upon completion of this offering, Steven M. Mariano, our founder, Chairman, President and Chief Executive Officer, directly and through trusts that he controls, will beneficially own shares representing approximately [     ]% of the voting power of our common stock. As a result of his ownership position, Mr. Mariano may have the ability to significantly influence matters requiring stockholder approval, including, without limitation, the election or removal of directors, mergers, acquisitions, changes of control of our company and sales of all or substantially all of our assets. Your interests as a stockholder may conflict with his interests, and the trading price of shares of our common stock could be adversely affected.
 
Provisions in our executive officers’ employment agreements and provisions in our certificate of incorporation and bylaws and under the laws of the State of Delaware and the State of Florida could impede an attempt to replace or remove our directors or otherwise effect a change of control of Patriot Risk Management, which could diminish the price of our common stock.
 
We have entered into employment agreements with our executive officers. These agreements provide for substantial payments upon a change in control. These payments may deter any transaction that would result in a change in control. See “Executive Compensation — Employment Agreements.”
 
Our charter and bylaws contain provisions that may entrench directors and make it more difficult for stockholders to replace directors even if the stockholders consider it beneficial to do so. In particular, stockholders are required to provide us with advance notice of stockholder nominations and proposals to be brought before any annual meeting of stockholders, which could discourage or deter a third party from conducting a solicitation of proxies to elect its own slate of directors or to introduce a proposal. In addition, our charter eliminates our stockholders’ ability to act without a meeting.
 
These provisions could delay or prevent a change of control that a stockholder might consider favorable. For example, these provisions may prevent a stockholder from receiving the benefit from any premium over the market price of our common stock offered by a bidder in a potential takeover. Even in the absence of an attempt to effect a change in management or a takeover attempt, these provisions may materially adversely affect the prevailing market price of our common stock if they are viewed as discouraging changes in management and takeover attempts in the future.
 
Further, our amended and restated certificate of incorporation and our amended and restated bylaws provide that the number of directors shall be fixed from time to time by our board of directors, provided that the board shall consist of at least three and no more than thirteen members. Our board of directors is divided into three classes with the number of directors in each class being as nearly equal as possible. Each director serves a three-year term. The classification and term of office for each of our directors is noted in the table listing our directors and executive officers under “Management — Directors, Executive Officers and Key Employees.” These provisions make it more difficult for stockholders to replace directors, which may materially adversely affect the prevailing market price of our common stock if they are viewed as discouraging changes in management and takeover attempts in the future.


35


Table of Contents

In addition, Section 203 of the Delaware General Corporation Law may limit the ability of an “interested stockholder” to engage in business combinations with us. An interested stockholder is defined to include persons owning 15% or more of any class of our outstanding voting stock. See “Description of Capital Stock — Anti-Takeover Effects of Delaware Law” and “Our Certificate of Incorporation and Bylaws.”
 
Florida insurance law prohibits any person from acquiring 5% or more of our outstanding voting securities or those of any of our insurance subsidiaries without the prior approval of the Florida OIR. However, a party may acquire less than 10% of our voting securities without prior approval if the party files a disclaimer of affiliation and control. Any person wishing to acquire control of us or of any substantial portion of our outstanding shares would first be required to obtain the approval of the Florida OIR or file such a disclaimer. In addition, any transaction that would constitute a change of control of Guarantee Insurance, including a change of control of Patriot, may require pre-notification in other states in which Guarantee Insurance operates. Obtaining these approvals may result in the material delay of, or may deter, any such transaction.


36


Table of Contents

 
FORWARD-LOOKING STATEMENTS
 
Some of the statements under the captions “Prospectus Summary,” “Risk Factors,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Business” and elsewhere in this prospectus may include forward-looking statements. These statements reflect the current views of our senior management with respect to future events and our financial performance. These statements include forward-looking statements with respect to our business and the insurance industry in general. Statements that include the words “expect,” “intend,” “plan,” “believe,” “project,” “estimate,” “may,” “should,” “anticipate” and similar statements of a future or forward-looking nature identify forward-looking statements for purposes of the federal securities laws or otherwise.
 
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:
 
  •  greater frequency or severity of claims and loss activity, including as a result of natural or man-made catastrophic events, than our underwriting, reserving or investment practices anticipate based on historical experience or industry data;
 
  •  increased competition on the basis of coverage availability, claims management, loss control services, payment terms, premium rates, policy terms, types of insurance offered, overall financial strength, financial ratings and reputation;
 
  •  regulatory risks, including further rate decreases in Florida and other states where we write business;
 
  •  the cyclical nature of the workers’ compensation insurance industry;
 
  •  negative developments in the workers’ compensation insurance industry;
 
  •  decreased level of business activity of our policyholders;
 
  •  decreased demand for our insurance;
 
  •  adverse developments regarding our legacy asbestos and environmental claims arising from policies written or assumed prior to 1983;
 
  •  changes in the availability, cost or quality of reinsurance and the failure of our reinsurers to pay claims in a timely manner or at all;
 
  •  changes in regulations or laws applicable to us, our policyholders or the agencies that sell our insurance;
 
  •  changes in rating agency policies or practices;
 
  •  changes in legal theories of liability under our insurance policies;
 
  •  developments in capital markets that adversely affect the performance of our investments;
 
  •  loss of the services of any of our senior management or other key employees;
 
  •  the effects of U.S. involvement in hostilities with other countries and large-scale acts of terrorism, or the threat of hostilities or terrorist acts; and
 
  •  changes in general economic conditions, including inflation and other factors.
 
The foregoing factors should not be construed as exhaustive and should be read together with the other cautionary statements included in this prospectus, including in particular the risks described under “Risk Factors” beginning on page 14 of this prospectus. If one or more of 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.


37


Table of Contents

 
USE OF PROCEEDS
 
We estimate that our net proceeds from this offering will be approximately $[     ] million, based on an assumed initial public offering price of $[     ] per share, which is the mid-point of the price range set forth on the cover page of this prospectus, and after deducting the estimated underwriting discounts and commissions and our estimated offering expenses. We estimate that our net proceeds will be approximately $[     ] million if the underwriters exercise their over-allotment option in full.
 
We intend to contribute approximately $[     ] million to Guarantee Insurance to support its premium writings. As described elsewhere in this prospectus, we have entered into a stock purchase agreement to acquire PF&C, a shell property and casualty insurance company. The acquisition of PF&C is subject to various regulatory approvals. If we obtain these regulatory approvals and consummate the acquisition on or prior to March 4, 2010, we plan instead to use approximately $16.7 million of the net proceeds of this offering to pay the purchase price for PF&C (of which approximately $15.5 million represents the capital and surplus of PF&C), to contribute approximately $[     ] million to PF&C to support its premium writings, and to contribute approximately $[     ] million to Guarantee Insurance to support its premium writings.
 
We expect that the remaining $[     ] million, or $[     ] million if we acquire PF&C, will be used to support our anticipated growth and general corporate purposes and to fund other holding company operations, including the repayment of all or a portion of our existing indebtedness and potential acquisitions, although we have no current understandings or agreements regarding any such acquisitions (other than PF&C).
 
If the underwriters exercise all or any portion of their over-allotment option, we intend to use all or a substantial portion of the net proceeds from any such exercise to pay down the balance of our credit facilities with Brooke Credit Corporation (Brooke) and ULLICO, Inc. (ULLICO). If the over-allotment option is exercised in full, we will use approximately $[     ] million and $[     ] of the net proceeds therefrom to pay off the credit facilities with Brooke and ULLICO, respectively, and the remaining $[     ] million, or $[     ] million if we acquire PF&C, for general corporate purposes.
 
Pending the use of the net proceeds from this offering as discussed above, we may invest some of the proceeds in certain short-term high-grade instruments.


38


Table of Contents

 
DIVIDEND POLICY
 
We do not expect to pay any cash dividends on our common stock for the foreseeable future. We currently intend to retain any additional future earnings to finance our operations and growth. 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 and other restrictions on the payment of dividends by us or by our subsidiaries to us, and other factors that our board of directors deems relevant.
 
Patriot Risk Management 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. Neither PRS nor PUI is statutorily restricted from paying dividends to us, although our credit facilities prohibit us and our operating subsidiaries from paying any dividends on our and their respective capital stock without the consent of our lenders. In addition, future debt agreements may contain certain prohibitions or limitations on the payment of dividends. Because Guarantee Insurance is, and if we acquire it, PF&C will be, regulated by the Florida OIR, both companies will be subject to significant regulatory restrictions limiting their ability to declare and pay dividends. In accordance with the terms of Guarantee Insurance’s redomestication to Florida which occurred on December 29, 2006, any and all dividends which may be paid by Guarantee Insurance prior to December 29, 2009 must be pre-approved by the Florida OIR.
 
At the time we acquired Guarantee Insurance, it had a large statutory unassigned deficit. As of September 30, 2009, Guarantee Insurance’s statutory unassigned deficit was $95.5 million. Under Florida law, insurance companies may only pay dividends out of available and accumulated surplus funds which are derived from realized net operating profits on their business and net realized capital gains, except under certain limited circumstances with the approval of the Florida OIR. Consequently, for the foreseeable future no dividends may be paid by Guarantee Insurance except with the prior approval of the Florida OIR.
 
For additional information regarding restrictions on the payment of dividends by us and our insurance company subsidiaries, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources” and “Business — Regulation — Dividend Limitations.”


39


Table of Contents

 
CAPITALIZATION
 
The table below sets forth our consolidated capitalization as of September 30, 2009 on an actual basis and on an as adjusted basis giving effect to (i) the sale of [          ] shares of common stock in this offering and (ii) the conversion of each outstanding share of Series A convertible preferred stock into [          ] shares of common stock at an assumed initial public offering price of $[     ] per share, which is the mid-point of the price range set forth on the cover page of this prospectus, and after deducting estimated underwriting discounts and commissions and our estimated offering expenses and assuming that the underwriters do not exercise their over-allotment option.
 
You should read this table in conjunction with the “Use of Proceeds, “Selected Historical Consolidated Financial Data” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” sections of this prospectus and our financial statements and related notes included in the back of this prospectus.
 
                 
    As of September 30, 2009  
    Actual     As Adjusted  
    (Unaudited)  
    (In thousands)  
 
Debt Outstanding
               
Notes payable
  $ 16,815     $ 16,815  
Surplus notes
    1,187       1,187  
Subordinated debentures
    1,634       1,634  
                 
Total debt outstanding
    19,636       19,636  
                 
Stockholders’ equity
               
Series A convertible preferred stock, par value $.001 per share, 1,200 shares authorized; 1,000 shares issued and outstanding, actual; no shares issued and outstanding, as adjusted(1)
    1,000        
Preferred stock, par value $.001 per share, 5,000,000 shares authorized; no shares issued and outstanding, actual and as adjusted
           
Common stock, par value $.001 per share, 40,000,000 shares authorized, 346,026 shares issued and outstanding, actual; [          ] shares issued or outstanding, as adjusted
    1       [     ]  
Series B common stock, par value $.001 per share, 4,000,000 shares authorized, 800,000 shares issued and outstanding, actual; no shares authorized, issued or outstanding, as adjusted(2)
    1        
Additional paid-in capital
    5,521       [     ]  
Retained earnings
    2,390       2,390  
Accumulated other comprehensive income (loss), net of deferred income tax expense (benefit)
    1,216     $ 1,216  
                 
Total stockholders’ equity
    10,129     $ [     ]  
                 
Total capitalization
  $ 29,765     $ [     ]  
                 
 
 
(1) At the closing of this offering, all outstanding shares of Series A convertible preferred stock will be automatically converted into [          ] shares of common stock, based on an assumed initial public offering price of $[     ] per share, which is the mid-point of the price range set forth on the cover page of this prospectus.
 
(2) At the closing of this offering, all outstanding shares of Series B common stock will be automatically converted into shares of common stock on a one-for-one basis.


40


Table of Contents

 
The number of shares of common stock shown to be outstanding after this offering excludes:
 
  •  up to [          ] shares of common stock that may be issued pursuant to the underwriters’ over-allotment option;
 
  •  163,500 shares of common stock issuable upon the exercise of options outstanding as of December 31, 2009;
 
  •  [          ] shares of common stock issuable upon the exercise of stock options we intend to grant to our directors, executive officers and other employees upon completion of this offering, at an exercise price equal to the initial public offering price;
 
  •  [          ] shares of common stock issuable upon the exercise of warrants we intend to issue to our existing stockholders upon completion of this offering, at an exercise price equal to the initial public offering price; and
 
  •  [          ] additional shares available for future issuance under our 2010 Stock Incentive Plan.


41


Table of Contents

 
DILUTION
 
As of September 30, 2009, our net tangible book value was $8.8 million, or $7.72 per share of common stock. Net tangible book value per share represents the amount of our total tangible assets less our total liabilities divided by the number of shares of our common stock outstanding. Our net tangible book value as of September 30, 2009 is presented in the table below on a pro forma basis, assuming the conversion of each outstanding share of Series A convertible preferred stock into [          ] shares of common stock based on an assumed public offering price of $[     ] per share, which is the mid-point of the price range set forth on the cover page of this prospectus. As of September 30, 2009, our pro forma net tangible book value was $[     ] million, or $[     ] per share of common stock. Our pro forma net tangible book value per share represents the amount of our total tangible assets less total liabilities divided by the number of shares of common stock outstanding. After giving effect to the issuance of [     ] shares of our common stock at the assumed initial public offering price of $[     ] per share, which is the mid-point of the price range set forth on the cover page of this prospectus, and the application of the estimated net proceeds therefrom, and after deducting estimated underwriting discounts and commissions and our estimated offering expenses, our pro forma net tangible book value as of September 30, 2009 would have been approximately $[     ] million, or $[     ] per share of common stock. This amount represents an immediate increase in net tangible book value of $[     ] per share to our existing stockholders and an immediate dilution of $[     ] per share from the assumed initial public offering price of $[     ] per share issued to new investors purchasing shares in this offering. The table below illustrates the dilution on a per share basis:
 
                 
Assumed initial public offering price per share
  $                
Pro forma net tangible book value per share as of September 30, 2008
               
Increase in pro forma net tangible book value per share attributable to this offering
  $                
                 
Pro forma net tangible book value per share after this offering
               
                 
Dilution per share to new investors in this offering
          $      (1 )
                 
 
 
(1) If the underwriters’ over-allotment is exercised in full, dilution per share to new investors will be $[     ].
 
The table below sets forth, as of September 30, 2009, the number of shares of our common stock issued (assuming the conversion of each share of our Series A convertible preferred stock into [     ] shares of common stock), the total consideration paid and the average price per share paid by our existing stockholders and our new investors in this offering, after giving effect to the issuance of [     ] shares of common stock in this offering at the assumed initial public offering price of $[     ] per share, before deducting underwriting discounts and commissions and our estimated offering expenses.
 
                                         
                            Average
 
    Shares Issued     Total Consideration     Price
 
    Number     Percent     Amount     Percent     per Share  
 
Existing stockholders
    [     ]       [     ] %   $ [     ]       [     ] %   $ [     ]  
New investors
    [     ]       [     ]     $ [     ]       [     ]       [     ]  
Total
    [     ]       100.0 %   $ [     ]       100.0 %     [     ]  
 
This table does not give effect to:
 
  •  up to [          ] shares of common stock that may be issued pursuant to the underwriters’ over-allotment option;
 
  •  163,500 shares of common stock issuable upon the exercise of options outstanding as of December 31, 2009;
 
  •  [          ] shares of common stock issuable upon the exercise of stock options we intend to grant to our directors, executive officers and other employees upon completion of this offering, at an exercise price equal to the initial public offering price;
 
  •  [          ] shares of common stock issuable upon the exercise of warrants we intend to issue to our existing stockholders upon completion of this offering, at an exercise price equal to the initial public offering price; and
 
  •  [          ] additional shares available for future issuance under our 2010 Stock Incentive Plan.
 
To the extent that options with an exercise price below the initial price to the public are exercised, there will be further dilution to new investors.


42


Table of Contents

 
SELECTED HISTORICAL CONSOLIDATED FINANCIAL INFORMATION
 
The following table sets forth selected consolidated financial information as of such dates and for such periods indicated below. The following income statement data for the nine months ended September 30, 2009 and 2008 and balance sheet data as of September 30, 2009 were derived from our unaudited consolidated financial statements included elsewhere in this prospectus. Such unaudited financial statements include, in the opinion of management, all adjustments, consisting only of normal recurring adjustments, which we consider necessary for a fair presentation of our financial position and results of operations. The income statement data for the years ended December 31, 2008, 2007 and 2006 and balance sheet data as of December 31, 2008 and 2007 were derived from our audited consolidated financial statements included elsewhere in this prospectus. The income statement data for the years ended December 31, 2005 and 2004 and balance sheet data as of December 31, 2006, 2005 and 2004 were derived from our audited consolidated financial statements that are not included in this prospectus. These historical results are not necessarily indicative of results to be expected in any future period. You should read the following summary 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.
 
                                                         
    Nine Months
                               
    Ended September 30,     Years Ended December 31,  
    2009     2008     2008     2007     2006     2005     2004  
    In thousands, except per share data and percentages  
 
Income Statement Data
                                                       
Gross premiums written
  $ 95,972     $ 94,878     $ 117,563     $ 85,810     $ 62,372     $ 47,576     $ 30,911  
Ceded premiums written
    56,573       52,926       71,725       54,894       42,986       23,617       22,702  
                                                         
Net premiums written
    39,399       41,952       45,838       30,961       19,386       23,959       8,209  
                                                         
Revenues
                                                       
Net premiums earned
    28,369       32,276       49,220       24,613       21,053       21,336       2,948  
Insurance services income
    9,753       4,706       5,657       7,027       7,175       4,369       6,429  
Net investment income
    1,354       1,487       2,028       1,326       1,321       1,077       233  
Net realized gains (losses) on investments
    903       (253 )     (1,037 )     (5 )     (1,346 )     (2,298 )     (4,632 )
                                                         
Total revenues
    40,379       38,216       55,868       32,961       28,203       24,484       4,978  
                                                         
Expenses
                                                       
Net losses and loss adjustment expenses
    15,864       20,719       28,716       15,182       17,839       12,022       2,616  
Net policy acquisition and underwriting expenses
    8,498       8,176       13,535       6,023       3,834       3,168       2,016  
Other operating expenses
    11,100       8,055       10,930       8,519       9,704       6,378       4,989  
Interest expense
    1,119       1,102       1,437       1,290       1,109       1,129       555  
                                                         
Total expenses
    36,581       38,052       54,618       31,014       32,486       22,697       10,176  
                                                         
Other income
          219       1,469             796             110  
Loss from write-off of deferred equity offering costs(1)
                (3,486 )                        
Gain on early extinguishment of debt(2)
                            6,586              
                                                         
Income (loss) before income tax expense benefit
    3,798       383       (767 )     1,947       3,099       1,787       (5,088 )
Income tax expense (benefit)
    1,422       (217 )     (643 )     (432 )     1,489       687       (751 )
                                                         
Net income (loss)
  $ 2,376     $ 600     $ (124 )   $ 2,379     $ 1,610     $ 1,100     $ (4,337 )
                                                         
Earnings Per Share
                                                       
Basic
  $ 1.95     $ 0.44     $ (0.09 )   $ 1.77     $ 1.16     $ 0.88       NM (3)
Diluted
    1.94       0.44       (0.09 )     1.76       1.15       0.87       NM (3)
Weighted Average Common Shares Outstanding:
                                                       
Basic
    1,216       1,361       1,361       1,342       1,392       1,251       NM (3)
Diluted
    1,225       1,370       1,361       1,351       1,398       1,258       NM (3)
Return on average equity(4)
    36.7 %     15.1 %     NM(6 )     58.5 %     107.0 %     NM(7 )     NM (8)
Selected Insurance Ratios(5)
                                                       
Net loss ratio
    55.9 %     64.2 %     58.3 %     61.7 %     84.7 %     56.3 %     NM (3)
Net expense ratio
    30.0 %     25.3 %     27.5 %     24.5 %     18.2 %     14.8 %     NM (3)
                                                         
Net combined ratio
    85.9 %     89.5 %     85.8 %     86.2 %     102.9 %     71.1 %     NM (3)
                                                         
 


43


Table of Contents

                                                 
    September 30,
    December 31,  
    2009     2008     2007     2006     2005     2004  
    In thousands  
 
Balance Sheet Data
                                               
Investments
  $ 47,051     $ 55,089     $ 56,816     $ 32,543     $ 20,955     $ 16,446  
Cash and cash equivalents
    7,452       8,333       4,946       17,841       20,420       3,965  
Amounts recoverable from reinsurers
    58,328       42,134       47,519       41,531       22,955       10,978  
Premiums receivable, net
    83,040       58,826       36,748       19,450       21,943       19,244  
Prepaid reinsurance premiums
    42,010       33,731       14,963       7,466       4,402       14,925  
Other assets
    19,910       13,179       14,248       11,838       9,563       8,957  
                                                 
Total assets
  $ 257,791     $ 211,292     $ 175,237     $ 130,669     $ 100,238     $ 74,515  
                                                 
Reserves for losses and loss adjustment expenses
  $ 83,210       74,550       69,881       65,953       39,478       19,885  
Unearned and advanced premium reserves
    63,702       44,613       29,160       15,643       13,214       20,185  
Reinsurance funds withheld and balances payable
    56,458       47,449       44,073       26,787       25,195       15,697  
Debt and accrued interest
    20,089       22,592       16,907       11,741       11,995       10,379  
Other liabilities
    24,203       14,951       9,780       7,851       10,040       8,324  
                                                 
Total liabilities
    247,662       204,155       169,801       127,975       99,922       74,470  
Stockholders’ equity
    10,129       7,137       5,436       2,694       316       45  
                                                 
Total liabilities and stockholders’ equity
  $ 257,791     $ 211,292     $ 175,237     $ 130,669     $ 100,238     $ 74,515  
                                                 
 
 
(1) In 2008, we wrote off approximately $3.5 million of deferred equity offering costs incurred in connection with our prior efforts to consummate an initial public offering in 2007 and 2008.
 
(2) In 2006, Guarantee Insurance entered into a settlement and termination agreement with the former owner of Guarantee Insurance that allowed for an early extinguishment of debt in the amount of $8.8 million in exchange for $2.2 million in cash and release of the indemnification agreement previously entered into by the parties. As a result, we recognized a gain on the early extinguishment of debt on a pre-tax basis of $6.6 million. We also recognized other income in connection with the forgiveness of accrued interest associated with the early extinguishment of debt on a pre-tax basis of $796,000.
 
(3) We do not believe this metric is meaningful for the period indicated.
 
(4) Return on average equity for a given period (annualized in the case of periods less than one year) is calculated by dividing net income for that period by average stockholders’ equity as of the beginning and end of the period.
 
(5) The net loss ratio is calculated by dividing net losses and loss adjustment expenses by net earned premiums. The net expense ratio is calculated by dividing net policy acquisition and underwriting expenses (which are comprised of gross policy acquisition costs and other gross expenses incurred in our insurance operations, net of ceding commissions earned from our reinsurers) by net earned premiums. The net combined ratio is the sum of the net loss ratio and the net expense ratio.
 
(6) In 2008, we reported a net loss of $124,000, principally as a result of a non-recurring loss from the write-off of deferred equity offering costs of approximately $3.5 million as described above. Due to this non-recurring charge, our return on average equity for 2008 was (2.0)%, which we do not believe is meaningful.

44


Table of Contents

 
(7) In 2005, we reported net income of $1.1 million. However, our average stockholders’ equity for 2005 was only approximately $180,000, which results in a return on average equity of 609.4%, which we do not believe is meaningful.
 
(8) In 2004, we reported a net loss of $4.3 million, principally as a result of a loss from the write-off of an investment in Foundation Insurance Company, a subsidiary of Tarheel Group, Inc., as described below under “Certain Relationships and Related Transactions.” Due to this change, our return on average equity for 2004 was (19,275.6)%, which we do not believe is meaningful.


45


Table of Contents

 
MANAGEMENT’S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 
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 captions “Risk Factors” and “Forward-Looking Statements.” These factors could cause our actual results for the second half of 2009 and beyond to differ materially from those expressed in, or implied by, those forward-looking statements.
 
Overview
 
We produce, underwrite and administer alternative market and traditional workers’ compensation insurance plans and provide claims services for insurance companies, segregated portfolio captives and reinsurers. Through our wholly owned insurance company subsidiary, Guarantee Insurance, we generally participate in a portion of the insurance underwriting risk. In our insurance services segment, we generate fee income by providing workers’ compensation claims services as well as agency and underwriting services. In our insurance segment, we generate underwriting income and investment income by providing alternative market workers’ compensation risk transfer solutions and traditional workers’ compensation insurance coverage.
 
Insurance Services Operations
 
Through our subsidiary, PRS Group, Inc. and its subsidiaries, which we collectively refer to as PRS, and our subsidiary, Patriot Underwriters, Inc. and its subsidiary, which we collectively refer to as PUI, we earn income for workers’ compensation claims services as well as agency and underwriting services. Workers’ compensation claims services include nurse case management, cost containment services and, beginning in 2009, claims administration and adjudication services. Cost containment services refer to workers’ compensation bill review and re-pricing services. Workers’ compensation agency and underwriting services include general agency services and, beginning in 2009, specialty underwriting, policy administration and captive management services. We currently provide these services to Guarantee Insurance for its benefit, for the benefit of segregated portfolio captives and for the benefit of Guarantee Insurance’s traditional business quota share reinsurers, all under the Patriot Risk Services brand. We also provide these services for the benefit of another insurance company under its brand, a practice which we refer to as business process outsourcing, as described below.
 
In the second quarter of 2009, we entered into an arrangement with ULLICO Casualty Company, which we refer to as our BPO client, to gain access to workers’ compensation insurance business in certain additional states, including California and Texas. ULLICO is licensed to write workers’ compensation insurance in 47 states plus the District of Columbia and is rated “B+” (Good) by A.M Best. Under this arrangement, we earn commissions for producing business and insurance services income for providing underwriting, policy and claims administration, nurse case management and cost containment services and, in certain cases, services to segregated portfolio cell captives on the business we produce for this client. For certain of these services, we earn insurance services income based on a percentage of premiums produced. For other services, we earn insurance services income based on a percentage of what we refer to as reference premiums produced. Reference premiums produced refers to premiums produced for large deductible policies. Premiums on large deductible policies are substantially reduced, through premium rate credits, due to the fact that the insurer has no exposure to losses below the per occurrence deductible. Reference premiums produced equal the premiums produced for large deductible policies, grossed up to include the premium credits applicable to the large deductible policy, as if the policy did not feature a per occurrence deductible. For the nine months ended September 30, 2009, premiums produced for our BPO client were approximately $19.4 million, and reference premiums produced were approximately $36.5 million. With respect to premiums produced for our BPO client, policy coverage is generally provided by our BPO client, which has the primary obligation to indemnify its policyholders for covered claims. Accordingly, such premiums produced for our BPO client are not included in gross written premiums in our consolidated results of operations. However, Guarantee Insurance assumes a


46


Table of Contents

portion of the premium and associated losses and loss adjustment expenses on the business we produce for our BPO client. This assumed written premium is included in our gross written premiums in our consolidated results of operations.
 
In the fourth quarter of 2009, we entered into BPO relationships with two other companies, and we continue to seek to enter into additional business process outsourcing relationships. These additional relationships may be solely distribution and insurance services relationships, where we do not assume any underwriting risk but earn commissions for producing business and insurance services income for providing underwriting, policy and claims administration, nurse case management and cost containment services and, in certain cases, services to segregated portfolio captives.
 
Insurance Operations
 
We currently write insurance in 22 states and the District of Columbia. For the nine months ended September 30, 2009, approximately 52% of our total direct and assumed premiums written involved workers’ compensation alternative market insurance solutions and approximately 48% represented workers’ compensation traditional business. For the nine months ended September 30, 2009 and the years ended December 31, 2008 and 2007, approximately 28%, 46% and 59% of our total direct premiums written, respectively, were concentrated in Florida.
 
For the nine months ended September 30, 2009, approximately 33% of our alternative market business direct premiums written were concentrated in Florida, and approximately 20%, 13% and 10% were concentrated in New Jersey, Georgia and New York, respectively. No other state accounted for more than 5% of our alternative market business direct premiums written for the nine months ended September 30, 2009.
 
For the nine months ended September 30, 2009, approximately 22% and 20% of our traditional business direct premiums written were concentrated in Florida and New Jersey, respectively, and between 5% and 10% were concentrated in each of Georgia, Indiana, Arkansas, New York, and Missouri. No other state accounted for more than 5% of our traditional business direct premiums written for the nine months ended September 30, 2009.
 
Investment income is an important part of our insurance operations. We hold invested assets associated with the statutory surplus we maintain for the benefit of our policyholders. Additionally, because a period of time elapses between the receipt of premiums and the ultimate settlement of claims, we hold invested assets associated with our reserves for losses and loss adjustment expenses which we believe will be paid at a future date. Generally, the period of time that elapses from the receipt of premium to the ultimate settlement of claims for workers’ compensation insurance is longer than many other property and casualty insurance products. Accordingly, we are generally able to generate more investment income on our loss and loss adjustment expense reserves than insurance companies operating in most other lines of business. As of September 30, 2009, our investment portfolio, including cash and cash equivalents, was approximately $54.5 million, and for the nine months ended September 30, 2009, our net investment income was approximately $1.4 million.
 
We utilize quota share and excess of loss reinsurance to maintain what we believe are appropriate leverage ratios and reduce our exposure to losses and loss adjustment expenses. Quota share reinsurance is a form of proportional reinsurance in which the reinsurer assumes an agreed upon percentage of each risk being insured and shares all premiums and losses with us in that proportion. Excess of loss reinsurance covers all or a specified portion of losses on underlying insurance policies in excess of a specified amount, or retention. The cost and limits of the reinsurance coverage we purchase vary from year to year based upon the availability of reinsurance at acceptable prices and our desired level of retention. Retention refers to the amount of risk we retain for our own account. See “Business — Reinsurance.”
 
Under the segregated portfolio cell captive insurance plans in our alternative market business, we provide workers’ compensation insurance to employers and facilitate the establishment of a segregated portfolio cell within a segregated portfolio captive by coordinating the necessary interactions among the party controlling the cell, the insurance agency, the segregated portfolio captive, its manager and insurance regulators in the


47


Table of Contents

jurisdiction where the captive is domiciled. Segregated portfolio cells may be controlled by policyholders, parties related to policyholders, insurance agencies or others. Once the segregated portfolio cell is established, Guarantee Insurance enters into a quota share reinsurance agreement (“captive reinsurance agreement”) with the segregated portfolio captive acting on behalf of the segregated portfolio cell. For the nine months ended September 30, 2009, Guarantee Insurance ceded to the segregated portfolio captive either 90% or between 10% and 50% of the risk up to a level specified in the captive reinsurance agreement. For the nine months ended September 30, 2009, approximately 93% of the direct premiums written by Guarantee Insurance that were subject to segregated portfolio arrangements were ceded on a 90% basis, and approximately 7% of such premiums were ceded on a 10% to 50% basis. If the aggregate covered losses for the segregated portfolio cell exceed the level specified in the reinsurance agreement, the segregated portfolio captive reinsures the entire amount of the excess losses up to the aggregate liability limit specified in the captive reinsurance agreement. If the aggregate losses for the segregated portfolio cell exceed the aggregate liability limit, Guarantee Insurance retains 100% of those excess losses. Any amount of losses in excess of $1.0 million per occurrence is not covered by the captive reinsurance agreement. To the extent that any loss exceeds $1.0 million per occurrence, the amount of such loss in excess of $1.0 million is reinsured under Guarantee Insurance’s excess of loss reinsurance program. See “Business — Reinsurance — Alternative Market Business.”
 
Under our traditional business, Guarantee Insurance had three quota share reinsurance treaties inforce for the nine months ended September 30, 2009 with Swiss Reinsurance America Corporation, one of the largest reinsurers in the United States and rated “A+” by A.M. Best Company, and two other authorized reinsurers. Any loss in excess of $1.0 million is also reinsured under Guarantee Insurance’s excess of loss reinsurance program for traditional business. See “Business — Reinsurance — Traditional Business”.
 
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 the workers’ compensation insurance 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 current workers’ compensation insurance market has been experiencing a soft market cycle in which underwriting capacity and price competition have increased. In our traditional workers’ compensation business, we have experienced increased price competition since 2007 in certain markets. In addition, for the nine months ended September 30, 2009 compared to the same period in 2008, we experienced a decrease in traditional business gross premiums written generally attributable to lower payrolls associated with increases in overall unemployment.
 
For the nine months ended September 30, 2009, we wrote approximately 47% of our direct premiums written in administered pricing states — Florida, Indiana and New Jersey. In administered pricing states, insurance rates are set by the state insurance regulators and are adjusted periodically. Rate competition generally is not permitted in these states. Therefore, rather than setting rates for the policies, our underwriting efforts in these states for our traditional business relate primarily to the selection of the policies we choose to write at the premium rates that have been set.
 
The Florida OIR has approved average statewide rate decreases in each of the past three years, and has also approved a rate decrease for 2010. If a state insurance regulator lowers premium rates, our insurance operations will be less profitable, and we may choose not to write policies in that state. We have responded to these rate decreases by expanding our alternative market business in Florida and strengthening our collateral on that business where appropriate. In addition, we have the ability to offer different kinds of policies in administered pricing states, including retrospectively rated policies and dividend policies, for which an insured can receive a return of a portion of the premium paid if the insured’s claims experience is favorable. We expect an increase in Florida experience modifications, which permit us to increase the premiums we charge based on a policyholder’s loss history. We anticipate that our ability to adjust to these market changes will create opportunities as our competitors with higher expense ratios find the Florida market less desirable.


48


Table of Contents

The cyclical nature of the industry, the actions of our competitors, state insurance regulation and general economic factors could cause our revenues and net income from insurance operations to fluctuate. We manage our insurance operations across market cycles by striving to maintain premium rates in non-administrative pricing states, deploy capital judiciously, manage our expenses and focus on underserved sectors within our target markets that we believe will provide opportunities for favorable underwriting margins.
 
In September 2003, our wholly-owned subsidiary, Patriot National Insurance Group, Inc., acquired Guarantee Insurance, a shell property and casualty insurance company that was not then writing new business, for a purchase price of approximately $9.5 million, in the form of $750,000 in cash and a note in the amount of approximately $8.8 million. At that time, Guarantee Insurance had a number of commercial general liability claims, including asbestos and environmental claims, that had been in run-off since 1983. The former owner of Guarantee Insurance agreed to indemnify us for certain losses in excess of reserves arising from these claims up to the amount of the original purchase price. On March 30, 2006, we entered into a settlement and termination agreement with the seller where the note issued as part of the purchase price was released in exchange for a cash payment of $2.2 million and the release of the seller’s agreement to indemnify us for losses in excess of reserves. In 2006, we recognized a pre-tax $6.6 million gain on early extinguishment of debt in connection with this settlement and termination agreement. As of September 30, 2009, we held net reserves in the amount of approximately $4.2 million for losses attributable to the legacy claims.
 
Principal Revenue and Expense Items
 
Our revenues consist primarily of the following:
 
Premiums Earned
 
Premiums earned represent the earned portion of our net premiums written. Net premiums written are equal to gross premiums written less premiums ceded to reinsurers. Gross premiums written include the estimated annual direct premiums written from each insurance policy we write or renew during the reporting period based on the policy effective date or the date the policy is bound, whichever is later, as well as premiums assumed.
 
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 yet 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, 2009 for an employer with constant payroll during the term of the policy, we would earn half of the premiums in 2009 and the other half in 2010.
 
Many of our policies renew on January 1 of each year. As a result, we have experienced some seasonality in our gross and net premiums written in that generally we write more new and renewal policies during the first quarter of the calendar year. The actual premium we earn on a policy is based on the actual payroll during the term of the policy. We conduct premium audits on our traditional and alternative market policyholders annually upon the expiration of each policy, including when the policy is renewed. The purpose of these audits is to verify that policyholders have accurately reported their payroll expenses and employee job classifications and therefore have paid us the premium required under the terms of their policies. In addition to annual audits, we selectively perform interim audits on certain classes of business if significant or unusual claims are filed or if the monthly reports submitted by a policyholder reflect a payroll pattern or any aberrations that cause underwriting, safety or fraud concerns.
 
Insurance Services Income
 
Insurance services income is a key component of our hybrid business model. In 2009, we began producing business and performing insurance services for our BPO client. We earn insurance services income for producing business, providing underwriting, policy and claims administration, nurse case management and cost containment services and, in certain cases, providing services to segregated portfolio cell captives on the business we produce for our BPO client. We collect fronting fees from policyholders and remit such fees to our BPO client. Additionally, Guarantee Insurance assumes a portion of the premium and associated losses


49


Table of Contents

and loss adjustment expenses on the business we produce for our BPO client. Commission income and other insurance services income attributable to underwriting, policy and claims administration services and services to segregated portfolio cell captives associated with this business are based on a percentage of premiums produced or reference premiums produced, as applicable, for our BPO client, reduced by an allowance for estimated insurance services income that will not be received due to the cancellation of policies prior to expiration and reductions in payroll. Income attributable to nurse case management and cost containment services is recognized in the period during which such services are provided.
 
Guarantee Insurance assumes a portion of the premium and associated losses and loss adjustment expenses on the business we produce for our BPO client, which is mutually determined by the parties for each policy. The portion of risk assumed by Guarantee Insurance on business we produced for our BPO client during the third quarter of 2009 ranged from approximately 10% to 100%. Based on the total amount of premiums on the business produced for our BPO client, Guarantee Insurance assumed an average of approximately 40% of the business produced during the third quarter of 2009, although we expect this percentage may vary significantly from quarter to quarter. For the nine months ended September 30, 2009, Guarantee Insurance assumed approximately 100% of the risk on large deductible business produced for our BPO client and 10% to 30% of the risk on all other business produced for our BPO client. In connection with business assumed by us under this arrangement, we provide collateral in the form of cash, letters of credit or other forms of acceptable collateral, as required by the agreement. No collateral was required as of September 30, 2009.
 
Our insurance services segment income includes all nurse case management, cost containment and other insurance services fee income earned by PRS and PUI. However, the fees earned by PRS and PUI that are attributable to the portion of the insurance risk that Guarantee Insurance retains and assumes from other insurance companies are eliminated upon consolidation. Therefore, our insurance services income, on a consolidated basis, consists of income for services provided to unaffiliated clients. With respect to business written by Guarantee Insurance, the fees earned by PRS represent the fees paid by segregated portfolio captives and our quota share reinsurers for services performed on their behalf and for which Guarantee Insurance is reimbursed through a ceding commission. For financial reporting purposes, we treat these ceding commissions as a reduction in net policy acquisition and underwriting expenses. With respect to business produced for our BPO client, the fees earned by PRS and PUI represent fees paid by the BPO client attributable to the portion of insurance risk it retains.
 
Because our insurance services income is currently generated principally from the services we provide to Guarantee Insurance for the benefit of segregated portfolio captives and our quota share reinsurers, our insurance services income is currently substantially dependent on Guarantee Insurance’s premium and risk retention levels. However, we expect that our nurse case management, cost containment and other insurance services operations will become less dependent over time on Guarantee Insurance’s premium and risk retention levels as we expand our business process outsourcing relationships and develop additional general agency appointments and enter into agreements with other BPO clients for nurse case management, cost containment and other insurance services.
 
General agency services on Guarantee Insurance’s alternative market segregated portfolio captive business were provided by PRS prior to 2008, pursuant to which Guarantee Insurance paid PRS a general agency commission, a portion of which was retained by PRS and a portion of which was paid by PRS as commission compensation to the producing agents. Effective January 1, 2008, Guarantee Insurance began working directly with agents to market segregated portfolio captive business and paying commissions directly to the producing agents. As a result, PRS ceased earning general agency commissions and ceased paying commissions to producing agents attributable to Guarantee Insurance business.
 
Net Investment Income and Net Realized Gains and Losses on Investments
 
Our net investment income includes interest and dividends earned on our invested assets, net of investment expenses. In 2007, we purchased tax exempt municipal debt securities, which are classified as available-for-sale, to help increase the after-tax contribution of net investment income. Tax exempt securities typically have an adverse effect on net investment income and pre-tax investment portfolio yields, which effect is generally offset by a reduction in aggregate effective federal income tax rates.


50


Table of Contents

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 34% to express yield on tax-exempt securities on the same basis as taxable securities. Net realized gains and losses on investments are reported separately from our net investment income. Net realized gains occur when investment securities are sold for more than their costs or amortized costs, as applicable. Net realized losses occur when 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.
 
Our expenses consist primarily of the following:
 
Losses and Loss Adjustment Expenses Incurred
 
Losses and loss adjustment expenses incurred represent our largest expense item. Losses and loss adjustment expenses are comprised of paid losses and loss adjustment expenses, estimates of future claim payments on claims reported in the period, changes in those estimates from prior reporting periods and costs associated with investigating, defending and servicing reported claims. These expenses fluctuate based on the amount and types of risks we insure. We record losses and loss adjustment expenses related to estimates of future claim payments based on case-by-case valuations and statistical analyses. We seek to establish reserves at the most likely ultimate exposure based on our historical claims experience. More serious claims typically take several years to close, and we revise our estimates as we receive additional information about the condition of injured employees and as industry conditions change. Our ability to estimate losses and loss adjustment expenses accurately at the time we price our insurance policies is a critical factor in our profitability.
 
Net Policy Acquisition and Underwriting Expenses
 
Net policy acquisition and underwriting expenses represent the costs we incur in connection with our insurance operations, principally costs to acquire, underwrite and administer traditional and alternative market workers’ compensation insurance policies. These expenses include commissions, salaries and benefits related to insurance operations, state and local premium taxes and fees and other operating costs, partially offset by ceding commissions we earn from reinsurers under our reinsurance program.
 
Other Operating Expenses
 
Other operating expenses represent the costs we incur other than those associated with our insurance operations, principally costs incurred in connection with our insurance services operations and holding company expenses. The costs associated with our insurance services operations include the cost of providing nurse case management services, preferred provider network costs for access to discounted health care services and commissions to producing agents. With respect to business produced for our BPO client, commissions to producing agencies and certain marketing and underwriting costs, which are generally based on a percentage of premiums produced or reference premiums produced, as applicable, for our BPO client, are reduced by (i) an allowance for estimated commissions that will not be paid due to the cancellation of policies prior to expiration and reductions in payroll and (ii) policy administration and claims costs, which are expensed as incurred. All such expenses are included in other operating expenses in our consolidated statements of income.
 
Interest Expense
 
Interest expense represents amounts we incur on our outstanding indebtedness based on the applicable interest rates during the relevant periods.
 
Income Tax Expense
 
Income tax expense represents both current and deferred federal income taxes incurred.
 
Measurement of Results
 
We use various measures to analyze the growth and profitability of our operations.


51


Table of Contents

For our insurance services operations, we measure growth in terms of fee income produced from insurance services, which is dependent on the number and size of claims being managed as well as the amount of premium we produce for other insurance companies. For our insurance operations, we measure growth in terms of gross and net premiums written and we measure underwriting profitability by examining our net loss, net expense and combined ratios. A combined ratio is the sum of the net loss ratio and the net underwriting expense ratio, each calculated as described below. We also measure our gross and net premiums written to surplus ratios to assess the adequacy of capital in relation to premiums written. We measure profitability in terms of pre-tax net income, net income and return on average equity.
 
Premiums Written
 
Gross premiums written represent the estimated gross premiums for the duration of the policy, recognized at the inception of the policy. We use gross premiums written to measure our sales for our insurance operations. Gross premiums written also correlates to our ability to generate net premiums earned and, with respect to the premiums we cede to segregated portfolio cell captives and our quota share reinsurers, ceding commissions and insurance services income.
 
Loss Ratio
 
We use calendar year and accident year loss ratios to measure our underwriting profitability. A calendar year loss ratio measures losses and loss adjustment expense for insured events occurring during a particular year, together with changes in loss reserves from prior accident years, as a percentage of premiums earned during that year. An accident year loss ratio measures losses and loss adjustment expenses for insured events occurring in a particular year, regardless of when they are reported, as a percentage of premium earned during that year. The net loss ratio is calculated by dividing net losses and loss adjustment expenses by net earned premiums. The net loss ratio measures claims experience, net of the effects of reinsurance, and therefore is a measure of the effectiveness of our underwriting efforts. We report our net loss ratio on both a calendar year and accident year basis.
 
Net Expense Ratio
 
The net expense ratio is calculated by dividing net policy acquisition and underwriting expenses (which are comprised of gross policy acquisition costs and other gross expenses incurred in our insurance operations, net of ceding commissions earned from our reinsurers) by net earned premiums. The expense ratio measures our operational efficiency in producing, underwriting and administering our insurance operations. The gross expense ratio is calculated before the effect of ceded reinsurance. We calculate our expense ratio on a net basis (after the effect of ceded premium and related ceding commissions) to measure the results of our consolidated insurance operations. Ceding commissions reduce our gross underwriting expenses in our insurance operations.
 
Combined Ratio
 
We use the combined ratio to measure the underwriting profitability of our insurance operations. The combined ratio is the sum of the net loss ratio and the net expense ratio.
 
Net Income and Return on Average Equity
 
We use net income to measure our profits and return on average equity to measure the effectiveness in utilizing our stockholders’ equity to generate net income on a consolidated basis. In determining return on average equity for a given period, net income is divided by the average of stockholders’ equity at the beginning and end of that period and annualized in the case of periods less than one year.
 
Outlook
 
Set forth below are certain of our objectives with respect to our business subsequent to this initial public offering. We caution you that these objectives may not materialize and are not indicative of the actual


52


Table of Contents

results that we will achieve. Many factors and future developments may cause our actual results to differ materially and significantly from the information set forth below. See “Risk Factors” and “Forward-Looking Statements.”
 
Upon completion of this initial public offering, the majority of the net proceeds of the offering will be contributed to Guarantee Insurance and, if we acquire it, PF&C, and deployed in accordance with our primary investment objectives of preserving capital and achieving an appropriate risk adjusted return, with an emphasis on liquidity to meet claims obligations.
 
Return on Average Equity
 
One of the key financial measures that we will use to evaluate our operating performance will be return on average equity. We will calculate return on average equity for a given year by dividing net income by the average of stockholders’ equity for that year. Our return on average equity was 36.7% for the nine months ended September 30, 2009. With the increased capitalization as a result of this initial public offering, we expect a lower return on average equity. Our objective over the long term is to produce a return on average equity of at least 15%. To help achieve our return on average equity objective, we may consider funding our operations, in part, with borrowings or other non-equity sources of capital in the future.
 
Indebtedness
 
We may utilize additional debt, as appropriate, to maintain a net leverage ratio on our insurance operations that satisfies the regulatory authorities that oversee Guarantee Insurance’s operations. Furthermore, we may utilize additional debt, as appropriate, in connection with the acquisition of an insurance or insurance services organization or book of business. Over the long term, we expect to target a debt to equity ratio of 10% to 25%.
 
Insurance Services Operations
 
Insurance Services Income
 
Our insurance services income comprised approximately 24% of total revenues for the nine months ended September 30, 2009. We target our insurance services income to be 30% to 40% of total revenues in the near term. Additionally, we target insurance services income to generate 20% to 40% of average return on equity in the near term.
 
Pre-Tax Margin on Insurance Services Income
 
Our pre-tax margin on insurance services income was 35% for the nine months ended September 30, 2009. Primarily due to economies of scale related to generally fixed holding company expenses allocated to the insurance services segment, we target our pre-tax margin on insurance services income to increase to 40% to 45% over the long term.
 
Insurance Operations
 
Mix of Business
 
Alternative market and traditional gross premiums written comprised approximately 49% and 57% of our total direct premiums written, respectively, for the nine months ended September 30, 2009. Upon completion of this offering, we plan to increase our alternative market business more significantly than our traditional business. In the near term, we target our alternative market gross premiums written to comprise 55% to 70% of our total direct premiums written.
 
Underwriting Ratios
 
The net loss ratio is calculated by dividing consolidated net losses and loss adjustment expenses by net earned premiums. The net expense ratio is calculated by dividing consolidated net policy acquisition and


53


Table of Contents

underwriting expenses (which are comprised of gross policy acquisition costs and other gross expenses incurred in our insurance operations, net of ceding commissions earned from our reinsurers) by net earned premiums. The net combined ratio is the sum of the net loss ratio and the net expense ratio. Our net loss ratio, net expense ratio and net combined ratio were 55.9%, 30.0% and 85.9% for the nine months ended September 30, 2009. Over the long term, we target a net combined ratio of less than 85% and a net loss ratio at between 55% and 65%. We expect our net expense ratio to decline over time as our alternative market direct premiums written increase in proportion to our total direct premiums written due to the fact that ceding commissions on our segregated portfolio cell captive business, which are recognized as a contra-expense, generally exceed our gross expense ratio. Additionally, we expect our net expense ratio to decline over time as our total direct premiums written increase and we realize certain economies of scale.
 
Aggregate Risk Retention Levels and Operating Leverage
 
Our aggregate risk retention level, as measured by dividing alternative market and traditional net premiums written by alternative market and traditional gross premiums written, was 42% for the nine months ended September 30, 2009. Over the long term, we target our aggregate risk retention level to decrease to 25% to 35% due to our expected increase in the proportion of alternative market direct premiums written, a substantial portion of which is comprised of segregated portfolio cell captive arrangements, on which we retained approximately 14% of the underwriting risk for the nine months ended September 30, 2009.
 
Our net operating leverage ratio, as measured by dividing net premiums earned by average stockholders’ equity, was approximately 7.8 to 1 for 2008. With the increased capital from this offering, we expect our net operating leverage ratio to decrease significantly. In the near term, we target a net leverage ratio of between 0.3 to 1 and 0.5 to 1. Actual operating leverage ratios may vary from targets due to factors that affect our ratings with various organizations and capital adequacy requirements imposed by insurance regulatory authorities. These factors include the amount of our statutory surplus and stockholders’ equity, premium growth, debt facilities, quality and terms of reinsurance and business mix.
 
Investment Leverage Ratio
 
We expect most of our investment portfolio to continue to principally consist of high quality fixed income securities. We plan to continue to pursue competitive investment returns while maintaining a diversified portfolio of securities with a primary emphasis on the preservation of principal through high credit quality issuers with limited exposure to any one issuer. We expect our investment income to increase as our invested assets grow, and we target a tax-adjusted yield on investment of 4.5% in the near term. As we fully deploy the capital from this offering, we expect to target an investment leverage ratio, which is the ratio of average invested assets to average equity, of between 1.0 to 1 and 1.5 to 1.
 
Reserving Methodology for Legacy Asbestos and Environmental Exposures
 
When we acquired Guarantee Insurance in 2003, it had certain asbestos and environmental liability exposures arising out of the sale of general liability insurance and participations in reinsurance assumed through underwriting management organizations, commonly referred to as pools. Generally, reserves for asbestos and environmental claims cannot be estimated with traditional loss reserving techniques that rely on historical accident year development factors due to the uncertainties surrounding asbestos and environmental liability claims. As of December 31, 2008, we had established reserves, net of reinsurance recoverables on unpaid losses, of approximately $3.0 million attributable to asbestos and environmental exposures. These reserves are attributable to 22 direct claims, Guarantee Insurance’s share of two reinsurance pool claims and our estimate of the impact of unreported claims. In one of these pools, Guarantee Insurance reinsured the risks of other insurers and then ceded a portion (generally 80%) of these reinsurance risks to other reinsurers, which we call participating pool reinsurers. Under this structure, Guarantee Insurance remains obligated for the total liability under each reinsurance contract it issued, to the extent any of the participating pool reinsurers fails to pay its share. Over time, Guarantee Insurance’s net liabilities under these reinsurance contracts have increased from approximately 20% to approximately 50% of the pooled risks, due to the insolvency of some participating pool reinsurers. In the other pool, Guarantee Insurance is one of a number of participating pool


54


Table of Contents

reinsurers, and its liability is based on the percentage share of the pool obligations it reinsures. Our reserves for direct asbestos and environmental liability claims are based on a detailed review of each case. Our reserves for pooled asbestos and environmental liability exposures are based on our share of aggregate reserves established by pool administrators through their consultation with independent actuarial consultants.
 
We believe that our reserve methodology results in net reserves for asbestos and environmental claims that are adequate to cover the ultimate cost of losses and loss adjustment expenses thereon. However, we believe that adopting the survival ratio reserve methodology for asbestos and environmental exposures would make our reserve methodology for these exposures generally consistent with our publicly held insurance company peers. Accordingly, we are evaluating the possibility of adopting this methodology. Under the survival ratio reserve methodology, our net reserve for asbestos and environmental liability exposures would be estimated based on a multiple of approximately 15 times our average net paid asbestos and environmental claims the three most recent years. If we had adopted the survival ratio reserve methodology as of December 31, 2008, our net reserve for asbestos and environmental exposures would have been approximately $5.1 million, representing an increase in net losses and loss adjustment expenses of approximately $2.1 million.
 
We expect to make a decision with respect to the adoption of the survival ratio reserve methodology in connection with the preparation of our financial statements for the fourth quarter of 2009. If we adopt this methodology, our pre-tax income for the period in which we increase our reserves will decrease by a corresponding amount.
 
Target Top Line for Fourth Quarter 2009
 
Our financial statements for the year ended December 31, 2009 are not yet available and have not been audited. However, for the fourth quarter of 2009, we expect direct premiums written of approximate $[     ] million to $[     ] million, premiums produced for our BPO client of approximately $[     ] million to $[     ] million, and reference premiums produced for our BPO client of approximately $[     ] million to $[     ] million.
 
Critical Accounting Policies
 
The following is a description of the accounting policies management considers important to the understanding of our financial condition and results of operations.
 
Reserves for Losses 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 losses and loss adjustment expenses represent the estimated cost of all reported and unreported losses and loss adjustment expenses incurred and unpaid at any given point in time based on facts and circumstances known to us at the time. Our reserves for losses and loss adjustment expenses are estimated using case-by-case valuations and statistical analyses. These estimates are inherently uncertain. In establishing these estimates, we make various assumptions regarding a number of factors, including frequency and severity of claims, length of time to achieve the ultimate settlement of claims, projected inflation of medical costs and wages, insurance policy coverage interpretations, judicial determinations and regulatory changes. Due to the inherent uncertainty associated with these estimates, our actual liabilities may be different from our original estimates. On a quarterly basis, we review our reserves for losses and loss adjustment expenses to determine whether any further adjustments are appropriate. Any resulting adjustments are included in the current period’s results. We do not discount loss and loss adjustment expense reserves for the time value of money from the date claims are incurred to the date they are paid. Additional information regarding our reserves for losses and loss adjustment expenses can be found in “Business — Loss and Loss Adjustment Expense Reserves.”
 
As a result of unfavorable development on prior accident year reserves, our estimate for incurred losses and loss adjustment expenses increased by approximately $1.7 million and $1.3 million for the nine months ended September 30, 2009 and for the year ended December 31, 2008, respectively. As a result of favorable


55


Table of Contents

development on prior accident year reserves, our estimate for incurred losses and loss adjustment expenses decreased by approximately $3.5 million for the year ended December 31, 2007. As a result of unfavorable development on prior accident year reserves, our estimate for incurred losses and loss adjustment expenses increased by approximately $2.5 million for the year ended December 31, 2006. See “Business — Reconciliation of Reserves for Losses and Loss Adjustment Expenses.’’
 
Amounts Recoverable from Reinsurers
 
Amounts recoverable from reinsurers represent the portion of our paid and unpaid losses and loss adjustment expenses that is assumed by reinsurers. These amounts are reported on our balance sheet as assets and do not reduce our reserves for losses and loss adjustment expenses because reinsurance does not relieve us of our primary obligation 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 losses and loss adjustment expenses and 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 losses and loss adjustment expenses for which we have reinsurance coverage remain outstanding for extended periods of time.
 
We have reinsurance agreements with both authorized and unauthorized reinsurers. Authorized reinsurers are licensed or otherwise authorized to conduct business in the state of Florida, Guarantee Insurance’s state of domicile. Under statutory accounting principles, Guarantee Insurance receives credit on its statutory financial statements for all paid and unpaid losses ceded to authorized reinsurers. Unauthorized reinsurers are not licensed or otherwise authorized to conduct business in the state of Florida. Under statutory accounting principles, Guarantee Insurance receives credit for paid and unpaid losses ceded to unauthorized reinsurers to the extent these liabilities are secured by funds held, letters of credit or other forms of acceptable collateral. With respect to authorized reinsurers, we manage our credit risk by generally selecting reinsurers with a financial strength rating of “A−” (Excellent) or better by A.M. Best and by performing quarterly credit reviews of our reinsurers. With respect to unauthorized reinsurers, including segregated portfolio captives, we manage our credit risk by generally maintaining collateral, typically in the form of funds withheld and letters of credit, to cover reinsurance recoverable balances. If one of our reinsurers suffers a credit downgrade, we may consider various options to lessen the risk of asset impairment, including commutation, novation and additional collateral.
 
In order to qualify for reinsurance accounting and provide accounting benefit to us, reinsurance agreements must transfer insurance risk to the reinsurer. Risk transfer standards under generally accepted accounting principles (GAAP) require that (a) the reinsurer assume significant insurance risk (underwriting risk and timing risk) under the reinsured portions of the underlying insurance agreements, and (b) it be reasonably possible that the reinsurer may realize a significant loss from the transaction. In determining whether the degree of risk transfer is adequate to qualify for reinsurance accounting, each reinsurance contract is evaluated on its own facts and circumstances. To the extent that the accounting risk transfer thresholds are not met, the reinsurance transaction is accounted for as a deposit. The treatment of reinsurance transactions as deposits does not mean that economic risk has not been transferred, but rather that the nature and the amount of the risk transferred do not sufficiently satisfy GAAP risk transfer criteria to be afforded reinsurance accounting treatment. We evaluate our reinsurance contracts at their inception and upon subsequent amendments to determine whether reinsurance accounting or deposit accounting is appropriate.
 
Our reinsurance recoverable balance was carried net of an allowance for doubtful accounts of $300,000 at September 30, 2009 and December 31, 2008. For the nine months ended September 30, 2009 and the years ended December 31, 2008, 2007 and 2006, we did not, in the aggregate, experience material difficulties in collecting balances from our reinsurers. No assurance can be given, however, regarding the future ability of our reinsurers to meet their obligations.


56


Table of Contents

Premiums Receivable
 
Premiums receivable are uncollateralized policyholder obligations due under normal policy terms requiring payment within a specified period from the invoice date. Premium receivable balances are reviewed for collectability and management provides an allowance for estimated doubtful accounts, which reduces premiums receivable. Our premiums receivable were carried net of an allowance for uncollectible accounts, based upon a specific impairment basis methodology, of $650,000 at September 30, 2009 and December 31, 2008. Due to an increase in the aging of our premiums receivable and exposure to uncollateralized balances, we may establish an additional allowance for accounts that may not be collectible but which we have not specifically identified as impaired. We believe that this methodology is consistent with the methodology utilized by our publicly held insurance company peers. We anticipate that the additional allowance amount that may be required based upon this analysis is between $500,000 and $1.0 million. This additional allowance, if determined by management to be appropriate, would be recorded in the fourth quarter of 2009. No assurance can be given regarding the future ability of our policyholders to meet their obligations.
 
Revenue Recognition
 
Through PRS, we earn insurance services income by providing nurse case management and cost containment services to Guarantee Insurance, on its behalf, on behalf of the segregated portfolio captives and on behalf of Guarantee Insurance’s quota share reinsurers. Through PRS and PUI, we also earn insurance services income by providing nurse case management, cost containment, claims administration, sales, underwriting, policy administration and, in certain cases, segregated portfolio captive management services to our BPO client.
 
Insurance services income for nurse case management services is based on a monthly charge per claimant. Insurance services income for cost containment services is based on a percentage of claim savings. Insurance services income for claims administration is based on a percentage of reference premiums produced for our BPO client (recognized on a pro rata basis over the period of time we are contractually obligated to administer the claims). Insurance services income for sales, underwriting and segregated portfolio cell captive setup, policy administration and captive management services is based on a percentage of premiums produced for our BPO client, reduced by an allowance for estimated insurance services income that will not be received due to the cancellation of policies prior to expiration and reductions in payrolls. Insurance services income for policy administration and captive management is based on a percentage of premiums produced for our BPO client, recognized on a pro rata basis over the lives of the policies produced.
 
Insurance services income includes all insurance services income earned by PRS and PUI. However, the insurance services income earned by PRS from Guarantee Insurance that is attributable to the portion of the insurance risk that Guarantee Insurance retains or assumes from our BPO client is eliminated upon consolidation. Therefore, our consolidated insurance services income consists of the fees earned by PUI and the portion of fees earned by PRS that are attributable to the portion of the insurance risk assumed by the segregated portfolio captives, assumed by Guarantee Insurance’s quota share reinsurers or retained by our BPO client.
 
Premiums are earned pro rata over the terms of the policies which are typically annual. The portion of premiums that will be earned in the future is deferred and reported as unearned premiums. We estimate earned but unbilled premiums at the end of the period by analyzing historical earned premium adjustments made and applying an adjustment percentage to premiums earned for the period. For the year ended December 31, 2008, we reduced our earned but unbilled premium percentage to reflect lower payrolls which we believe were largely reflective of employment trends in the economy. For the nine months ended September 30, 2009 and the year ended December 31, 2008, we did not experience any material changes in estimates related to premiums earned, including earned but unbilled premiums. No assurance can be given that there will be no material changes in estimates related to premiums earned, including earned but unbilled premiums, in the future.


57


Table of Contents

Deferred Policy Acquisition Costs and Deferred Ceding Commissions
 
We defer commission expenses, premium taxes and certain marketing, sales and underwriting costs that vary with and are primarily related to the acquisition of insurance policies. We also defer associated ceding commissions. These acquisition costs are capitalized and charged to expense ratably as premiums are earned. In calculating deferred policy acquisition costs and deferred ceding commissions, we only include costs to the extent of their estimated realizable value, which gives effect to the premiums expected 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 deferred policy acquisition costs and deferred ceding commissions are highly dependent upon estimated future profitability of unearned premiums. If unearned premiums are less than our expected claims and expenses after considering investment income, we reduce the related deferred policy acquisition costs. For the nine months ended September 30, 2009 and the years ended December 31, 2008 and 2007, we did not, in the aggregate, experience material changes in our deferred policy acquisition costs or deferred ceding commissions in connection with changes in estimated recoverability. No assurance can be given, however, regarding the future recoverability of deferred policy acquisition costs or deferred ceding commissions.
 
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 will impact 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, we consider whether it is more likely than not that we will generate future taxable income during the periods in which those temporary differences become deductible. We consider the scheduled reversal of deferred tax liabilities, tax planning strategies and projected future taxable income in making this assessment. If necessary, we will establish a valuation allowance to reduce the deferred tax assets to the amounts that are more likely than not to be realized.
 
At December 31, 2006, we provided a full valuation allowance on the deferred tax asset attributable to net operating loss carry forwards generated by The Tarheel Group, Inc., or Tarheel. On April 1, 2007, when our majority stockholder contributed all the outstanding capital stock of Tarheel to Patriot Risk Management, we determined that our operating performance, coupled with our expectations to generate future taxable income, indicated that it was more likely than not that we would be able to utilize this asset to offset future taxes and, accordingly, we reversed this valuation allowance. The deferred tax asset associated with net operating loss carry forwards from Tarheel and its subsidiary, Tarheel Insurance Management Company, or TIMCO, was fully utilized as of September 30, 2009. As of September 30, 2009 and December 31, 2008, no other deferred tax assets have been deemed more likely than not to be unrealizable and, accordingly, no valuation allowance was deemed necessary for unrealizable deferred tax assets. No assurance can be given, however, regarding the future realization of deferred tax assets.
 
Assessments
 
We are subject to various assessments related to our insurance operations, including assessments for state guaranty funds and second injury funds. 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 may be partially recovered through a reduction in future premium taxes. In accordance with Financial Accounting Standards Board (FASB) guidance contained in Accounting Standards Codification (ASC) 450, Contingencies, we establish a provision for these assessments at the time the amounts are probable and estimable. Assessments based on premiums are generally paid one year after the calendar year in which


58


Table of Contents

the policies are written. Assessments based on losses are generally paid within one year of when claims are paid by us. For the nine months ended September 30, 2009 and the years ended December 31, 2008 and 2007, we did not experience any material changes in our estimates of assessments for state guaranty funds and second injury funds. No assurance can be given, however, regarding the future changes in estimates of such assessments.
 
Share-Based Compensation Costs
 
In December 2004, the FASB issued guidance for accounting for stock-based compensation costs, now part of ASC 718, Compensation-Stock Compensation, which requires the compensation costs relating to stock options granted or modified after December 31, 2005 to be recognized in financial statements using the fair value of the equity instruments issued on the grant date of such instruments and to be recognized as compensation expense over the period during which an individual is required to provide service in exchange for the award (typically the vesting period). We adopted this guidance effective January 1, 2006, and the impact of the adoption was not significant to our financial statements for the nine months ended December 31, 2009 or 2008 or the years ended December 31, 2008 or 2007. We estimate share-based compensation costs of approximately $[     ], $[     ] and $[     ] for the years ending December 31, 2010, 2011 and 2012, respectively, relating to stock options that we have granted and expect to grant to our management and members of our board of directors, recognized on a pro rata basis over the vesting period. As of September 30, 2009, we had 163,500 outstanding options. For the nine months ended September 30, 2009 and the years ended December 31, 2008 and 2007, we did not experience any material changes in our estimates of share-based compensation costs. No assurance can be given, however, regarding the future changes in estimates of share-based compensation costs.
 
The fair value of the underlying common stock for all option grants made between December 2005 and July 2007 was determined by the board of directors to be $8.02, which was based on the board’s evaluation of our financial condition and results of operations. Our financial condition, as measured by our internal financial statements and by Guarantee Insurance’s statutory surplus levels and uncertainties related to our abilities to increase premium writings due to surplus constraints, did not change materially between December 2005 and July 2007. We did not secure an independent appraisal to verify that valuation because we concluded that an independent appraisal would not result in a more meaningful or accurate determination of fair value under the circumstances.
 
The intrinsic value of outstanding vested and unvested options based on the midpoint of the price range set forth on the cover page of this prospectus is $[     ] and $[     ], respectively.
 
The increase from the $8.02 per share fair value as of each stock option grant date from December 30, 2005 to July 10, 2007 to the estimated initial public offering price is largely attributable to two principal factors:
 
  •  The first factor is the liquidity driven valuation premium inherently available to a company as it transitions from privately held to publicly traded status.
 
  •  The second factor relates to our growth prospects, which have improved because the additional capital from this offering will allow us to increase our gross premiums written and retain more of our business, together with improved prospects for claim and cost containment and insurance services income.
 
No options or stock awards were granted during the nine months ended September 30, 2009 or the year ended December 31, 2008.
 
See Note 8 to our consolidated interim financial statements as of September 30, 2009 and for the nine months then ended and Note 12 to our consolidated financial statements as of December 31, 2008 and for the year then ended for more information regarding our stock option plans, stock options and stock awards granted during 2007 and 2006.


59


Table of Contents

Impairment of Invested Assets
 
Impairment of an invested asset results in a reduction of the carrying value of the asset and the realization of a loss when the fair value of the asset declines below our carrying value 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 invested assets. We consider various factors in determining if a decline in the fair value of a security is other-than-temporary, including the scope of the decline in value, the amount of time that the fair value of the asset has been below carrying value, the financial condition of the issuer and our intent and ability to hold the asset for a period sufficient for us to recover its value.
 
For the nine months ended September 30, 2009, we did not recognize any other-than-temporary impairments. For the year ended December 31, 2008, we recognized an other-than-temporary impairment charge of approximately $875,000 related to investments in certain equity securities. Additionally, during 2008, we recognized an other-than-temporary-impairment charge of approximately $355,000 on our investment of approximately $400,000 in certain Lehman Brothers Holdings, Inc. bonds as a result of Lehman Brothers’ bankruptcy. For the year ended December 31, 2007, we did not recognize any other than temporary impairments. For the year ended December 31, 2006, Tarheel invested approximately $1.7 million in Foundation Insurance Company, a limited purpose captive insurance subsidiary of Tarheel that reinsured workers’ compensation program business, in order to permit Foundation to settle certain obligations relating to its business. We wrote down this investment in 2006. No assurance can be given regarding future changes in estimates related to other-than-temporary impairment of our investment securities.
 
Adoption of New Accounting Standards and Recent Accounting Pronouncements
 
Accounting Standards Codification
 
In June 2009, the FASB issued Statement of Financial Accounting Standards (SFAS) No. 168, “The FASB Accounting Standards Codification and the Hierarchy of Generally Accepted Accounting Principles, a replacement of FASB Statement No. 162 (the Codification). The Codification reorganized existing U.S. accounting and reporting standards issued by the FASB and other related private sector standard setters into a single source of authoritative accounting principles arranged by topic. The Codification supersedes all existing U.S. accounting standards. All other accounting literature not included in the Codification, other than Securities and Exchange Commission guidance for publicly traded companies, is considered non-authoritative. The Codification was effective on a prospective basis for interim and annual reporting periods ending after September 15, 2009. The adoption of the Codification changed our references to U.S. GAAP accounting standards, but did not impact our results of operations or financial position.
 
Business Combinations
 
In December 2007, the FASB issued revised guidance for the accounting for business combinations. The revised guidance, which is now part of ASC 805, Business Combinations, is effective for acquisitions during the fiscal years beginning after December 15, 2008, and early adoption is prohibited. This revised guidance establishes principles and requirements for how the acquirer of a business recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed and any non-controlling interest in the acquired entity. The revised guidance also provides guidance for recognizing and measuring the goodwill acquired in the business combination and determines what information to disclose to enable users of the financial statements to evaluate the nature and financial effects of the business combination. The adoption of this revised guidance on January 1, 2009 did not have an impact on our results of operations or financial position. The future impact of the adoption of this revised guidance will depend upon the extent and magnitude of future acquisitions, if any.
 
Additional Fair Value Measurement Guidance
 
In April 2009, the FASB issued new guidance for determining when a transaction is not orderly and for estimating fair value when there has been a significant decrease in the volume and level of activity for an asset


60


Table of Contents

or liability. The new guidance, which is now part of ASC 820, Fair Value Measurements and Disclosures, is effective for periods ending after June 15, 2009 with early adoption permitted for periods ending after March 15, 2009. Retrospective application is not permitted. This new guidance requires disclosure of the inputs and valuation techniques used, as well as any changes in valuation techniques and inputs used during the period, to measure fair value in interim and annual periods. In addition, the presentation of the fair value hierarchy is required to be presented by major security type as described in ASC 320. The adoption of this new guidance on June 30, 2009 did not have a material impact on our results of operations or financial position.
 
Disclosure about Fair Value of Financial Instruments
 
In April 2009, the FASB issued new guidance related to the disclosure of the fair value of financial instruments. The new guidance, which is now part of ASC 825, Financial Instruments, was effective for periods ending after June 15, 2009 with early adoption permitted for periods ending after March 15, 2009. The new guidance requires disclosure of the fair value of financial instruments whenever a publicly traded company issues financial information in interim reporting periods in addition to the annual disclosure required at yearend. The adoption of this new guidance on June 30, 2009 did not have a material impact on our disclosures since all of our material financial instruments are carried at fair value.
 
Other-Than-Temporary Impairments
 
In April 2009, the FASB issued new guidance for the accounting for other-than-temporary impairments. The new guidance, which is now part of ASC 320, Investments — Debt and Equity Securities, was effective for periods ending after June 15, 2009 with early adoption permitted for periods ending after March 15, 2009. Under the new guidance, an other-than-temporary impairment is recognized when an entity has the intent to sell a debt security or when it is more likely than not that an entity will be required to sell the debt security before its anticipated recovery in value. The new guidance also changes the presentation and amount of other-than-temporary impairment losses recognized in the income statement for instances in which a company does not intend to sell a debt security, or it is more likely than not that a company will not be required to sell a debt security prior to the anticipated recovery of its remaining cost basis. We separate the credit loss component of the impairment from the amount related to all other factors and report the credit loss component in net realized investment gains (losses). The impairment related to all other factors is reported in accumulated other comprehensive income, net of deferred income taxes. In addition, the new guidance expands disclosures related to other-than-temporary impairments related to debt securities and requires such disclosures in both interim and annual periods. The adoption of the new guidance on June 30, 2009 did not have any impact on our results of operations or financial position.
 
Subsequent Events
 
In May 2009, the FASB issued new guidance for accounting for subsequent events. The new guidance, which is now part of ASC 855, Subsequent Events, was effective for interim and annual periods ending after June 15, 2009. The new guidance establishes general standards of accounting for and disclosure of events that occur after the balance sheet date but before the financial statements are issued or are available to be issued. Additionally, the new guidance requires the disclosure of the date through which an entity has evaluated subsequent events and the basis for that date. The adoption of the new guidance on June 30, 2009 did not have any impact on our results of operations or financial position.
 
Fair Value Measurement of Liabilities
 
In August 2009, the FASB issued new guidance for the accounting for the fair value measurement of liabilities. The new guidance, which is now part of ASC 820, Fair Value Measurements and Disclosures, is effective for interim and annual periods beginning after August 27, 2009. The new guidance provides clarification that in certain circumstances in which a quoted price in an active market for an identical liability is not available, an entity is required to measure fair value using one or more of the following valuation techniques: The quoted price of the identical when traded as an asset, the quoted price for similar liabilities or similar liabilities when traded as an asset or another valuation technique that is consistent with the principles


61


Table of Contents

of fair value measurements. We do not expect that the provisions of the new guidance will have a material effect on our results of operations or financial position.
 
Results of Operations
 
Our results of operations are discussed below in two parts. The first part discusses our consolidated results of operations. The second part discusses our results of operations by segment.
 
Consolidated Results of Operations
 
Nine Months Ended September 30, 2009 Compared to Nine Months Ended September 30, 2008
 
Overview of Operating Results.  Net income for the nine months ended September 30, 2009 was $2.4 million compared to $600,000 for the comparable period in 2008. Income before income taxes for the nine months ended September 30, 2009 was $3.8 million compared to $383,000 for the comparable period in 2008. The increase in income before income taxes was principally the result of a 107% increase in insurance services income, a 3.6 percentage point decrease in net combined ratio and a $1.2 million increase in net realized gains on investments, partially offset by a 12% decrease in net premiums earned and a 38% increase in other operating expenses.
 
Gross Premiums Written.  Gross premiums written were $96.0 million for the nine months ended September 30, 2009 compared to $94.9 million for the comparable period in 2008, an increase of $1.1 million or 1%. The increase was principally attributable to our assumption of approximately $7.8 million of premiums produced for our BPO client, beginning in the second quarter of 2009. This was partially offset by a $7.5 million decrease in traditional business direct premiums written. Gross premiums written by line of business were as follows:
 
                 
    Nine Months Ended
 
    September 30,  
    2009     2008  
    In thousands  
 
Direct business:
               
Alternative market
  $ 42,163     $ 42,168  
Traditional business
    44,378       51,912  
                 
Total direct business
    86,541       94,080  
                 
Assumed business
               
BPO client
    7,824        
NCCI National Workers’ Compensation Insurance Pool
    1,607       798  
                 
Total assumed business
    9,431       798  
                 
Total
  $ 95,972     $ 94,878  
                 
 
Gross premiums written on alternative market business were $42.2 million for both the nine months ended September 30, 2009 and 2008. Increases in alternative market gross premiums written, primarily attributable to new agency captive business and the transfer or renewal of approximately $5.4 million of traditional business to alternative market agency captive business during the nine months ended September 30, 2008, were offset by the January 1, 2009 non-renewal of our then largest alternative market policyholder, which represented approximately $15.4 million of gross premiums written upon renewal for the nine months ended September 30, 2008, together with lower payrolls associated with increases in overall unemployment.
 
Gross premiums written on traditional business were $44.4 million for the nine months ended September 30, 2009 compared to $51.9 million for the comparable period in 2008, a decrease of $7.5 million or 15%. The decrease in traditional business gross premiums written was generally attributable to lower payrolls associated with increases in overall unemployment, and also to the fact that approximately $5.4 million


62


Table of Contents

of traditional business was transferred to or renewed as alternative market agency captive business during the nine months ended September 30, 2009.
 
Net Premiums Written.  Net premiums written were $39.4 million for the nine months ended September 30, 2009 compared to $42.0 million for the comparable period of 2008, a decrease of $2.6 million or 6%. The decrease in net premiums written was primarily attributable to a $3.6 million increase in ceded premiums written, partially offset by the $1.1 million increase in gross premiums written discussed above. We ceded approximately 58% and 44% of our traditional business for the nine months ended September 30, 2009 and 2008, respectively. For the nine months ended September 30, 2009, we had a 25% quota share reinsurance agreement on traditional business in all states and a 68% quota share reinsurance agreement in three states (Florida, New Jersey and Georgia), which business collectively comprised approximately 52% of our traditional direct premiums written. For the nine months ended September 30, 2008, we had a 50% quota share reinsurance agreement in all but three states. We ceded approximately 72% and 71% of our alternative market business for the nine months ended September 30, 2009 and 2008, respectively. In addition, the increase in ceded premiums written was attributable to a premium rate adjustment of approximately $1.3 million on an excess loss reinsurance agreement covering risks attaching from July 1, 2005 through June 30, 2006.
 
Net Premiums Earned.  Net premiums earned were $28.4 million for the nine months ended September 30, 2009, compared to $32.3 million for the comparable period in 2008, a decrease of $3.9 million or 12%. The decrease was generally commensurate with the decrease in net premiums written.
 
Insurance Services Income.  Insurance services income was $9.8 million for the nine months ended September 30, 2009, compared to $4.7 million for the comparable period in 2008, an increase of $5.0 million or 107%.Insurance services income from nurse case management and cost containment services increased to $6.1 million for the nine months ended September 30, 2009 from $4.2 million for the comparable period in 2008, an increase of $1.9 million or 64%, due to the increase in exposures serviced by PRS. Additionally, PUI and PRS recognized approximately $3.5 million of fee income for the nine months ended September 30, 2009 related to the production, underwriting and administration of business on behalf of our BPO client pursuant to an agreement entered into during the second quarter of 2009. This increase was partially offset by a $406,000 decrease in fees for general agency services during the nine months ended September 30, 2008. The majority of these services were terminated in 2008.
 
Net Investment Income.  Net investment income was $1.4 million for the nine months ended September 30, 2009, compared to $1.5 million for the comparable period in 2008, a decrease of $133,000 or 9%. The decrease in net investment income was attributable to a decrease in our average investment portfolio during the period, principally associated with the payment of reinsurance premiums in early 2009 associated with a quota share reinsurance agreement we entered into effective December 31, 2008, pursuant to which we ceded unearned premium reserves, net of ceding commissions, of approximately $8.1 million in order for Guarantee Insurance to satisfy certain regulatory leverage ratio requirements. Additionally, the book yield and taxable equivalent book yield on our portfolio at September 30, 2009 were 3.92% and 4.48%, respectively, compared to 4.16% and 4.77%, respectively, at September 30, 2008. The reduced yield on our portfolio of approximately 25 to 30 basis points reflects lower yields available in the fixed income securities market as our securities mature and new cash is deployed.
 
Net Realized Gains on Investments.  Net realized gains on investments were $903,000 for the nine months ended September 30, 2009, compared to net realized losses of $253,000 for the comparable period of 2008, an increase of $1.2 million. The increase was principally attributable to the sale of certain asset-backed and mortgage-backed securities, the proceeds of which were used to pay net reinsurance premiums of approximately $8.1 million as discussed above.
 
Net Losses and Loss Adjustment Expenses.  Net losses and loss adjustment expenses were $15.9 million for the nine months ended September 30, 2009, compared to $20.7 million for the comparable period in 2008, a decrease of $4.9 million or 23%. Our consolidated calendar period net loss ratio was 55.9% for the nine months ended September 30, 2009, compared to 64.2% for comparable period in 2008, a decrease of 8.3 percentage points. The decrease in the loss ratio was the result of favorable accident period loss experience


63


Table of Contents

for the nine months ended September 30, 2009 as well as lower adverse development on prior accident periods for the nine months ended September 30, 2009 versus the comparable period in 2008. For the nine months ended September 30, 2009, we recorded unfavorable development of approximately $1.5 million on our workers’ compensation business, primarily attributable to the 2007 accident year, and approximately $248,000 on our legacy asbestos and environmental exposures and commercial general liability exposures from prior accident years. For the nine months ended September 30, 2008, we recorded unfavorable development of approximately $2.2 million on our workers’ compensation business and approximately $745,000 on our legacy asbestos and environmental exposures and commercial general liability exposures from prior accident years.
 
Net Policy Acquisition and Underwriting Expenses.  Net policy acquisition and underwriting expenses were $8.5 million for the nine months ended September 30, 2009, compared to $8.2 million for the comparable period in 2008, an increase of $322,000 or 4%. The increase was the net result in changes in our gross expense ratio and effective ceding commission ratio as described below.
 
Net policy acquisition and underwriting expenses are comprised of gross policy acquisition and underwriting expenses, which include agent commissions, premium taxes and assessments and general operating expenses associated with insurance operations, net of ceding commissions on ceded quota share reinsurance premiums on traditional and alternative market business, as follows:
 
                 
    Nine Months Ended
 
    September 30,  
    2009     2008  
    Dollar amounts in thousands  
 
Direct and assumed business:
               
Gross policy acquisition and underwriting expenses
  $ 23,548     $ 21,963  
Gross premiums earned
    77,154       70,829  
                 
Gross policy acquisition and underwriting expense ratio
    30.5 %     31.0 %
                 
Alternative market and traditional business ceded on a quota share basis:
               
Ceding commissions
    15,050       13,787  
Ceded premiums earned
    44,047       36,679  
                 
Effective ceding commission rate
    34.2 %     37.6 %
                 
Excess of loss reinsurance ceded premiums earned
    4,738       1,874  
                 
Net business:
               
Net policy acquisition and underwriting expenses
    8,498       8,176  
Net premiums earned
    28,369       32,276  
                 
Net policy acquisition and underwriting expense ratio
    30.0 %     25.3 %
                 
 
Gross policy acquisition and underwriting expenses were $23.5 million for the nine months ended September 30, 2009, compared to $22.0 million for the comparable period in 2008, an increase of $1.6 million or 7%. The increase in gross policy acquisition and underwriting expenses was generally consistent with the growth in gross premiums earned. Our gross expense ratio was 30.5% for the nine months ended September 30, 2009, compared to 31.0% for the comparable period in 2008. The decrease in our gross expense ratio was principally attributable to emerging economies of scale for the nine months ended September 30, 2009 compared to the comparable period in 2008, partially offset by an increase in net policy acquisition and underwriting expenses allocated from the holding company as discussed below.
 
Ceding commissions on alternative market and traditional business ceded on a quota share basis were $15.1 million for the nine months ended September 30, 2009 compared to $13.8 million for comparable period in 2008, an increase of $1.3 million or 9%. Our blended effective ceding commission rate on alternative market and traditional business quota share reinsurance was 34.2% for the nine months ended September 30, 2009, compared to 37.6% for the comparable period in 2008. The decrease in the blended effective ceding commission rate was principally attributable to a lower ceding commission rate on a traditional business quota


64


Table of Contents

share reinsurance treaty we entered into effective January 1, 2009. In addition, certain of our agency-owned captives have lower ceding commission rates than other captives. For the nine months ended September 30, 2009, 64% of the direct premiums written subject to segregated portfolio captive arrangements were derived from agency-owned captives, as compared to 13% for the comparable period in 2008.
 
Our net policy acquisition and underwriting expense ratio was 30.0% for the nine months ended September 30, 2009, compared to 25.3% for the comparable period in 2008. The increase in our net expense ratio was principally attributable to a lower ceding commission rate on a traditional business quota share reinsurance treaty entered into effective January 1, 2009 and an increase in the allocation of holding company expenses as discussed below.
 
Other Operating Expenses.  Other operating expenses, which are primarily comprised of holding company expenses and expenses attributable to our insurance services operations, were $11.1 million for the nine months ended September 30, 2009, compared to $8.1 million for the comparable period in 2008, an increase of $3.0 million or 38%. Other operating expenses included approximately $9.4 million and $5.4 million associated with insurance services operations for the nine months ended September 30, 2009 and 2008, respectively, and $1.7 million and $2.7 million associated with holding company operations for the nine months ended September 30, 2009 and 2008, respectively. The $4.0 million increase in expenses associated with insurance services operations was attributable to infrastructure growth to support our expanding nurse case management and cost containment services, together with marketing, underwriting and policy administration costs incurred by PUI in connection with gross premiums produced for our BPO client.
 
The decrease in expenses associated with holding company operations was primarily attributable to an increase in the percentage of holding company expenses allocated to insurance and insurance services segments and a true-up of state income tax expenses for the nine months ended September 30, 2009, resulting in a state income tax benefit of approximately $220,000. Allocable holding company operating expenses, which include all expenses other than holding company stock compensation expense, state income taxes, loan guaranty fees, amortization of capitalized loan costs and certain legal fees associated with holding company matters, are incurred for the benefit of the holding company and our operating segments and allocated to each segment based on the proportion of such costs devoted to each segment. For the nine months ended September 30, 2009, approximately 67% of allocable holding company operating expenses were allocated to the insurance and insurance services segments. For the comparable period in 2008, approximately 38% of allocable holding company operating expenses were allocated to the insurance and insurance services segments. The increase in the portion of allocable holding company expenses allocated to insurance and insurance services segments was attributable to the decrease in holding company resources devoted to capital raising efforts and other holding company matters for the nine months ended September 30, 2009.
 
Interest Expense.  Interest expense was $1.1 million for both the nine months ended September 30, 2009 and 2008. The aggregate principal balance of our notes payable was approximately $18.0 million and $15.4 million at September 30, 2009 and 2008, respectively. The increase in the principal balance was attributable to a $5.5 million loan made to us on December 31, 2008, partially reduced by monthly principal payments on all of our notes payable. Our debt generally bears interest at a fixed percentage above the Federal Reserve prime rate. The increase in interest expense associated with the increase in the principal balance of our notes payable was offset by the fact that the Federal Reserve prime rate was 3.25% for the nine months ended September 30, 2009, and ranged from 5.00% to 7.25% for the nine months ended September 30, 2008.
 
Income Tax Expense.  Federal income tax expense was $1.4 million for the nine months ended September 30, 2009 compared to an income tax benefit of $217,000 for the comparable period in 2008. For the nine months ended September 30, 2009, our income tax expense at the statutory rate, which was approximately $1.3 million, was reduced by approximately $155,000 for tax exempt investment income and approximately $131,000 for a decrease in reserve for uncertain tax positions and increased by approximately $204,000 for a true-up of our prior year tax provision and approximately $213,000 for other items, net. For the nine months ended September 30, 2008, our income tax expense at the statutory rate, which was approximately $130,000, was reduced by approximately $178,000 and $290,000 for tax exempt investment


65


Table of Contents

income and a decrease in reserves for uncertain tax positions, respectively, and increased by approximately $121,000 for other items, net.
 
2008 Compared to 2007
 
Overview of Operating Results.  Our net loss for 2008 was $124,000 compared to net income of approximately $2.4 million for 2007. Our loss before income taxes for 2008 was $767,000 compared to income before income taxes of $1.9 million for 2007. The $2.7 million decrease in income before income taxes was the result of the write-off of approximately $3.5 million of deferred equity offering costs in 2008 incurred in connection with our efforts to consummate an initial public offering and other-than-temporary impairment charges on our investment portfolio of approximately $1.2 million, together with a $1.7 million increase in holding company expenses in 2008, principally attributable to increased staffing and other internal costs in anticipation of an initial public offering and associated expanded business opportunities. These charges were partially offset by a 1.6 percentage point decrease in our combined ratio from insurance operations, together with a 103% increase in net premiums earned, and the recognition of approximately $1.5 million of other income in 2008 associated with gains on the commutation of certain alternative market segregated portfolio cell captive reinsurance treaties.
 
Gross Premiums Written.  Gross premiums written were $117.6 million for 2008 compared to $85.8 million for 2007, an increase of $31.8 million or 37%. Gross premiums written by line of business were as follows:
 
                 
    2008     2007  
    In thousands  
 
Direct business:
               
Alternative market
  $ 47,374     $ 34,316  
Traditional business
    69,182       50,599  
                 
Total direct business
    116,556       84,915  
Assumed business(1)
    1,007       895  
                 
Total
  $ 117,563     $ 85,810  
                 
 
 
(1) Represents premiums assumed as a result of our participation in the NCCI National Workers’ Compensation Insurance Pool.
 
Gross premiums written on alternative market business for 2008 were $47.4 million for 2008 compared to $34.3 million for 2007, an increase of $13.1 million or 38%. The increase in alternative market gross premiums written was primarily attributable to business with certain professional employer organizations and professional temporary staffing organizations on which we retain the risk. These plans may be converted to risk sharing arrangements in the future. The increase was also attributable to an increase in segregated portfolio cell captive reinsurance business and certain large deductible plans, the latter of which we began writing in 2008.
 
Gross premiums written on traditional business were $69.2 million for 2008, compared to $50.6 million for 2007, an increase of $18.6 million or 37%. The increase in traditional business gross premiums written was attributable to an increase in policy counts. Traditional business policy counts increased by 75%, to 5,305 at December 31, 2008 from 3,034 at December 31, 2007. The increase in policy counts was principally attributable to our geographic expansion beyond Florida and the Midwest, together with the expansion of our traditional business pay-as-you-go plan. The increase in policy counts was partially offset by an 11% decrease in average annual in-force premium per policy, from approximately $16,400 at December 31, 2007 to approximately $12,000 at December 31, 2008. The decrease in average annual in-force premium per policy was principally attributable to mandatory rate decreases in the state of Florida, an administered pricing state where we wrote approximately 30% of our traditional business direct premiums written in 2008. The majority of the increase in gross premiums written on traditional business in 2008 came from New Jersey, where gross


66


Table of Contents

premiums written on traditional business were $9.7 million for 2008 compared to $2.4 million for 2007, an increase of $7.3 million or 307%.
 
Net Premiums Written.  Net premiums written were $45.8 million for 2008, compared to $31.0 million for 2007, an increase of $14.9 million or 48%. The $31.8 million period-over-period increase in gross premiums written was partially offset by a $16.9 million increase in ceded premiums written. The increase in ceded premiums written was primarily attributable to (i) an increase in gross premiums written on traditional business (which was subject to a 50% quota share reinsurance treaty excluding certain states), (ii) an increase in premiums written on alternative market business ceded to segregated portfolio cell captives (which was generally subject to 50% to 90% quota share reinsurance treaties) and (iii) a quota share reinsurance agreement we entered into effective December 31, 2008 pursuant to which we ceded 37.83% of our gross unearned premium reserves, or approximately $12.9 million. These increases in ceded premiums written were partially offset by the commutation of certain alternative market segregated portfolio cell captive reinsurance agreements in 2008, which resulted in a reduction in ceded premiums written of approximately $8.2 million.
 
Net Premiums Earned.  Net premiums earned were $49.2 million for 2008, compared to $24.6 million for 2007, an increase of $24.6 million or 100%. The increase was attributable to the increase in net premiums written, exclusive of the effects of the quota share reinsurance agreement we entered into effective December 31, 2008, for which no ceded premium was earned in 2008 because premiums are recognized as revenue on a pro rata basis over the terms of the policies written.
 
Insurance Services Income.  Insurance services income earned by PRS was $5.7 million for 2008, compared to $7.0 million for 2007, a decrease of $1.4 million or 19%. Insurance services income in 2008 and 2007 was generated principally from nurse case management, cost containment and captive management services provided for the benefit of segregated portfolio captives and our quota share reinsurers. The decrease in insurance services income was attributable to lower fees associated with general agency services, which decreased to $361,000 in 2008 from $2.3 million in 2007 due to termination of these services effective January 1, 2008. This decrease was partially offset by an increase in insurance services income associated with nurse case management and cost containment services, which increased to $5.1 million in 2008 from $4.6 million in 2007 due to an increase in the number of claims subject to nurse case management and bill review. Insurance services income attributable to services provided to parties other than segregated portfolio captives and our quota share reinsurers increased to $241,000 in 2008 from $98,000 in 2007.
 
Net Investment Income.  Net investment income was $2.0 million for 2008, compared to $1.3 million for 2007. Gross investment income was $2.5 million in both 2008 and 2007. The average of our beginning and ending investment portfolio, including cash and cash equivalents, increased to $62.6 million for 2008, compared to $57.1 million for 2007, an increase of $5.5 million, or 10%. The increase in our net investment income attributable to the increase in invested assets was partially offset by the fact that the tax adjusted yield on our debt portfolio fell to 4.99% at December 31, 2008 from 5.19% at December 31, 2007, due to prevailing market conditions in the debt securities market. The increase in our net investment income attributable to the increase in invested assets was also offset by a lower pre-tax yield on tax-exempt state and political subdivision debt securities, which we began to own in the second quarter of 2007. Investment expenses were $478,000 for 2008 compared to $1.2 million for 2007, a decrease of $714,000 or 60%. Investment expenses are principally comprised of interest expense credited to funds-held balances on alternative market segregated portfolio captive arrangements. Interest is credited to funds-held balances based on 3-month U.S. Treasury bill rates. The decrease in investment expenses was primarily attributable to a decrease in short term interest rates due to prevailing credit market conditions as well as a decrease in funds-held balances.
 
Net Realized Losses on Investments.  Net realized losses on investments were approximately $1.0 million for 2008, compared to $5,000 for 2007. Net realized losses on investments in 2008 include an other-than-temporary impairment charge of approximately $875,000 related to investments in certain equity securities purchased in 2005 and approximately $350,000 on our investment of approximately $400,000 in certain bonds issued by Lehman Brothers Holdings, Inc., which filed for bankruptcy in September 2008.


67


Table of Contents

Other Income.  Other income was $1.5 million for 2008. We did not recognize other income for 2007. Other income for 2008 represents the recapture of funds held balances and other collateral pursuant to the commutation of six segregated portfolio cell captives in 2008.
 
Loss From Write-Off of Deferred Equity Offering Costs.  In 2008, we recorded a loss from the write-off of deferred equity offering costs of approximately $3.5 million, principally representing legal and audit expenses incurred in 2007 and 2008 in connection with our efforts to consummate an initial public offering, which was suspended in the fourth quarter of 2008 due to market conditions.
 
Net Losses and Loss Adjustment Expenses.  Net losses and loss adjustment expenses were $28.7 million for 2008 compared to $15.2 million for 2007, an increase of $13.5 million or 89%. The increase was attributable to a 103% increase in net premiums earned. Our calendar year net loss ratio was 58.3% for 2008 compared to 61.7% for 2007, a decrease of 3.4 percentage points. The decrease in the loss ratio was principally the result of favorable loss experience for accident year 2008, which was 54.9% compared to 75.7% for accident year 2007.
 
The favorable 2008 accident year loss ratio was partially offset by adverse development in 2008 on prior accident year net losses and loss adjustment expenses of approximately $584,000 and $710,000 on workers’ compensation and legacy commercial general liability, asbestos and environmental exposures, respectively. In 2007, incurred losses and loss adjustment expenses attributable to prior accident years decreased by approximately $3.5 million. Of this $3.5 million, approximately $2.2 million relates to favorable development on workers’ compensation reserves attributable to the fact that 165 claims incurred in 2004 and 2005 were ultimately settled in 2007 for approximately $600,000 less than the specific case reserves that had been established for these exposures at December 31, 2006. In addition, as a result of this favorable case reserve development during 2007, we reduced our loss development factors utilized in estimating claims incurred but not yet reported resulting in a reduction of estimated incurred but not reported reserves as of December 31, 2007. The $3.5 million of favorable development in 2007 also reflects approximately $1.3 million of favorable development on legacy asbestos and environmental exposures and commercial general liability exposures as a result of the further run-off of this business and additional information received from pool administrators on pooled business in which we participate. See “Business — Legacy Claims.”
 
Net Policy Acquisition and Underwriting Expenses.  Net policy acquisition and underwriting expenses were $13.5 million for 2008 compared to $6.0 million for 2007, an increase of $7.5 million.
 
Net policy acquisition and underwriting expenses are comprised of gross policy acquisition and underwriting expenses, which include agent commissions, premium taxes and assessments and general


68


Table of Contents

operating expenses associated with insurance operations, net of ceding commissions on ceded quota share reinsurance premiums on traditional and alternative market segregated portfolio captive business, as follows:
 
                 
    2008     2007  
    Dollar amounts in thousands  
 
Direct and assumed business:
               
Gross policy acquisition and underwriting expenses
  $ 31,499     $ 22,644  
Gross premiums earned
    100,070       73,715  
                 
Gross policy acquisition and underwriting expense ratio
    31.5 %     30.7 %
                 
Alternative market and traditional business ceded on a quota share basis:
               
Ceding commissions
    17,964       16,621  
Ceded premiums earned
    46,748       44,589  
                 
Effective ceding commission rate
    38.4 %     37.3 %
                 
Excess of loss reinsurance ceded premiums earned
    4,102       4,513  
                 
Net business:
               
Net policy acquisition and underwriting expenses
    13,535       6,023  
Net premiums earned
    49,220       24,613  
                 
Net policy acquisition and underwriting expense ratio
    27.5 %     24.5 %
                 
 
Gross policy acquisition and underwriting expenses were $31.5 million for 2008, compared with $22.6 million for 2007, an increase of $8.9 million or 39%. The increase in gross policy acquisition and underwriting expenses was generally consistent with the growth in gross premiums earned. Our gross expense ratio was 31.5% for 2008 compared to 30.7% for 2007. The increase in our gross expense ratio was principally attributable to incremental expenses for professional fees and additional compensation and compensation-related costs associated with the hiring of additional members of senior management as we positioned our company for growth and diversification as well as establishing infrastructure to support the requirements of being a publicly held company. These additional expenses were partially offset by (i) economies of scale as certain of our gross policy acquisition and underwriting expenses did not increase in proportion to gross premiums earned, (ii) a decrease in the portion of holding company expenses allocated to insurance operations as discussed more fully under Other Operating Expenses, and (iii) lower commission expenses in connection with the fact that, effective January 1, 2008, Guarantee Insurance began working directly with agents to market segregated portfolio captive insurance business and paying commissions directly to the producing agents rather than paying a higher general agency commission to PRS.
 
Ceding commissions on alternative market and traditional business ceded on a quota share basis were $18.0 million for 2008, compared to $16.6 million for 2007, an increase of $1.3 million or 8%. Our blended effective ceding commission rate on alternative market and traditional business quota share reinsurance was 38.4% for 2008 compared to 37.3% for 2007. The increase was principally attributable to the proportional increase in ceded quota share reinsurance premiums on our alternative market business, which have a higher effective ceding commission rate than ceded premiums on our traditional business.
 
Our net policy acquisition and underwriting expense ratio was 27.5% for 2008, compared to 24.5% for 2007. The ceding commission rates we earn on our alternative market business and traditional business quota share reinsurance are higher than our gross policy acquisition and underwriting expense ratio. Accordingly, if we cede more business on a quota share basis, our net policy acquisition and underwriting expense ratio decreases, and if we cede less business on a quota share basis, our net policy acquisition and underwriting expense ratio increases. The increase in our net expense ratio was principally the result of the fact that a smaller portion of our gross premiums were ceded on a quota share basis in 2008. To a lesser extent, the increase in our net expense ratio was due to the increase in our gross expense ratio.


69


Table of Contents

Other Operating Expenses.  Other operating expenses, which are primarily comprised of holding company expenses and expenses attributable to our insurance services operations, were $10.9 million for 2008, compared to $8.5 million for 2007, an increase of $2.4 million or 28%. Other operating expenses included approximately $7.8 million and $7.1 million associated with insurance services operations for 2008 and 2007, respectively, and $3.1 million and $1.4 million associated with holding company operations for 2008 and 2007, respectively. The increase in expenses associated with insurance services operations was attributable to the increase in insurance services income associated with nurse case management and cost containment services. The increase was also attributable to a higher allocation of holding company expenses to our insurance services operations.
 
The increase in expenses associated with holding company operations reflects a substantial reduction in the proportion of holding company expenses allocated to the insurance segment, partially offset by an increase in the proportion of holding company expenses allocated to the insurance services segment. Allocable holding company operating expenses, which include all expenses other than holding company stock compensation expense, loan guaranty fees and amortization of capitalized loan costs, are incurred for the benefit of the holding company and our operating segments and allocated to each segment based on the proportion of such costs devoted to each segment. For 2008, approximately 30% of allocable holding company operating expenses were allocated to the insurance segment, approximately 30% were allocated to the insurance services segment and approximately 40% were retained by the holding company based on our estimate of costs devoted to the insurance segment, insurance services segment and holding company matters. These allocations principally reflect the time and effort devoted to our planned initial public offering during 2008. For 2007, approximately 80% of allocable holding company operating expenses were allocated to the insurance segment, approximately 8% were allocated to the insurance services segment and approximately 12% were retained by the holding company, as we determined that a higher proportion of holding company costs were devoted to insurance operations.
 
Interest Expense.  Interest expense was $1.4 million for 2008, compared to $1.3 million for 2007, an increase of $147,000 or 11%. The increase was attributable to the fact that we borrowed an additional $5.7 million in September 2007 and another $1.5 million from Mr. Mariano, our Chairman and Chief Executive Officer and the beneficial owner of a majority of our outstanding shares, in June 2008. Interest expense associated with these additional borrowings was substantially offset by a decrease in the effective interest rate on the debt, which is based on the Federal Reserve prime rate.
 
Income Tax Expense.  We recognized an income tax benefit of approximately $643,000 for 2008, compared to $432,000 for 2007. For 2008, our income tax benefit at the statutory rate, which was approximately $261,000, was increased by approximately $238,000 related to tax exempt investment income and a $290,000 reduction in the reserve for uncertain tax positions, partially offset by the tax effect of other permanent tax differences of approximately $146,000.
 
For 2007, our income tax expense at the statutory rate, which was approximately $662,000, was reduced by approximately $1.9 million attributable to a change in the valuation allowance related to the deferred tax asset arising from Tarheel net operating loss carry forwards. For the three months ended March 31, 2007 and the years ended December 31, 2006 and 2005, management did not consider it more likely than not that Tarheel would generate future taxable income against which Tarheel net operating loss carry forwards could be utilized and, accordingly, maintained a 100% valuation allowance on the deferred tax asset attributable to Tarheel net operating loss carry forwards. On April 1, 2007, Mr. Mariano, our Chairman, President and Chief Executive Officer and the beneficial owner of a majority of our outstanding shares, contributed all the outstanding capital stock of Tarheel to Patriot Risk Management with the result that Tarheel and its subsidiary, TIMCO, became wholly-owned indirect subsidiaries of Patriot Risk Management. In conjunction with the business contribution, management deemed the prospects for Tarheel business to generate future taxable income and utilize Tarheel net operating loss carry forwards, subject to annual limitations, to be more likely than not and, accordingly, eliminated the valuation allowance on the deferred tax asset associated with Tarheel net operating losses.


70


Table of Contents

Additionally, our income tax expense at the statutory rate for 2007 was reduced by approximately $85,000 related to tax exempt investment income and increased by approximately $711,000 in connection with the increase in the reserve for uncertain tax positions and approximately $192,000 of other net permanent tax differences.
 
2007 Compared to 2006
 
Overview of Operating Results.  Net income for 2007 was $2.4 million compared to $1.6 million for 2006. The $769,000 increase in net income is comprised of a $1.1 million decrease in pre-tax net income and a $1.9 million decrease in income tax expense. The $1.1 million decrease in pre-tax net income is comprised principally of a $7.4 million decrease in pre-tax net income related to the 2006 gain on early extinguishment of debt and associated other income, which represents the forgiveness of accrued interest on the extinguished debt, partially offset by an increase in pre-tax net income related to (i) a 16.7 percentage point decrease in our combined ratio from insurance operations, (ii) a $437,000 increase in pre-tax net income from insurance services operations and (iii) a decrease in net realized losses of $1.3 million.
 
The $1.9 million decrease in income tax expense is principally attributable to the fact that we maintained a valuation allowance equal to 100% of the deferred tax assets associated with net operating loss carry forwards attributable to Tarheel operations until April 2007, at which time we reversed the valuation allowance, as discussed more fully below.
 
Gross Premiums Written.  Gross premiums written for 2007 were $85.8 million compared to $62.4 million for 2006, an increase of $23.4 million or 38%. Gross premiums written by line of business were as follows:
 
                 
    2007     2006  
    In thousands  
 
Direct business:
               
Alternative market
  $ 34,316     $ 33,921  
Traditional business
    50,599       26,636  
                 
Total direct business
    84,915       60,557  
Assumed business(1)
    895       1,815  
                 
Total
  $ 85,810     $ 62,372  
                 
 
 
(1) Represents premiums assumed as a result of our participation in the NCCI National Workers’ Compensation Insurance Pool.
 
Gross premiums written on alternative market business for 2007 were $34.3 million compared to $33.9 million for 2006, an increase of $395,000 or 1%.
 
The increase was attributable to traditional business, for which gross premiums written for 2007 were $50.6 million compared to $26.6 million for 2006, an increase of $24.0 million or 90%. The increase in traditional business gross premiums written was attributable to an increase in policy counts. Traditional business policy counts increased by 127%, from 1,340 at December 31, 2006 to 3,034 at December 31, 2007. The increase in policy counts was principally attributable to the expansion of the traditional business pay-as-you-go plan. The increase in policy counts was partially offset by an 11% decrease in average annual in-force premium per policy, from approximately $18,500 at December 31, 2006 to approximately $16,400 at December 31, 2007. The decrease in average annual in-force premium per policy was principally attributable to mandatory rate decreases in the state of Florida, an administered pricing state where we wrote approximately 41% of our traditional business direct premiums written in 2007. The majority of the increase in gross premiums written on traditional business came from Florida, where gross premiums written on traditional business were $20.8 million for 2007 compared to $7.1 million for 2006, an increase of $13.7 million or 193%.
 
Net Premiums Written.  Net premiums written for 2007 were $31.0 million compared to $19.4 million for 2006, an increase of $11.6 million or 60%. The $23.4 million period-over-period increase in gross


71


Table of Contents

premiums written was partially offset by a $11.9 million increase in ceded premiums written. The increase in ceded premiums written was primarily attributable to the increase in gross premiums written on traditional business, which was subject to a 50% quota share reinsurance treaty (excluding certain states) for the full year 2007, but only the second half of 2006.
 
Net Premiums Earned.  Net premiums earned for 2007 were $24.6 million compared to $21.1 million for 2006, an increase of $3.6 million or 17%. The increase was attributable to the increase in net premiums written, recognized as revenue on a pro rata basis over the terms of the policies written.
 
Insurance Services Income.  Insurance services income by PRS for 2007 was $7.0 million compared to $7.2 million for 2006, a decrease of $148,000 or 2%. Insurance services income in 2007 and 2006 was generated principally from nurse case management and cost containment services provided for the benefit of segregated portfolio captives and our quota share reinsurers. In addition, as consideration for providing insurance services, segregated portfolio captives and our quota share reinsurers paid PRS general agency commission compensation, a portion of which was retained by PRS and a portion of which was paid by PRS as commission compensation to the producing agents.
 
The decrease in insurance services income was attributable to lower fees associated with general agency services, which decreased to $2.3 million in 2007 from $3.0 million in 2006 due to lower earned premiums subject to general agency services. Additionally, insurance services income attributable to services provided to parties other than segregated portfolio captives and our quota share reinsurers decreased to $107,000 in 2007 from $373,000 in 2006, primarily as a result of the termination or sale of service relationships that Tarheel had with other third parties. These decreases were partially offset by an increase in insurance services income associated with nurse case management and cost containment services, which increased to $4.6 million in 2007 from $3.6 million in 2006 due to an increase in the number of claims subject to nurse case management and bill review and a larger portion of the insurance risk assumed by our quota share reinsurers.
 
Net Investment Income.  Net investment income for 2007 and 2006 was $1.3 million. Gross investment income for 2007 was $2.5 million compared to $2.1 million for 2006, an increase of $465,000 or 23%. The increase is a reflection of a higher weighted average invested asset base, the result of growth in net premiums written and the corresponding lag between the collection of premiums and the payment of claims. The increase in gross investment income attributable to a higher invested asset base was somewhat offset by the fact that a portion of our fixed maturity securities at December 31, 2007 were tax-exempt state and political subdivision debt securities, which generate lower pre-tax yields. We had no tax-exempt state and political subdivision debt securities at December 31, 2006. Investment expenses for 2007 were $1.2 million compared to $732,000 for 2006, an increase of $461,000 or 63%. Investment expenses are principally comprised of interest expense credited to funds-held balances related to alternative market segregated portfolio captive arrangements. The increase in investment expenses was attributable to an increase in funds-held balances from December 31, 2006 to December 31, 2007.
 
Net Realized Losses on Investments.  Net realized losses on investments for 2007 were $5,000 compared to $1.3 million for 2006. In 2007, we did not recognize any other-than-temporary impairments. In 2006, we recognized realized losses of approximately $1.7 million in connection with Tarheel’s investment in Foundation, which was deemed to be other-than-temporarily impaired. This was partially offset by realized gains on the sales of equity securities.
 
Other Income.  We did not recognize any other income for 2007. For 2006, we recognized $796,000 of other income in connection with the forgiveness of accrued interest associated with the early extinguishment of debt.
 
Net Losses and Loss Adjustment Expenses.  Net losses and loss adjustment expenses were $15.2 million for 2007 compared to $17.8 million for 2006, a decrease of $2.7 million or 15%, despite an increase in net premiums earned. The decrease was attributable to a lower calendar year net loss ratio which was 61.7% for 2007 compared to 84.7% for 2006, a decrease of 23.0 percentage points. The decrease in the loss ratio was principally the result of favorable development in 2007 on both workers’ compensation and legacy reserves associated with prior accident years, combined with unfavorable development in 2006 on both workers’


72


Table of Contents

compensation and legacy reserves associated with prior accident years. Our net loss ratio was 75.7% for accident year 2007 compared to 72.8% for accident year 2006, an increase of 2.9 percentage points.
 
As a result of favorable development on prior accident year reserves, incurred losses and loss adjustment expenses decreased by approximately $3.5 million for the year ended December 31, 2007. Of this $3.5 million, approximately $2.2 million relates to favorable development on workers’ compensation reserves attributable to the fact that 165 claims incurred in 2004 and 2005 were ultimately settled in 2007 for approximately $600,000 less than the specific case reserves that had been established for these exposures at December 31, 2006. In addition, as a result of this favorable case reserve development during 2007, we reduced our loss development factors utilized in estimating claims incurred but not yet reported resulting in a reduction of estimated incurred but not reported reserves as of December 31, 2007. The $3.5 million of favorable development in 2007 also reflects approximately $1.3 million of favorable development on legacy asbestos and environmental exposures and commercial general liability exposures as a result of the further run-off of this business and additional information received from pool administrators on pooled business that we participate in. See “Business — Legacy Claims.”
 
As a result of adverse development on prior accident year reserves, incurred losses and loss adjustment expenses increased by approximately $2.5 million for the year ended December 31, 2006. Of the $2.5 million, approximately $2.0 million relates to workers’ compensation claims and approximately $500,000 to legacy asbestos and environmental exposures and commercial general liability exposures. The adverse development on workers’ compensation claims primarily resulted from approximately $1.5 million of unallocated loss adjustment expenses paid in 2006 related to the 2004 and 2005 accident years in excess of amounts reserved for these expenses as of December 31, 2005. In addition, based upon additional information that became available on known claims during 2006, we strengthened our reserves by approximately $500,000 for the 2004 and 2005 accident years. The reserves for legacy claims were increased due to information received from pool administrators as well as additional consideration of specific outstanding claims.
 
Net Policy Acquisition and Underwriting Expenses.  Net policy acquisition and underwriting expenses were $6.0 million for 2007 compared to $3.8 million for 2006, an increase of $2.2 million or 57%.
 
Net policy acquisition and underwriting expenses are comprised of gross policy acquisition and underwriting expenses, which include agent commissions, premium taxes and assessments and general operating expenses associated with insurance operations, net of ceding commissions on ceded quota share reinsurance premiums on traditional and alternative market segregated portfolio captive business, as follows:
 
                 
    2007     2006  
    Dollar amounts in thousands  
 
Direct and assumed business:
               
Gross policy acquisition and underwriting expenses
  $ 22,644     $ 18,622  
Gross premiums earned
    73,715       60,672  
                 
Gross policy acquisition and underwriting expense ratio
    30.7 %     30.7 %
                 
Alternative market and traditional business ceded on a quota share basis:
               
Ceding commissions
    16,621       14,788  
Ceded premiums earned
    44,589       37,391  
                 
Effective ceding commission rate
    37.3 %     39.5 %
                 
Excess of loss reinsurance ceded premiums earned
    4,513       2,228  
                 
Net business:
               
Net policy acquisition and underwriting expenses
    6,023       3,834  
Net premiums earned
    24,613       21,053  
                 
Net policy acquisition and underwriting expense ratio
    24.5 %     18.2 %
                 


73


Table of Contents

Gross policy acquisition and underwriting expenses were $22.6 million for 2007 compared with $18.6 million for 2006, an increase of $4.0 million or 22%. The increase in gross policy acquisition and underwriting expenses was generally consistent with the growth in gross premiums earned. Our gross expense ratio was 30.7% for both 2007 and 2006.
 
Ceding commissions on alternative market and traditional business ceded on a quota share basis were $16.6 million for 2007 compared to $14.8 million for 2006, an increase of $1.8 million or 12%. Our blended effective ceding commission rate on alternative market and traditional business quota share reinsurance was 37.3% for 2007 compared to 39.5% for 2006. The decrease was principally attributable to the proportional increase in ceded quota share reinsurance premiums on our traditional business, which have a lower effective ceding commission rate than ceded premiums on our alternative market business.
 
Our net policy acquisition and underwriting expense ratio was 24.5% for 2007 compared to 18.2% for 2006. The ceding commission rates we earn on our alternative market business and traditional business quota share reinsurance are higher than our gross policy acquisition and underwriting expense ratio. Accordingly, if we cede more business on a quota share basis, our net policy acquisition and underwriting expense ratio decreases, and if we cede less business on a quota share basis, our net policy acquisition and underwriting expense ratio increases. In addition, on our alternative market business quota share reinsurance, we recoup a portion our excess of loss reinsurance costs from the segregated portfolio captives. Accordingly, our excess of loss reinsurance costs are lower, in proportion to gross earned premium, on our alternative market business. The increase in our net expense ratio was principally the result of an increase in excess of loss ceded earned premium associated with the increase in our traditional business and, to a lesser extent, the fact that a smaller portion of our gross premiums were ceded on a quota share basis in 2007 at a lower blended effective ceding commission rate.
 
Other Operating Expenses.  Other operating expenses, which are primarily comprised of holding company expenses and expenses attributable to our insurance services operations, were $8.5 million for 2007 compared to $9.7 million for 2006, a decrease of $1.2 million or 12%. For 2007, other operating expenses included approximately $7.1 million associated with insurance services operations and $1.4 million associated with holding company operations. For 2006, other operating expenses included approximately $6.4 million associated with insurance services operations and $3.3 million associated with holding company operations. The decrease in other operating expenses was primarily attributable to a higher allocation of holding company expenses to insurance operations in 2007 compared to 2006, resulting in an increase in net policy acquisition and underwriting expenses and a corresponding decrease in other operating expenses.
 
Interest Expense.  Interest expense for 2007 was $1.3 million compared to $1.1 million for 2006, an increase of $181,000 or 16%. The increase was attributable to the fact that we borrowed an additional $5.7 million in September 2007 at an interest rate equal to the Federal Reserve prime rate plus 4.5%.
 
Income Tax Expense.  We recognized an income tax benefit of $432,000 for 2007 compared to an income tax expense of $1.5 million for 2006. The decrease in income tax expense was principally the result of changes in the valuation allowance related to the deferred tax asset arising from Tarheel net operating loss carry forwards. For the three months ended March 31, 2007 and the years ended December 31, 2006 and 2005, management did not consider it more likely than not that Tarheel would generate future taxable income against which Tarheel net operating loss carry forwards could be utilized and, accordingly, maintained a 100% valuation allowance on the deferred tax asset attributable to Tarheel net operating loss carry forwards. On April 1, 2007, Mr. Mariano, our Chairman, President and Chief Executive Officer and the beneficial owner of a majority of our outstanding shares, contributed all the outstanding capital stock of Tarheel to Patriot Risk Management with the result that Tarheel and its subsidiary, TIMCO, became wholly-owned indirect subsidiaries of Patriot Risk Management. In conjunction with the business contribution, management deemed the prospects for Tarheel business to generate future taxable income and utilize Tarheel net operating loss carry forwards, subject to annual limitations, to be more likely than not and, accordingly, eliminated the valuation allowance on the deferred tax asset associated with Tarheel net operating losses.
 
In June 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes — an interpretation of FASB Statement No. 109” (FIN 48), which clarifies the accounting and financial


74


Table of Contents

reporting for uncertain tax positions. FIN 48 prescribes a recognition threshold and measurement attributes for the financial statement recognition, measurement and presentation of uncertain tax positions taken or expected to be taken in an income tax return. We adopted the provisions of FIN 48 effective January 1, 2007. Reserves for uncertain tax positions associated with FIN 48 were approximately $421,000 and $711,000 at December 31, 2008 and 2007, respectively. We had no accrued interest or penalties related to uncertain tax positions as of December 31, 2008 or 2007.
 
Excluding changes in the valuation allowance and excluding the effect of changes in reserve for uncertain tax positions in accordance with FIN 48, our effective tax rate was approximately 39% for 2007 compared to 33% for 2006. The increase in effective tax rate, exclusive of changes in the valuation allowance and reserve for uncertain tax positions, was primarily attributable to Tarheel pre-tax net losses in the first quarter of 2007 for which no tax benefit was recognized due to the then uncertainty of ultimate recoverability.
 
Segment Information
 
We manage our operations through two business segments: insurance services and insurance. The insurance services segment provides workers’ compensation claims services and agency and underwriting services. Workers compensation claims services include nurse case management, cost containment services and claims administration and adjudication services. Cost containment services refer to workers’ compensation bill review and re-pricing services. Workers’ compensation agency and underwriting services include general agency services and specialty underwriting, policy administration and captive management services. We currently provide the services principally to Guarantee Insurance, segregated portfolio captives and Guarantee Insurance’s quota share reinsurers. In the insurance segment, we provide workers’ compensation policies to businesses. These products include both alternative market products and traditional insurance. The products offered in our insurance segment encompass a variety of options designed to fit the needs of our policyholders and employer groups.
 
We consider many factors in determining reportable segments including economic characteristics, production sources, products or services offered and regulatory environment. Certain items are not allocated to segments, including gains on the early extinguishment of debt, holding company expenses and interest expense. The accounting policies of the segments are the same as those described in the summary of significant accounting policies contained in the notes to our consolidated financial statements. We manage our segments on the basis of both pre-tax and after-tax net income, and, accordingly, our business segment results


75


Table of Contents

are shown for all periods to include pre-tax net income (losses), income tax expenses (benefits) and net income (losses). Business segment results are as follows:
 
                                                 
    Nine Months
       
    Ended September 30,     Year Ended December 31,  
    2009     2008     2008     2007     2006     2005  
                In thousands              
 
Insurance Services Segment
                                               
Revenues — insurance services income
  $ 14,448     $ 9,031     $ 12,308     $ 11,325     $ 10,208     $ 6,552  
                                                 
Pre-tax net income
  $ 5,041     $ 3,666     $ 4,452     $ 4,201     $ 3,764     $ 2,358  
Income tax expense (benefit)
    1,713       1,246       1,513       (481 )     1,744       938  
                                                 
Net income
  $ 3,328     $ 2,420     $ 2,939     $ 4,682     $ 2,020     $ 1,420  
                                                 
Insurance Segment
                                               
Revenues:
                                               
Premiums earned, net
  $ 28,369     $ 32,276     $ 49,220     $ 24,613     $ 21,053     $ 21,336  
Investment income, net
    1,354       1,487       2,028       1,326       1,321       1,077  
Net realized gains (losses) on investments
    903       (253 )     (1,037 )     (5 )     393       (1,348 )
                                                 
Total revenues
  $ 30,626     $ 33,510     $ 50,211     $ 25,934     $ 22,767     $ 21,065  
                                                 
Pre-tax net income (loss)
  $ 1,568     $ 509     $ 2,773     $ 431     $ (1,939 )   $ 3,692  
Income tax expense (benefit)
    751       (174 )     495       951       (689 )     1,198  
                                                 
Net income
  $ 817     $ 683     $ 2,278     $ (520 )   $ (1,250 )   $ 2,494  
                                                 
 
Insurance Services Segment Results of Operations
 
Nine Months Ended September 30, 2009 Compared to Nine Months Ended September 30, 2008
 
Insurance Services Income.  Insurance services segment income consists of both income for services provided to Guarantee Insurance, which is eliminated in consolidation, and income for services provided to unaffiliated clients, which, on a consolidated basis, represents our insurance services income. For the nine months ended September 30, 2009 and 2008, insurance services segment income and insurance services income were as follows:
 
                 
    Nine Months Ended
 
    September 30,  
    2009     2008  
    In thousands  
 
Insurance services income
  $ 9,753     $ 4,706  
Insurance services income for services provided to Guarantee Insurance, eliminated in consolidation
    4,695       4,325  
                 
Insurance services segment income
  $ 14,448     $ 9,031  
                 
 
Insurance services segment income was $14.4 million for the nine months ended September 30, 2009, compared to $9.0 million for the comparable period in 2008, an increase of $5.4 million or 60%. Insurance services segment income from nurse case management and cost containment services increased to $10.6 million for the nine months ended September 30, 2009 from $7.9 million for the comparable period in 2008, an increase of $2.6 million or 33%, due to the increase in Guarantee Insurance exposures serviced by PRS. Additionally, PUI recognized approximately $3.5 million of fee income for the nine months ended September 30, 2009 related to the production, underwriting and administration of business on behalf of our BPO client pursuant to an agreement entered into during the second quarter of 2009. This was partially offset by a $776,000 decrease in fees for general agency and reinsurance brokerage services provided to Guarantee


76


Table of Contents

Insurance during the nine months ended September 30, 2008. The majority of these services were terminated in 2008.
 
Pre-Tax Net Income.  Pre-tax net income for the insurance services segment was $5.0 million for the nine months ended September 30, 2009, compared to $3.7 million for the comparable period in 2008, an increase of $1.4 million or 38%. The increase in pre-tax net income was attributable to the increase in insurance services segment income, partially offset by an increase in insurance services segment operating expenses to $9.4 million for the nine months ended September 30, 2009 from $5.4 million for the comparable period in 2008. The increase in expenses associated with insurance services segment operations was primarily attributable to marketing, underwriting and policy administration costs incurred by PUI in connection with gross premiums produced for our BPO client, for which we provide general agency, underwriting and captive management services and claims services.
 
Income Tax Expense.  Income tax expense for the insurance services segment was $1.7 million for the nine months ended September 30, 2009, compared to $1.2 million for the comparable period in 2008. The effective tax rate for the insurance services segment was approximately 34% for both the nine months ended September 30, 2009 and 2008.
 
Net Income.  Net income for the insurance services segment was $3.3 million for the nine months ended September 30, 2009, compared to $2.4 million for the comparable period in 2008. The increase in net income was attributable to the increase in pre-tax net income as discussed above, partially offset by the increase in operating expenses and income tax expense.
 
2008 Compared to 2007
 
Insurance Services Income.  Insurance services segment income consists of both income for services provided to Guarantee Insurance, which is eliminated in consolidation, and income for services provided to unaffiliated clients, which, on a consolidated basis, represents our insurance services income. For 2008 and 2007, insurance services segment income and insurance services income were as follows:
 
                 
    Year Ended December 31,  
    2008     2007  
    In thousands  
 
Insurance services income
  $ 5,657     $ 7,027  
Insurance services income for services provided to Guarantee Insurance, eliminated in consolidation
    6,651       4,298  
                 
Insurance services segment income
  $ 12,308     $ 11,325  
                 
 
Insurance services segment income was $12.3 million for 2008, compared to $11.3 million for 2007, an increase of $1.0 million or 9%. Insurance services segment income for both years was comprised of nurse case management and cost containment services provided to Guarantee Insurance, for our benefit and for the benefit of segregated portfolio captives and our quota share reinsurers. Insurance services segment income from nurse case management and cost containment services increased to $11.0 million for 2008, compared to $7.2 million for 2007, due to an increase in the number of claims subject to nurse case management and medical bill review.
 
Insurance services segment income in 2007 was also generated from general agency services on Guarantee Insurance business, pursuant to which Guarantee Insurance paid PRS general agency commission compensation, a portion of which was retained by PRS and a portion of which was paid by PRS as commission compensation to the producing agents. Effective January 1, 2008, Guarantee Insurance began working directly with agents to market segregated portfolio captive business and paying commissions directly to the producing agents. As a result, PRS ceased earning general agency commissions and ceased paying commissions to the producing agents on Guarantee Insurance business. Insurance services segment income from general agency services was $361,000 for 2008, which was attributable to premiums earned in 2008 but written prior to January 1, 2008, compared to $3.1 million for 2007.


77


Table of Contents

 
Insurance services segment income from reinsurance brokerage services was $685,000 for 2008, compared to $967,000 for 2007, a decrease of $282,000 or 29%. The decrease in insurance services segment income from reinsurance brokerage services was attributable to the fact that we appointed a third-party reinsurance broker of record in 2008, from whom we were paid a portion of the reinsurance commissions pursuant to a commission sharing agreement. Insurance services segment income attributable to services provided to parties other than segregated portfolio captives and our quota share reinsurers increased to $241,000 in 2008 from $98,000 in 2007.
 
Pre-Tax Net Income.  Pre-tax net income for the insurance services segment was $4.5 million for 2008, compared to $4.2 million for 2007, an increase of $251,000 or 6%. The increase in pre-tax net income was generally commensurate with an increase in insurance services segment income to $12.3 million for 2008 compared to $11.3 million for 2007. Expenses associated with the insurance services segment, which include general expenses for nurse case managers, bill review administrators and all associated activities and infrastructure, network access fees and commissions, increased at a lower rate than the increase in insurance services segment income due to improved economies of scale. This was partially offset by an increase in expenses allocated from the holding company to the insurance services segment, which are allocated based on the proportion of such costs devoted to the segment. For 2008 and 2007, approximately 28% and 9% of holding company expenses were allocated to the insurance services segment, respectively.
 
Income Tax Expense.  Income tax expense for the insurance services segment was $1.5 million for 2008, compared to an income tax benefit of $481,000 for 2007. In 2007, we recorded a $1.9 million decrease in the valuation allowance related to the deferred tax asset arising from net operating loss carryforwards on the insurance services operations of Tarheel. On April 1, 2007, Mr. Mariano, our Chairman, President and Chief Executive Officer and the beneficial owner of a majority of our outstanding shares, contributed all the outstanding capital stock of Tarheel to us with the result that Tarheel and its subsidiary, TIMCO, became our wholly-owned indirect subsidiaries. In conjunction with the business contribution, management deemed the prospects for Tarheel business to generate future taxable income and utilize Tarheel net operating loss carryforwards, subject to annual limitations, to be more likely than not and, accordingly, eliminated the valuation allowance on the deferred tax asset associated with Tarheel net operating losses. The effective tax rate for the insurance services segment, excluding the decrease in the valuation allowance for 2007, was approximately 34% for both 2008 and 2007.
 
Net Income.  Net income for the insurance services segment was $2.9 million for 2008 compared to $4.7 million for 2007. The decrease in net income was attributable to the decrease in the valuation allowance on the deferred tax asset associated with Tarheel net operating losses for 2007, partially offset by the increase in pre-tax net income as discussed above.
 
2007 Compared to 2006
 
Insurance Services Income.  Insurance services segment income both income consists of both income for services provided to Guarantee Insurance, which is eliminated in consolidation, and income for services provided to unaffiliated clients, which, on a consolidated basis, represents our insurance services income. For 2007 and 2006, insurance services segment income and insurance services income were as follows:
 
                 
    Year Ended December 31,  
    2007     2006  
    In thousands  
 
Insurance services income
  $ 7,027     $ 7,175  
Insurance services income for services provided to Guarantee Insurance, eliminated in consolidation
    4,298       3,033  
                 
Insurance services segment income
  $ 11,325     $ 10,208  
                 
 
Insurance services segment income for 2007 was $11.3 million compared to $10.2 million for 2006, an increase of $1.1 million or 11%. The increase in insurance services segment income was principally attributable to nurse case management and cost containment services, which increased to $7.2 million in 2007


78


Table of Contents

from $4.8 million in 2006 due to an increase in the number of claims subject to nurse case management and cost containment. Additionally, insurance services segment income attributable to reinsurance brokerage fees from Guarantee Insurance increased to $967,000 for 2007 compared to $625,000 for 2006. These increases were partially offset by a $1.6 million decrease in commissions associated with general agency services, which decreased to $3.2 million in 2007 from $4.8 million in 2006 due to lower earned premium associated with segregated portfolio cell captives serviced by PRS.
 
Pre-Tax Net Income.  Pre-tax net income for 2007 for the insurance services segment was $4.2 million compared to $3.8 million for 2006, an increase of $437,000 or 12%. The increase was generally commensurate with an increase in insurance services segment income to $11.3 million for 2007 compared to $10.2 million for 2006.
 
Income Tax Expense (Benefit).  Income tax benefit for the insurance services segment was $481,000 for 2007, compared to income tax expense of $1.7 million for 2006. In 2007, we recorded a $1.9 million decrease in the valuation allowance related to the deferred tax asset arising from Tarheel net operating loss carryforwards as discussed above. Excluding changes in the valuation allowance, the effective tax rate for the insurance services segment was approximately 34% for both 2007 and 2006.
 
Net Income.  Net income for the insurance services segment was $4.7 million for 2007, compared to $2.0 million for 2006. The increase in net income was commensurate with the increase in pre-tax net income and the changes in the valuation allowance on the deferred tax asset associated with Tarheel net operating losses discussed above.
 
Insurance Segment Results of Operations
 
Nine Months Ended September 30, 2009 Compared to Nine Months Ended September 30, 2008
 
Net Premiums Earned.  Net premiums earned were $28.4 million for the nine months ended September 30, 2009, compared to $32.3 million for the comparable period in 2008, a decrease of $3.9 million or 12%. The decrease was generally commensurate with the decrease in net premiums written, which was attributable to an increase in ceded premiums written, partially offset by an increase in gross premiums written, as discussed above.
 
Net Investment Income.  Net investment income was $1.4 million for the nine months ended September 30, 2009, compared to $1.5 million for the comparable period in 2008, a decrease of $133,000 or 9%. The decrease in net investment income was attributable to a decrease in our average investment portfolio during the period, principally associated with the payment of reinsurance premiums in early 2009 associated with a quota-share reinsurance agreement we entered into effective December 31, 2008, pursuant to which we ceded unearned premiums reserves, net of ceding commissions, of approximately $8.1 million in order for Guarantee Insurance to satisfy certain regulatory leverage ratio requirements. Additionally, the book yield and taxable equivalent book yield on our portfolio at September 30, 2009 were 3.92% and 4.48%, respectively, compared to 4.16% and 4.77%, respectively, at September 30, 2008. The reduced yield on our portfolio of approximately 25 to 30 basis points reflects lower yields available in the fixed income securities market as our securities mature and new cash is deployed.
 
Net Realized Gains on Investments.  Net realized gains on investments were $903,000 for the nine months ended September 30, 2009, compared to net realized losses of $253,000 for the comparable period of 2008, an increase of $1.2 million. The increase was principally attributable to the sale of certain asset-backed and mortgage-backed securities, the proceeds of which were used to pay net reinsurance premiums of approximately $8.1 million, as discussed above.
 
Pre-Tax Net Income.  Pre-tax net income for the insurance segment was $1.6 million for the nine months ended September 30, 2009, compared to $509,000 for the comparable period in 2008, an increase of $1.1 million. The increase was attributable to the increase in net realized gains on investments and a decrease in our loss and loss adjustment expense ratio to 55.9% for the nine months ended September 30, 2009 from 64.2% for the comparable period in 2008, partially offset by a premium rate adjustment of approximately


79


Table of Contents

$1.3 million on an excess loss reinsurance agreement covering risks attaching from July 1, 2005 through June 30, 2006.
 
Income Tax Expense.  Income tax expense for the insurance segment was $751,000 for the nine months ended September 30, 2009, compared to an income tax benefit of $174,000 for the comparable period in 2008. The effective tax rate for the insurance segment was approximately 48% for the nine months ended September 30, 2009, 14 percentage points above the 34% statutory rate, primarily attributable to a true up of the prior year tax provision. For the nine months ended September 30, 2008, our insurance segment recognized a decrease in reserves for uncertain tax positions of approximately $290,000, resulting in an effective income tax benefit rate for the period of 34%.
 
Net Income.  Net income for the insurance segment was $817,000 for the nine months ended September 30, 2009, compared to $683,000 for the comparable period in 2008, an increase of $134,000 or 20%. The increase in net income was the result of an increase in pre-tax net income, partially offset by an increase in income tax expense, as discussed above.
 
2008 Compared to 2007
 
Net Premiums Earned.  Net premiums earned were $49.2 million for 2008, compared to $24.6 million for 2007, an increase of $24.6 million or 100%. The increase was attributable to the increase in net premiums written, exclusive of the effects of the quota share reinsurance agreement we entered into effective December 31, 2008 for which no ceded premium was earned in 2008, recognized as revenue on a pro rata basis over the terms of the policies written.
 
Net Investment Income.  Net investment income was $2.0 million for 2008, compared to $1.3 million for 2007. Gross investment income was $2.5 million for both 2008 and 2007. The average of our beginning and ending investment portfolio, including cash and cash equivalents, increased to $62.6 million for 2008 compared to $57.1 million for 2007, an increase of $5.5 million, or 10%. The increase in our invested asset base was partially offset by the fact that the tax adjusted yield on our debt portfolio fell to 4.99% at December 31, 2008 from 5.19% at December 31, 2007 due to prevailing market conditions in the debt securities market. The increase in our invested asset base was also offset by lower pre-tax yield tax-exempt state and political subdivision debt securities, which we began to own in the second quarter of 2007. Investment expenses were $478,000 for 2008 compared to $1.2 million for 2007, a decrease of $714,000 or 60%. Investment expenses are principally comprised of interest expense credited to funds-held balances on alternative market segregated portfolio captive arrangements. Interest is credited to funds-held balances based on 3-month U.S. Treasury Bill rates. The decrease in investment expenses was primarily attributable to a decrease in short term interest rates due to prevailing credit market conditions.
 
Net Realized Losses on Investments.  Net realized losses on investments were approximately $1.0 million for 2008, compared to $5,000 for 2007. Net realized losses on investments in 2008 include an other-than-temporary impairment charge of approximately $875,000 related to investments in certain equity securities and approximately $350,000 on investment of approximately $400,000 in certain Lehman Brothers Holdings, Inc. bonds, as a result of Lehman Brothers’ bankruptcy filing.
 
Pre-Tax Income.  Pre-tax net income for the insurance segment was approximately $2.8 million for 2008, compared to $431,000 for 2007. The increase in pre-tax net income was primarily attributable to an increase in underwriting income attributable to a $24.6 million, or 100%, increase in net earned premiums and, to a lesser extent, a decrease in the portion of holding company expenses allocated to the segment and an increase in net investment income. These factors were partially offset by other-than-temporary impairment charges of approximately $1.0 million and lower commission expenses in connection with the fact that, effective January 1, 2008, Guarantee Insurance began working directly with agents to market segregated portfolio captive insurance business and paying commissions directly to the producing agents rather than paying a higher general agency commission to PRS. Holding company expenses are allocated to the insurance segment based on the proportion of such costs devoted to the segment. For 2008 and 2007, approximately 30% and 80% of holding company expenses were allocated to the insurance services segment, respectively.


80


Table of Contents

Income Tax Expense.  Income tax expense for the insurance segment was approximately $495,000 for 2008, compared to $951,000 for 2007. For 2008, the income tax expense for the insurance segment at the statutory rate, which was approximately $943,000, was reduced by approximately $238,000 related to tax exempt investment income and $290,000 related to the reduction in reserve for uncertain tax positions. For 2007, the income tax expense for the insurance segment at the statutory rate, which was approximately $146,000, was increased by approximately $711,000 in connection with the increase in reserve for uncertain tax positions, together with other net permanent tax differences.
 
Net Income.  Net income for the insurance segment was approximately $2.3 million for 2008, compared to a net loss of $520,000 for 2007. The increase in net income was attributable to the increase in pre-tax net income and changes in the reserve for uncertain tax positions as discussed above.
 
2007 Compared to 2006
 
Net Premiums Earned.  Net premiums earned were $24.6 million for 2007, compared to $21.1 million for 2006, an increase of $3.5 million or 17%. The increase was attributable to the increase in net premiums written, as discussed above, recognized as revenue on a pro rata basis over the terms of the policies written.
 
Net Investment Income.  Net investment income for 2007 and 2006 was $1.3 million. Gross investment income was $2.5 million for 2007, compared to $2.1 million for 2006, an increase of $465,000 or 23%. The increase is a reflection of a higher weighted average invested asset base, the result of growth in net premiums written and the lag between the collection of premiums and the payment of claims. The increase in gross investment income attributable to a higher invested asset base was somewhat offset by the fact that a portion of our fixed maturity securities at December 31, 2007 were tax-exempt state and political subdivision debt securities, which generate lower pre-tax yields. We had no tax-exempt state and political subdivision debt securities at December 31, 2006. Investment expenses were $1.2 million for 2007 compared to $732,000 for 2006, an increase of $461,000 or 63%. Investment expenses are principally comprised of interest expense credited to funds held balances related to our alternative market segregated portfolio captive reinsurers. The increase in investment expenses was attributable to an increase in funds held balances from December 31, 2006 to December 31, 2007.
 
Net Realized Gains (Losses) on Investments.  Our insurance segment had $5,000 of net realized losses on investments for 2007, compared to $393,000 of net realized gains on investments for 2006. Realized gains and losses on investments occur from time to time in connection with the sale of debt securities prior to their maturity and equity securities.
 
Pre-Tax Net Income (Loss).  Pre-tax net income for the insurance segment was $431,000 for 2007, compared to a pre-tax loss of $1.9 million for 2006. The increase in pre-tax net income primarily reflects a lower calendar year loss ratio in 2007 as discussed above.
 
Income Tax Expense (Benefit).  Income tax expense for the insurance segment was $951,000 for 2007, compared to an income tax benefit of $689,000 for 2006. For 2007, the income tax expense for the insurance segment at the statutory rate, which was approximately $146,000, was increased by approximately $711,000 in connection with the increase in reserve for uncertain tax positions, together with other net permanent tax differences. For 2006, the income tax benefit for the insurance segment was approximately 36% of the insurance segment’s pre-tax net loss.
 
Net Income (Loss).  Net loss for the insurance segment was $520,000 for 2007 compared to a net loss of $1.3 million for 2006. The reduction in the net loss was commensurate with the increase in pre-tax net income, partially offset by the increase in income tax expense.
 
Liquidity and Capital Resources
 
Sources and Uses of Funds
 
Patriot Risk Management is organized as a holding company with two principal operating units — insurance services through PRS and PUI, and insurance through Patriot National Insurance Group, Inc. Patriot


81


Table of Contents

Risk Management’s principal liquidity needs include debt service, payments of income taxes, payment of certain holding company costs not attributable to subsidiary operations and, in the future, may include stockholder dividends.
 
Historically, Patriot Risk Management’s principal source of liquidity has been, and we expect will continue to be, dividends from PRS, as well as financing through borrowings, issuances of our securities and fees received under intercompany agreements as described below. In addition, we expect to retain approximately $20 million of the net proceeds from this offering at the holding company for general corporate purposes.
 
At the time we acquired Guarantee Insurance, it had a large statutory unassigned deficit. As of September 30, 2009, Guarantee Insurance’s statutory unassigned deficit was $94.7 million. Under Florida law, insurance companies may only pay dividends out of available and accumulated surplus funds derived from realized net operating profits on their business and net realized capital gains, except under limited circumstances with the prior approval of the Florida OIR. Moreover, pursuant to a consent order issued by the Florida OIR on December 29, 2006 in connection with the redomestication of Guarantee Insurance from South Carolina to Florida, Guarantee Insurance is prohibited from paying dividends, without Florida OIR approval, until December 29, 2009. Therefore, it is unlikely that Guarantee Insurance will be able to pay dividends for the foreseeable future without the prior approval of the Florida OIR. Currently, Guarantee Insurance does not plan to pay cash dividends on its common stock.
 
We presently expect that the net proceeds that the holding company retains from this offering, projected cash flows from dividends from our insurance and insurance services operating companies, and cash flows from intercompany agreements with our insurance and insurance services companies will provide Patriot Risk Management with sufficient liquidity to repay our debt, pay income taxes on behalf of Patriot and fund holding company operating expenses not attributable to subsidiary operations for the next two years.
 
We plan to contribute approximately $[     ] million of the net proceeds from this offering to Guarantee Insurance to support its premium writings. As described elsewhere in this prospectus, we have entered into a stock purchase agreement to acquire PF&C, a shell property and casualty insurance company. Our acquisition of PF&C is subject to various regulatory approvals. If we obtain these regulatory approvals and consummate the acquisition on or prior to March 4, 2010, we plan instead to use approximately $16.7 million of the net proceeds from this offering to pay the purchase price for PF&C (of which approximately $15.5 million represents the capital and surplus of PF&C), to contribute approximately $[     ] million to, PF&C to support its premium writings, and to contribute approximately $[     ] million to Guarantee Insurance, to support its premium writings.
 
We expect that the remaining $[     ] million, or [     ] million if we acquire PF&C, will be used to support our anticipated growth and general corporate purposes and to fund other holding company operations, including the repayment of all or a portion of the Brooke loans and the ULLICO loan and potential acquisitions, although we have no current understandings or agreements regarding any such acquisitions (other than PF&C).
 
If the underwriters exercise all or any portion of their over-allotment option, we intend to use all or a substantial portion of the net proceeds from any such exercise to pay down the balance of our credit facilities with Brooke and ULLICO. If the over-allotment option is exercised in full, we will use approximately $[     ] million of the net proceeds to pay off these credit facilities and the remaining $[     ] million, or $[     ] million if we acquire PF&C, for general corporate purposes.
 
Pursuant to a tax allocation agreement by and among Patriot Risk Management and its subsidiaries, Patriot Risk Management computes and pays federal income taxes on a consolidated basis. At the end of each consolidated return year, each subsidiary computes and pays to Patriot Risk Management its respective share of the federal income tax liability primarily based on separate return calculations. During the nine months ended September 30, 2009, Guarantee Insurance paid approximately $300,000 to Patriot Risk Management under this agreement.


82


Table of Contents

Pursuant to a Management Services Agreement dated as of January 1, 2004 between Patriot Risk Management and Guarantee Insurance, Patriot Risk Management provides Guarantee Insurance with strategic planning and capital raising, prospective acquisition management, human resources and benefits administration and certain other management services. Patriot Risk Management bills Guarantee Insurance for its share of the actual costs of such services on a monthly basis. During the nine months ended September 30, 2009, Patriot Risk Management recouped approximately $1.1 million from Guarantee Insurance under this agreement. Additionally, Patriot Risk Management bills PRS for a portion of the actual costs for such services. During the nine months ended September 30, 2009, Patriot Risk Management recouped approximately $1.1 million from PRS for its share of such services.
 
Pursuant to a Managed Care Services Agreement between Guarantee Insurance and Patriot Risk Services, dated as of January 1, 2006, Patriot Risk Services provides nurse case management and cost containment services for Guarantee Insurance’s benefit and for the benefit of segregated portfolio captives and our quota share reinsurers. During the nine months ended September 30, 2009, Patriot Risk Services earned a total of $14.4 million under this agreement, $4.6 million of which represented consideration for services performed for the benefit of Guarantee Insurance and are eliminated in consolidation. The remaining $9.8 million earned by Patriot Risk Services under this agreement represents income derived from segregated portfolio captives, our quota share reinsurers and our BPO client for services performed on their behalf and is reflected as insurance services income on our consolidated income statement.
 
Pursuant to a Subrogation Services Agreement and an Investigation Services Agreement, each dated as of January 1, 2009, between Guarantee Insurance and Patriot Recovery, Inc., Patriot Recovery, Inc. provides subrogation recovery services and investigative services to Guarantee Insurance. During the nine months ended September 30, 2009, Patriot Recovery, Inc. earned approximately $6,000 of fee income under these agreements.
 
Pursuant to an Expense Reimbursement Agreement effective April 1, 2009 between Guarantee Insurance and PUI, Guarantee Insurance pays salaries and certain other expenses on behalf of PUI. Guarantee Insurance bills PUI for these salaries and certain other expenses on a monthly basis. During the nine months ended September 30, 2009, Guarantee Insurance recouped approximately $1.9 million from PUI under this agreement.
 
Operating Activities
 
In our insurance services operations, our principal source of operating funds is insurance services income generated by PRS and PUI. PRS currently provides a range of insurance services primarily to Guarantee Insurance, for its benefit and for the benefit of segregated portfolio captives and our quota share reinsurers. PRS and PUI also provide insurance services to our BPO client. Our primary use of operating funds in our insurance services operations is for the payment of operating expenses.
 
In our insurance operations, our principal sources of operating funds are premium collections and investment income. Premiums are generally collected over the terms of the policies. Installments booked but deferred and not yet due represent estimated future premium amounts to be paid ratably over the terms of in-force policies based upon established payment arrangements.
 
Our primary uses of operating funds in our insurance operations include payments of claims, reinsurance premiums and operating expenses. Currently, we pay claims using cash flow from operations and invest our excess cash in debt securities. We forecast claim payments based on our historical trends as well as loss development factors from the NCCI. We seek to manage the funding of claim payments by actively managing available cash and forecasting cash flows on a short- and long-term basis. Claims paid, net of reinsurance, were $18.2 million, $13.5 million and $10.4 million for 2008, 2007 and 2006, respectively. Since our inception in 2004, we generally have funded claim payments from cash flow from operations, principally premiums, net of amounts ceded to our reinsurers, and net investment income. With the proceeds of this offering, we presently expect to maintain sufficient cash flows from operations to meet our anticipated claim obligations and operating needs for the next two years. However, depending on our level of premium writings, retention and acquisition activity, we may need to raise more capital over time to support our operations.


83


Table of Contents

Other factors may also influence our need to raise additional capital. As of September 30, 2009, Guarantee Insurance had approximately $2.7 million of intercompany receivables, $975,000 of which had been outstanding for more than 90 days (although subsequent to September 30, 2009, all intercompany receivables that had been outstanding for more than 30 days were repaid). Under statutory accounting rules, Guarantee Insurance is required to record the amount of any intercompany receivables that have been outstanding for more than 90 days as a non-admitted asset. Therefore, to the extent that any intercompany receivables have been outstanding for more than 90 days, Guarantee Insurance will be required to non-admit the amount of such receivables, which will result in a corresponding decrease in the surplus of Guarantee Insurance. At year end, if the amount of our premium writings relative to the amount of our surplus causes Guarantee Insurance to be out of compliance with certain statutory leverage ratios, we may need to obtain additional reinsurance, reduce our insurance writings or raise additional capital before year end to contribute to Guarantee Insurance in order to satisfy regulatory leverage ratio requirements. See “Risk Factors — Risks Related to Our Business — We are subject to extensive state regulation; regulatory and legislative changes may adversely impact our business.”
 
We purchase reinsurance to help protect us against severe claims and catastrophic events and to help maintain desired capital ratios. Based on our estimates of future claims, we believe we are sufficiently capitalized to satisfy the deductibles, retentions and aggregate limits in our annual reinsurance program effective July 1, 2009. We reevaluate our reinsurance program at least annually, taking into consideration a number of factors, including cost of reinsurance, liquidity requirements, operating leverage and coverage terms. If we decrease our retention levels, or maintain our current retention levels and the cost of reinsurance increases, assuming no material change in our loss ratio, our cash flows from operations would decrease because we would cede a greater portion of our premiums written to our reinsurers. Conversely, if we increase our retention levels, or maintain our current retention levels and the cost of reinsurance declines, assuming no material change in our loss ratio, our cash flow from operations would increase. We do not have any immediate plans to materially increase or reduce our retention levels subsequent to this offering.
 
Investment Activities
 
Our investment portfolio, including cash and cash equivalents, was approximately $54.5 million at September 30, 2009. The first priority of our investment strategy is capital preservation, with a secondary focus on achieving an appropriate risk adjusted return. We seek to manage our investment portfolio such that the security maturities provide adequate liquidity relative to our expected claims payout pattern. We expect to maintain sufficient liquidity from funds generated from operations to meet our anticipated insurance obligations and operating and capital expenditure needs, with excess funds invested in accordance with our investment guidelines. We anticipate that all of our debt securities would be available to be sold in response to changes in interest rates or changes in the availability of and yields on alternative investments. Accordingly, our debt securities are classified as available for sale and stated at fair value, with net unrealized gains and losses included in accumulated other comprehensive income net of deferred income taxes.
 
Financing Activities
 
We had a note payable to the former owner of Guarantee Insurance, with a principal balance of $8.8 million as of March 30, 2006. On that date, we entered into a settlement and termination agreement with the former owner of Guarantee Insurance that allowed for the early extinguishment of the $8.8 million note payable for $2.2 million in cash and release of the indemnification agreement previously entered into by the parties. We recognized an associated gain on the early extinguishment of debt of $6.6 million in 2006.
 
Effective March 30, 2006, we entered into a loan agreement for $8.7 million with an interest rate equal to the Federal Reserve prime rate plus 4.5% (7.75% at September 30, 2009). The loan was originally entered into with Brooke and was subsequently syndicated among 23 banks. This loan, which we refer to as the Original Brooke loan, is, now administered by Quivira Capital, LLC. The proceeds of the Original Brooke loan, net of loan and guaranty fee costs, totaled approximately $7.2 million and were used to provide $3.0 million of additional surplus to Guarantee Insurance, pay the $2.2 million early extinguishment of debt noted above, provide $750,000 to Tarheel to settle certain liabilities of Foundation Insurance Company, redeem common


84


Table of Contents

stock for approximately $1.0 million and for general corporate purposes. In September 2007, we borrowed an additional $5.7 million from the same lender under the same interest rate terms as the Original Brooke loan, and we refer to this loan together with the Original Brooke loan as the Brooke loans. The proceeds of the additional loan, net of loan and guaranty fee costs, totaled approximately $4.9 million and were used to provide $3.0 million of additional surplus to Guarantee Insurance and to pay federal income taxes of approximately $1.9 million on our 2006 gain on early extinguishment of debt. The principal balance and accrued interest associated with this loan at September 30, 2009 were approximately $11.4 million and $36,000, respectively. Principal and interest payments, based on the prevailing Federal Reserve prime rate at September 30, 2009, are approximately $186,000 per month. Due to the variable rate, payment amounts may change.
 
On December 31, 2008, we borrowed approximately $5.5 million from ULLICO under the same terms as the Brooke loans. The proceeds of this loan, which we refer to as the ULLICO loan, net of loan and guaranty fee costs, totaled approximately $5.0 million and were used to provide additional surplus to Guarantee Insurance. The principal balance and accrued interest associated with the ULLICO loan at September 30, 2009 were approximately $5.0 million and $16,000, respectively. Principal and interest payments, based on the prevailing Federal Reserve prime rate at September 30, 2009, are approximately $81,000 per month. Due to the variable rate, payment amounts may change.
 
The Brooke loans and the ULLICO loan are guaranteed by Mr. Mariano, our Chairman, President and Chief Executive Officer and the beneficial owner of a majority of our outstanding shares. Mr. Mariano has pledged all of the shares of our capital stock beneficially owned by him, and which may be acquired by him in the future, as security for his guarantee of the ULLICO loan. We pay a guaranty fee of 4% of the principal balance on these loans to Mr. Mariano each year.
 
The Brooke loans and the ULLICO loan are secured by a first lien on all the assets of Patriot Risk Management, PRS Group, Inc., Patriot National Insurance Group, Inc., Patriot Risk Services, Inc., Patriot Underwriters, Inc. and Patriot Risk Management of Florida, Inc. (each a “borrower”). In connection with the ULLICO loan, the lenders under the Brooke loan and ULLICO entered into an intercreditor agreement under which the parties agreed that repayment and collateral security for the Brooke loan and the ULLICO loan will be on a pari passu basis. The loan agreements, as amended, contain covenants including, among other things, a prohibition on the sale, transfer or conveyance of the assets securing the loans that are not in the ordinary course of business by a borrower without the lender’s consent, certain limitations on the incurrence of future indebtedness, financial covenants requiring us to maintain consolidated stockholders’ equity exceeding $5.5 million on a GAAP basis and Guarantee Insurance to maintain policyholders’ surplus exceeding $14.5 million on a GAAP basis, limitations on certain changes in management and the board of directors without the lender’s consent and a prohibition on making material changes to agency relationships or business operations without each lender’s consent. Additionally, none of the borrowers may pay dividends on its capital stock without each lender’s consent.
 
The lenders may declare outstanding amounts under the loan agreements to be due and payable immediately by us if any borrower defaults. Additionally, certain affiliates of the borrowers are prohibited from soliciting, writing, processing or servicing insurance policies of our customers for a period of five years if there has been a default. Events of default include among others, the following:
 
  •  non-payment of principal or interest within ten days of the payment due date or any other material nonperformance;
 
  •  failure to maintain an employment agreement with Steven M. Mariano or find a suitable replacement for him if he should die or become legally incapacitated;
 
  •  insolvency of any borrower or Guarantee Insurance;
 
  •  cessation of Steven M. Mariano’s direct or indirect 51% or more ownership and/or profit interest in us or 51% or more voting control of Patriot Risk Management;
 
  •  transfer of direct or indirect ownership of the other borrowers;


85


Table of Contents

 
  •  regulatory supervision, control or rehabilitation of Guarantee Insurance, failure of Guarantee Insurance to meet certain risk based capital ratios, or revocation or suspension of Guarantee Insurance’s certificate of authority by the state of Florida or any other regulatory body having authority over it;
 
  •  material impairment of the value of collateral;
 
  •  deviation by Guarantee Insurance from certain underwriting guidelines without the prior written consent of the lenders;
 
  •  entry by Guarantee Insurance into any contract that involves the payment of expenses in excess of 10% of the borrowers’ combined annual revenues without the prior written consent of the lenders;
 
  •  failure of Guarantee Insurance to perform its business obligations under material contracts; and
 
  •  attempts by other creditors of a borrower to collect any debt any borrower owes through a court proceeding.
 
At September 30, 2009, we were in compliance with the financial covenants of these loans. Although we were not in compliance with certain non-financial covenants, we expect to obtain a waiver from the lenders regarding these covenants, as well as a waiver of the event of default provision relating to Mr. Mariano ceasing to control at least 51% of Patriot Risk Management.
 
On June 26, 2008, we borrowed $1.5 million from our Chairman, President, Chief Executive Officer and the beneficial owner of a majority of our outstanding shares, pursuant to a promissory note that bears interest at the rate equal to the Federal Reserve prime rate plus 3% (6.25% at September 30, 2009). The net proceeds of the loan totaled approximately $1.3 million and were contributed to the surplus of Guarantee Insurance to support its premium writings. Concurrently with the loan, Mr. Mariano personally borrowed $1.5 million to fund his loan to us. The loan to Mr. Mariano contains terms similar to the terms contained in the note between Mr. Mariano and us. Because Mr. Mariano personally obtained this loan for our benefit, we paid him a loan origination fee of $187,000. The principal balance of the loan, which is payable on demand by the lender subject to the cash flow requirements of Patriot, was approximately $363,000 at September 30, 2009. There was no accrued interest on the loan at September 30, 2009. Subsequent to September 30, 2009, the loan was repaid in full.
 
In connection with the Brooke loans, the loan from Mr. Mariano and the ULLICO loan, we incurred approximately $2.5 million in issuance costs, which have been capitalized and are being amortized over the estimated terms of the debt. Unamortized debt issuance costs of approximately $1.8 million are included in other assets on the unaudited consolidated balance sheet as of September 30, 2009.
 
Between July and August 2004, Guarantee Insurance issued five fully subordinated surplus notes in the aggregate amount of $1.3 million to certain policyholders. The aggregate principal balance and accrued interest associated with these notes at September 30, 2009 were approximately $1.2 million and $190,000, respectively. The notes are unsecured, are subordinated to all general liabilities and claims of policyholders and creditors of Guarantee Insurance, have stated maturities of five years and an interest rate of 3%. The principal and interest due under the subordinated surplus notes are not carried as a legal liability of Guarantee Insurance, but are considered to be a special surplus on Guarantee Insurance’s statutory financial statements. No payments of interest or principal may be made on these subordinated notes unless either (i) the total adjusted capital and surplus of Guarantee Insurance exceeds 400% of the authorized control level risk-based capital (calculated in accordance with the rules promulgated by the NAIC) stated in Guarantee Insurance’s most recent annual statement filed with the appropriate state regulators, or (ii) Guarantee Insurance obtains regulatory approval to make such payments.
 
Between May and August 2005, we issued subordinated debentures totaling approximately $2.0 million. The debentures had an initial 3-year term, subject to renewal at the end of the term, generally for an additional 3-year term. Certain of the subordinated debentures are subject to renewal for up to two additional 1-year terms. The debentures bear interest at the rate of 3%. The principal balance and accrued interest on these debentures as of September 30, 2009 were approximately $1.6 million and $211,000, respectively.


86


Table of Contents

The following table summarizes our outstanding notes payable, surplus notes payable and subordinated debentures, including accrued interest thereon, as of September 30, 2009:
 
                                 
                  Interest
    Principal
 
                  Rate at
    and
 
Year of
            Interest Rate
  September 30,
    Accrued
 
Issuance
 
Description
  Years Due    
Terms
  2009     Interest  
                        In thousands  
 
2006/2007
  Brooke loans     2009 — 2016     Federal Reserve prime rate plus 4.5%     7.75 %   $ 11,481  
2008
  ULLICO loan      2009 — 2016     Federal Reserve prime rate plus 4.5%     7.75       5,023  
2008
  Steven Mariano loan     2009     Federal Reserve prime rate plus 3.0%     6.25       363  
2004
  Surplus notes payable     2009     3.0%     3.00       1,377  
                                 
                              18,244  
2005
  Subordinated debentures     2011     3.0%     3.00       1,845  
                                 
                            $ 20,089  
                                 


87


Table of Contents

Nine Months Ended September 30, 2009 Compared to Nine Months Ended September 30, 2008
 
Net cash used in operating activities was $8.1 million for the nine months ended September 30, 2009, compared to $4.5 million for the comparable period in 2008, an increase of $3.5 million. The increase in net cash used in operating activities was primarily attributable to the payment of reinsurance premiums associated with a quota share reinsurance agreement we entered into effective December 31, 2008, pursuant to which we ceded unearned premium reserves, net of ceding commissions, of approximately $8.1 million. The components of net cash used in operating activities are as follows:
 
                 
    Nine Months Ended
 
    September 30,  
    2009     2008  
    In thousands  
 
Net income
  $ 2,376     $ 600  
Non-cash decreases in net income
    1,365       837  
Changes in balances generally reflecting growth in net premiums written(1)
    (7,498 )     (11,614 )
Changes in balances generally reflecting claim payment patterns(2)
    (7,534 )     7,823  
Other items(3)
    3,235       (2,171 )
                 
    $ (8,056 )   $ (4,525 )
                 
 
 
(1) Includes premiums receivable, unearned and advanced premium reserves, reinsurance funds withheld and balances payable, prepaid reinsurance premiums and funds held by ceding companies and other amounts due from reinsurers
 
(2) Includes reserves for losses and loss adjustment expenses and reinsurance recoverable balances on paid and unpaid losses and loss adjustment expenses
 
(3) Principally changes in other assets and accounts payable and accrued expenses
 
Net cash provided by investing activities was $9.2 million for the nine months ended September 30, 2009 compared to net cash used in investment activities of $960,000 for the comparable period in 2008, an increase of $10.2 million. For the nine months ended September 30, 2009, the principal components of net cash provided by investing activities included sales and maturities of debt securities of $20.5 million and sales of equity securities of $329,000, partially offset by purchases of debt securities of $10.8 million, net purchases of short-term investments of $427,000 and purchases of fixed assets of $407,000. For the nine months ended September 30, 2008, the principal components of net cash used in investing activities included purchases of debt securities of $15.7 million, net purchases of short-term investments of $144,000 and purchases of fixed assets of $87,000, partially offset by sales and maturities of debt securities of $15.0 million.
 
Net cash used in financing activities was $2.1 million for the nine months ended September 30, 2009 compared to net cash provided by financing activities of $739,000 for the comparable period in 2008. For the nine months ended September 30, 2009, net cash used in financing activities included repayment of notes payable of $2.6 million, partially offset by the payment of a receivable from a related party for Series A convertible preferred stock of $500,000. For the nine months ended September 30, 2008, net cash provided by financing activities included proceeds from notes payable of $1.5 million, partially offset by repayment of notes payable of $761,000.


88


Table of Contents

2008 Compared to 2007
 
Net cash used in operating activities was $4.4 million for 2008 compared to net cash provided by operating activities of $7.1 million for 2007, a decrease of $11.5 million. The components of net cash provided by (used in) operating activities are as follows:
 
                 
    2008     2007  
    In thousands  
 
Net income (loss)
  $ (124 )   $ 2,379  
Non-cash decreases in net income
    688       202  
Changes in balances generally reflecting growth in net premiums written(1)
    (21,974 )     5,877  
Changes in balances generally reflecting claim payment patterns(2)
    10,054       (2,060 )
Other items(3)
    6,971       729  
                 
    $ (4,385 )   $ 7,127  
                 
 
 
(1) Includes premiums receivable, unearned and advanced premium reserves, reinsurance funds withheld and balances payable, prepaid reinsurance premiums and funds held by ceding companies and other amounts due to reinsurers
 
(2) Includes reserves for losses and loss adjustment expenses and reinsurance recoverable balances on paid and unpaid losses and loss adjustment expenses
 
(3) Principally changes in accounts payable and accrued expenses
 
Net cash provided by investing activities was $1.4 million for 2008 compared to net cash used in investing activities of $25.0 million for 2007, an increase of $26.4 million. For 2008, the components of net cash provided by investing activities included proceeds from sales and maturities of debt securities of $19.1 million, partially offset by purchases of debt securities, net purchases of short-term investments and purchases of fixed assets totaling $17.6 million. For 2007, the components of net cash used by investing activities included purchases of debt securities and fixed assets and net purchases of short-term investments $46.1 million, partially offset by proceeds from sales and maturities of debt and equity securities totaling $21.1 million.
 
Net cash provided by financing activities was $6.3 million for 2008 compared to $5.0 million for 2007, an increase of $1.3 million. For 2008, net cash provided by financing activities included proceeds from notes payable of approximately $6.9 million and proceeds from the issuance of preferred stock, net of receivable from related party, of $500,000. These factors were partially offset by the repayment of notes payable of approximately $1.1 million. For 2007, net cash used by financing activities include proceeds from notes payable to Brooke of $5.7 million, partially offset by repayment of notes payable of $586,000 and net disbursements for the redemption of common stock of $100,000.


89


Table of Contents

2007 Compared to 2006
 
Net cash provided by operating activities was $7.1 million in 2007 compared to $5.0 million in 2006, an increase of $2.1 million. The components of net cash provided by operating activities are as follows:
 
                 
    2007     2006  
    In thousands  
 
Net income
  $ 2,379     $ 1,610  
Non-cash income derived from early extinguishment of debt and related other income
          (7,382 )
Non-cash charges related to net realized investment losses
    5       1,346  
Other non-cash decreases (increases) in net income
    202       1,081  
Changes in balances typically reflecting growth in net premiums written(1)
    5,877       3,414  
Changes in balances typically reflecting claim payment patterns(2)
    (2,060 )     7,899  
Other items(3)
    724       (2,979 )
                 
    $ 7,127     $ 4,989  
                 
 
 
(1) Includes premiums receivable, unearned and advanced premium reserves, reinsurance funds withheld and balances payable, prepaid reinsurance premiums and funds held by ceding companies and other amounts due to reinsurers
 
(2) Includes reserves for losses and loss adjustment expenses and reinsurance recoverable balances on paid and unpaid losses and loss adjustment expenses
 
(3) Principally changes in accounts payable and accrued expenses
 
Net cash used in investing activities was $25.0 million in 2007 compared to $13.7 million in 2006, an increase of $11.3 million. In 2007, the primary components of net cash used in investing activities included purchases of debt securities, short-term investments and fixed assets totaling $46.1 million, offset by proceeds from sales and maturities of debt and equity securities totaling $21.1 million. In 2006, the primary components of net cash used in investing activities included purchases of debt securities and, to a much lesser extent, equity securities and fixed assets totaling $25.2 million, offset by proceeds from sales and maturities of debt and equity securities and short-term investments totaling $11.5 million. The increase in net cash used in investing activities in 2007 over 2006 was attributable to increased cash flows from higher premium volume, together with the deployment of $5.7 million of additional proceeds from notes payable as discussed below.
 
Net cash provided by financing activities was $5.0 million in 2007 compared to $6.1 million in 2006, a decrease of $1.1 million. In 2007, we received $5.7 million of proceeds from notes payable, redeemed common stock for $100,000 and made interest and principal payments on notes payable totaling $586,000. In 2006, we received $8.7 million of proceeds from notes payable, issued common stock for $1.4 million, redeemed common stock for $1.0 million, made interest and principal payments on notes payable totaling $2.3 million and paid dividends of $600,000.
 
Investment Portfolio
 
Our primary investment objective is capital preservation. Our secondary objectives are to achieve an appropriate risk-adjusted return and maintain an appropriate match between the duration of our investment portfolio and the duration of the claims obligations in our insurance operations.
 
At December 31, 2006, we did not anticipate that our fixed maturity securities would be available to be sold in response to changes in interest rates or changes in the availability of and yields on alternative investments and, accordingly, these securities were classified as held to maturity and stated at amortized cost.
 
In 2007, we purchased state and political subdivision debt securities with the intent that such securities would be available to be sold in response to changes in interest rates or changes in the availability of and yields on alternative investments. Accordingly, we classified these state and political subdivision debt securities


90


Table of Contents

as available for sale and stated them at fair value, with net unrealized gains and losses included in accumulated other comprehensive income net of deferred income taxes.
 
At December 31, 2007, the increased volatility in the debt securities market substantially increased the likelihood that we would, on a routine basis, desire to sell our debt securities and redeploy the proceeds into alternative asset classes or into alternative securities with better yields or lower exposure to decreases in fair value. We anticipated that all of our debt securities would be available to be sold in response to changes in interest rates or changes in the availability of and yields on alternative investments. Accordingly, we transferred all of our debt securities that were not already classified as available for sale from held to maturity to available for sale. All of our debt securities at December 31, 2008 and 2007 were stated at fair value, with net unrealized gains and losses included in accumulated other comprehensive income net of deferred income taxes. In connection with the transfer of debt securities from held to maturity to available for sale, we recognized a net unrealized gain of approximately $215,000, which is included in other comprehensive income for the year ended December 31, 2007.
 
Our fixed maturity securities, which are classified as available-for-sale, and certain cash equivalent investments are managed by Gen Re — New England Asset Managers (a subsidiary of Berkshire Hathaway, Inc.), an independent asset manager that operates under investment guidelines approved by our board of directors. Cash and cash equivalents include cash on deposit, commercial paper, short-term municipal securities, pooled short-term money market funds and certificates of deposit. Our fixed maturity securities available for sale include obligations of the U.S. Treasury or U.S. agencies, obligations of states and their subdivisions, long-term certificates of deposit, U.S. dollar-denominated obligations of U.S. corporations, mortgage-backed securities, collateralized mortgage obligations, mortgages guaranteed by the Federal National Mortgage Association and the Government National Mortgage Association, and asset-backed securities. We did not have any equity securities at September 30, 2009. Our real estate portfolio consists of one residential property in Florida. See “Business — Investments.”
 
We manage our investment credit risk through a diversification strategy that reduces our exposure to any business sector or security. See “Business — Investments” for additional information. Our investment portfolio, including cash and cash equivalents, had a carrying value of $54.5 million at September 30, 2009, and is summarized below:
 
                 
          Percentage of
 
    Fair Value     Portfolio  
    (In thousands)        
 
Debt securities available for sale:
               
U.S. government securities
  $ 3,599       6.6 %
U.S. government agencies
    308       0.6  
Asset-backed and mortgage-backed securities
    13,887       25.4  
State and political subdivisions
    16,376       30.0  
Corporate securities
    11,964       22.0  
                 
Total fixed maturity securities
    46,134   </