UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

x                               ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2006

Or

o                                  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from            to           

Commission file number 000-50070

SAFETY INSURANCE GROUP, INC.

(Exact name of registrant as specified in its charter)

 

20 Custom House Street, Boston, Massachusetts 02110

(Address of principal executive offices including zip code)

(617) 951-0600

(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:

Title of each class	Name of each exchange on which registered
Common Shares, $0.01 par value per share	NASDAQ Global Select Market

 

Indicate by check mark whether the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes    o    No    x

Indicate by check mark whether the registrant is not required to file reports pursuant to Section 13 of Section 15(d) of the Act.    Yes    o    No    x

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes    x    No    o

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.    x

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

Large accelerated filer    o    Accelerated filer    x    Non-accelerated filer    o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act)  Yes  o  No  x

The aggregate market value of the registrant’s voting and non-voting common equity (based on the closing sales price on NASDAQ) held by non-affiliates of the registrant as of June 30, 2006, was approximately $679,472,762.

As of February 26, 2007, there were 16,100,432 Common Shares with a par value of $0.01 per share outstanding.

Documents Incorporated by Reference

Portions of the registrant’s definitive proxy statement for its Annual Meeting of Shareholders to be held on May 18, 2007, which Safety Insurance Group, Inc. (the “Company”, “we”, “our”, “us”) intends to file within 120 days after its December 31, 2006 year-end, are incorporated by reference into Part III hereof.

SAFETY INSURANCE GROUP, INC.
Table of Contents

			Page No.
PART I.
Item 1.	Business			1
Item 1A.	Risk Factors			30
Item 1B.	Unresolved Staff Comments			35
Item 2.	Properties			35
Item 3.	Legal Proceedings			36
Item 4.	Submission of Matters to a Vote of Security Holders			36
PART II.
Item 5.	Market for Registrant’s Common Equity and Related Stockholder Matters			37
Item 6.	Selected Financial Data			39
Item 7.	Management’s Discussion and Analysis of Financial Condition and Results of Operation			42
Item 7A.	Quantitative and Qualitative Disclosures About Market Risk			69
Item 8.	Financial Statements and Supplementary Data			70
Item 9.	Changes in and Disagreements With Accountants on Accounting and Financial Disclosure			98
Item 9A.	Controls and Procedures			98
Item 9B.	Other Information			98
PART III.
Item 10.	Directors, Executive Officers and Corporate Governance			99
Item 11.	Executive Compensation			99
Item 12.	Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters			100
Item 13.	Certain Relationships and Related Transactions, and Directors Independence			100
Item 14.	Principal Accountant Fees and Services			100
PART IV.
Item 15.	Exhibits, Financial Statement Schedules			100
SIGNATURES				109

 

In this Form 10-K, all dollar amounts are presented in thousands, except average premium, average claim and per claim data, share, and per share data.

PART I.

ITEM 1.                 BUSINESS

General

We are a leading provider of private passenger automobile insurance in Massachusetts. In addition to private passenger automobile insurance (which represented 76.0% of our direct written premiums in 2006), we offer a portfolio of property and casualty insurance products, including commercial automobile, homeowners, dwelling fire, umbrella and business owner policies. Operating exclusively in Massachusetts through our insurance subsidiaries, Safety Insurance Company (“Safety Insurance”), Safety Indemnity Insurance Company (“Safety Indemnity”) and Safety Property and Casualty Insurance Company (“Safety P&C”) which was organized in December 2006 but has not yet commenced writing business (together referred to as the “Insurance Subsidiaries”), we have established strong relationships with 652 independent insurance agents in 760 locations throughout Massachusetts. We have used these relationships and our extensive knowledge of the Massachusetts market to become the second largest private passenger automobile carrier, capturing an approximate 11.2% share of the Massachusetts private passenger automobile insurance market, and the third largest commercial automobile carrier, with an 11.8% share of the Massachusetts commercial automobile insurance market, in 2006 according to statistics compiled by Commonwealth Automobile Reinsurers (“CAR”). In addition, we were also ranked the 44th largest automobile writer in the country according to A.M. Best, based on 2005 direct written premiums. We were incorporated under the laws of Delaware in 2001, but through our predecessors, we have underwritten insurance in Massachusetts since 1979.

We have maintained profitability in part by managing our cost structure through, for example, the use of technology. Our share of the Massachusetts private passenger automobile insurance market has grown from 10.4% in 2001 to 11.2% in 2006 and we have continued to expand our product offerings. Our direct written premiums have increased by 33.4% between 2001 and 2006, from $471,866 to $629,511. However, our direct written premiums decreased by 3.0% between 2005 and 2006 as a result of a state mandated private passenger automobile rate decrease of 8.7% effective January 1, 2006. On December 15, 2006 the Commissioner of Insurance further reduced the private passenger automobile rates 11.7% effective April 1, 2007. As a result, we anticipate a further reduction in private passenger automobile direct written premiums for 2007.

Website Access to Information

The Internet address for our website is www.SafetyInsurance.com. All of our press releases and United States Securities and Exchange Commission (‘SEC”) reports are available for viewing or download at our website. These documents are made available on our website as soon as reasonably practicable after each press release is made and SEC report is filed with, or furnished to, the SEC. Copies of any current public information about our company are available without charge upon written, telephone, faxed or e-mailed request to the Office of Investor Relations, Safety Insurance Group, Inc., 20 Custom House Street, Boston, MA 02110, Tel: 877-951-2522, Fax: 617-603-4837, or e-mail: InvestorRelations@SafetyInsurance.com. The materials on our website are not part of this report on Form 10-K nor are they incorporated by reference into this report and the URL above is intended to be an inactive textual reference only.

Our Competitive Strengths

We Have Strong Relationships with Independent Agents.   In 2005, independent agents accounted for approximately 78.2% of the Massachusetts automobile insurance market measured by direct written

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premiums as compared to only about 40.9% nationwide, according to A.M. Best. For that reason, our strategy is centered around, and we sell exclusively through, a network of 652 independent agents (of which 157 are Exclusive Representative Producers (“ERPs”)) in 760 locations throughout Massachusetts. In order to support our independent agents and enhance our relationships with them, we:

·       Provide our agents with a portfolio of property and casualty insurance products at competitive prices to help our agents address effectively the insurance needs of their clients;

·       Provide our agents with a variety of technological resources which enable us to deliver superior service and support to them; and

·       Offer our agents competitive commission schedules and profit sharing programs.

Through these measures, we strive to become the preferred provider of the independent agents in our agency network and capture a growing share of the total insurance business written by these agents in Massachusetts. We must compete with other insurance carriers for the business of independent agents.

We Have an Uninterrupted Record of Profitable Operations.   In every year since our inception in 1979, we have been profitable. We have achieved our profitable growth by, among other things:

·       Increasing by 9.0% the number of private passenger automobile exposures we underwrite from 427,000 in 2001 to 465,416 in 2006 and the average premium we receive per automobile exposure from $918 to $1,019.

·       Maintaining a statutory combined ratio (refer to page 41 for a definition of statutory combined ratio) that is consistently below industry averages;

·       Taking advantage of the institutional knowledge our management has amassed during our long operating history in the unique Massachusetts market;

·       Introducing new lines of insurance products, such as homeowners, which unlike private passenger automobile do not have state-established maximum premium rates;

·       Investing in technology to simplify internal processes and enhance our relationships with our agents; and

·       Maintaining a high-quality investment portfolio.

We Are a Technological Leader.   We have dedicated significant human and financial resources to the development of advanced information systems. Our technology efforts have benefited us in two distinct ways. First, we continue to develop technology that empowers our independent agent customers to make it easier for them to transact business with their clients and with the Insurance Subsidiaries. In our largest business line, private passenger automobile insurance, our agents now submit approximately 98% of all applications for new policies or endorsements for existing policies to us electronically through our proprietary information portal, the Agents Virtual Community (“AVC”). Second, our investment in technology has allowed us to re-engineer internal back office processes to provide more efficient service at lower cost. Our adjusted statutory expense ratios have been below the average industry statutory expense ratio in each of the past five years. Our systems have also improved our overall productivity, as evidenced by our direct written premiums per employee increasing to $1,087 in 2006 from $929 in 2001.

We Have an Experienced, Committed and Knowledgeable Management Team.   Our senior management team owns approximately 7% of the common stock of Safety Insurance Group, Inc. on a fully diluted basis. Our senior management team, led by our President, Chief Executive Officer and Chairman of the Board, David F. Brussard, has an average of over 27 years of industry experience per executive, as well as an average of over 25 years of experience with Safety. The team has demonstrated an ability to operate successfully within the regulated Massachusetts private passenger automobile insurance market.

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Our Strategy

To achieve our goal of increasing shareholder value, our strategy is to maintain and develop strong independent agent relationships by providing our agents with a full package of insurance products and information technology services. We believe this strategy will allow us to:

·       Further penetrate the Massachusetts private passenger and commercial automobile insurance markets;

·       Continue to selectively cross-sell homeowners, dwelling fire, personal umbrella in the personal lines market and business owner policies, commercial property package and commercial umbrella in the commercial lines market in order to capture a larger share of the total Massachusetts property and casualty insurance business written by each of our independent agents; and

·       Continue to expand our technology to enable independent agents to more easily serve their customers and conduct business with us, thereby strengthening their relationships with us.

The Massachusetts Property and Casualty Insurance Market

Introduction.   We are licensed by the Commonwealth of Massachusetts Commissioner of Insurance (“the Commissioner”) to transact property and casualty insurance in Massachusetts. All of our business is extensively regulated by the Commissioner.

The Massachusetts Market for Private Passenger Automobile Insurance.   Private passenger automobile insurance is heavily regulated in Massachusetts. In many respects, the private passenger automobile insurance market in Massachusetts is unique, in comparison to other states. This is due to a number of factors, including unusual regulatory conditions, the market dominance of domestic companies, the relative absence of large national companies, and the heavy reliance on independent insurance agents as the market’s principal distribution channel. For many insurance companies, these factors present substantial challenges, but we believe they provide us a competitive advantage, because, as our financial history shows, we have a thorough understanding of this market.

The principal factors that generally distinguish the Massachusetts private passenger automobile insurance market from that market in other states are as follows:

·       Compulsory Insurance. Massachusetts motorists must obtain automobile insurance prior to registering a vehicle with the Registry of Motor Vehicles. Insurers are required to notify the Registry of Motor Vehicles when coverage is cancelled and the Registry of Motor Vehicles is authorized to seize the license plates of uninsured motor vehicles.

·       “Take All Comers.” With very few exceptions, CAR, which is the residual market program for automobile insurance in Massachusetts, may not refuse to cover an applicant. Servicing carriers of CAR, such as us, may not refuse to issue a policy to an applicant based on the applicant’s driving record or other underwriting criteria commonly used by insurers in other states to decide whether to insure a motorist.

·       Standard Policy Form. The policy form that is used by all automobile insurers is developed by the Commissioner and must be used by all companies. The policy consists of several mandatory coverages: no fault coverage (i.e., “personal injury protection”); minimum limits of bodily injury and property damage liability coverage; and coverage for accidents caused by uninsured or hit-and-run motorists. In addition to these standard mandatory coverages, several additional optional coverages (such as higher bodily injury and property damage liability coverages, and collision and comprehensive coverages) must be offered. No carrier may offer any other type of coverage or deductible or use any form of policy endorsement without the prior approval of the Commissioner, which can be granted only after a formal hearing.

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·       Premium Rates are “fixed and established” by the Commissioner. In Massachusetts, automobile insurance companies are obligated to use premium rates that are determined on an annual basis by the Commissioner. As a matter of law, the Commissioner’s rate must be adequate, which the Massachusetts courts have ruled requires that the rate be sufficient to allow insurers the opportunity to earn a reasonable rate of return. The rate setting process involves a lengthy and complex administrative proceeding in which the Commissioner considers historic information related to claim costs as well as outside factors affecting insurance costs. Different data is presented for the Commissioner’s consideration by the Automobile Insurers Bureau (on behalf of the insurance industry), the State Rating Bureau, and the Massachusetts Attorney General. At the close of this proceeding, the Commissioner sets a premium rate for each of several classes of drivers, many different types of vehicles, and thirty-three different geographic territories within Massachusetts. The Commissioner usually sets the rate on or before December 15th of the preceding year. The Commissioner mandated average rate decreases in private passenger automobile premiums of 8.7% and 1.7% for 2006 and 2005, respectively, and an increase of 2.5% for 2004. Beginning in 2007 the effective date of the Commissioner’s rate decision will be April 1st of each year as compared to January 1st of 2006 and prior rate decisions. Hence, the 2006 rates will be in effect from January 1, 2006, until March 31, 2007. The Commissioner announced on December 15, 2006, an 11.7% statewide average rate decrease effective April 1, 2007. In addition, the Commissioner annually establishes the minimum commission rate that insurers must pay their auto insurance agents. The Commissioner approved a commission rate, as a percentage of premiums of 11.8%, 10.9%, and 10.5%, in 2006, 2005, and 2004, respectively. The Commissioner approved a commission rate of 13.0% effective April 1, 2007.

·       Safe Driver Insurance Plan. In other states, insurance companies are free to design their own systems for rewarding drivers with superior driving records by providing lower prices to such drivers and charging higher prices for drivers who have caused claims or who have poor driving records. In Massachusetts, all companies must use the system the Commissioner has developed. Known as the Safe Driver Insurance Plan, the system was revised effective January 1, 2006 and is based on points assessed for at-fault accidents and conviction of certain traffic violations. The Plan consists of a series of points ranging from 0 points to 45 points, with each point above 0 points imposing surcharges on motorists. The revised Plan offers credits to motorists with two excellent driver awards, an Excellent Driver Discount Plus (Credit code 99) for a driver with no accidents or violations in the preceding 6 years, and an Excellent Driver Discount (Credit code 98) for a driver with no accidents or violations in the preceding 5 years. Each driver is assigned points by the state. The Safe Driver Insurance Plan system is revenue neutral, which means that the aggregate cost of the discounts must be funded by the aggregate income of the surcharges.

·       Price competition is limited. An insurer may charge less than the Commissioner’s fixed and established premium rates by offering discounts to all members of a particular class of motorists, but only if the discount is approved by the Commissioner after a public hearing. During the years 1996 to 2001, most insurance companies offered rate discounts for drivers with the best driving records. We offered competitively priced discounts during the 1996 to 2001 time period, but like most of our competitors, we have discontinued using these discounts since 2001. Only two companies offered such discounts in 2005, further reduced to one company in 2006.

·       Affinity Group Marketing. In addition to the use of class discounts, insurers can charge lower rates than the Commissioner’s fixed rate by providing discounts to all members of an affinity group. An affinity group consists of all of the employees of a particular employer or the members of a trade union, association or other organization. These discounts must be filed with the Commissioner and are subject to the Commissioner’s approval. We currently offer discounts to 192 groups

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representing approximately 9.0% of the private passenger automobile policies we issue, with discounts ranging from 3% to 5%.

·       Exclusive Representative Producers. As noted above, the Commissioner sets a different rate for each of thirty-three territories in Massachusetts. The methodology the Commissioner uses to adjust the rates among each territory results in the reduction of rates in high cost urban communities from the actuarially appropriate rate while increasing rates in suburban and rural parts of Massachusetts. As a result, in the aggregate, rates in urban communities are considered inadequate by most insurers. In order to ensure that motorists living in such communities have access to automobile insurance, licensed insurance producers located in such areas who have not been appointed as a voluntary agent of a company may apply to CAR, to be appointed as an involuntary agent, or ERP, of an insurer selected by CAR. ERPs are assigned to all insurers writing private passenger automobile insurance in Massachusetts and ERP assignments are generally based upon an insurer’s market share. On September 30, 2005, the Commissioner instructed CAR to complete a redistribution of all ERPs to establish for all servicing carriers overall parity in the quantity and quality of their ERP exposures. ERP assignments and other recent related developments are discussed further in Item 7—Management’s Discussion and Analysis of Financial Condition and Results of Operations, Executive Summary and Overview.

·       Commonwealth Automobile Reinsurers. In order to protect insurers from the assignment of ERPs and certain other insurance regulatory conditions, the Massachusetts Legislature created CAR, which runs a reinsurance pool. CAR is governed by a committee that is appointed by the Commissioner, but its rules and decisions are subject to the review and approval of the Commissioner. Under CAR’s current rules, companies may cede to the reinsurance pool private passenger policies that they determine are not likely to be profitable. As a result, CAR operates at an underwriting deficit. This deficit is allocated among every private passenger automobile insurance company based on a complex formula that takes into consideration a company’s voluntary market share, the amount of business it cedes to CAR and credits the company earns under a system CAR has designed to encourage carriers to voluntarily write business in selected under-priced classes and territories. We have developed underwriting and actuarial analysis systems to evaluate the profitability of ceding a risk to CAR or writing it voluntarily. CAR also runs a reinsurance pool for commercial automobile policies and beginning January 1, 2006, we are one of six servicing carriers that can service commercial automobile policies for CAR. Commercial automobile business that is not written in the voluntary market is apportioned to one of the six servicing carriers who handle the business on behalf of CAR. The underwriting result of CAR’s commercial automobile pool is allocated among every Massachusetts commercial automobile insurance company, based each company’s commercial automobile voluntary market share.

·       Proposed Reform of CAR. On December 31, 2004, the then Commissioner approved new rules for CAR, which became effective on January 1, 2005 (the “Approved Rules”). Pursuant to the Approved Rules, CAR’s current system of assigning ERPs to each insurer and providing reinsurance to insurers is to be replaced by the Massachusetts Autombile Insurance Plan (the “MAIP”). The MAIP is a type of assigned risk plan similar to that used to manage the automobile insurance residual market in most other states. On June 20, 2005, the Massachusetts Superior Court ruled that the Commissioner lacked the statutory authority to implement the Approved Rules and ordered them vacated. As a result, the Approved Rules did not go into effect. The Commissioner appealed the decision of the Massachusetts Superior Court. On August 23, 2006, the Massachusetts Supreme Judicial Court overturned the decision of the Massachusetts Superior Court and unanimously ruled that the Commissioner did not need legislative approval to put in place the provisions in the Approved Rules which establish an assigned risk plan. On December 13, 2006, the Commissioner approved changes to the MAIP that called for three year phase in of an assigned risk

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plan beginning April 1, 2007, to minimize disruption to consumers and agents. On January 19, 2007, following the dismissal of the Commissioner by newly elected Governor Deval Patrick, Acting Commissioner Joseph G. Murphy suspended the MAIP Rules (the “Suspended Rules”) for a period not to exceed 90 days. A hearing was held on February 15, 2007, for testimony regarding the Suspended Rules and recommendations or amendments to those Rules. At this time we are unable to predict whether the Suspended Rules will be delayed for more than 90 days, modified, adopted or rescinded. The Suspended Rules and other recent related developments are discussed further in Item 7—Management’s Discussion and Analysis of Financial Condition and Results of Operations, Executive Summary and Overview.

·       Dominance of Domestic Companies. Many large national private passenger automobile insurance writers, such as State Farm, Allstate, Progressive, Berkshire Hathaway (GEICO), and Farmers, write very little or no private passenger automobile insurance business in Massachusetts. We actively participate in major industry policy-making organizations in Massachusetts, such as the Automobile Insurers Bureau and CAR, where our employees serve on a number of committees.

·       Prominence of Independent Insurance Agents. Finally, and perhaps most importantly to our Company’s success, approximately 78.2% of the direct written premiums in the Massachusetts automobile insurance market was placed by independent agents in 2005, according to A.M. Best. Nationally, independent agents wrote only about 40.8% of the automobile insurance market in 2005, according to A.M. Best. Accordingly, to be successful, a company must have a strategy designed to encourage the best agents to place their best business with that company. We have designed a system of agent commissions, profit sharing, bonuses and other strategies, such as our information technology capabilities, that we believe favorably distinguishes our company from our competitors. We aggressively market our company to independent agents in attempting to get the best agents and the best business.

Products

Historically, we have focused on underwriting private passenger automobile insurance, which is written through our subsidiary, Safety Insurance, at rates that are determined on an annual basis by the Commissioner. In 1989, we formed Safety Indemnity to offer commercial automobile insurance at preferred rates. Since 1997, we have expanded the breadth of our product line in order for agents to address a greater portion of their clients’ insurance needs by selling multiple products. Homeowners, business owners policies, personal umbrella, dwelling fire and commercial umbrella insurance are written by Safety Insurance at standard rates, and written by Safety Indemnity at preferred rates. In December 2006, we formed Safety P&C which will be used to add a third pricing tier to certain of our insurance products for our agents to sell to their clients. The table below shows our premiums in each of these product lines for the periods indicated and the portions of our total premiums each product line represented.

 

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Our product lines are as follows:

Private Passenger Automobile (76.0% of 2006 direct written premiums).   Private passenger automobile insurance is our primary product, and we support all Massachusetts policy forms and limits of coverage. Private passenger automobile policies provide coverage for bodily injury and property damage to others, no-fault personal injury coverage for the insured/insured’s car occupants, and physical damage coverage for an insured’s own vehicle for collision or other perils. We have priced our private passenger coverage competitively by offering group discounts since 1995 and Safe Driver Insurance Plan rate deviations from 1996 to 2001. Since 2001, we have not filed for any Safe Driver Insurance Plan deviation. We currently offer approximately 192 affinity group discount programs ranging from 3% to 5% discounts.

Commercial Automobile (14.0% of 2006 direct written premiums).   Our commercial automobile program supports all Massachusetts policy forms and limits of coverage including endorsements that broaden coverage over and above that offered on the standard Massachusetts policy forms. Commercial automobile policies provide coverage for bodily injury and property damage to others, no-fault personal injury coverage, and physical damage coverage for an insured’s own vehicle for collision or other perils resulting from the ownership or use of commercial vehicles in a business. We offer insurance for commercial vehicles used for business purposes such as private passenger-type vehicles, trucks, tractors and trailers, and insure individual vehicles as well as commercial fleets. Commercial automobile policies are written at a standard rate with qualifying risks eligible for preferred lower rates. We received approval for a rate increase of 2.1% effective December 16, 2004, and did not file for a rate change during 2005 or 2006.

Homeowners (7.9.% of 2006 direct written premiums).   We offer a broad selection of coverage forms for qualified policyholders. Homeowners policies provide coverage for losses to a dwelling and its contents from numerous perils, and coverage for liability to others arising from ownership or occupancy. We write policies on homes, condominiums, and apartments. We offer loss-free credits of up to 16% for eight years of loss free experience, along with a discount of 15% when a home is written together with an automobile. All forms of homeowners coverage are written at a standard rate with qualifying risks eligible for preferred lower rates. We received approval for a rate increase of 3.4% effective March 1, 2007.

Business Owners Policies (1.5% of 2006 direct written premiums).   We serve eligible small and medium sized commercial accounts with a program that covers apartments and residential condominiums; mercantile establishments, including limited cooking restaurants; offices, including office condominiums; processing and services businesses; special trade contractors; and wholesaling businesses. Business owner policies provide liability and property coverage for many perils, including business interruption from a covered loss. Equipment breakdown coverage is automatically included, and a wide range of additional coverage is available to qualified customers. We write policies for business owners at standard rates with qualifying risks eligible for preferred lower rates.

Commercial Package Policies (Included in our Business Owners Policies direct written premiums).   For larger commercial accounts, or those clients that require more specialized or tailored coverages, we offer a commercial package policy program that covers a more extensive range of business enterprises. Commercial package policies provide any combination of property, general liability, crime and inland marine insurance. Property automatically includes equipment breakdown coverage, and a wide range of additional coverage is available to qualified customers. We write commercial package policies at standard rates with qualifying risks eligible for preferred lower rates.

Personal Umbrella (Less than 0.3% of 2006 direct written premiums).   We offer personal excess liability coverage over and above the limits of individual automobile, watercraft, and homeowner’s insurance policies to clients. We offer a discount of 10% when an umbrella policy is written together with an automobile insurance policy. We write policies at standard rates with limits of $1,000 to $5,000.

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Dwelling Fire (0.3% of 2006 direct written premiums).   We underwrite dwelling fire insurance, which is a limited form of a homeowner’s policy for non-owner occupied residences. We offer superior construction and protective device credits, with a discount of 5% when a dwelling fire policy is issued along with an automobile policy. We write all forms of dwelling fire coverage at standard rates with qualifying risks eligible for preferred lower rates.

Commercial Umbrella (Less than 0.1% of 2006 direct written premiums).   We offer an excess liability product to clients for whom we underwrite both commercial automobile and business owner policies. The program is directed at commercial automobile risks with private passenger-type automobiles or light and medium trucks. We write commercial umbrella policies at standard rates with limits ranging from $1,000 to $5,000.

Inland Marine (Included in our Homeowners direct written premiums).   We offer inland marine coverage as an endorsement for all homeowners and business owner policies, and as part of our commercial package policy. Inland marine provides additional coverage for jewelry, fine arts and other items that a homeowners or business owner policy would limit or not cover. Scheduled items valued at more than $5 must meet our underwriting guidelines and be appraised.

Watercraft (Included in our Homeowners direct written premiums).   We offer watercraft coverage for small and medium sized pleasure craft with maximum lengths of 32 feet, valued at less than $75 and maximum speed of 39 knots. We write this coverage as an endorsement to our homeowner’s policies.

In the wake of the September 11, 2001 tragedies, the insurance industry is also impacted by terrorism, and we have filed and received approval for a number of terrorism endorsements from the Commissioner, which limit our liability and property exposure according to the Terrorism Risk Insurance Act of 2002, and the Terrorism Risk Insurance Extension Act of 2005. See “Reinsurance”, discussed below.

Distribution

We distribute our products exclusively through independent agents, unlike some of our competitors, which use multiple distribution channels. We believe this gives us a competitive advantage with the agents. We have two types of independent agents: those with which we have voluntarily entered into an agreement, which we refer to as voluntary agents, and those that CAR has assigned to us as ERPs. With the exception of our ERPs, we do not accept business from insurance brokers. Our voluntary agents have authority pursuant to our voluntary agency agreement to bind our Insurance Subsidiaries for any coverage that is within the scope of their authority. We reserve the ability under Massachusetts law to cancel any coverage, other than private passenger automobile insurance, within the first 30 days after it is bound. In total, our 652 independent agents have 760 offices (some agencies have more than one office) and approximately 4,500 customer service representatives.

Voluntary Agents.   In 2006, we obtained approximately 77.0% of our direct written premiums for automobile insurance and 100% of our direct written premiums for all of our other lines of business through our voluntary agents. As of February 28, 2007, we had agreements with 495 voluntary agents. Our voluntary agents are located in all regions of Massachusetts.

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We look for agents with profitable portfolios of business. To become a voluntary agent for our Company, we generally require that an agency: (i) have been in business for at least five years; (ii) have exhibited a three year private passenger average ratio of losses, excluding loss adjustment expenses, to net earned premiums (“pure loss ratio”) of 64.0% or less on the portion of the agent’s portfolio that we would underwrite; (iii) make a commitment for us to underwrite at least 500 policies from the agency during the first twelve months after entering an agreement with us; and (iv) offer multiple product lines. Every year, we review the performance of our agents during the prior year. If an agent fails to meet our profitability standards, we try to work with the agent to improve the profitability of the business it places with us. We generally terminate contracts each year with a few agencies, which, despite our efforts, have been consistently unable to meet our standards. Although independent agents usually represent several unrelated insurers, our goal is to be one of the top two insurance companies represented in each of our agencies, as measured by premiums. No individual agency generated more than 3.0% of our direct written premiums in 2006.

Exclusive Representative Producers.   In 2006, our ERPs generated approximately 23.0% of our direct written premiums for automobile insurance. As of December 31, 2006, we had 63 private passenger automobile ERPs. CAR defines ERPs as licensed dwelling fire or casualty insurance agents or brokers who have a place of business in Massachusetts, but have no existing voluntary independent agency relationship with an automobile insurer conducting business in Massachusetts. An ERP’s policy portfolio typically includes a significant percentage of what are considered to be under-priced automobile policies.

Massachusetts law guarantees that CAR provide motor vehicle insurance coverage to all qualified applicants. To facilitate this system, under CAR’s current rules, any qualified licensed insurance producer that is unable to obtain a voluntary automobile relationship with an insurer becomes an ERP and is assigned to an insurer, which is then required to write that agent’s policies. The number of mandated ERP policies assigned to a Massachusetts insurance carrier is intended to be proportionate to its voluntary market share. However, because no insurer can control the relative volumes of voluntary and ERP business with certainty, carriers are usually either relatively oversubscribed or undersubscribed with ERP policies. Periodically, CAR assigns or re-assigns an ERP to the most undersubscribed insurer.

On September 30, 2005, the Commissioner instructed CAR to complete a redistribution of all ERPs to establish for all servicing carriers overall parity in the quantity and quality of their ERP exposures. The redistribution plan for ERPs, as adopted by the CAR Governing Committee on November 16 and December 14, 2005, was approved by the Commissioner on January 27, 2006. On January 31, 2006, CAR notified each reassigned ERP and all servicing carriers of the redistribution. According to the January 31, 2006 CAR Private Passenger ERP Redistribution Summary, 18 Safety ERPs with 25,590 exposures were assigned to other servicing carriers beginning with new business effective March 1, 2006 and renewal business May 1, 2006. In addition, CAR assigned 29 ERPs with 24,670 exposures from other servicing carriers to Safety. However 25 of these ERPs with 23,116 exposures were given voluntary contracts by their former servicing carrier or other carriers and were, as a result, no longer eligible for assignment to Safety as ERPs. The redistribution and other recent related CAR developments are discussed further in Item 7—Management’s Discussion and Analysis of Financial Condition and Results of Operations, Executive Summary and Overview.

Beginning January 1, 2006, CAR implemented a Limited Servicing Carrier Program (the “LSC program”) for ceded commercial automobile policies. CAR approved Safety and five other servicing carriers through a Request for Proposal to process approximately $200,000 of ceded commercial automobile business based on CAR data as of December 31, 2005, which will be spread equitably among the six servicing carriers. CAR assigned 353 voluntary agents (many of which were already voluntary agents of Safety) and 103 ERPs to Safety for the LSC program.

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The table below shows our direct written exposures in each of our product lines for the periods indicated and the change in exposures for each product line.

 

Our total written exposures increased by 0.4% for the year ended December 31, 2006. The increase was the result of our voluntary agent written exposures increasing by 3.3% and our ERP written exposures decreasing by 11.4%. Our private passenger exposures decreased by 1.0% primarily as a result of the CAR ERP redistribution. Our commercial automobile exposures increased by 12.3% primarily as a result of the CAR LSC program. Our homeowners and dwelling fire exposures decreased 0.3% and 3.2%, respectively, due to our continued re-underwriting of coastal properties. Our business owners policies, personal umbrella and commercial umbrella exposures increased 22.5%, 2.9% and 25.9% respectively primarily as a result of our voluntary agents efforts to sell multiple products to their clients

Marketing

We view the independent agent as our customer and business partner. As a result, our marketing efforts focus on developing interdependent relationships with leading Massachusetts agents that write profitable business and positioning ourselves as the preferred insurance carrier of those agents, thereby receiving a larger portion of each agent’s aggregate business. We do not market ourselves to potential policyholders. Our principal marketing strategies are:

·       To offer a range of products, which we believe enables our agents to meet the insurance needs of their clients, and overcomes agents’ resistance to placing their clients’ automobile insurance and other coverages with different insurers;

·       To price our products competitively, including offering discounts when and where appropriate for safer drivers and for affinity groups, and also offering account discounts for policyholders that have both an automobile and homeowners policy with us;

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·       To offer agents competitive commissions, with incentives for placing their more profitable business with us; and

·       To provide a level of support and service that enhances the agent’s ability to do business with its clients and with us.

Commission Schedule and Profit Sharing Plan.   We have several programs designed to attract profitable new private passenger automobile business from agents by paying them more than the minimum commission the law requires (which is 11.8% of premiums for 2006, and 13.0% in 2007). We recognize our top performing agents by making them members of our President’s Club or Executive Club. In 2006, President’s Club members received a commission equal to 17.0% of premiums for each new policy with a safe driver credit code of 99 and 98 (drivers with no accidents or violations in the prior six and five years respectively), while Executive Club members received a commission equal to 14.0% of premiums for such policies. In 2006, 62.7% of our drivers were in Safe Driver Insurance Plan credit code 99 and 98, as compared to 62.7% for the Massachusetts private passenger automobile industry as a whole, based on the number of drivers per month in each step according to CAR.

Further, we have a competitive agency incentive commission program under which we pay agents up to 8.0% of premiums based on the loss ratio on their business.

We have received no inquiries from the Commissioner, the Massachusetts Attorney General, or any other government agency relative to how we conduct our contingent commissions and profit sharing programs.

Service and Support.   We believe that the level and quality of service and support we provide helps differentiate us from other insurers. We have made a significant investment in information technology designed to facilitate our agents’ business. Our AVC website helps agents manage their work efficiently. We provide a substantial amount of information online that agents need to serve their customers, such as information about the status of new policies, bill payments and claims. Providing this type of content reduces the number of customer calls we receive and empowers the agent’s customer service representatives by enabling them to respond to customers’ inquiries while the customer is on the telephone. Finally, we believe that the knowledge and experience of our employees enhance the quality of support we provide.

Underwriting

Our underwriting department is responsible for a number of key decisions affecting the profitability of our business, including:

·       Pricing of discounts offered on our private passenger automobile product;

·       Pricing of our commercial automobile, homeowners, dwelling fire, personal umbrella, business owners policies, commercial umbrella and commercial package products;

·       Determining which policies to cede to CAR’s reinsurance pool and which to retain; and

·       Evaluating whether to accept transfers of a portion of an existing or potential new agent’s portfolio from another insurer.

We are organized into three underwriting units, a separate unit for Massachusetts private passenger automobile, a separate unit for all other personal lines underwriting including homeowners, dwelling fire, personal umbrella and inland marine coverages, and a separate unit for commercial lines, including commercial auto, business owners policies, commercial umbrella and commercial package policies.

Pricing.   Our pricing strategy for private passenger automobile insurance primarily depends on the maximum permitted premium rates and minimum permitted commission levels mandated by the

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Commissioner. For several years prior to 2002, we offered discounts off the state-mandated rates to drivers in the lower Safe Driver Insurance Plan steps, as did a number of other insurers. However, starting in 1998, we began to reduce the discounts we offered, in light of the reductions or minimal increases in average rates the Commissioner has mandated in each year since 1998. We currently do not offer any Safe Driver Insurance Plan credit code-based discounts.

Although we do not currently offer any Safe Driver Insurance Plan discounts, we do offer group discounts to members of 192 affinity groups, including the Boston College Alumni Association, the Massachusetts Bar Association and the Massachusetts Medical Society. In general, we target affinity groups with a mature and stable membership base along with favorable driving records, offering between a 3% and 5% discount (with 4% being the average discount offered). Approximately 9.0% of the private passenger policies we issue receive an affinity group discount.

Subject to Commissioner review, CAR sets the premium rates for commercial automobile policies reinsured through CAR. Subject to Commissioner review, we set rates for commercial automobile policies that are not reinsured through CAR, and for all other insurance lines we offer, including homeowners, dwelling fire, personal umbrella, commercial umbrella, commercial package policies and business owner policies. We base our rates on industry loss cost data, our own loss experience, residual market deficits, catastrophe modeling and prices charged by our competitors in the Massachusetts market. We have two pricing tiers for most products, utilizing Safety Insurance for standard rates and Safety Indemnity for preferred rates. In December 2006, we formed Safety P&C which will be used to add a third pricing tier to our insurance products for our agents to sell to their clients. We received approval for a rate increase of 2.1% for our commercial automobile line effective December 16, 2004, and did not file for a rate change during 2005 or 2006. We received approval for a rate increase of 3.4% for our homeowners line effective March 1, 2007.

Cede/Retain Decisions.   Under CAR’s current rules for private passenger policies, we must decide, within 23 days after the effective date of a new policy or before renewing an existing policy, whether to cede it to CAR’s reinsurance pool. Each Massachusetts private passenger automobile insurer must bear a portion of the losses of the private passenger reinsurance pool. Under CAR’s current rules, we are able to reduce our total allocated share of the losses of the reinsurance pool by ceding less business to the pool than our proportionate share. As a result, in determining whether to cede an under priced policy to CAR’s private passenger automobile reinsurance pool, we attempt to evaluate whether we are likely to incur greater total losses by ceding it to the pool or by retaining it. According to the January 19, 2007 CAR Cession Volume Analysis—Private Passenger Report, as of November 30, 2006, we have ceded 4.9% of our private passenger automobile business to the pool in 2006, compared to an average of 5.1% for the industry. Our goal is to cede only those policies that incur less total losses resulting from a cession to CAR, than the total losses incurred by retaining the policy.

CAR also runs a reinsurance pool for commercial automobile policies and beginning January 1, 2006, we are one of six servicing carriers that can service commercial automobile policies for CAR. Commercial automobile business that is not written in the voluntary market is apportioned to one of the six servicing carriers who handle the business on behalf of CAR. Each Massachusetts commercial automobile insurer must bear a portion of the losses of the commercial reinsurance pool that is serviced by the six servicing carriers.

Bulk Policy Transfers and New Voluntary Agents.   From time to time, we receive proposals from existing voluntary agents to transfer a portfolio of the agent’s business from another insurer to us. Our underwriters model the profitability of these portfolios before we accept these transfers. Among other things, we usually require that the private passenger portion of the portfolio have a pure loss ratio of 64.0% or less on the portion of the agent’s portfolio that we would underwrite. In addition, we require any new voluntary agent to commit to transfer a portfolio to us consisting of at least 500 policies.

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Policy Processing and Rate Pursuit.   Our underwriting department assists in processing policy applications, endorsements, renewals and cancellations. In the past three years, we have introduced new proprietary software that enables agents to connect to our network and enter policy and endorsement applications for private passenger automobile insurance from their office computers. In our private passenger automobile insurance line, our agents now submit approximately 98% of all applications for new policies or endorsements for existing policies through our proprietary information portal, the AVC.

Our rate pursuit team aggressively monitors all insurance transactions to make sure we receive the correct premium for the risk insured. We accomplish this by verifying Massachusetts pricing criteria, such as proper classification of drivers, the make, model and age of insured vehicles and the availability of discounts. We verify that operators are properly listed and classified, assignment of operators to vehicles, vehicle garaging, vehicle pre-inspection requirements and in some cases the validity of discounts. In our homeowners and dwelling fire lines, our team has completed a project to update the replacement costs for each dwelling. We use third-party software to assist in these appraisal efforts.

Technology

The focuses of our information technology effort are:

·       to constantly reengineer internal processes to allow more efficient operations, resulting in lower operating costs;

·       to make it easier for independent agents to transact business with us; and

·       to enable agents to efficiently provide their clients with a high level of service.

We believe that our technology initiatives have increased revenue and decreased costs. For example, these initiatives have allowed us to reduce the number of call-center transactions which we perform, and to transfer many manual processing functions from our internal operations to our independent agents. We also believe that these initiatives have contributed to our overall increases in productivity. In 1990, we had 399 employees and $154,997 in direct written premiums. As of December 31, 2006, we had 579 employees and $629,511 in direct written premiums, which represents an increase from $388 direct written premiums per employee in 1990 to $1,087 direct written premiums per employee in 2006.

Internal Applications (Intranet).   Our employees access our proprietary applications through our corporate intranet. Our intranet applications streamline internal processes and improve overall operational efficiencies in areas including:

Claims.   Our claims workload management application allows our claims and subrogation adjusters to better manage injury claims. Subrogation refers to the process by which we are reimbursed by other insurers for claims costs we incur due to the fault of their insureds. The use of this application has reduced the time it takes for us to respond to and settle casualty claims, which we believe helps reduce the total amount of our claims expense.

The automated adjuster assignment system categorizes our new claims by severity and assigns them to the appropriate adjuster responsible for investigation. Once assigned, the integrated workload management tools facilitate the work of promptly assigning appraisers, investigating liability, issuing checks and receiving subrogation receipts.

The RadicalGlass.com application allows our claims department to contain glass costs by increasing the windshield repair to replacement ratio. For every windshield that is repaired rather than replaced there is an average savings of $290 per windshield claim.

A VIP Claims Center was introduced during 2006 to provide increased service levels to our independent insurance agents and their clients. The VIP Claims Center uses a network of rental car

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centers and auto body repair shops to provide a higher level of service to the clients of the independent insurance agents while reducing costs, such as rental, through reduced cycle times.

Billing.   Proprietary billing systems, integrated with the systems of our print and lock-box vendors, expedite the processing and collection of premium receipts and finance charges from agents and policyholders. We believe the sophistication of our direct bill system helps us to limit our bad debt expense. In both 2006 and 2005 our bad debt expense as a percentage of direct written premiums was less than 0.2%.

External Applications.   Agency employees can securely access business critical applications through our corporate extranet, which we call AVC. AVC includes Web-enabled applications, advanced security and an Internet-enabled communications network, which we believe constitutes many of our agents’ only high-speed Internet connection. We believe that AVC is unique to the Massachusetts private passenger automobile insurance industry because using AVC allows an agent to access a variety of vendors and other carriers over the Internet through a single portal. We currently have a patent application pending on AVC. The patent application pertains to the method and system by which AVC delivers customer services to independent insurance agents. The capability for agency personnel to schedule online appointments with third-party vendors (such as glass repair retailers and rental car agencies) for their clients is also available. We designed AVC to be scalable so that these types of vendors and potentially, other insurers, can link to the network and create a “once and done” environment for the independent agent.

Listed below are examples of the business critical applications agents may access through AVC.

New Business and Endorsement Processing.   Agents can perform new business and endorsement processing with our point of sale application. Agents can upload policy data to our system directly from their agency system or rate quote software in AVC’s secure Web environment without having to re-enter policy information. Agents are then able to download many of these transactions to their agency management system the next business day.

Inquiry Access.   Inquiry Access is a customer service application designed to provide agency customer service representatives with real-time access to our database of insured information. This application allows agents to view the status of claims, billing and policy detail.

Policyholder Inquiry.   Policyholder Inquiry provides 24 hours a day, 7 days a week self-service account information to our policyholders through our website or through their independent agents’ websites. This application provides policyholders with round-the-clock access to billing and claims information.

Other Tools and Services.   AVC gives agents access to electronic versions of underwriting manuals, which include updated guidelines for acceptable risks, commission levels and product pricing. Further, we have our agents using third-party software (the XNET Cost Estimator from Marshall Swift/Boeck) that we make available through AVC to help assess home replacement costs. This initiative helps ensure that we receive the correct premium with respect to homeowners policies and provide the correct level of coverage against home loss. Finally, we provide agents a daily report of all their insurance transactions processed through AVC. This report allows our agents to monitor their performance and review profitability goals.

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Claims

Because of the unique differences between the management of casualty claims and property claims, we use separate departments for each of these types of claims.

Casualty Claims

We have a proven record of settling casualty claims below the industry average in Massachusetts. According to the Automobile Insurers Bureau, our average casualty claim settlement during the period from January 1994 through June 30, 2006, was $5,514, approximately 3.9% lower than the Massachusetts industry average of $5,737.

We have adopted stringent claims settlement procedures, which include guidelines that establish maximum settlement offers for soft tissue injuries, which constituted approximately 72% of our bodily injury claims. If we are unable to settle these claims within our guidelines, we generally take the claim to litigation. We believe that these procedures result in providing our adjusters with a uniform approach to negotiation.

We believe an important component of handling claims efficiently is prompt investigation and settlement. We find that faster claims settlements often result in less expensive claims settlements. Our E-Claim reporting system is an online product that reduces the time it takes for agents to notify our adjusters about claims, thereby enabling us to contact third-party claimants and other witnesses quickly. After business hours we outsource claims adjustment support to an independent firm whose employees contact third-party claimants and other witnesses. We believe that early notification results in our adjusters conducting prompt investigations of claims and compiling more accurate information about those claims. Our claims workload management software also assists our adjusters in handling claims quickly.

We believe the structure of our casualty claims unit allows us to respond quickly to claimants anywhere in the Commonwealth of Massachusetts. Comprising 122 people, the department is organized into distinct claim units that contain loss costs for soft tissue injuries. Field adjusters are located geographically for prompt response to claims, with our litigation unit focused on managing loss costs and litigation expenses for serious injury claims.

Additionally, we utilize a special unit to investigate fraud in connection with casualty claims. This special unit has one manager and nine employees. In cases where adjusters suspect fraud in connection with a claim, we deploy this special unit to conduct investigations. We deny payment to claimants in cases in which we have succeeded in accumulating sufficient evidence of fraud.

Property Claims

Our property claims unit handles property claims arising in our private passenger and commercial automobile, homeowners and other insurance lines. Process automation has streamlined our property claims function. Many of our property claims are now handled by the agents through AVC using our Power Desk software application. As agents receive calls from claimants, Power Desk permits the agent to immediately send information related to the claim directly to us and to an independent appraiser selected by the agent to value the claim. Once we receive this information, an automated system redirects the claim to the appropriate internal adjuster responsible for investigating the claim to determine liability. Upon determination of liability, the system automatically begins the process of seeking a subrogation recovery from another insurer, if liable. We believe this process results in a shorter time period from when the claimant first contacts the agent to when the claimant receives a claim payment, while enabling our agents to build credibility with their clients by responding to claims in a timely and efficient manner. We benefit from decreased labor expenses from the need for fewer employees to handle the reduced property claims call volume.

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Another important factor in keeping our overall property claims costs low is collecting subrogation recoveries. We track the amounts we pay out in claims costs and identify cases in which we believe we can reclaim some or all of those costs through the use of our automated workload management tools.

Reserves

Significant periods of time can elapse between the occurrence of an insured loss, the reporting of the loss to the insurer and the insurer’s payment of that loss. To recognize liabilities for unpaid losses, insurers establish reserves as balance sheet liabilities representing estimates of amounts needed to pay reported and unreported losses and the expenses associated with investigating and paying the losses, or loss adjustment expenses. Every quarter, we review and establish our reserves. Regulations promulgated by the Commissioner require us to annually obtain a certification from either a qualified actuary or an approved loss reserve specialist that our loss and loss adjustment expenses reserves are reasonable.

When a claim is reported, claims personnel establish a “case reserve” for the estimated amount of the ultimate payment. The amount of the reserve is primarily based upon an evaluation of the type of claim involved, the circumstances surrounding each claim and the policy provisions relating to the loss. The estimate reflects informed judgment of such personnel based on general insurance reserving practices and on the experience and knowledge of the claims person. During the loss adjustment period, these estimates are revised as deemed necessary by our claims department based on subsequent developments and periodic reviews of the cases.

In accordance with industry practice, we also maintain reserves for estimated losses incurred but not yet reported. Incurred but not yet reported reserves are determined in accordance with commonly accepted actuarial reserving techniques on the basis of our historical information and experience. We make adjustments to incurred but not yet reported reserves quarterly to take into account changes in the volume of business written, claims frequency and severity, our mix of business, claims processing and other items that can be expected to affect our liability for losses and loss adjustment expenses over time.

When reviewing reserves, we analyze historical data and estimate the impact of various loss development factors, such as our historical loss experience and that of the industry, legislative enactments, judicial decisions, legal developments in imposition of damages, and changes and trends in general economic conditions, including the effects of inflation. There is no precise method, however, for evaluating the impact of any specific factor on the adequacy of reserves, because the eventual development of reserves is affected by many factors. After taking into account all relevant factors, management believes that our provision for unpaid losses and loss adjustment expenses at December 31, 2006, is adequate to cover the ultimate net cost of losses and claims incurred as of that date.

Management determines its loss and LAE reserves estimates based upon the analysis of the Company’s actuaries. Management has established a process for the Company’s actuaries to follow in establishing reasonable reserves. The process consists of meeting with our claims department, establishing ultimate incurred losses by using development models accepted by the actuarial community, and reviewing the analysis with management. The Company’s estimate for loss and LAE reserves, net of the effect of ceded reinsurance, ranges from a low of $327,472 to a high of $377,497 as of December 31, 2006. The Company’s loss and LAE reserves, based on management’s best estimate, were set at $370,980 as of December 31, 2006. The ultimate liability may be greater or less than reserves carried at the balance sheet date. Establishment of appropriate reserves is an inherently uncertain process, and there can be no certainty that currently established reserves will prove adequate in light of subsequent actual experience. To the extent that reserves are inadequate and are strengthened, the amount of such increase is treated as a charge to earnings in the period that the deficiency is recognized. To the extent that reserves are redundant and are released, the amount of the release is a credit to earnings in the period the redundancy is recognized. We do not discount any of our reserves.

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The following table presents development information on changes in the reserves for losses and loss adjustment expenses (“LAE”) of our Insurance Subsidiaries for the three years ended December 31, 2006.

 

At the end of each period, the reserves were re-estimated for all prior accident years. Our prior year reserves decreased by $42,747, $39,620 and $6,778 during 2006, 2005 and 2004, respectively. The decrease in prior year reserves during 2006 resulted from re-estimations of prior year ultimate loss and LAE liabilities and is primarily composed of reductions of $23,945 in the Company’s retained automobile reserves and $14,006 in the CAR assumed reserves. It is not appropriate to extrapolate future favorable or unfavorable development of reserves from this past experience.

The following table represents the development of reserves, net of reinsurance, for calendar years 1996 through 2006. The top line of the table shows the reserves at the balance sheet date for each of the indicated years. This represents the estimated amounts of losses and loss adjustment expenses for claims arising in all years that were unpaid at the balance sheet date, including losses that had been incurred but not yet reported to us. The upper portion of the table shows the cumulative amounts paid as of the end of each successive year with respect to those claims. The lower portion of the table shows the re-estimated amount of the previously recorded reserves based on experience as of the end of each succeeding year, including cumulative payments made since the end of the respective year. The estimate changes as more information becomes known about the payments, frequency and severity of claims for individual years. Favorable loss development, shown as a cumulative redundancy in the table, exists when the original reserve estimate is greater than the re-estimated reserves at December 31, 2006.

Information with respect to the cumulative development of gross reserves (that is, without deduction for reinsurance ceded) also appears at the bottom portion of the table.

In evaluating the information in the table, it should be noted that each amount entered incorporates the effects of all changes in amounts entered for prior periods. Thus, if the 2004 estimate for a previously incurred loss was $150,000 and the loss was reserved at $100,000 in 2000, the $50,000 deficiency (later estimate minus original estimate) would be included in the cumulative redundancy (deficiency) in each of the years 2000-2004 shown in the table. It should further be noted that the table does not present accident or policy year development data. In addition, conditions and trends that have affected the development of

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liability in the past may not necessarily recur in the future. Accordingly, it is not appropriate to extrapolate future redundancies or deficiencies from the table.