item 14 principal accounting fees services information required item incorporated herein reference information appearing “principal accounting firm fees services” 2007 proxy statement part iv item 15 item 14 principal accounting fees services information required item incorporated herein reference information appearing ‘‘principal accounting firm fees services’’ 2006 proxy statement part iv item 15 item 7 management’s discussion analysis financial condition results operations following discussion analysis financial condition results operations read conjunction consolidated financial statements related notes included elsewhere report discussion analysis includes certain forwardlooking statements subject risks uncertainties factors described “risk factors” item 1a elsewhere report could cause actual results differ materially expressed implied forwardlooking statements see “forwardlooking statements” overview james river group inc insurance holding company owns manages specialty propertycasualty insurance companies focused specialty insurance niches seek • earn profit underwriting • produce return average equity 15 greater earning profit underwriting means intend premiums earn period sufficient pay losses loss adjustment expenses incur period well expenses associated operations use underwriting profit loss basis evaluating underwriting performance strategy operate lower expense ratio many competitors focus efforts specialty insurance market profits historically better standard market underwrite risk individually order apply expertise risk underwrite use technology provide employees managers timely accurate information business actively manage claims accordance terms insurance contracts underwriting profit year ended december 31 2006 359 million increase underwriting profit 98 million reported 2005 company recorded 212 million pretax basis costs net reinsurance connection hurricanes primarily hurricane katrina including reinsurance reinstatements calculate return equity dividing net income average stockholders’ equity period annualized basis overall financial goal produce annual return equity least 150 return average equity 178 year ended december 31 2006 94 year ended december 31 2005 116 year ended december 31 2004 third quarter 2005 raised 846 million initial public offering see “initial public offering” result comparison yearoveryear return equity include proceeds offering organized three reportable segments separately managed business units • excess surplus insurance segment offers commercial excess surplus lines liability property insurance 48 states district columbia james river insurance company james river insurance • workers’ compensation insurance segment offers workers’ compensation coverage primarily residential construction industry north carolina early 2007 virginia stonewood insurance company stonewood insurance • corporate segment consists management treasury activities holding company interest expense associated debt james river insurance stonewood insurance financial strength rating “a” excellent best results operations following table summarizes results years ended december 31 2006 2005 2004 year ended december 31 2006 compared year ended december 31 2005 net income year ended december 31 2006 347 million 217 per diluted share compared net income 121 million 094 per diluted share 2005 net income 2005 included 212 million pretax basis 138 million aftertax basis costs net reinsurance connection hurricanes primarily hurricane katrina including reinsurance restatements combined ratio year ended december 31 2006 835 combined ratio measure underwriting performance represents relationship incurred losses loss adjusting expenses operating expenses net earned premiums combined ratio less 100 indicates underwriting profit combined ratio greater 100 reflects underwriting loss combined ratio 2006 includes 79 million net favorable reserve development prior accident years including 84 million excess surplus insurance segment’s casualty business 211000 workers’ compensation insurance segment offset 716000 adverse development excess surplus insurance segment’s property business combined ratio year ended december 31 2005 916 included effect hurricanes noted additionally 2005 included 49 million net favorable reserve development prior accident years including 31 million excess surplus insurance segment’s casualty business 23 million favorable reserve development excess surplus insurance segment’s property business 171000 direct business written workers’ compensation insurance segment favorable development workers’ compensation insurance segment offset 696000 adverse development prior accident years related company’s initial allocation north carolina involuntary workers’ compensation pool intercompany reinsurance pooling agreement place james river insurance stonewood insurance best employ capital insurance subsidiaries report segment information ‘‘management’s discussion analysis financial condition results operations’’ prior effects intercompany reinsurance pooling agreement since evaluate operating performance reportable segments prepooling basis premiums following table summarizes growth premium volume component business segment 2006 premium amounts reflect increase renewal business well penetration growth company’s broker agency networks increase broker agency network follows • number brokers submitting business excess surplus insurance segment grew 153 209 2005 241 2006 • number agencies workers’ compensation insurance network grew 66 137 december 31 2005 146 december 31 2006 gross written premiums workers’ compensation insurance segment 2006 2005 included 36 44 million respectively assumed premiums allocation north carolina involuntary workers’ compensation pool ratio net written premiums gross written premiums referred net retention years ended december 31 2006 2005 net retention 766 583 respectively net retention excess surplus insurance segment 741 2006 536 2005 lower retention 2005 result impact quota share reinsurance contract effective january 1 2005 ceded written premiums related quota share treaty 2005 totaled 400 million additionally ceded 61 million premiums 2005 reinsurers reinstate reinsurance coverage used reinsurance limits due significant hurricane losses noted additionally effect net retention quota share contract reinstatement premiums partially offset decision increase amount risk retain reinsurance primary casualty policies sold james river insurance net retention workers’ compensation insurance segment 892 2006 878 2005 premiums earned ratably terms insurance policies generally twelve months net earned premiums affected significant growth written premiums prior year underwriting results following table compares combined ratios segment excess surplus insurance segment results excess surplus insurance segment follows combined ratio excess surplus insurance segment year ended december 31 2006 790 comprised loss ratio 563 expense ratio 227 underwriting results major line business within excess surplus insurance segment follows loss ratio year ended december 31 2006 affected net favorable reserve development prior accident years 84 million excess surplus insurance segment’s casualty business offset 716000 adverse reserve development excess surplus insurance segment’s property business including 13 million relating hurricanes katrina wilma 2005 loss ratio significantly affected hurricane losses primarily hurricane katrina incurred 101 million loss adjustment expenses net reinsurance hurricanes also affected loss ratio reducing 2005 net earned premiums 129 million including 61 million reinstatement reinsurance premiums noted addition losses aforementioned hurricanes loss ratio also affected favorable reserve development prior accident years 31 million excess surplus insurance segment’s casualty business 23 million favorable reserve development excess surplus insurance segment’s property business expense ratio excess surplus insurance segment increased 227 2006 201 2005 expense ratio 2006 2005 reflected strong expense management commissions operating expenses well use technology process administer insurance business cost efficient manner increase expense ratio 2006 primarily due fact 2005 expense ratio benefited ceding commission james river insurance received quota share reinsurance contract totaled 97 million quota share treaty also affected expense ratio reducing net earned premiums 400 million 2005 expense ratio 2005 also affected hurricanes net impact reduce operating expenses 18 million commissions well previously noted reduction net earned premiums 129 million workers’ compensation insurance segment results workers’ compensation insurance segment follows combined ratio workers’ compensation insurance segment year ended december 31 2006 938 comprised loss ratio 682 expense ratio 257 loss ratio included 235000 favorable reserve development direct business written company prior accident years balance increase loss ratio attributable loss experience year attributable modest increase severity 2006 expense ratio workers’ compensation insurance segment improved significantly prior year principally due economies scale achieved segment third full year operations included expense ratio 2006 310000 08 percentage points anticipated guaranty fund assessments amount represents improvement prior year’s assessments 720000 28 percentage points combined ratio workers’ compensation insurance segment year ended december 31 2005 969 comprised loss ratio 627 expense ratio 342 loss ratio 2005 included 171000 favorable reserve development direct business written company prior accident years offset 696000 adverse development prior accident years related company’s initial allocation north carolina involuntary workers’ compensation pool reserves company’s gross reserve losses loss adjustment expenses december 31 2006 3003 million amount 748 relates amounts incurred reported ibnr company’s gross reserves losses loss adjustment expenses segment summarized follows december 31 2006 amount net reserves 2098 million related ibnr 801 total company’s net reserves losses loss adjustment expenses segment summarized follows operating expenses operating expenses company include underwriting acquisition insurance expenses excess surplus insurance segment workers’ compensation insurance segment well expenses corporate segment corporate segment operating expenses corporate segment include personnel costs associated holding company employees directors’ fees professional fees various corporate expenses majority costs reimbursed subsidiaries amount reimbursement included primarily underwriting expenses results insurance subsidiaries amounts operating expenses corporate segment represent expenses holding company reimbursed subsidiaries including costs associated potential acquisitions strategic initiatives costs vary periodtoperiod based status initiatives total operating expenses corporate segment 38 million 12 million years ended december 31 2006 2005 respectively significant increase operating expenses corporate segment prior year attributable planned increases legal consulting expenses notably associated public registrant particularly costs associated implementation internal control documentation testing requirements sarbanesoxley act included total 26 million increase expenses corporate segment 986000 compensation expense year ended december 31 2006 relating expensing stock options connection adoption financial accounting standards board fasb statement 123 revised 2004 sharebased payment statement 123 r effective january 1 2006 see “recent accounting pronouncements” investing results net investment income year ended december 31 2006 193 million 102 million year ended december 31 2005 increase net investment income reflects significant growth invested assets 3395 million december 31 2005 4947 million december 31 2006 well increase yield fixed income securities growth invested assets result increase net written premiums well 200 million net proceeds offering junior subordinated debt june 2006 following table summarizes investment returns fixed maturity equity securities classified availableforsale carried fair value unrealized gains losses securities reported net tax separate component accumulated comprehensive income loss average duration fixed maturity security portfolio december 31 2006 2005 approximately 47 42 years respectively amortized cost fair value investments availableforsale securities follows amortized cost fair value investments fixed maturity securities summarized contractual maturity follows december 31 2006 investment portfolio unrealized loss 20 million representing 04 cost amortized cost portfolio majority unrealized losses fixed maturity securities december 31 2006 interest rate related security portfolio fair value greater 920 amortized cost december 31 2006 none fixed maturity securities unrealized losses ever missed delinquent scheduled principal interest payment december 31 2006 969 fixed maturity security portfolio rated ‘‘a’’ better standard poor’s received equivalent rating another nationally recognized rating agency concluded none availableforsale securities unrealized losses december 31 2006 experienced otherthantemporary impairment considered intent ability hold securities sufficient amount time allow recovery value determination fourth quarter 2005 concluded one security portfolio rated investment grade standard poor’s experienced impairment otherthantemporary accordingly took impairment writedown 92000 security also concluded none availableforsale securities unrealized losses december 31 2005 experienced otherthantemporary impairment fourth quarter 2006 began invest equity securities principally various market indices time 100 cash invested assets may invested equity securities december 31 2006 balance equity securities 87 million represented 16 total cash invested assets 2004 portion 2005 investment bond mutual fund classified equity security consolidated balance sheet balance cash equivalents 403 million december 31 2006 percentage cash equivalents cash invested assets december 31 2006 75 compared 108 december 31 2005 larger percentage cash invested assets cash equivalents december 31 2005 fund anticipated property insurance claim payments hurricane losses interest expense interest expense 43 million 27 years ended december 31 2006 2005 respectively related debt outlined may 2004 issued 150 million senior debt due april 29 2034 net proceeds us 145 million senior debt redeemable holder subject sinking fund requirements interest accrues quarterly payable arrears floating rate per annum equal threemonth libor plus 385 senior debt redeemable prior stated maturity option whole part may 15 2009 terms senior debt contain certain covenants among things restrict assuming senior indebtedness secured common stock subsidiaries’ capital stock issuing shares subsidiaries’ capital stock compliance covenants december 31 2006 sold trust preferred securities three delaware statutory trusts sponsored whollyowned us trust used net proceeds sale trust preferred securities purchase floating rate junior subordinated debt following table summarizes nature terms junior subordinated debt trust preferred securities outstanding december 31 2006 provided full irrevocable unconditional guarantee obligations trusts trust preferred securities indenture junior subordinated debt contains certain covenants compliance december 31 2006 december 31 2006 2005 ratio total debt outstanding total capitalization defined total debt plus total stockholders’ equity 214 176 respectively use capital support premium growth accordingly debt part capital structure allows us generate higher earnings per share book value per share results could using equity capital alone target debt total capitalization ratio 350 less income taxes years ended december 31 2006 2005 income tax expense differs amounts computed applying federal statutory income tax rate income taxes primarily due interest income taxadvantaged state municipal securities effective tax rates 318 301 respectively years ended december 31 2006 2005 state municipal securities represented 412 289 fixed maturity security portfolio december 31 2006 2005 respectively although state municipal securities represented larger portion fixed maturity security portfolio december 31 2006 previous year effective tax rate increased since growth taxable income grew faster taxadvantaged income year ended december 31 2005 compared year ended december 31 2004 net income year ended december 31 2005 121 million 094 per diluted share compared net income 88 million 093 per diluted share 2004 net income 2005 included 212 million pretax basis 138 million aftertax basis costs net reinsurance connection hurricanes primarily hurricane katrina including reinsurance restatements combined ratio year ended 2005 916 combined ratio 2005 included 212 million effect hurricanes noted additionally 2005 included 49 million net favorable reserve development prior accident years including 31 million excess surplus insurance segment’s casualty business 23 million favorable reserve development excess surplus insurance segment’s property business 171000 direct business written workers’ compensation insurance segment favorable development workers’ compensation insurance segment offset 696000 adverse development prior accident years related company’s initial allocation north carolina involuntary workers’ compensation pool combined ratio year ended december 31 2004 901 unaffected significant windrelated loss events include effects 156000 favorable reserve development prior accident years premiums following table summarizes growth premium volume component business segment increases premiums stonewood insurance noted reflect fact stonewood insurance wrote first insurance policy effective january 1 2004 additionally premium amounts reflect increase renewal business growth company’s broker agency networks • number brokers submitting business excess surplus insurance segment grew 403 149 209 2004 2005 respectively • number agencies workers’ compensation insurance network grew 245 110 137 december 31 2004 2005 respectively stonewood insurance receive ‘‘a’’ excellent rating best april 2004 accordingly lack rating limited direct written premium production first quarter year gross written premiums stonewood insurance 2005 also included 44 million assumed premiums initial allocation north carolina involuntary workers’ compensation pool years ended december 31 2005 2004 net retention 583 843 respectively net retention excess surplus insurance segment 536 2005 843 2004 decrease net retention 2005 driven impact quota share reinsurance contract effective january 1 2005 ceded written premiums related quota share treaty 2005 totaled 400 million additionally ceded 61 million premiums reinsurers reinstate reinsurance coverage used reinsurance limits due significant hurricane losses noted quota share reinsurance treaty present 2004 additionally increased amount risk retain reinsurance policies sold james river insurance 2004 adjusted estimated reinsurance premium ceding rate one retrospective experience rated reinsurance treaties based loss experience reinsured book business impact adjustment increase net earned premiums 2004 484000 trueup premiums earned 2003 increase losses loss adjustment expenses incurred approximately 290000 net retention workers’ compensation insurance segment 878 2005 844 2004 increase net retention 2005 included effects initial allocation premiums north carolina involuntary workers’ compensation pool premiums 44 million 2005 fully retained company premiums earned ratably terms insurance policies generally twelve months net earned premiums affected significant growth written premiums underwriting results following table compares combined ratios segment excess surplus insurance segment results excess surplus insurance segment follows combined ratio excess surplus insurance segment year ended december 31 2005 888 comprised loss ratio 688 expense ratio 201 loss ratio 2005 significantly affected hurricane losses primarily hurricane katrina incurred 101 million losses loss adjustment expenses net reinsurance hurricanes also affected loss ratio reducing 2005 net earned premiums 129 million including 61 million reinstatement reinsurance premiums previously noted addition losses aforementioned hurricanes loss ratio also affected favorable reserve development prior accident years 31 million excess surplus insurance segment’s casualty business 23 million favorable reserve development excess surplus insurance segment’s property business underwriting results major line business within excess surplus insurance segment follows expense ratio excess surplus insurance segment improved 201 2005 224 2004 expense ratio 2005 2004 reflected strong expense management commission expenses operating expenses well use technology process administer insurance business cost efficient manner expense ratio 2005 also benefited ceding commission james river insurance received quota share reinsurance contract totaled 97 million quota share treaty also affected expense ratio reducing net earned premiums 400 million 2005 expense ratio 2005 also affected hurricanes net impact reduce operating expenses 18 million commissions well previously noted reduction net earned premiums 129 million workers’ compensation insurance segment results workers’ compensation insurance segment follows combined ratio workers’ compensation insurance segment year ended december 31 2005 969 comprised loss ratio 627 expense ratio 342 loss ratio 2005 included 171000 favorable reserve development direct business written prior accident years offset 696000 adverse development prior accident years related company’s initial allocation north carolina involuntary workers’ compensation pool included expense ratio 2005 720000 28 percentage points guaranty fund assessments combined ratio workers’ compensation insurance segment year ended december 31 2004 1500 comprised loss ratio 735 expense ratio 765 loss ratio 2004 negatively affected claims administration expenses high relative low volume claims activity first year workers’ compensation insurance operations additionally underwriting expenses earned premium therefore expense ratio 2004 affected startup nature business operating expenses operating expenses company include underwriting acquisition insurance expenses excess surplus insurance segment workers’ compensation insurance segment well expenses corporate segment corporate segment operating expenses corporate segment include personnel costs associated holding company employees directors’ fees professional fees various corporate expenses majority costs reimbursed subsidiaries amount reimbursement included primarily underwriting expenses results insurance subsidiaries amounts operating expenses corporate segment represent expenses holding company reimbursed subsidiaries including costs associated potential acquisitions strategic initiatives costs may vary periodtoperiod based status initiatives total operating expenses corporate segment 12 million 879000 years ended december 31 2005 2004 respectively significant increase operating expenses corporate segment prior year attributable planned increases legal consulting expenses notably associated public registrant investing results net investment income year ended december 31 2005 102 million 36 million year ended december 31 2004 increase net investment income reflects significant growth invested assets 1750 million december 31 2004 3395 million december 31 2005 growth invested assets result increase net written premiums 846 million proceeds initial public offering underwriters’ exercise overallotment option august 2005 well net proceeds offering junior subordinated debt following table summarizes investment returns fourth quarter 2005 concluded one securities portfolio rated investment grade standard poor’s experienced impairment otherthantemporary accordingly took impairment writedown 92000 security also concluded none availableforsale securities unrealized losses december 31 2005 none availableforsale securities unrealized losses december 31 2004 experienced otherthantemporary impairment considered intent ability hold securities sufficient amount time allow recovery value determination interest expense interest expense 27 million 793000 years ended december 31 2005 2004 respectively interest expense related 150 million senior notes 227 million junior subordinated notes issued may december 2004 interest notes paid floating rate based threemonth libor increase interest expense 2005 due fact notes outstanding full year 2005 portions 2004 well higher interest rate environment 2005 income taxes year ended december 31 2005 income tax expense differs amounts computed applying federal statutory income tax rate income taxes primarily due interest income taxadvantaged state municipal securities 2005 effective tax rate 301 state municipal securities represented 289 fixed maturity security portfolio december 31 2005 effective tax rate 157 year ended december 31 2004 income tax expense 2004 differs amounts computed applying federal statutory income tax rate income taxes 2004 due use net operating loss carryforwards offset taxable income period june 30 2004 established tax valuation allowance equal total deferred tax assets net existing deferred tax liabilities current income tax expense 2004 concluded likely would realize entire deferred tax asset based conclusion primarily fact generated taxable income inceptiontodate basis sufficient exhaust net operating loss carryforwards created startup phase accordingly valuation allowance deferred tax asset december 31 2005 2004 liquidity capital resources sources uses funds organized holding company operations conducted whollyowned subsidiaries accordingly holding company receives cash loans banks issuance equity debt securities including initial public offering august 2005 corporate service fees dividends received insurance subsidiaries payments subsidiaries pursuant consolidated tax allocation agreement transactions payment dividends insurance subsidiaries limited statute general restrictions require dividends paid earned surplus limit aggregate amount dividends distributions subsidiaries may declare pay within twelve month period without advance regulatory approval maximum amount dividends available us insurance subsidiaries 2007 without regulatory approval 327 million however insurance regulators broad powers prevent reduction statutory surplus inadequate levels could refuse permit payment dividends december 31 2006 cash invested assets holding company totaled 143 million net written premium surplus ratio defined net written premiums statutory surplus reviewed management well rating agency component leverage efficiency deployed capital relatively limited operating history rating agency’s metrics require us lower premium surplus ratio competitors years ended december 31 2006 2005 2004 premium surplus ratio 10 09 15 10 respectively june 15 2006 james river group inc arranged sale 200 million trust preferred securities trust preferred securities james river capital trust iii trust delaware statutory trust sponsored whollyowned company trust created solely purpose issuing trust preferred securities trust used proceeds sale trust preferred securities purchase 206 million company’s floating rate junior subordinated debentures junior subordinated debt issued trust indenture junior subordinated debt sole asset trust preferred securities sole liabilities trust junior subordinated debt matures june 15 2036 unless accelerated earlier interest trust preferred securities interest paid company trust junior subordinated debt payable quarterly arrears september 15 2006 interest accrued per annum rate 83 september 15 2006 quarterly thereafter interest rate reset per annum rate equal threemonth libor determination date defined indenture plus margin 30 company right defer interest payments junior subordinated debt five years without triggering event default trust preferred securities subject mandatory redemption like amount upon repayment junior subordinated debt stated maturity date five years issue date contemporaneously optional prepayment whole part junior subordinated debt company provided full irrevocable unconditional guarantee payments amounts due trust preferred securities indenture contains certain covenants company compliance december 31 2006 description amounts outstanding terms junior subordinated debt senior debt see “year ended december 31 2006 compared year ended december 31 2005 interest expense” cash flows sources operating funds consist primarily premiums written investment income proceeds offerings debt equity securities use operating cash flows primarily pay operating expenses losses loss adjustment expenses income taxes net cash provided operating activities 1332 million 2006 compared 1068 million 2005 net cash provided operating activities years primarily attributable cash received written premiums exceeding cash disbursed operating expenses losses loss adjustment expenses net cash provided financing activities 2006 included net proceeds offering trust preferred securities june 2006 net cash provided financing activities 2005 included net proceeds 846 million initial public offering repayment 20 million notes receivable directors executive officers april 2005 net cash provided financing activities 2004 373 million included 214 million net proceeds issuance junior subordinated debt 145 million net proceeds issuance senior debt 13 million net proceeds issuance 13500 shares series b convertible preferred stock reinsurance enter reinsurance contracts limit exposure potential losses arising large risks provide additional capacity growth reinsurance contracted excess loss quota share reinsurance contracts excess loss reinsurance reinsurer agrees assume portion ceding company’s losses excess specified amount excess loss reinsurance premium payable reinsurer negotiated parties based assessment amount risk ceded reinsurer excess loss reinsurance reinsurer share proportionately ceding company’s losses quota share reinsurance reinsurer agrees assume specified percentage ceding company’s losses arising defined class business exchange corresponding percentage premium years ended december 31 2006 2005 2004 net retention 766 583 843 respectively following summary casualty reinsurance place december 31 2006 1 policies occurrence limit 10 million higher quota share percentage set retention 500000 excess casualty policy limits excess 50 million purchase facultative reinsurance policies also write underlying primary casualty policy quota share reinsurance reduces excess casualty retention 100000 added retention primary casualty coverage results total retention 11 million risk following summary property reinsurance place december 31 2006 1 per risk limits excess 50 million reinsured facultative reinsurance runoff coverage company’s 100 million excess 50 million reinsurance program place prior june 1 2006 property reinsurance renewal 2 250000 noncatastrophe losses additionally property reinsurance treaty covers per occurrence exposure terrorism provided terrorism risk insurance act 2002 treaty covers 30 million excess 20 million per risk use catastrophemodeling software analyze risk severe losses hurricanes earthquakes model portfolio insurance policies force month track accumulations exposed values geographically manage concentration one area fourth quarter 2005 began reducing exposure hurricane losses writing new renewal primary property insurance wind coverage within 100 miles southeast gulf coasts united states within 30 miles northeast coast united states reducing concentration exposed limits 50 mile area 500 million less new renewal policies measure exposure potential catastrophe losses terms probable maximum loss estimate amount would expect pay one catastrophe event specified period time ie return period manage potential loss purchasing catastrophe reinsurance coverage effective june 1 2006 purchased catastrophe reinsurance 175 million excess 25 million per event retention coverage one reinstatement event exhaust coverage additionally property quota share reinsurance treaty effectively provides coverage single occurrence 100 ceded premium estimated 218 million period june 1 2006 may 31 2007 property quota reinsurance treaty subject reinstatement premiums aggregate cap ceded losses combination property catastrophe quota share reinsurance treaties provides coverage single occurrence approximately 39 million based upon computer modeling 39 million gross catastrophe loss expected exceed 500 year return period event 39 million gross property catastrophe loss company estimate net tax cost approximately 28 million including reinstatement premiums addition retention would retain losses excess reinsurance coverage limits year ended december 31 2005 net retention affected quota share reinsurance contract effective january 1 2005 contract transferred portion risk related certain propertycasualty business written james river insurance 2005 reinsurers exchange portion direct written premiums business transferring risk reinsurers reduced amount capital required support insurance operations james river insurance 2005 ceded earned premiums related quota share treaty 400 million ceded losses loss adjustment expenses 365 million reinsurance ceding commissions 97 million 2006 impact contract pretax income 234000 treaty renewed 2006 reinsurance contracts relieve us obligations policyholders failure reinsurer honor obligations could result losses us therefore establish allowances amounts considered uncollectible december 31 2006 allowance uncollectible reinsurance recoverables james river insurance stonewood insurance generally target reinsurers best financial strength ratings ‘‘a’’ excellent better december 31 2006 reinsurance recoverables unpaid losses 905 million reinsurance recoverables paid losses 70 million included reinsurance recoverables paid unpaid losses december 31 2006 124 million recoverables related hurricane katrina losses 150 million recoverables related hurricane wilma 11 million total recoverables paid unpaid losses december 31 2006 reinsurers rated ‘‘a’’ better best collateralized letters credit contractual obligations commitments following table illustrates contractual obligations commitments due dates december 31 2006 reserve losses loss adjustment expenses payments due period table based upon reserve losses loss adjustment expenses december 31 2006 actuarial estimates expected payout patterns line business result calculation reserve losses loss adjustment expenses payments due period subject uncertainties associated determining level reserve losses loss adjustment expenses additional uncertainties arising difficulty predicting claims including claims yet reported us paid actual payments losses loss adjustment expenses period vary perhaps materially table extent current estimates reserve losses loss adjustment expenses vary actual ultimate claims amounts result variations expected actual payout patterns option may redeem senior notes junior subordinated notes 2009 2011 1000 principal amount however senior notes junior subordinated notes mature 2034 2036 ratings james river insurance stonewood insurance financial strength rating “a” excellent best assigns 16 ratings insurance companies currently range “a” superior “f” liquidation “a” excellent fourth highest rating issued best “a” excellent rating assigned insurers best’s opinion excellent ability meet ongoing obligations policyholders rating intended provide independent opinion insurer’s ability meet obligation policyholders evaluation directed investors financial strength ratings assigned best impact ability insurance companies attract retain agents brokers risk profiles submissions insurance companies receive “a” excellent ratings obtained james river insurance stonewood insurance consistent companies’ business plans allow companies actively pursue relationships agents brokers identified marketing plans notes receivable employees directors part 2003 series b convertible preferred stock offerings loaned total 26 million employees directors purchase shares notes receivable due 2013 classified reduction stockholders’ equity consolidated balance sheet april 2005 notes receivable executive officers directors totaling 20 million repaid additional 10000 repaid august 2005 leaving 535000 notes receivable nonexecutive employees outstanding december 31 2006 2005 initial public offering may 3 2005 filed registration statement form s1 securities exchange commission initial public offering common stock registration statement declared effective august 8 2005 august 9 2005 completed tenforone split common stock stockholders record date immediately prior closing initial public offering august 12 2005 outstanding series convertible preferred stock series b convertible preferred stock including shares representing accrued unpaid dividends converted 9956413 shares common stock addition amended restated certificate incorporation increase number authorized shares common stock 1000 million decrease number authorized shares preferred stock 50 million gross proceeds sale 4444000 shares common stock initial public offering price per share 1800 totaled 800 million costs associated initial public offering included 66 million underwriting issuance costs august 26 2005 underwriters initial public offering exercised overallotment option additional 666600 shares common stock issued sold 1800 initial public offering price per share gross proceeds transaction 120 million underwriting costs 840000 reconciliation nongaap measures following table reconciles underwriting profit loss individual segment whole company consolidated income taxes believe measures useful investors evaluating performance company insurance segments objective consistently earn underwriting profits evaluate performance insurance segments allocate resources based primarily underwriting profit loss insurance segments definition underwriting profit loss insurance segments underwriting profit loss may comparable companies critical accounting policies estimates identified accounting estimates critical understanding results operations financial position critical accounting estimates defined estimates important portrayal results operations financial condition require us exercise significant judgment use significant judgment concerning future results developments applying critical accounting estimates preparing consolidated financial statements judgments estimates affect reported amounts assets liabilities revenues expenses disclosure material contingent assets liabilities actual results may differ materially estimates assumptions used preparing consolidated financial statements evaluate estimates regularly using information believe relevant detailed discussion significant accounting policies see notes 2006 audited consolidated financial statements included form 10k reserve losses loss adjustment expenses reserve losses loss adjustment expenses represents estimated ultimate cost reported unreported losses loss adjustment expenses incurred unpaid balance sheet date discount reserve estimate reserve using individual casebasis valuations reported claims also use statistical analyses estimate cost losses loss adjustment expenses incurred reported us ibnr estimates based historical information industry information estimates future trends may affect frequency claims changes average cost claims may arise future relatively new company historical loss experience limited utilize two primary actuarial methods arrive loss reserve estimates line business first incurred bornhuetterferguson method estimates reserve based initial expected loss ratio expected reporting patterns losses based industry data actual reported losses loss adjustment expenses primary method loss ratio method estimates reserve applying expected loss ratio net earned premiums statutory line business methods expected loss ratio used established using judgment based primarily industry data experience management team writing similar insurance coverages expected loss ratio used loss ratio method judgmentally adjusted level reported losses specific accident year specific statutory line business leads us conclude ultimate loss ratio differ initial expected loss ratio expected loss ratio used incurred bornhuetterferguson method typically adjusted initially set mechanics method already incorporate departures expected reported losses reserve calculations primary factor contributing difference methods incurred bornhuetterferguson method incorporates assumptions regarding industry reporting patterns estimated percentage ultimate losses reported particular valuation date losses level reported losses loss adjustment expenses reflected loss ratio method since incurred bornhuetterferguson method includes reported losses estimates future development patterns sensitive level reported losses loss ratio method generally selected actuarial method yields highest reserve statutory line business best estimate consistently applied methodology 2006 2005 believe generally selecting higher two actuarial methods statutory line business basis best reserve estimates appropriate early stage history given insurance companies limited historical experience two primary actuarial methods utilize industry data losses casualty business often take number years develop write difficult classes business typically meet risk criteria standard carriers believe sufficient evidence time conclude ultimate loss ratios significantly better expected loss ratios generally selecting higher two primary actuarial methods basis best reserve estimates consistent belief future information becomes available us develop experience may adjust change actuarial methods future methods may necessarily result selecting highest estimate actuarial methods events magnitude hurricanes katrina wilma occurred 2005 involve complex coverage issues established reserves case believe reflect complexity claims estimating reserves losses loss adjustment expenses relating hurricanes katrina wilma used case reserve estimates based information obtained site inspections adjusters terms coverage provided policies estimated reserves incurred reported claims using judgment based progress settling claims actual results may differ materially estimates assumptions used preparing consolidated financial statements 2006 experienced 13 million adverse development net losses loss adjustment expenses hurricanes katrina wilma december 31 2006 aggregate reserve sum results selected estimates statutory line business plus reserve losses loss adjustment expenses associated hurricanes katrina wilma estimated described aggregate reserve reflects best estimate since generally selected higher two actuarial methods financial statement date aggregate reserve includes components calculated using incurred bornhuetterferguson method components calculated using loss ratio method combination methods varies statutory line business period estimated net reserve december 31 2006 using incurred bornhuetterferguson method 1819 million using loss ratio method 1943 million instances recorded reserve estimate derived using loss ratio method best reserve estimate expected loss ratio used method derived management’s experience lines business write current underwriting criteria generally expected loss ratios used loss ratio method decline accident year ages result methodology gives weight bornhuetterferguson method mature accident years reserve estimates individual point estimates constitute actuarial range record reserve estimate derived incurred bornhuetterferguson method best estimate level actual reported losses provides sufficient evidence ultimate loss ratio exceed expected loss ratio level actual reported losses provides sufficient evidence ultimate loss ratio less expected loss ratio generally reduce expected loss ratio used loss ratio method reserve estimates derived using incurred bornhuetterferguson method driven assumptions related expected loss ratio expected reporting pattern losses reserve estimates derived using loss ratio method driven assumptions related expected loss ratio sensitive reporting patterns table quantifies impact reasonably likely changes two variables expected loss ratio expected reporting pattern losses would recorded reserve losses loss adjustment expenses december 31 2006 reporting pattern scenarios apply incurred bornhuetterferguson analysis table expected loss ratio expected reporting pattern refer assumptions related two variables made calculating net reserves recorded december 31 2006 sensitivity analysis based weightedaverage assumptions presented following table expected loss ratio assumptions expected loss ratio represents weighted average expected loss ratios used statutory lines business expected loss ratio line weighted based net earned premiums expected reporting pattern assumptions expected reporting pattern represents weighted average percentage ultimate losses assumed reported us december 31 2006 statutory lines business weighted based net earned premiums believe loss ratios 5 expected loss ratio constitute reasonable range expectations major line business addition believe adjustments made speed slow reporting patterns sensitivity analysis reasonably likely outcomes incurred bornhuetterferguson method slowing reporting pattern results increase estimate reserves reported losses seen smaller percentage ultimate reported losses resulting increase estimated unreported losses similarly using faster reporting pattern results decrease estimate reserves determining amounts slow accelerate reporting patterns sensitivity analysis presented applied judgment reflect fact variability reasonably likely reporting pattern outcomes varies major line business little variability around expected reporting patterns excess surplus insurance property lines property claims typically reported relatively quickly conversely considerably variability around expected reporting patterns excess surplus insurance casualty lines losses casualty business often take number years develop reporting patterns workers’ compensation insurance generally slower reporting patterns excess surplus insurance property lines generally faster reporting patterns excess surplus insurance casualty lines accordingly variability around expected reporting patterns workers’ compensation insurance greater excess surplus insurance property lines less excess surplus insurance casualty lines impact recording net reserve losses highest value sensitivity analysis would reduce net income 116 million reduce stockholders’ equity december 31 2006 54 impact recording net reserve losses lowest value sensitivity analysis would increase net income 112 million increase stockholders’ equity december 31 2006 52 changes net reserve losses loss adjustment expenses would immediate impact liquidity would affect cash flow future periods incremental reduced amount losses paid reserves driven number important assumptions including litigation regulatory trends legislative activity social economic patterns claims inflation assumptions reserve estimates reflect current inflation legal claims settlements assume subject losses significant new legal liability theories reserve estimates also assume experience significant losses mass torts incur losses future mass torts known us today possible predict impact changes environment new mass torts expanded legal theories liability emerge ibnr claims may differ substantially ibnr reserves reserve estimates assume significant changes regulatory legislative environment impact potential changes regulatory legislative environment difficult quantify absence specific significant new regulation legislation event significant new regulation legislation attempt quantify impact business ibnr reserve estimates inherently less precise case reserve estimates 5 change net ibnr reserves december 31 2006 would equate 84 million change reserve losses loss adjustment expenses 55 million change net income 25 change stockholders’ equity december 31 2006 although believe reserve estimates reasonable possible actual loss experience may conform assumptions specifically actual ultimate loss ratio could differ initial expected loss ratio actual reporting patterns losses could differ expected reporting patterns based industry data accordingly ultimate settlement losses related loss adjustment expenses may vary significantly estimates included financial statements regularly review estimates adjust necessary experience develops new information becomes known us adjustments included current operations losses loss adjustment expenses 2006 reflect 79 million favorable development reserve losses loss adjustment expenses december 31 2005 favorable development consisted 77 million favorable development excess surplus insurance segment comprised various statutory lines favorable adverse development 235000 favorable development workers’ compensation insurance segment losses loss adjustment expenses 2005 reflect 49 million favorable development reserve losses loss adjustment expenses december 31 2004 favorable development consisted 54 million favorable development excess surplus insurance segment offset 525000 adverse development workers’ compensation insurance segment see “results operations” losses loss adjustment expenses 2004 reflect 156000 favorable development reserve losses loss adjustment expenses held december 31 2003 excess surplus lines insurance segment investments carry securities classified “availableforsale” fair value unrealized gains losses securities net deferred taxes reported separate component accumulated comprehensive income securities classified “heldtomaturity” “trading” evaluate investments regularly determine whether declines value otherthantemporary determine security experienced otherthantemporary impairment recognized realized investment loss consider number factors assessing whether impairment otherthantemporary including amount percentage fair value cost amortized cost b length time fair value cost amortized cost c intent ability hold security sufficient period time allow recovery value addition fixed maturity securities also consider credit quality ratings securities special emphasis securities downgraded investment grade recognized impairment loss 92000 2005 fixed maturity security portfolio see “investing results” recognize impairment losses either 2006 2004 began investing equities fourth quarter 2006 anticipate investing 100 cash invested assets equities 2007 manage risk limiting investment single corporation 30 assets income taxes review need valuation allowance related deferred tax assets quarter reduce deferred tax assets valuation allowance determine likely deferred tax assets realized assessment whether valuation allowance needed requires us use significant judgment assessment includes consideration amount taxable income generated since formed 2002 trends earnings future expectations income tax expense 2004 reflects reduction deferred tax valuation allowance 19 million establish valuation allowance deferred tax assets december 31 2006 2005 2004 deferred tax assets liabilities measured using enacted tax rates expected apply taxable income years temporary differences financial statement carrying amounts assets liabilities respective tax bases expected recovered settled stock based compensation december 2004 fasb issued statement 123r revision statement 123 accounting stockbased compensation statement 123r supersedes accounting principles board opinion 25 accounting stock issued employees apb opinion 25 amends fasb statement 95 statement cash flows adopted statement 123r using modified prospective method january 1 2006 prior may 3 2005 date filed form s1 securities exchange commission used minimum value method calculate pro forma disclosures required statement 123 continue account portion awards granted prior may 3 2005 modified cancelled repurchased subsequent date using intrinsic value method prescribed apb opinion 25 related interpretive guidance options granted prior january 1 2006 fixed number shares exercise price equal fair value shares date grant recognized compensation expense stock options adopted statement 123r began recognizing expense associated awards issued may 3 2005 awards modified repurchased cancelled date income statement award’s vesting period using modified prospective method compensation expense amounts related options recognized straightline basis award’s vesting period income statement result adopting statement 123r january 1 2006 income taxes net income 2006 986000 640000 lower respectively continued account sharebased compensation apb opinion 25 reported basic diluted earnings per share 2006 would increased 004 003 respectively adopted statement 123r adoption statement 123r material effect statement cash flows use blackscholesmerton option pricing model determining fair value option grants following table summarizes assumptions used estimate fair value sharebased awards issued may 3 2005 awards expected term based midpoint vesting period contractual term award stock price volatility assumption significant variable estimating value option stock price volatility measure amount stock price fluctuated expected fluctuate period blackscholesmerton option pricing model higher volatility assumption results higher value option lower volatility assumption results lower option value stock price volatility estimated based stock price volatility data similar propertycasualty companies period following respective initial public offerings since historical stock price information limited period subsequent initial public offering august 2005 riskfree interest rate assumption based sevenyear us treasury rate date grant dividend yield assumption based upon fact dividends expected granted life options time options granted detailed discussion significant accounting policies see notes 2006 audited consolidated financial statements included form10k recent accounting pronouncements june 2006 fasb issued fasb interpretation 48 accounting uncertainty income taxes interpretation fasb statement 109 fin 48 fin 48 clarifies accounting uncertain tax positions interpretation prescribes recognition threshold measurement attribute financial statement recognition measurement tax position taken expected taken tax return fin 48 effective fiscal years beginning december 15 2006 earlier adoption permitted currently evaluating impact adopting fin 48 financial statements expect adoption interpretation material impact financial position results operations september 2006 fasb issued statement 157 fair value measurement statement 157 statement 157 defines fair value establishes framework measuring fair value generally accepted accounting principles expands disclosures fair value measurements statement 157 effective financial statements issued fiscal years beginning november 15 2007 earlier application encouraged currently evaluating impact adopting statement 157 financial statements outlook 2007 anticipate achieving annual return equity least 15 growth gross written premiums 10 20 item 7a item 7 management’s discussion analysis financial condition results operations following discussion analysis financial condition results operations read conjunction consolidated financial statements related notes included elsewhere report discussion analysis includes certain forwardlooking statements subject risks uncertainties factors described ‘‘risk factors’’ item 1a elsewhere report could cause actual results differ materially expressed implied forwardlooking statements see ‘‘forwardlooking statements’’ overview james river group inc holding company owns manages propertycasualty insurance companies focused specialty insurance niches seek earn profit underwriting means intend premiums earn period sufficient pay losses loss adjustment expenses lae incur period well expenses associated operations two insurance subsidiaries james river insurance company james river insurance excess surplus lines insurance company authorized write business 48 states district columbia stonewood insurance company stonewood insurance workers’ compensation insurance company primarily markets products residential construction industry north carolina insurance companies individually underwrite risk issue policy companies grant underwriting authority insurance agents brokers consolidated results include results holding company two insurance subsidiaries three whollyowned subsidiaries net income 2005 121 million 094 per diluted share compared net income 88 million 093 per diluted share 2004 net income 2005 included 124 million aftertax costs hurricane katrina net reinsurance including reinsurance reinstatement premiums net income 2005 also benefited favorable development prior accident year reserves direct business 36 million aftertax direct written premiums 2005 increased 660 2366 million 1425 million 2004 combined ratio 2005 916 compared 901 2004 results operations following table summarizes results years ended december 31 2005 2004 2003 year ended december 31 2005 compared year ended december 31 2004 gross written premiums direct written premiums plus assumed written premiums increased 691 1425 million 2004 2410 million 2005 growth broker network james river insurance agency network stonewood insurance key drivers increase gross written premiums james river insurance produced 2074 million gross written premiums 2005 compared 1334 million 2004 stonewood insurance produced 336 million gross written premiums 2005 compared 92 million 2004 gross written premiums stonewood insurance 2005 included 44 million assumed premiums participation involuntary workers’ compensation pool north carolina stonewood insurance wrote first insurance policy effective january 1 2004 results 2004 include renewal premiums direct written premiums 2005 included 76 million renewal premiums net written premiums 1406 million 2005 170 increase compared 1202 million 2004 written premium ceding ratio ceded written premiums direct written premiums increased 424 2005 157 2004 change written premium ceding ratio principally due quota share reinsurance contract effective january 1 2005 transfers portion risk related certain propertycasualty business written james river insurance 2005 reinsurers exchange portion direct written premiums business ceded written premiums related quota share treaty 2005 totaled 400 million also ceded 61 million reinstatement premiums reinsurers reinstate reinsurance coverage used reinsurance limits 2005 due losses hurricane katrina net earned premiums grew 551 1175 million 2005 compared 758 million 2004 premiums earned ratably terms insurance policies generally 12 months ceded earned premiums related quota share treaty 400 million 2005 net earned premium growth 2005 also reduced 61 million ceded reinstatement reinsurance premiums due losses hurricane katrina net investment income 2005 102 million 182 36 million 2004 increase net investment income reflects significant growth cash invested assets 1952 million december 31 2004 3805 million december 31 2005 growth cash invested assets came net written premiums 846 million net proceeds initial public offering including underwriters’ exercise overallotment option gross investment yield investment expenses average cash invested assets 2005 38 gross investment yield average fixed maturity security balance 2005 40 significantly increased holdings taxadvantaged state municipal fixed maturity securities past twelve months believe considering taxadvantaged characteristics state municipal securities represent good value relative market segments tax equivalent yield average fixed maturity security balance 44 2005 2004 gross investment yield average cash invested assets 31 gross investment yield average fixed maturity security balance 35 tax equivalent yield average fixed maturity security balance 36 largest component income 2005 2004 interest earned notes receivable employees directors notes annual interest rate 45 interest notes 52000 2005 117000 2004 decline interest notes receivable 2005 consistent decline amount outstanding notes receivable year april 2005 notes receivable executive officers directors totaling 20 million repaid borrowers additional 10000 repaid august 2005 leaving 535000 notes receivable outstanding december 31 2005 employees executive officers realized investment losses 252000 2005 71000 2004 realized investment losses 2005 included 92000 writedown bond issued finance company united states automobile manufacturer impairment value deemed otherthantemporary writedowns securities otherthantemporary impairment 2004 losses lae totaled 792 million 2005 665 compared losses lae 476 million 2004 loss ratio losses lae net earned premiums 674 2005 compared 628 2004 incurred 79 million losses lae net reinsurance hurricane katrina 2005 hurricane katrina also impacted loss ratios result 61 million reinstatement reinsurance premiums ceded 2005 effect reducing net earned premiums loss ratio 2005 benefited 49 million favorable loss lae reserve development related 2004 2003 accident years insurance subsidiaries experienced 2005 rollforward reserve losses lae net reinsurance presented foregoing rollforward shows 49 million redundancy developed 2005 reserve losses lae held december 31 2004 development 25 million 593000 respectively favorable development occurred excess surplus insurance segment’s casualty lines related 2004 2003 accident years favorable development 2005 excess surplus insurance segment’s property lines related 2004 accident year 24 million favorable development partially offset 525000 adverse development 2005 workers’ compensation insurance segment related 2004 accident year results consisting 696000 adverse development share north carolina involuntary workers’ compensation pool’s 2004 accident year results offset 171000 favorable reserve development related 2004 accident year direct business written workers’ compensation insurance segment foregoing reconciliation also shows 156000 redundancy developed 2004 reserve losses lae held december 31 2003 analysis gross reserve net reserve losses lae major line business december 31 2005 presented provided insurance coverage could reasonably expected produce material levels asbestos claims activity addition believe exposed environmental liability claims specifically underwritten priced environmental exposure asbestos environmental exposure policies issued fidelity prior june 30 2003 date acquired company subject reinsurance agreement trust agreement american empire see ‘‘ reinsurance’’ net losses paid 2005 totaled 53 million net lae paid totaled 50 million total net losses lae paid 103 million net losses paid 2004 totaled 17 million net lae paid totaled 20 million total net losses lae paid 37 million increase net losses lae paid 2004 2005 consistent growth insurance operations operating expenses 2005 totaled 284 million 375 operating expenses incurred 2004 207 million operating expenses 2005 consisted commissions net reinsurance ceding commissions earned underwriting expenses net deferred policy acquisition costs 100 million amortization deferred policy acquisition costs 172 million costs 12 million operating expenses 2004 consisted commissions underwriting expenses net deferred policy acquisition costs 70 million amortization deferred policy acquisition costs 129 million costs 879000 reinsurance ceding commissions earned 208 million 2005 compared 59 million 2004 97 million 2005 ceding commissions coming quota share reinsurance contract portion costs acquiring insurance business principally commissions certain policy underwriting issuance costs vary primarily related production insurance business deferred 2005 198 million costs deferred 108 million related commissions 90 million related acquisition expenses 2004 201 million costs deferred 134 million related commissions 67 million related acquisition expenses deferred policy acquisition costs charged operating expenses proportion premiums earned estimated policy term generally 12 months expense ratio expressed percentage operating expenses net earned premiums 242 2005 273 2004 expense ratio 2005 negatively impacted hurricane katrina whose net impact reduce operating expenses year 18 million reduce net earned premiums year 129 million resulting increase expense ratio 10 point 2004 expense ratio negatively impacted expense ratio 765 experienced workers compensation insurance segment stonewood insurances first year insurance operations workers’ compensation insurance segment expense ratio 342 2005 interest expense totaled 27 million 2005 compared 793000 2004 interest expense relates 150 million senior notes 227 million junior subordinated notes issued may december 2004 interest notes paid floating rate based threemonth libor see liquidity capital resources ‘‘senior notes junior subordinated notes’’ increase interest expense 2005 due notes outstanding full year 2005 outstanding partial year 2004 due higher threemonth libor rates 2005 2004 effective tax rate 301 2005 157 2004 income tax expense 2005 differs amount computed applying federal statutory income tax rate income taxes primarily due interest taxadvantaged state municipal securities income tax expense 2004 differs amounts computed applying federal statutory income tax rate income taxes 2004 due use net operating loss carryforwards offset taxable income period june 30 2004 established tax valuation allowance equal total deferred tax assets net existing deferred tax liabilities current income tax expense quarter ended september 30 2004 concluded likely would realize entire deferred tax asset based conclusion primarily fact generated taxable income inceptiontodate basis sufficient exhaust net operating loss carryforwards created startup phase accordingly establish valuation allowance deferred tax asset september 30 2004 period subsequent date year ended december 31 2004 compared year ended december 31 2003 direct written premiums gross written premiums increased 288 368 million 2003 1425 million 2004 since james river insurance wrote first insurance policy effective july 1 2003 stonewood insurance wrote first insurance policy effective january 1 2004 results reflect full year insurance operations insurance subsidiaries 2003 results reflect six months james river insurance operations 2003 results include revenues stonewood insurance expenses 2003 include startup costs associated stonewood insurance growth agency network addition new underwriting divisions james river insurance also contributed growth 2004 net written premiums 1202 million 2004 338 increase compared 274 million 2003 net written premiums grew 2003 larger percentage direct written premiums grew purchased less reinsurance 2004 2003 written premium ceding ratio declined 157 2004 254 2003 primarily result decision increase amount risk retain reinsurance primary casualty policies sold james river insurance 405000 10 million effective july 1 2004 also contributing decline written premium ceding ratio lower overall reinsurance costs 2004 compared 2003 addition stonewood insurance operations 2004 since written premium ceding ratio stonewood insurance 156 2004 254 ratio experienced company whole 2003 also adjustment reduce estimated ceding rate one retrospective experience rated reinsurance treaties 2004 net earned premiums grew 1389 51 million 2003 758 million 2004 premiums earned ratably terms insurance policies generally 12 months result net earned premiums first six months insurance operations 2003 low relative net written premiums period premiums earned 2003 ratable portion business written last six months year benefit business written prior periods net investment income 2004 36 million 791 407000 2003 reflecting significant growth cash invested assets 793 million december 31 2003 1952 million december 31 2004 growth cash invested assets came net premiums written offerings debt equity securities gross investment yield average cash invested assets 2004 31 gross investment yield average fixed maturity security balance 2004 35 significantly increased holdings taxadvantaged state municipal fixed maturity securities 2004 tax equivalent yield average fixed maturity security balance 36 2004 gross investment yield average cash invested assets 2003 13 low investment yield 2003 reflected low interest rate environment period particularly shortterm instruments majority assets invested cash equivalents shortterm investments 2003 hired investment managers invest available funds highquality fixed maturity securities fourth quarter 2003 fixed maturity securities purchased late year minimal impact investment yield year largest component income 2004 2003 interest earned notes receivable employees directors interest notes 117000 2004 55000 2003 increase 2004 due fact notes outstanding entire year 2004 portion 2003 realized investment losses 71000 2004 realized gains losses 2003 writedowns securities otherthantemporary impairments 2004 2003 losses lae totaled 476 million 2004 representing 1311 increase compared losses lae 34 million 2003 loss ratio improved 628 2004 663 2003 loss ratio 2004 included impact 156000 favorable loss lae reserve development 2003 accident excess surplus insurance segment experienced 2004 loss ratio 2003 negatively impacted fixed costs related claims administration expenses high relative low volume claims activity first six months insurance operations net losses paid 2004 totaled 17 million net lae paid totaled 20 million total net losses lae paid 37 million net losses paid 2003 totaled 9000 net lae paid totaled 180000 total paid net losses lae 189000 operating expenses 2004 totaled 207 million 202 operating expenses incurred 2003 68 million operating expenses 2004 consisted commissions underwriting expenses net deferred policy acquisition costs 70 million amortization deferred policy acquisition costs 129 million costs 879000 2004 201 million costs deferred 134 million related commissions 67 million related acquisition expenses expense ratio 273 2004 compared 1345 2003 expense ratio 2004 negatively impacted 765 expense ratio workers compensation insurance segment stonewood insurances first year insurance operations operating expenses 2003 included 37 million expenses incurred insurance subsidiaries build infrastructure needed prior commencing insurance operations interest expense totaled 793000 2004 interest expense related 150 million senior notes 227 million junior subordinated notes issued 2004 interest expense 2003 quarter ended september 30 2004 concluded likely would realize entire deferred tax asset based conclusion primarily generation taxable income inceptiontodate basis sufficient exhaust net operating loss carryforwards created startup phase accordingly valuation allowance established deferred tax assets december 31 2004 income tax expense 16 million recognized 2004 representing excess tax expense taxable income earned year reduction tax valuation allowance year income tax expense benefit recognized income statement 2003 deferred tax assets offset deferred tax valuation allowance results business segment organized three reportable segments separately managed business units • excess surplus insurance segment offers commercial excess surplus lines liability property products james river insurance • workers compensation insurance segment offers workers compensation insurance coverage stonewood insurance • corporate segment consists certain management treasury activities holding company interest expense associated debt intercompany reinsurance pooling agreement place james river insurance stonewood insurance intercompany reinsurance pooling agreement became effective january 1 2004 agreement called pooling business written companies january 1 2004 allocation 70 pooled premiums losses lae operating expenses james river insurance 30 stonewood insurance development december 31 2003 reserve losses lae also allocated 70 james river insurance 30 stonewood insurance 2005 james river insurance 80 share stonewood insurance 20 share intercompany pool report segment information ‘‘managements discussion analysis financial condition results operations’’ prior effects intercompany reinsurance pooling agreement evaluate operating performance reportable segments prepooling basis excess surplus insurance results excess surplus insurance segment follows 1 see ‘‘ reconciliation nongaap measure’’ underwriting results major line business within excess surplus insurance segment follows gross written premiums direct written premiums 2005 increased 555 2074 million 1334 million 2004 james river insurance wrote first insurance policy effective july 1 2003 gross direct written premiums 2003 totaled 368 million gross direct written premiums 2004 included 208 million renewal premiums gross direct written premiums 2005 included 755 million renewal premiums increase gross direct written premiums 2005 also driven increase number brokers submitting insurance business james river insurance 143 three months ended december 31 2004 199 three months ended december 31 2005 written premium ceding ratio excess surplus insurance segment 464 2005 157 2004 254 2003 increase written premium ceding ratio 2005 driven impact new quota share reinsurance contract effective january 1 2005 see ‘‘reinsurance’’ ceded written premiums related quota share treaty 2005 totaled 400 million also ceded additional 61 million reinstatement premiums reinsurers reinstate reinsurance coverage used reinsurance limits due losses hurricane katrina effects quota share contract reinstatement premiums hurricane katrina written premium ceding ratio 2005 partially offset reduction written premium ceding ratio resulting decision increase amount risk retain reinsurance primary casualty policies sold james river insurance 405000 10 million effective july 1 2004 effective july 1 2005 increased retention property excess loss treaty james river insurance 10 million november 1 2005 entered quota share reinsurance treaty reduced retention excess property coverage 750000 per risk 15 first 50 million 2004 adjusted estimated reinsurance premium ceding rate one retrospective experience rated reinsurance treaties based loss experience reinsured book business impact adjustment increase net earned premiums 2004 484000 trueup premiums earned 2003 increase losses lae incurred approximately 290000 written premium ceding ratio 2003 254 exceeded 2004 ratio primarily due lower risk retained primary casualty policies 2003 loss ratio excess surplus insurance segment 688 620 663 2005 2004 2003 respectively incurred 79 million losses lae net reinsurance hurricane katrina 2005 hurricane katrina also impacted loss ratios result 61 million ceded reinstatement premiums effect reducing net earned premiums loss ratio 2005 impacted 54 million favorable loss lae reserve development 2003 2004 accident years favorable development included 25 million 593000 respectively favorable development james river insurance casualty lines related 2004 2003 accident years favorable development 2005 also included 24 million james river insurance property lines related 2004 accident year expense ratio excess surplus insurance segment improved 201 2005 224 2004 expense ratio 2005 2004 reflected strong expense management commission expenses operating expenses use technology process administer insurance business cost efficient manner expense ratio 2005 also benefited ceding commission james river insurance received quota share reinsurance contract totaled 97 million quota share treaty also impacted expense ratio reducing net earned premiums 400 million 2005 expense ratio 2005 negatively impacted hurricane katrina reduced net earned premiums 2005 129 million operating expenses 18 million 654 expense ratio 2003 reflected high level expenses james river insurances first year operations compared relatively small amount earned premiums year workers compensation insurance results workers compensation insurance segment follows 1 see ‘‘ reconciliation nongaap measure’’ workers’ compensation insurance segment began writing business january 2004 results segment 2003 consisted 5000 investment income 12 million expenses 12 million loss taxes gross written premiums 2005 increased 336 million 92 million 2004 gross written premiums stonewood insurance 2005 included 44 million assumed premiums participation involuntary workers’ compensation pool north carolina since stonewood insurance wrote first insurance policy effective january 1 2004 results 2004 include renewal premiums direct written premiums 2005 included 76 million renewal premiums december 31 2005 137 agents workers compensation insurance segment network compared 110 december 31 2004 stonewood insurance receive ‘‘a−’’ excellent rating best april 2004 lack rating limited direct written premium production first quarter year stonewood insurance’s participation involuntary workers’ compensation pool north carolina reduced income taxes 11 million 2005 although premium rates workers’ compensation policies fixed final premium policy vary based difference estimated payroll customer time policy written final audited payroll customer policy period change estimate second quarter 2005 related premium earned workers’ compensation insurance segment result payroll audit process resulted increase income taxes 419000 written premium ceding ratio 2005 140 workers compensation insurance segment compared 156 2004 retain 500000 risk per occurrence workers compensation insurance policies risk excess 500000 200 million ceded reinsurers retain risk loss claims 200 million limit ceded reinsurers 100 million one life loss ratio workers compensation insurance segment 627 735 2005 2004 respectively loss ratio workers’ compensation insurance segment 2005 negatively impacted 952 loss ratio year stonewood insurance’s share north carolina involuntary workers’ compensation pool’s results loss ratio workers compensation insurance segment 2005 benefited 171000 favorable reserve development related direct workers’ compensation business written stonewood insurance related 2004 accident year loss ratio 2004 negatively impacted claims administration expenses high relative low volume claims activity first year workers compensation insurance operations 2004 adjusting expenses 86 net earned premiums workers compensation insurance segment expense ratio workers’ compensation insurance segment improved 342 2005 765 2004 underwriting expenses 2005 included 720000 guaranty fund assessment expenses expense ratio workers compensation insurance segment 2004 negatively impacted costs required establish infrastructure handle high volume insurance activity corporate results corporate segment follows net investment income corporate segment increased 133000 2004 803000 2005 increase net investment income 2004 2005 2003 2004 reflects use portion proceeds offerings senior notes junior subordinated notes 2004 create bond portfolio holding company also retained portion proceeds initial public offering cash invested assets holding company december 31 2005 fair value cash invested assets holding company totaled 323 million funds invested holding company insurance subsidiaries require additional capital contributions needed corporate purposes including potential acquisitions net investment income 2003 56000 reflects low interest rate environment period fact holding company’s funds 2003 invested low yielding cash equivalents income corporate segment includes interest notes receivable employees directors 52000 2005 117000 2004 55000 2003 decline interest notes receivable consistent decline amount outstanding notes receivable 26 million december 31 2004 535000 december 31 2005 interest notes receivable 2003 reflects fact notes receivable outstanding portion 2003 operating expenses corporate segment 12 million 2005 879000 2004 336000 2003 expenses corporate segment include personnel costs associated holding company employees directors fees professional fees various corporate expenses majority costs reimbursed subsidiaries amount reimbursement included primarily underwriting expenses results excess surplus insurance workers compensation insurance segments amounts expenses corporate segment presented represent expenses holding company reimbursed subsidiaries interest expense totaled 27 million 793000 2005 2004 respectively interest expense related 150 million senior notes 227 million junior subordinated notes issued may december 2004 liquidity capital resources sources uses funds organized holding company operations conducted whollyowned insurance company subsidiaries holding company receives cash loans banks issuance equity debt securities including initial public offering august 2005 corporate service fees dividends received insurance subsidiaries payments subsidiaries pursuant consolidated tax allocation agreement transactions receive corporate service fees subsidiaries reimburse us operating expenses incur reimbursement expenses corporate service fees based budgeted costs expect incur mark expected costs file consolidated federal income tax return subsidiaries corporate tax allocation agreement participant gets tax charge tax refund amount participant would paid received filed separate return basis internal revenue service may use proceeds sources contribute capital insurance subsidiaries order support premium growth repurchase common stock retire outstanding indebtedness pay interest dividends taxes business purposes payment dividends insurance subsidiaries us limited statute general restrictions require dividends paid earned surplus limit aggregate amount dividends distributions subsidiaries may declare pay within 12 month period without advance regulatory approval ohio domiciliary state james river insurance limitation greater statutory net income preceding calendar year 10 statutory surplus end preceding calendar year north carolina domiciliary state stonewood insurance limitation lesser statutory net income preceding calendar year 10 statutory surplus end preceding calendar year addition insurance regulators broad powers prevent reduction statutory surplus inadequate levels could refuse permit payment dividends maximum amounts calculated applicable formula maximum amount dividends available us insurance subsidiaries 2006 without regulatory approval 145 million december 31 2005 cash invested assets holding company totaled 323 million extent insurance subsidiaries require capital 2006 amount available holding company would anticipate issuing trust preferred securities debt holding company 2006 cash flows sources operating funds consist primarily written premiums investment income proceeds offerings debt equity securities use operating cash flows primarily pay operating expenses losses lae summary cash flows follows net cash provided operating activities 1068 million 2005 compared 805 million 2004 net cash provided operating activities years primarily attributable cash received written premiums exceeding cash disbursed operating expenses losses lae increase net cash provided operating activities reflects growth premium cash receipts 2005 compared 2004 exceeded growth cash disbursed operating expenses losses lae net cash provided operating activities 2003 totaled 110 million reflecting startup nature operations period absence insurance operations first six months 2003 net cash provided financing activities 2005 includes net proceeds 846 million initial public offering see initial public offering’’ repayment 20 million notes receivable executive officers directors april 2005 see ‘‘notes receivable employees directors’’ 2004 net cash provided financing activities 373 million included 13 million net proceeds issuance 13500 shares series b convertible preferred stock may 2004 145 million net proceeds issuance unsecured floating rate senior debentures refer senior notes 214 million net proceeds issuance junior subordinated debentures refer junior subordinated notes see ‘‘senior notes junior subordinated notes’’ used proceeds senior notes junior subordinated notes provide additional capital insurance subsidiaries working capital us 2003 issued 85000 shares series convertible preferred stock proceeds net issuance costs totaling 84 million net proceeds sale series convertible preferred stock shares 69 million received 2002 also issued 700000 series b convertible preferred stock shares 2003 proceeds net issuance costs notes receivable employees directors 672 million result transactions net cash provided financing activities 2003 totaled 688 million initial public offering may 3 2005 filed registration statement form s1 securities exchange commission initial public offering common stock registration statement declared effective august 8 2005 august 9 2005 effected 10 1 split common stock stockholders record date immediately prior closing initial public offering august 12 2005 outstanding series convertible preferred stock series b convertible preferred stock including shares representing accrued unpaid dividends converted 9956413 shares common stock addition amended restated certificate incorporation increase number authorized shares common stock 100000000 decrease number authorized shares preferred stock 5000000 gross proceeds sale 4444000 shares common stock initial public offering price per share 1800 totaled 800 million costs associated initial public offering included 56 million underwriting costs 995000 issuance costs august 26 2005 underwriters initial public offering exercised overallotment option additional 666600 shares common stock issued sold 1800 initial public offering price per share gross proceeds transaction 120 million underwriting costs 840000 used portion net proceeds initial public offering overallotment exercise contribute 520 million james river insurance 85 million stonewood insurance third quarter 2005 remaining net proceeds retained holding company provide working capital us august 8 2005 issued 416895 options purchase common stock initial public offering price 1800 per share certain employees september 13 2005 issued 35084 options purchase common stock chief executive officer exercise price 2100 per share fair value shares date grant senior notes junior subordinated notes may 2004 issued 150 million senior notes due april 29 2034 net proceeds us 145 million senior notes redeemable holder subject sinking fund requirements interest accrues quarterly payable arrears floating rate per annum equal threemonth libor plus 385 senior notes redeemable prior stated maturity option whole part may 15 2009 terms indenture senior notes contain certain covenants among things restrict assuming senior indebtedness secured common stock subsidiaries’ capital stock selling issuing shares subsidiaries’ capital stock compliance covenants indenture december 31 2005 may december 2004 sold trust preferred securities two delaware statutory business trusts sponsored whollyowned us trust used net proceeds sale trust preferred securities purchase floating rate junior subordinated notes following table summarizes nature terms junior subordinated notes trust preferred securities outstanding december 31 2005 provided full irrevocable unconditional guarantee payment obligations trusts trust preferred securities indentures junior subordinated notes contain certain organizational covenants compliance december 31 2005 december 31 2005 2004 ratio total debt outstanding total capitalization defined total debt outstanding plus total stockholders equity 176 318 respectively use capital support premium growth debt part capital structure allows us generate higher earnings per share book value per share results could using entirely equity capital support premium growth target debt total capitalization ratio 350 less notes receivable employees directors december 31 2004 notes receivable employees directors totaling 26 million issued connection sale series b convertible preferred stock notes receivable due 2013 classified reduction stockholders equity consolidated balance sheet april 2005 notes receivable executive officers directors totaling 20 million repaid borrowers additional 10000 repaid august 2005 leaving 535000 notes receivable employees executive officers outstanding december 31 2005 contractual obligations commitments following table illustrates contractual obligations commitments due date december 31 2005 reserve losses lae payments due period table based upon reserve losses lae december 31 2005 actuarial estimates expected payout patterns line business result calculation reserve losses lae payments due period subject uncertainties associated determining level reserve losses lae additional uncertainties arising difficulty predicting claims including claims yet reported us paid actual payments losses lae period vary perhaps materially table extent current estimates reserve losses lae vary actual ultimate claims amounts result variations expected actual payout patterns option may redeem senior notes junior subordinated notes 2009 100 principal amount however senior notes junior subordinated notes mature 2034 return equity one key financial measures use evaluate operating performance return equity calculate return equity dividing net income average stockholders equity period overall financial goal produce return equity least 150 longterm return equity 94 2005 116 2004 cash invested assets december 31 2005 cash invested assets consist fixed maturity securities cash equivalents december 31 2005 december 31 2004 investments fixed maturity securities carrying values fair values 3395 million 1727 million respectively fixed maturity securities classified availableforsale carried fair value unrealized gains losses securities reported net tax separate component accumulated comprehensive income loss average duration fixed maturity security portfolio december 31 2005 approximately 42 years cash invested assets per outstanding common share 2525 december 31 2005 amortized cost fair value investments fixed maturity securities follows amortized cost fair value investments fixed maturity securities summarized contractual maturity follows following table shows gross unrealized losses fair values investments aggregated investment category length time individual securities continuous unrealized loss position majority unrealized losses fixed maturity securities interest rate related two fixed maturity securities unrealized losses december 31 2005 fair values greater 93 amortized cost rated investment grade standard poor’s received equivalent rating another nationally recognized rating agency none fixed maturity securities unrealized losses ever missed delinquent scheduled principal interest payment december 31 2005 977 fixed maturity security portfolio rated ‘‘a−’’ better standard poors received equivalent rating another nationally recognized rating agency fourth quarter 2005 concluded one two securities portfolio rated investment grade standard poor’s fixed maturity security issued finance company united states automobile manufacturer experienced impairment otherthantemporary accordingly took impairment writedown 92000 security conclusion due primarily difficult operational industry issues facing issuer fact security downgraded investment grade investment grade two nationally recognized rating agencies fourth quarter 2005 appear imminent events transactions would cause value security increase significantly foreseeable future security portfolio rated investment grade unrealized loss 72000 december 31 2005 concluded security experienced otherthantemporary impairment december 31 2005 also concluded none availableforsale securities unrealized losses december 31 2005 experienced otherthantemporary impairment determining securities unrealized losses december 31 2005 experienced otherthantemporary impairment considered intent ability hold securities sufficient amount time allow recovery value cash equivalents 410 million december 31 2005 percentage cash invested assets cash equivalents 108 december 31 2005 compared 104 december 31 2004 larger percentage cash invested assets cash equivalents december 31 2005 fund expected property insurance claim payments hurricane katrina deferred policy acquisition costs portion costs acquiring insurance business principally commissions certain policy underwriting issuance costs vary primarily related production insurance business deferred policy acquisition costs totaled 139 million 155 unearned premiums net reinsurance december 31 2005 deferred policy acquisition costs totaled 113 million 171 unearned premiums net reinsurance december 31 2004 reinsurance enter reinsurance contracts limit exposure potential losses arising large risks provide additional capacity growth reinsurance refers arrangement company called reinsurer agrees contract often referred treaty assume specified risks written insurance company known ceding company paying insurance company portion insurance companys losses arising specified classes insurance policies reinsurance contracted excess loss quota share reinsurance contracts quota share reinsurance reinsurer agrees assume specified percentage ceding companys losses arising defined class business exchange corresponding percentage premium excess loss reinsurance reinsurer agrees assume portion ceding companys losses excess specified amount excess loss reinsurance premium payable reinsurer negotiated parties based assessment amount risk ceded reinsurer share proportionately ceding companys losses june 30 2004 retained approximately 500000 per risk coverages excess loss reinsurance contracts except primary casualty coverages retained 405000 per risk effective july 1 2004 increased retention primary casualty excess loss reinsurance treaty james river insurance 10 million effective july 1 2005 increased retention property excess loss reinsurance treaty james river insurance 10 million november 1 2005 entered quota share reinsurance treaty reduced retention excess property coverage 750000 per risk 15 first 50 million reinsurance contracts relieve us obligations policyholders failure reinsurer honor obligations could result losses us therefore establish allowances amounts considered uncollectible december 31 2005 allowance uncollectible reinsurance recoverables james river insurance stonewood insurance generally target reinsurers best financial strength ratings ‘‘a’’ excellent better liability coverages ‘‘a−’’ excellent better property coverages december 31 2005 reinsurance recoverables unpaid losses 1105 million reinsurance recoverables paid losses 115 million included reinsurance recoverables unpaid losses december 31 2005 441 million recoverables related hurricane katrina losses 122 million recoverables related hurricane wilma 21 million total recoverables paid unpaid losses december 31 2005 reinsurers rated ‘‘a’’ better best collateralized letters credit trust agreement american empire 459000 unsecured december 31 2005 balance collected january 2006 monitor aggregate property exposures geographic area use computer models analyze risk severe losses hurricanes earthquakes measure exposure catastrophe losses terms probable maximum loss pml estimate highest amount would expect pay one catastrophe event specified period time manage potential loss purchasing catastrophe reinsurance coverage effective june 1 2004 purchased catastrophe reinsurance coverage 50 million per event excess 20 million per event retention effective june 1 2005 increased catastrophe reinsurance coverage 360 million per event excess 20 million per event retention catastrophe reinsurance coverage place effective june 1 2005 one reinstatement event exhausted 360 million coverage ceded 27 million reinstatement premium catastrophe reinsurers 2005 additionally ceding losses hurricane wilma catastrophe reinsurance coverage effective november 1 2005 purchased additional catastrophe reinsurance coverage provides additional 65 million coverage may 31 2006 time acquisition fidelity excess surplus insurance company fidelity june 2003 fidelity reinsurance agreement parent american empire surplus lines insurance company american empire reinsurance agreement fidelity ceded liabilities insurance business wrote assumed june 30 2003 american empire american empire fidelity also entered trust agreement american empire established trust account fidelity beneficiary trust agreement american empire must maintain assets current fair value greater equal ultimate net aggregate losses recoverable reinsurance agreement cessions reinsurance agreement net third party reinsurance december 31 2005 reinsurance recoverables american empire 28 million recoverables secured trust assets 41 million reinsurance recoverables third party reinsurers associated business fidelity wrote acquired 41 million december 31 2005 event third party reinsurers default obligations recoverables would become subject reinsurance agreement american empire accordingly american empire indemnify us uncollectible third party reinsurance recoverables trust assets limited cash investments permitted ohio insurance laws none trust assets capital stock fixed income securities investment grade additional security great american insurance company great american affiliate american empire irrevocably unconditionally guaranteed performance american empire obligations reinsurance agreement trust agreement great american empire financial strength ratings ‘‘a’’ excellent best remain liable liabilities ceded reinsurance agreement event trust assets insufficient cover ultimate net aggregate losses recoverable reinsurance agreement american empire great american default respective obligations entered quota share reinsurance contract effective january 1 2005 transferred portion risk related certain propertycasualty business written james river insurance 2005 reinsurers exchange portion direct written premiums business transferring risk reinsurers also reduced amount capital required support insurance operations james river insurance terms agreement james river insurance cedes portion liability occurrence primary property business includes business written general casualty manufacturers contractors primary property divisions james river insurance receives ceding commission equal 25 ceded earned premium pays reinsurer margin equal 45 ceded earned premium quota share reinsurance contract reinsurers receive margin loss position contract ceding commission cannot reduced certain circumstances based underwriting results james river insurance entitled additional profit contingent commission amount equal reinsurers’ profits margin earn additional profit contingent commission 2005 based underwriting results business ceded treaty james river insurance maintains fundsheld account credited interest fixed rate 375 annually fundsheld account balance recorded liability consolidated balance sheet december 31 2005 balance account 220 million fundsheld account balance represents excess ceded earned premium interest credited ceded paid losses lae company’s ceding commission reinsurers’ margin assets supporting fundsheld liability segregated restricted contract loss ratio cap 115 means cannot cede losses excess 115 loss ratio reinsurer 2005 ceded earned premiums related quota share treaty 400 million ceded loss lae 365 million reinsurance ceding commissions 97 million reinsurers’ margin 0 ratings james river insurance stonewood insurance financial strength rating ‘‘a−’’ excellent best assigns 16 ratings insurance companies currently range ‘‘a’’ superior ‘‘f’’ liquidation ‘‘a−’’ excellent fourth highest rating issued best ‘‘a−’’ excellent rating assigned insurers bests opinion excellent ability meet ongoing obligations policyholders rating intended provide independent opinion insurers ability meet obligation policyholders evaluation directed investors financial strength ratings assigned best impact ability insurance companies attract retain agents brokers risk profiles submissions insurance companies receive ‘‘a−’’ excellent ratings obtained james river insurance stonewood insurance consistent companies business plans allow companies actively pursue relationships agents brokers identified marketing plans reconciliation nongaap measure underwriting profit loss insurance segments defined net earned premiums less losses lae operating expenses two insurance segments excess surplus insurance segment workers compensation insurance segment definition underwriting profit loss may comparable definition underwriting profit loss companies evaluate performance insurance segments allocate resources based primarily underwriting profit loss insurance segments believe useful measure investors evaluating performance insurance segments objective consistently earn underwriting profits following table reconciles underwriting profit loss insurance segments individual segment consolidated income loss taxes critical accounting policies estimates identified accounting policies estimates critical understanding results operations financial position critical accounting estimates defined estimates important portrayal financial condition results operations require us exercise significant judgment use significant judgment concerning future results developments applying critical accounting estimates preparing consolidated financial statements actual results may differ estimates evaluate estimates regularly using information believe relevant detailed discussion significant accounting policies see note 1 2005 audited consolidated financial statements included report reserve losses loss adjustment expenses reserve losses lae represents estimated ultimate cost reported unreported losses lae incurred unpaid balance sheet date discount reserve losses lae estimate reserve losses lae using individual casebasis valuations reported claims also use statistical analyses estimate cost losses lae incurred reported us estimates based historical information estimates future trends may affect frequency claims changes average cost claims may arise future relatively new company historical loss experience limited utilize two primary actuarial methods arrive loss reserve estimates line business one primary methods incurred bornhuetterferguson method utilizes initial expected loss ratio losses lae incurred net earned premiums expected reporting patterns losses based industry data actual reported losses lae estimate reserve primary method loss ratio method estimates reserve applying expected loss ratio net earned premiums line business methods expected loss ratio established using judgment based primarily industry data experience management team writing similar insurance coverages expected loss ratio used loss ratio method judgmentally adjusted level reported losses specific accident year line business leads us conclude ultimate loss ratio differ expected loss ratio initial expected loss ratio used incurred bornhuetterferguson method typically adjusted initially set mechanics method already incorporate departures expected reported losses reserve calculations change actuarial methods 2005 although exercise judgment estimating reserves hurricanes katrina wilma generally selected actuarial method yields highest reserve line business best estimate december 31 2005 aggregate reserve sum results selected estimates line business plus reserve losses lae associated hurricanes katrina wilma estimated described aggregate reserve reflects best estimate since selected higher two actuarial methods financial statement date aggregate reserve includes components calculated using incurred bornhuetterferguson method components calculated using loss ratio method combination methods varies line business period primary factor contributing difference methods incurred bornhuetterferguson method incorporates assumptions regarding industry reporting patterns losses reported losses lae reflected loss ratio method means incurred bornhuetterferguson method sensitive level reported losses loss ratio method events magnitude hurricanes katrina wilma occurred 2005 involve complex coverage issues aware resources may somewhat scarce affected areas accordingly established reserves case believe reflect complexity claims potential price increases associated demand labor materials storm affected areas estimating reserves losses lae relating hurricanes katrina wilma used case reserve estimates based information obtained site inspections adjusters terms coverage provided policies estimated reserves incurred reported claims using judgment based assessment property insurance exposures path storms actual results may differ materially estimates assumptions used preparing consolidated financial statements estimated net reserve december 31 2005 using incurred bornhuetterferguson method 997 million estimated net reserve december 31 2005 using loss ratio method 1044 million reserve estimates individual point estimates constitute actuarial range instances recorded reserve estimate derived using loss ratio method best reserve estimate expected loss ratio used method derived managements experience lines business write current underwriting criteria record reserve estimate derived incurred bornhuetterferguson method best estimate level actual reported losses provides sufficient evidence ultimate loss ratio exceed expected loss ratio level actual reported losses provides sufficient evidence ultimate loss ratio less expected loss ratio generally reduce expected loss ratio used loss ratio method believe generally selecting higher two primary actuarial methods line business basis best reserve estimates early stage history appropriate given insurance companies limited historical experience two primary actuarial methods utilize industry data losses casualty business often take number years develop write difficult classes business typically meet risk criteria standard carriers believe sufficient evidence time conclude ultimate loss ratios significantly better expected loss ratios generally selecting higher two primary actuarial methods basis best reserve estimates consistent belief future information becomes available us develop experience casualty business may adjust change actuarial methods future methods may necessarily result selecting highest estimate actuarial methods reserve estimates derived using incurred bornhuetterferguson method driven assumptions related expected loss ratio expected reporting pattern losses reserve estimates derived using loss ratio method driven assumptions related expected loss ratio sensitive reporting patterns reporting pattern means estimated percentage ultimate losses particular line business reported valuation date table quantifies impact reasonably likely changes two variables expected loss ratio expected reporting pattern losses would recorded reserve losses lae december 31 2005 reporting pattern scenarios apply incurred bornhuetterferguson analysis table expected loss ratio expected reporting pattern refer assumptions related two variables made calculating net reserves recorded december 31 2005 sensitivity analysis based weightedaverage assumptions presented table expected loss ratio assumptions expected loss ratio represents weightedaverage expected loss ratios used lines business expected loss ratio line weighted based net earned premiums expected reporting pattern assumptions expected reporting pattern represents weightedaverage percentage ultimate losses assumed reported us december 31 2005 lines business weighted based net earned premiums believe loss ratios 5 expected loss ratio constitute reasonable range expectations major line business addition believe adjustments made speed slow reporting patterns sensitivity analysis reasonably likely outcomes incurred bornhuetterferguson method slowing reporting pattern results increase estimate reserves reported losses seen smaller percentage ultimate reported losses resulting increase estimated unreported losses similarly using faster reporting pattern results decrease estimate reserves determining amounts slow accelerate reporting patterns sensitivity analysis presented applied judgment reflect fact variability reasonably likely reporting pattern outcomes varies major line business little variability around expected reporting patterns excess surplus insurance property lines property claims typically reported relatively quickly conversely considerably variability around expected reporting patterns excess surplus insurance casualty lines losses casualty business often take number years develop reporting patterns workers compensation insurance generally slower reporting patterns excess surplus insurance property lines generally faster reporting patterns excess surplus insurance casualty lines accordingly variability around expected reporting patterns workers compensation insurance greater excess surplus insurance property lines less excess surplus insurance casualty lines impact recording net reserve losses highest value sensitivity analysis would reduce net income 69 million reduce stockholders equity december 31 2005 39 impact recording net reserve losses lowest value sensitivity analysis would increase net income 68 million increase stockholders equity december 31 2005 39 changes net reserve losses lae would immediate impact liquidity would affect cash flow future periods incremental reduced amount losses paid reserves driven number important assumptions including litigation regulatory trends legislative activity social economic patterns claims inflation assumptions reserve estimates reflect current inflation legal claims settlements assume subject losses significant new legal liability theories reserve estimates also assume experience significant losses mass torts incur losses future mass torts known us today possible predict impact changes environment new mass torts expanded legal theories liability emerge incurred reported commonly referred ibnr claims may differ substantially ibnr reserves reserve estimates assume significant changes regulatory legislative environment impact potential changes regulatory legislative environment difficult quantify absence specific significant new regulation legislation event significant new regulation legislation attempt quantify impact business modify reserves accordingly reserve estimates assume inflation assumption implicitly built expected loss ratio continue future unexpected changes loss cost inflation occur changes general inflationary trends changes medical technology procedures changes legal theories liability estimated impact additional one percent increase loss cost inflation december 31 2005 increase loss lae reserves approximately 850000 decrease net income 553000 reduce stockholders equity 03 increase reserves would immediate impact liquidity would reduce cash flow time incremental losses paid ibnr reserve estimates inherently less precise case reserve estimates 5 change net ibnr reserves december 31 2005 would equate 47 million change reserve losses lae 31 million change net income 17 change stockholders equity although believe reserve estimates reasonable possible actual loss experience may conform assumptions specifically actual ultimate loss ratio could differ initial expected loss ratio actual reporting patterns losses could differ expected reporting patterns based industry data accordingly ultimate settlement losses related lae may vary significantly estimates included consolidated financial statements regularly review estimates adjust necessary experience develops new information becomes known us adjustments included current operations losses lae 2005 reflect 49 million favorable development reserve losses lae december 31 2004 favorable development consisted 54 million favorable development excess surplus insurance segment offset 525000 adverse development workers’ compensation insurance segment see ‘‘results operations’’ losses lae 2004 reflect 156000 favorable development reserve losses lae held december 31 2003 investments evaluate investments regularly determine whether declines value otherthantemporary determine security experienced otherthantemporary impairment recognized realized investment loss consider number factors assessing whether impairment otherthantemporary including amount percentage fair value amortized cost length time fair value amortized cost credit quality ratings securities special emphasis securities downgraded investment grade also consider intent ability hold security sufficient period time allow recovery value recognized impairment loss 92000 2005 fixed maturity security portfolio see cash invested assets recognize impairment losses 2004 2003 carry securities classified ‘‘availableforsale’’ fair value unrealized gains losses securities net deferred taxes reported separate component accumulated comprehensive income securities classified ‘‘heldtomaturity’’ ‘‘trading’’ income taxes review need valuation allowance related deferred tax assets quarter reduce deferred tax assets valuation allowance determine likely portion deferred tax assets realized assessment whether valuation allowance needed requires us use significant judgment assessment includes consideration amount taxable income generated since formed 2002 trends earnings future expectations income tax expense 2004 reflects reduction deferred tax valuation allowance 19 million establish valuation allowance deferred tax assets december 31 2005 2004 deferred tax assets liabilities measured using enacted tax rates expected apply taxable income years temporary differences financial statement carrying amounts assets liabilities respective tax bases expected recovered settled reinsurance treaties james river insurance contain retrospective experience rated provisions cost reinsurance purchased james river insurance amount ceding commission james river insurance receives reinsurers varies based level incurred losses ceded reinsurers subject maximum minimum specified reinsurance contract estimate ultimate loss experience determining amounts record consolidated financial statements premiums ceded reinsurers ceding commissions earned james river insurance loss experience develops adjust ceded premium rates ceding commission rates reflect loss experience although believe estimates reasonable possible actual loss experience may conform assumptions regularly review estimates adjust necessary experience develops new information becomes known adjustments included current operations impact adjustments 2004 increase net earned premiums 2004 484000 trueup premiums earned 2003 increase losses lae approximately 290000 adjustments 2004 related one reinsurance treaty effective july 1 2003 june 30 2004 adjustments assumptions related retrospective experience rated reinsurance provisions 2005 reinsurance premiums commissions losses lae reinsured business accounted basis consistent used accounting original policies issued terms reinsurance contracts reinsurance recoverables prepaid reinsurance premiums reported assets amounts payable reinsurers receivable reinsurers netted right offset exists receive ceding commissions connection certain ceded reinsurance ceding commissions recorded reduction operating expenses intangible insurance assets possess intangible insurance assets indefinite life financial accounting standards board fasb statement 142 goodwill intangible assets prescribes intangible asset indefinite useful life amortized instead tested impairment least annual basis based comparison fair value carrying value performing impairment evaluation intangible assets first determine intangible assets purchased continue indefinite life next determine fair value intangible assets compare fair value carrying value carrying value exceeds fair value recognize impairment writedown fair value intangible asset impairment reported earnings impairment writedowns years ended december 31 2005 2004 2003 see note 1 audited consolidated financial statements included elsewhere annual report discussion significant accounting policies acquisition summary june 30 2003 acquired fidelity renamed james river insurance company american empire surplus lines insurance company american empire member american financial group purchase price totaled 289 million including 84000 acquisition expenses purchase fidelity acquired surplus lines approval 40 states district columbia insurance licenses four states recorded intangible insurance assets 42 million connection purchase intangible insurance assets arise regulatory approvals granted various state insurance departments write insurance business excess surplus lines basis states regulatory approvals granted routinely renew little cost provided complied rules regulations expect cash flows related regulatory approvals transact insurance business continue indefinitely concluded intangible assets indefinite lives fidelity ceded liabilities insurance business wrote assumed june 30 2003 american empire american empire fidelity also entered trust agreement american empire established trust account fidelity beneficiary trust agreement american empire must maintain assets current fair value greater equal ultimate net aggregate losses recoverable reinsurance agreement additional security great american irrevocably unconditionally guaranteed performance american empire obligations reinsurance agreement trust agreement see ‘‘reinsurance’’ recent accounting pronouncements december 16 2004 fasb issued statement 123 revised 2004 sharebased payment statement 123r revision statement 123 accounting stockbased compensation statement 123r supersedes accounting principles board opinion 25 accounting stock issued employees apb opinion 25 amends fasb statement 95 statement cash flows statement 123r requires sharebased payments employees including grants stock options recognized financial statements based fair values statement 123r pro forma disclosure longer alternative financial statement recognition stock option awards made adoption statement 123r adopted statement 123r january 1 2006 awards issued prior may 3 2005 date filed form s1 securities exchange commission use minimum value method calculate pro forma disclosures required statement 123 adopted statement 123r january 1 2006 continued account portion awards outstanding prior may 3 2005 using provisions apb opinion 25 related interpretive guidance awards issued may 3 2005 awards modified repurchased cancelled date use fair value method calculate pro forma disclosures required statement 123 adopted statement 123r january 1 2006 began recognizing expense associated awards consolidated statement operations award’s remaining vesting period using modified prospective method compensation expense 2006 associated options granted subsequent may 3 2005 expected approximately 900000 amount terms fair values awards issued future uncertain total impact adoption statement 123r financial statements known time november 2005 fasb issued fsp fas 1151 meaning otherthantemporary impairment application certain investments fsp 1151 addresses determination investment considered impaired whether impairment otherthantemporary measurement impairment loss fsp also includes accounting considerations subsequent recognition otherthantemporary impairment requires certain disclosures unrealized losses recognized otherthantemporary impairments fsp 1151 amends fasb statement 115 accounting certain investments debt equity securities nullifies certain requirements eitf 031 meaning otherthantemporary impairments application certain investments fsp 1151 effective reporting periods beginning december 15 2005 believe existing policies recognizing otherthantemporary impairments consistent guidance fsp 1151 therefore adoption fsp 1151 expected material impact consolidated financial condition results operations outlook 2006 anticipate achieving annual return equity least 15 writing combined ratio 80 90 also expect growth gross written premiums 20 30 2006 item 7a item 7a quantitative qualitative disclosures market risk market risk potential economic loss arising principally adverse changes fair value financial instruments major components market risk affecting us credit risk interest rate risk credit risk credit risk potential economic loss arising principally adverse changes financial condition specific debt issuer reinsurer address risk associated debt issuers investing fixed maturity securities investment grade securities rated “bbb” higher standard poor’s received equivalent rating another nationally recognized rating agency monitor financial condition issuers fixed maturity securities portfolio outside investment managers assist us process utilize ratings changes report security watch list schedule securities unrealized loss positions part process security rated “bbb” higher standard poor’s time purchase downgraded “bbb” hold evaluate security impairment discussing security investment advisors make decision either dispose security continue hold finally employ stringent diversification rules limit credit exposure single issuer business sector address risk associated reinsurers generally targeting reinsurers best financial strength ratings “a” excellent better effort minimize exposure insolvency reinsurers security committee consisting chief financial officer corporate actuary evaluates acceptability reviews financial condition reinsurer annually addition security committee continually monitors rating downgrades involving reinsurers december 31 2006 11 million reinsurance recoverables either companies best ratings “a” excellent better collateralized letter credit trust agreement interest rate risk interest rate risk may incur economic losses due adverse changes interest rates primary market risk investment portfolio interest rate risk associated investments fixed maturity securities fluctuations interest rates direct impact market valuation securities fixed maturity securities fair value 4860 million december 31 2006 subject interest rate risk manage exposure interest rate risk assetliability matching process management risk characteristics duration credit variability cash flows critical elements risks assessed regularly balanced within context liability capital position outside investment managers assist us process sensitivity analysis table illustrates sensitivity fair value fixed maturity securities selected hypothetical changes interest rates december 31 2006 selected scenarios predictions future events rather illustrate effect events may fair value fixed maturity securities stockholders’ equity fourth quarter 2006 company began investing equity securities principally various market indices equity securities produced higher returns fixed maturity investments long run sensitive shortterm fluctuations equity markets december 31 2006 equity portfolio total fair value 87 million hypothetical 20 increase fair value equity securities would increase fair value 104 million increase stockholders’ equity 05 alternatively 20 decrease fair value equity securities would decrease fair value 70 million decrease stockholders’ equity 05 interest expense would also affected hypothetical change interest rates december 31 2006 583 million floating rate debt consisting 150 million senior notes 433 million junior subordinated notes assuming amount remains constant hypothetical 100 basis point increase interest rates would increase annual interest expense 583000 200 basis point increase would increase interest expense 12 million hypothetical 100 basis point decrease interest rates would reduce annual interest expense 583000 200 basis point decrease would reduce interest expense 12 million item 8 item 7a quantitative qualitative disclosures market risk market risk potential economic loss principally arising adverse changes fair value financial instruments major components market risk affecting us credit risk interest rate risk credit risk credit risk potential economic loss principally arising adverse changes financial condition specific debt issuer reinsurer address risk associated debt issuers investing fixed maturity securities investment grade securities rated ‘‘bbb−’’ higher standard poors monitor financial condition issuers fixed maturity securities portfolio outside investment managers assist us process utilize ratings changes report security watch list schedule securities unrealized loss positions part process security rated ‘‘bbb−’’ higher standard poors time purchase downgraded ‘‘bbb−’’ hold evaluate security impairment discussing security investment advisors make decision either dispose security continue hold finally employ stringent diversification rules limit credit exposure single issuer business sector address risk associated reinsurers generally targeting reinsurers best financial strength ratings ‘‘a’’ excellent better liability coverages ‘‘a−’’ excellent better property coverages effort minimize exposure insolvency reinsurers security committee consisting chief financial officer corporate actuary evaluates acceptability reviews financial condition reinsurer annually addition security committee continually monitors rating downgrades involving reinsurers december 31 2005 16 million reinsurance recoverables either companies best ratings ‘‘a’’ excellent better collateralized letter credit trust agreement american empire explained collected january 2006 address risk associated business fidelity wrote acquired monitoring trust assets trust account established american empire pursuant reinsurance agreement american empire obligated ensure assets trust equal greater ultimate net aggregate losses recoverable reinsurance agreement american empire also monitor amount reinsurance recoverables third party reinsurers business written fidelity prior acquisition since recoverables become subject reinsurance agreement american empire third party reinsurers default obligations december 31 2005 trust assets fair value 41 million exceeded 28 million reinsurance recoverables american empire date recoverables third party reinsurers associated business fidelity wrote acquired totaled 41 million december 31 2005 additional security great american insurance company affiliate american empire unconditionally guaranteed performance american empire obligations reinsurance agreement trust agreement interest rate risk interest rate risk may incur economic losses due adverse changes interest rates primary market risk investment portfolio interest rate risk associated investments fixed maturity securities fluctuations interest rates direct impact market valuation securities fixed maturity securities fair value 3395 million december 31 2005 subject interest rate risk manage exposure interest rate risk assetliability matching process management risk characteristics duration credit variability cash flows critical elements risks assessed regularly balanced within context liability capital position outside investment managers assist us process sensitivity analysis table illustrates sensitivity fair value fixed maturity securities selected hypothetical changes interest rates december 31 2005 selected scenarios predictions future events rather illustrate effect events may fair value fixed maturity securities stockholders equity interest expense would also affected hypothetical change interest rates december 31 2005 377 million floating rate debt consisting 150 million senior notes 227 million junior subordinated notes assuming amount remains constant hypothetical 100 basis point increase interest rates would increase annual interest expense 377000 200 basis point increase would increase interest expense 754000 hypothetical 100 basis point decrease interest rates would reduce annual interest expense 377000 200 basis point decrease would reduce interest expense 754000 item 8 item 8 financial statements supplementary data financial statements financial statement schedules listed accompanying index consolidated financial statements schedules filed part report item 9 item 8 financial statements supplementary data financial statements financial statement schedules listed accompanying index consolidated financial statements schedules filed part report item 9 item 15 exhibits financial statement schedules documents filed part report financial statements financial statement schedules listed accompanying index consolidated financial statements schedules filed part report exhibits listed accompanying index exhibits filed part report b exhibits see item 15a c schedules see item 15a schedules provision made applicable accounting regulations securities exchange commission required related instructions inapplicable therefore omitted page report independent registered public accounting firm consolidated balance sheets december 31 2006 2005 consolidated income statements years ended december 31 2006 2005 2004 consolidated statements changes stockholders’ equity years ended december 31 2006 2005 2004 consolidated statements cash flows years ended december 31 2006 2005 2004 notes consolidated financial statements years ended december 31 2006 2005 2004 schedule summary investments s1 schedule ii condensed financial information registrant s2 schedule iii supplementary insurance information s7 signatures pursuant requirements section 13 15d securities exchange act 1934 amended registrant duly caused report signed behalf undersigned thereunto duly authorized james river group inc date march 8 2007 j adam abram j adam abram president chief executive officer pursuant requirements securities exchange act 1934 amended report signed following persons behalf registrant capacities dates indicated signature title date richard w wright chairman board march 7 2007 richard w wright j adam abram president chief executive officer march 8 2007 j adam abram director michael oakes executive vice president march 8 2007 michael oakes chief financial officer gregg davis executive vice president finance march 8 2007 gregg davis treasurer matthew bronfman director march 6 2007 matthew bronfman alan n colner director march 6 2007 alan n colner joel l fleishman director march 6 2007 joel l fleishman dallas w luby director march 8 2007 dallas w luby john sinnott director march 3 2007 john sinnott michael h steinhardt director march 2 2007 michael h steinhardt wellford tabor director march 1 2007 wellford tabor james l zech director march 8 2007 james l zech nicolas zerbib director march 8 2007 nicolas zerbib index financial statements schedules page report independent registered public accounting firm consolidated balance sheets december 31 2006 2005 consolidated income statements years ended december 31 2006 2005 2004 consolidated statements changes stockholders’ equity years ended december 31 2006 2005 2004 consolidated statements cash flows years ended december 31 2006 2005 2004 notes consolidated financial statements years ended december 31 2006 2005 2004 schedule summary investments s1 schedule ii condensed financial information registrant s2 schedule iii supplementary insurance information s7 report independent registered public accounting firm board directors stockholders james river group inc audited accompanying consolidated balance sheets james river group inc subsidiaries december 31 2006 2005 related consolidated statements income changes stockholders’ equity cash flows three years period ended december 31 2006 audits also included financial statement schedules listed index item 15a financial statements schedules responsibility company’s management responsibility express opinion financial statements schedules based audits conducted audits accordance standards public company accounting oversight board united states standards require plan perform audit obtain reasonable assurance whether financial statements free material misstatement audit includes examining test basis evidence supporting amounts disclosures financial statements audit also includes assessing accounting principles used significant estimates made management well evaluating overall financial statement presentation believe audits provide reasonable basis opinion financial statements referred present fairly material respects consolidated financial position james river group inc subsidiaries december 31 2006 2005 consolidated results operations cash flows three years period ended december 31 2006 conformity us generally accepted accounting principles also opinion related financial statement schedules considered relation basic financial statements taken whole present fairly material respects information set forth therein discussed note 1 consolidated financial statements 2006 james river group inc subsidiaries changed method accounting sharebased payments also audited accordance standards public company accounting oversight board united states effectiveness company’s internal control financial reporting december 31 2006 based criteria established internal control integrated framework issued committee sponsoring organizations treadway commission report dated march 5 2007 expressed unqualified opinion thereon ernst young llp richmond virginia march 5 2007 james river group inc subsidiaries consolidated balance sheets see accompanying notes james river group inc subsidiaries consolidated balance sheets continued see accompanying notes james river group inc subsidiaries consolidated income statements see accompanying notes james river group inc subsidiaries consolidated statements changes stockholders’ equity thousands except share data see accompanying notes james river group inc subsidiaries consolidated statements cash flows see accompanying notes james river group inc subsidiaries notes consolidated financial statements years ended december 2006 2005 2004 1 accounting policies organization james river group inc subsidiaries referred company delawaredomiciled holding company organized purpose acquiring managing insurance entities consolidated financial statements include results james river group inc following whollyowned subsidiaries respective dates inception acquisition applicable james river insurance company james river insurance ohiodomiciled excess surplus lines insurance company authorized write business 48 states district columbia james river management company inc provides management services james river insurance potomac risk services inc potomac formed 2004 provide surplus lines brokerage services potomac operating activities 2006 2005 2004 stonewood insurance company stonewood insurance north carolinadomiciled workers’ compensation insurance company licensed november 2003 write insurance primarily residential construction industry north carolina stonewood insurance begin writing workers’ compensation coverage virginia early 2007 stonewood insurance management company inc provides management services stonewood insurance basis presentation consolidated financial statements notes prepared accordance united states generally accepted accounting principles insurance company subsidiaries vary respects statutory accounting practices prescribed permitted various state insurance departments significant intercompany transactions balances eliminated preparation consolidated financial statements conformity united states generally accepted accounting principles requires management make estimates assumptions affect amounts reported consolidated financial statements accompanying disclosures estimates inherently subject change actual results may ultimately differ estimates james river group inc subsidiaries notes consolidated financial statements years ended december 2006 2005 2004 1 accounting policies continued investments fixed maturity securities equity securities classified “availableforsale” carried fair value unrealized gains losses securities net deferred taxes reported separate component accumulated comprehensive income loss company securities classified “heldtomaturity” “trading” fair value generally represents quoted market value prices securities traded public marketplace prices analytically determined using bid closing prices securities traded public marketplace premiums discounts mortgagebacked securities assetbacked securities amortized accrued using constant yield method considers anticipated prepayments date purchase extent estimated lives securities change result changes estimated prepayment rates adjustments included net investment income using retrospective method realized investment gains losses determined specific identification basis interest income recognized earned dividend income recognized exdividend date company evaluates investments regularly determine whether declines value otherthantemporary company determines security experienced otherthantemporary impairment loss recognized realized investment loss factors company considers evaluating whether otherthantemporary impairment occurred include amount percentage fair value amortized cost b length time fair value amortized cost c company’s intent ability hold security sufficient period time allow recovery value fixed maturity securities company considers credit quality rating security special emphasis securities downgraded investment grade shortterm investments reported cost include investments readily convertible known amounts cash maturities 12 months less upon acquisition company cash equivalents company considers highly liquid investments maturities three months less date purchase cash equivalents premiums earned pro rata basis terms policies generally 12 months portion premiums written applicable unexpired terms policies force recorded unearned premiums receivable agents’ balances premiums receivable agents’ balances carried face value net allowance doubtful accounts approximates fair value allowance doubtful accounts represents estimate amounts considered uncollectible based company’s assessment collectibility receivables past due allowance doubtful accounts 13 million 485000 december 31 2006 december 31 2005 respectively bad debt expense 11 million 2006 444000 2005 86000 2004 receivables written allowance doubtful accounts totaled 265000 2006 45000 2005 0 2004 account balances charged allowance means collection exhausted potential recovery considered remote james river group inc subsidiaries notes consolidated financial statements years ended december 2006 2005 2004 1 accounting policies continued deferred policy acquisition costs vary primarily related production insurance business deferred principal costs deferred commissions agents certain policy underwriting issue costs net ceding commissions related reinsurance ceded amortization policy acquisition costs charged expense proportion premium earned estimated policy life extent unearned premiums existing policies adequate cover related costs expenses deferred policy acquisition costs charged earnings company considers anticipated investment income determining whether premium deficiency exists reserve losses loss adjustment expenses reserve losses loss adjustment expenses represents estimated ultimate cost reported unreported losses loss adjustment expenses incurred unpaid balance sheet date company discount reserve losses loss adjustment expenses estimated using individual casebasis valuations statistical analyses estimates subject effects trends loss severity frequency management limited historical loss information available making loss reserve estimates company utilized two primary actuarial methods arrive loss reserve estimates first method utilizes management’s initial expected loss ratio losses loss adjustment expenses incurred net earned premiums expected reporting patterns losses based insurance industry data company’s actual reported losses loss adjustment expenses estimate reserve primary method estimates reserve applying expected loss ratio net earned premiums line business management generally selected actuarial method yields highest reserve line business best estimate management believes practice using higher two methods appropriate since company limited historical experience two primary actuarial methods utilize industry data losses company’s casualty business often take number years develop company writes difficult classes business typically meet risk criteria standard carriers events magnitude hurricanes katrina wilma involve complex coverage issues estimating reserve losses loss adjustment expenses hurricanes katrina wilma occurred 2005 management used case reserve estimates based information obtained site inspections company’s adjustors terms coverage provided policies management estimated reserves incurred reported claims hurricanes katrina wilma using judgment based assessment property insurance exposures path storms company’s progress settling claims december 31 2006 aggregate reserve losses loss adjustment expenses sum results selected actuarial method line business plus reserve losses loss adjustment expenses associated hurricanes katrina wilma estimated described although management believes reserve losses loss adjustment expenses reasonable possible company’s actual incurred losses loss adjustment expenses conform assumptions inherent determination reserves specifically company’s actual ultimate loss ratio could differ management’s initial expected loss ratio company’s actual reporting patterns losses could differ expected reporting patterns based industry data accordingly ultimate settlement losses related loss adjustment expenses may vary significantly estimates included company’s financial statements estimates reviewed continually management adjusted necessary experience develops new information becomes known adjustments included current operations james river group inc subsidiaries notes consolidated financial statements years ended december 2006 2005 2004 1 accounting policies continued reinsurance certain premiums losses ceded insurance companies various excess loss quotashare reinsurance contracts company enters reinsurance contracts limit exposure large losses provide additional capacity growth reinsurance premiums commissions losses loss adjustment expenses reinsured business accounted basis consistent used accounting original policies issued terms reinsurance contracts reinsurance recoverables prepaid reinsurance premiums reported assets amounts payable reinsurers receivable reinsurers netted right offset exists company receives ceding commissions connection certain ceded reinsurance ceding commissions recorded reduction operating expenses income taxes deferred tax assets deferred tax liabilities provided future tax consequences attributable temporary differences financial statement carrying amounts assets liabilities respective tax bases deferred tax assets liabilities measured using enacted tax rates expected apply taxable income years temporary differences expected recovered settled deferred tax assets reduced valuation allowance management believes likely deferred tax assets realized intangible insurance assets company accounts intangible assets accordance financial accounting standards board fasb statement 142 goodwill intangible assets statement 142 management determined company’s intangible assets indefinite life statement 142 requires intangible assets indefinite useful lives capitalized tested impairment least annually evaluating whether impairment intangible asset management determines fair value intangible asset compares resulting fair value carrying value intangible asset carrying value exceeds fair value intangible asset written fair value impairment reported earnings property equipment net property equipment reported cost less accumulated depreciation depreciated principally straightline basis estimated useful lives generally three ten years depreciable assets james river group inc subsidiaries notes consolidated financial statements years ended december 2006 2005 2004 1 accounting policies continued new accounting standards stock based compensation december 16 2004 financial accounting standards board fasb issued statement 123 revised 2004 sharebased payment statement 123r revision statement 123 accounting stockbased compensation statement 123r supersedes accounting principles board opinion 25 accounting stock issued employees apb opinion 25 amends fasb statement 95 statement cash flows company adopted statement 123r using modified prospective method january 1 2006 prior adoption statement 123r company accounted stock option grants using intrinsic value method prescribed apb opinion 25 accordingly pro forma disclosures required statement 123 company used minimum value method estimating compensation expense options issued prior may 3 2005 date company filed form s1 securities exchange commission used fair value method estimating compensation expense options issued subsequent may 3 2005 result compensation expense recognized company’s financial statements prior january 1 2006 options granted prior january 1 2006 exercise price equal market value underlying common stock date grant january 1 2006 company adopted fair value recognition provisions statement 123r using modified prospective method options granted subsequent may 3 2005 options granted prior may 3 2005 modified repurchased cancelled subsequent january 1 2006 expense amounts recognized straightline basis award’s vesting period company’s income statement expense recognized company’s financial statements related options issued prior may 3 2005 long options modified repurchased cancelled date options granted prior may 3 2005 modified repurchased cancelled result adopting statement 123r january 1 2006 company recognized 986000 operating expenses sharebased compensation related tax benefit 346000 2006 company’s income taxes net income 2006 986000 640000 lower respectively company continued account sharebased compensation apb opinion 25 basic diluted earnings per share 2006 004 003 lower respectively company continued account sharebased compensation apb opinion 25 adoption statement 123r material effect company’s statement cash flows prior period financial statements restated result adoption statement 123r purposes pro forma disclosures required statement 123r estimated value options amortized expense option’s vesting period awards issued prior may 3 2005 excluded pro forma disclosure minimum value method used determine value awards issued may 3 2005 fair value method used following table summarizes effect net income earnings per share fair value method applied year ended december 31 2005 thousands except per share data james river group inc subsidiaries notes consolidated financial statements years ended december 2006 2005 2004 recent accounting pronouncements june 2006 fasb issued fasb interpretation 48 accounting uncertainty income taxes interpretation fasb statement 109 fin 48 fin 48 clarifies accounting uncertain tax positions interpretation prescribes recognition threshold measurement attribute financial statement recognition measurement tax position taken expected taken tax return fin 48 effective fiscal years beginning december 15 2006 earlier adoption permitted company currently evaluating impact adopting fin 48 anticipate adoption material impact company’s financial position results operations 2007 september 2006 fasb issued statement 157 fair value measurements statement 157 statement 157 defines fair value establishes framework measuring fair value generally accepted accounting principles expands disclosures fair value measurements statement 157 effective financial statements issued fiscal years beginning november 15 2007 earlier application encouraged company currently evaluating impact adopting statement 157 financial statements 2 earnings per share common stock data per share amounts periods reflect tenforone split company’s common stock effective august 9 2005 shareholders record date james river group inc subsidiaries notes consolidated financial statements years ended december 2006 2005 2004 3 investments company’s investments availableforsale securities summarized follows 2004 portion 2005 company investment bond mutual fund classified equity security consolidated balance sheet james river group inc subsidiaries notes consolidated financial statements years ended december 2006 2005 2004 3 investments continued amortized cost fair value investments fixed maturity securities december 31 2006 summarized contractual maturity follows actual maturities may differ securities borrowers right call prepay obligations without penalties following table shows company’s gross unrealized losses fair value aggregated investment category length time individual securities continuous unrealized loss position james river group inc subsidiaries notes consolidated financial statements years ended december 2006 2005 2004 3 investments continued majority unrealized losses fixed maturity securities interest rate related fixed maturity securities unrealized loss december 31 2006 fair value greater 92 amortized cost three rated investment grade standard poor’s another nationally recognized rating agency fixed maturity securities ratings investment grade december 31 2006 aggregate fair value 15 million aggregate net unrealized gain 25000 december 31 2006 company held 366 securities unrealized loss position total fair value 2870 million gross unrealized losses 55 million none fixed maturity securities unrealized losses ever missed delinquent scheduled principal interest payment december 31 2006 969 company’s fixed maturity security portfolio rated “a” better standard poor’s received equivalent rating another nationally recognized rating agency management concluded none fixed maturity securities unrealized loss december 31 2006 experienced otherthantemporary impairment management considered intent ability hold securities sufficient time allow recovery value determination fourth quarter 2005 company realized impairment writedown 92000 one security management concluded security experienced impairment otherthantemporary due primarily difficult operational industry issues facing issuer fact security downgraded investment grade investment grade two nationally recognized rating agencies fourth quarter 2005 appear imminent events transactions would cause value security increase significantly foreseeable future james river group inc subsidiaries notes consolidated financial statements years ended december 2006 2005 2004 3 investments continued major categories company’s net investment income summarized follows company’s realized gains losses investments summarized follows following table summarizes change company’s gross unrealized gains losses investment type december 31 2006 2005 investments fair value 97 million 90 million respectively deposit state insurance departments satisfy regulatory requirements james river group inc subsidiaries notes consolidated financial statements years ended december 2006 2005 2004 4 deferred policy acquisition costs analysis deferred policy acquisition costs follows 5 intangible insurance assets intangible insurance assets consist authority write insurance excess surplus lines basis 40 states district columbia acquired 2003 intangible assets arise regulatory approvals granted various state insurance departments write insurance business respective states nonadmitted basis insurance authorities granted routinely renewed little cost provided insurer complied rules regulations cash flows related regulatory approvals transact insurance business expected continue indefinitely management concluded intangible assets indefinite life accordingly impairment write recognized assets 6 property equipment net property equipment consists following james river group inc subsidiaries notes consolidated financial statements years ended december 2006 2005 2004 7 reserve losses loss adjustment expenses following table provides reconciliation beginning ending reserve balances losses loss adjustment expenses net reinsurance gross amounts reported consolidated balance sheet foregoing reconciliation shows 79 million redundancy developed 2006 reserve losses loss adjustment expenses held december 31 2005 favorable reserve development included 77 million favorable development excess surplus insurance segment 235000 favorable development direct business written workers’ compensation insurance segment excess surplus insurance segment favorable development included 37 million favorable development casualty lines 2004 accident year 42 million favorable development casualty lines 2005 accident year partially offset 780000 adverse development property lines 2005 accident year primarily related 2005 hurricanes foregoing reconciliation shows 49 million redundancy developed 2005 reserve losses loss adjustment expenses held december 31 2004 favorable reserve development consisted 54 million favorable development excess surplus insurance segment offset 525000 adverse development workers’ compensation insurance segment excess surplus insurance segment favorable development included 25 million favorable development casualty lines 2004 accident year 24 million favorable development property lines 2004 accident year 593000 favorable development casualty lines 2003 accident year workers’ compensation insurance segment reserve development consisted 696000 adverse development related company’s share north carolina involuntary workers’ compensation pool’s 2004 accident year results offset 171000 favorable development direct business written workers’ compensation insurance segment 2004 accident year foregoing reconciliation also shows 156000 redundancy developed 2004 reserve losses loss adjustment expenses held december 31 2003 james river group inc subsidiaries notes consolidated financial statements years ended december 2006 2005 2004 7 reserve losses loss adjustment expenses continued company provided insurance coverage could reasonably expected produce material levels asbestos claims activity addition company believe exposed environmental liability claims specifically underwritten priced environmental exposure asbestos environmental exposure policies issued fidelity excess surplus insurance company fidelity prior july 1 2003 subject reinsurance agreement trust agreement see note 8 reinsurance company’s insurance subsidiaries remain liable policyholders reinsurers unable meet contractual obligations applicable reinsurance agreements minimize exposure significant losses reinsurance insolvencies company evaluates financial condition reinsurers monitors concentrations credit risk company’s reinsurance contracts generally require reinsurers authorized reinsurers state insurance regulations experience rating downgrades rating agencies specified levels fund share company’s ceded outstanding losses loss adjustment expense reserves typically use irrevocable unconditional letter credit december 31 2006 company reinsurance recoverables unpaid losses 905 million reinsurance recoverables paid losses 70 million 11 million reinsurance recoverables december 31 2006 companies best ratings “a” excellent better collateralized letters credit trust agreement american empire surplus lines insurance company american empire including 10 million single reinsurer longer writing new insurance business december 31 2006 reinsurance recoverables paid unpaid losses three reinsurers 187 million 122 million 82 million representing approximately 400 total balance reinsurance recoverables american empire totaled 34 million representing approximately 35 total balance reinsurance recoverables outstanding december 31 2006 december 31 2006 prepaid reinsurance premiums three reinsurers totaled 85 million 67 million 49 million representing approximately 637 total balance company entered quota share reinsurance contract effective january 1 2005 transferred portion risk related certain propertycasualty insurance business written james river insurance 2005 reinsurers exchange portion direct written premiums business transferring risk reinsurers also reduced amount capital required support insurance operations james river insurance quota share reinsurance contract company received ceding commission equal 25 ceded earned premium paid reinsurance margin equal 45 ceded earned premium reinsurers receive margin loss position contract ceding commission reduced certain circumstances based underwriting results company entitled additional profit contingent commission amount equal reinsurers’ profits margin company earn additional profit contingent commission 2005 2006 based underwriting results business ceded treaty company maintains funds held account credited interest rate 375 annually funds held account shown liability accompanying consolidated balance sheets december 31 2006 2005 balance account 156 million 220 million respectively funds held account balance represents excess ceded earned premium interest credited ceded paid losses loss adjustment expenses company’s ceding commission reinsurers’ margin assets supporting funds held liability segregated restricted contract loss ratio cap 115 means company cede losses excess 115 ceded earned premiums reinsurers 2005 ceded earned premiums related quota share reinsurance treaty 400 million ceded losses loss adjustment expenses 365 million reinsurance ceding commissions 97 million reinsurers’ margin 0 year ended december 31 2006 impact quota share reinsurance treaty reduce pretax income 234000 quota share reinsurance treaty renewed 2006 june 30 2003 company acquired outstanding stock fidelity renamed james river insurance company fidelity certain insurance liabilities ceded parent american empire reinsurance agreement reinsurance agreement june 30 2003 immediately prior closing reinsurance agreement amended fidelity ceded liabilities resulting direct assumed business written june 30 2003 american empire reinsurance agreement amended secured trust agreement fidelity american james river group inc subsidiaries notes consolidated financial statements years ended december 2006 2005 2004 8 reinsurance continued empire trust agreement irrevocable unconditional guarantee great american insurance company affiliate american empire december 31 2006 fair value assets trust 42 million exceeded 34 million reinsurance recoverables american empire reinsurance activity summarized follows assumed earned premiums percentage net earned premiums 15 24 00 years ended december 31 2006 2005 2004 respectively assumed written premiums 36 million 44 million 0 years ended december 31 2006 2005 2004 respectively 9 senior debt may 26 2004 james river group inc issued 150 million unsecured floating rate senior debentures senior debt due april 29 2034 unless accelerated earlier indenture senior debt redeemable holder subject sinking fund requirements net proceeds company totaled 145 million used provide capital company’s insurance subsidiaries additional working capital company interest accrues quarterly payable arrears per annum rate threemonth libor determination date defined indenture plus 385 senior debt redeemable prior stated maturity option company whole part may 15 2009 b entirety time prior may 15 2009 upon occurrence continuation certain tax event generally defined change united states tax law whereby interest payable company longer deductible federal income tax purposes terms indenture generally provide long senior debt outstanding neither company subsidiaries may • assume permit exist indebtedness secured encumbrance capital stock company subsidiaries senior debt • issue sell transfer otherwise dispose shares securities convertible warrants rights options subscribe purchase shares capital stock subsidiary company compliance covenants indenture december 31 2006 interest payable included accrued expenses accompanying consolidated balance sheets james river group inc subsidiaries notes consolidated financial statements years ended december 2006 2005 2004 10 junior subordinated debt james river group inc arranged sale trust preferred securities trust preferred securities james river capital trust james river capital trust ii james river capital trust iii trust collectively trusts delaware statutory trusts sponsored whollyowned company trust created solely purpose issuing trust preferred securities accordance fasb interpretation 46 consolidation variable interest entities interpretation arb 51 trusts consolidated company financial statements trust used proceeds sale trust preferred securities purchase company’s floating rate junior subordinated debentures junior subordinated debt issued trust indenture collectively indentures junior subordinated debt sole asset trust preferred securities sole liabilities trust company purchased outstanding common stock trusts company’s investment trusts included assets accompanying consolidated balance sheets following table summarizes nature terms junior subordinated debt trust preferred securities interest trust preferred securities interest paid company trusts junior subordinated debt payable quarterly arrears per annum rate threemonth libor determination date defined indentures plus margin described table company right defer interest payments junior subordinated debt five years without triggering event default james river group inc subsidiaries notes consolidated financial statements years ended december 2006 2005 2004 10 junior subordinated debt continued trust preferred securities subject mandatory redemption like amount upon repayment junior subordinated debt stated maturity date b contemporaneously optional prepayment junior subordinated debt company conjunction special event defined c five years issue date contemporaneously optional prepayment whole part junior subordinated debt company provided full irrevocable unconditional guarantee payments amounts due trust preferred securities indentures contain certain covenants company compliance december 31 2006 interest payable included accrued expenses accompanying consolidated balance sheets 11 capital stock common stock may 3 2005 company filed registration statement form s1 securities exchange commission purpose making initial public offering common stock company’s registration statement declared effective august 8 2005 august 9 2005 company increased number authorized shares common stock 2000000 100000000 affected tenforone split company’s common stock shareholders record date common stock share per share amounts restated give retroactive effect stock split immediately prior closing initial public offering august 12 2005 85000 shares company’s outstanding series convertible preferred stock series preferred stock 713500 shares company’s series b convertible preferred stock series b preferred stock including shares representing accrued unpaid dividends converted 9956413 shares common stock gross proceeds sale 4444000 shares common stock initial public offering price per share 1800 totaled 800 million costs associated initial public offering included 56 million underwriting costs 995000 issuance costs august 26 2005 underwriters initial public offering exercised overallotment option additional 666600 shares common stock issued 1800 initial public offering price per share gross proceeds transaction 120 million underwriting costs 840000 company pay dividends common stockholders 2006 2005 2004 following table summarizes number shares common stock issuable reserved future issuance december 31 2006 convertible preferred stock august 9 2005 company set number authorized shares preferred stock preferred stock 5000000 james river group inc subsidiaries notes consolidated financial statements years ended december 2006 2005 2004 11 capital stock continued convertible preferred stock continued series b convertible preferred stock may 5 2004 company increased number shares designated series b preferred stock 700000 713500 extended series b preferred stock offering connection offering company issued 13500 series b preferred stock shares gross proceeds transaction totaled 13 million holders series preferred stock series b preferred stock entitled cumulative noncompounding dividends rate 60 per annum percentage preferred stock purchase price prior initial public offering preferred dividends declared immediately prior closing company’s initial public offering august 12 2005 company’s outstanding preferred stock including shares representing accrued unpaid dividends converted 9956413 shares common stock conversion preferred stock dividends effect decreasing retained earnings 99 million increasing common stock 11000 increasing additional paidin capital 99 million 12 stock options warrants company’s shareholders approved two incentive compensation plans 2003 incentive plan 2005 incentive plan plans effective march 23 2006 board directors determined grant future stockbased awards 2003 incentive plan options previously granted directors key employees 2005 incentive plan key employees directors third party service providers generally consultants agents advisors independent contractors involved marketing selling company’s securities eligible receive share awards subject individual annual aggregate award limits form options share appreciation rights restricted share awards units performance shares units sharebased awards well cashbased awards date sharebased awards granted options directors key employees sharebased equity awards plans issued discretion compensation committee company’s board directors options awarded date vest four year period commencing date grant exercisable ten years date grant options issued pursuant 2005 incentive plan vest immediately event change control company defined plan december 31 2006 maximum number shares available issuance 2005 incentive plan 1184013 summary option activity plans year ended december 31 2006 follows james river group inc subsidiaries notes consolidated financial statements years ended december 2006 2005 2004 12 stock options warrants continued reserved shares issued satisfy stock option exercises december 31 2006 29 million estimated unrecognized compensation costs related nonvested option awards expected charged earnings weightedaverage period 28 years year ended december 31 2006 company received cash stock option exercises 474000 related income tax benefit totaled 75000 intrinsic value difference fair value options exercise strike price options exercised year ended december 31 2006 totaled 820000 year ended december 31 2005 company received cash stock option exercises 30000 related income tax benefit totaled 2000 intrinsic value options exercised year ended december 31 2005 totaled 8000 following table summarizes certain stock option information exercise price december 31 2006 value options granted estimated date grant using blackscholesmerton option pricing model grants issued may 3 2005 minimum value option pricing model grants prior date following assumptions blackscholesmerton option pricing model developed use estimating fair value traded options vesting restrictions fully transferable addition option valuation models require input highly subjective assumptions including expected stock price volatility company’s stock options characteristics significantly different traded options changes subjective input assumptions materially affect fair value estimate management’s opinion existing models necessarily provide reliable single measure fair value stock options minimum value option pricing model used grants issued prior may 3 2005 consider expected stock price volatility valuing options granted blackscholesmerton option pricing model used grants subsequent may 3 2005 considers expected stock price volatility valuing options granted company became publicly traded august 2005 sufficient historical stock price information available company estimate stock price volatility result company utilized stock price volatility data similar propertycasualty companies period initial public stock offerings basis determining expected stock price volatility use valuing company’s 2006 2005 stock option grants expected term based midpoint vesting period contractual term award riskfree interest rate assumption based sevenyear us treasury rate date grant james river group inc subsidiaries notes consolidated financial statements years ended december 2006 2005 2004 12 stock options warrants continued dividend yield assumption based upon fact dividends expected declared life options time options granted weightedaverage value options issued 2006 2005 2004 determined described 1201 831 221 respectively part extended series b preferred stock offering 2003 company issued 8550 series b units series b unit consists one series b preferred share one warrant purchase 175 shares common stock exercise price 1000 per share common stock subject adjustment vesting period associated exercise warrants expire october 31 2013 james river group inc employment agreement president chief executive officer terms agreement amended president granted certain circumstances options purchase common stock equal 50 total number shares common stock securities convertible common stock offered company equity financing transactions time company raised aggregate 2500 million equity exercise price per share option grant equal fair market value company’s common stock closing financing transaction 13 income taxes company files consolidated federal income tax return subsidiaries consolidated financial statements december 31 2003 company net operating loss carryforwards 47 million net operating loss carryforwards used offset taxable income year ended december 31 2004 company’s effective income tax rate pretax income differs prevailing corporate federal income tax rate summarized follows james river group inc subsidiaries notes consolidated financial statements years ended december 2006 2005 2004 13 income taxes continued significant components net deferred tax asset current prevailing tax rate summarized follows management periodically reviews need valuation allowance related deferred tax assets prior 2004 management established tax valuation allowance equal total deferred tax assets net existing deferred tax liabilities current income tax expense 2004 management concluded likely company would realize entire deferred tax asset management based conclusion primarily fact company generated taxable income inceptiontodate basis sufficient exhaust company’s net operating loss carryforwards created startup phase valuation allowance established company’s deferred tax assets thereafter components changes deferred tax valuation allowance recorded follows james river group inc subsidiaries notes consolidated financial statements years ended december 2006 2005 2004 14 operating expenses operating expenses consist following 15 employee benefits company offers savings plans savings plans qualify section 401k internal revenue code participants may contribute certain percentages pretax salary savings plans subject statutory limitations company matches employee contributions rate 100 maximum contribution 6 participant’s earnings subject certain statutory limits years ended december 31 2006 2005 2004 company’s expense associated savings plans totaled 671000 540000 386000 respectively 16 related party transactions january 2003 company entered consulting agreement chairman board directors pursuant agreement chairman received annual fee 60000 exchange services capacity chairman board directors services august 2005 consulting agreement terminated immediately following initial public offering company entered new consulting agreement whereby chairman receives annual fee 40000 consulting services agreement may terminated either party 90 days written notice expenses related agreement totaled 40000 52000 60000 years ended december 31 2006 2005 2004 respectively part 2003 series b preferred stock offerings company loaned total 26 million employees directors purchase shares respective transactions notes annual interest rate 45 reported accompanying consolidated balance sheets reduction stockholders’ equity april 2005 20 million outstanding loans extended directors executive officers repaid full additional 10000 repaid third quarter 2005 leaving 535000 loans outstanding interest notes years ended december 31 2006 2005 2004 totaled 24000 52000 117000 respectively recorded income accompanying income statements beginning 2003 company contracted two investment advisory firms manage company’s investment portfolio member company’s board directors partner one firms years ended december 31 2006 2005 2004 company incurred expenses 153000 89000 44000 respectively firm fees charged agreement comparable fees charged company’s investment advisory service provider member company’s board directors also director broker produced 216 million 73 company’s direct written premiums 2006 157 million 66 company’s direct written premiums 2005 broker produce company’s direct written premiums 2004 commissions paid broker years ended december 31 2006 2005 terms comparable commission rates company’s brokers james river group inc subsidiaries notes consolidated financial statements years ended december 2006 2005 2004 17 commitments contingent liabilities company leases certain office space operating leases expire various times subject renewal options market rates prevailing time renewal rental expense leases 812000 650000 514000 years ended december 31 2006 2005 2004 respectively december 31 2006 future minimum payments noncancelable operating leases follows thousands company subleased certain office space 2008 amounts received sublease 150000 company party various lawsuits arising ordinary course operations company believes ultimate resolution matters materially impact financial position results operations 18 comprehensive income loss following table summarizes components comprehensive income loss james river group inc subsidiaries notes consolidated financial statements years ended december 2006 2005 2004 19 segment information company three reportable segments separately managed business unit “excess surplus insurance” segment primarily offers commercial excess surplus lines liability property insurance products “workers’ compensation insurance” segment offers workers’ compensation insurance coverages “corporate other” segment consists certain management treasury activities james river group inc interest expense associated company’s senior debt junior subordinated debt accounting policies reportable segments described summary significant accounting policies segment revenues reportable segment consist net earned premiums net investment income realized investment gains losses income segment profit loss reportable segment measured underwriting profit loss generally defined net earned premiums less losses loss adjustment expenses operating expenses insurance segments segment results reported prior effects intercompany reinsurance pooling agreement company’s insurance subsidiaries james river group inc subsidiaries notes consolidated financial statements years ended december 2006 2005 2004 19 segment information continued following table reconciles underwriting profit loss insurance segments individual segment consolidated income taxes company 14 underwriting divisions 13 excess surplus insurance segment one workers’ compensation insurance segment underwriting division focuses specific industry group coverage gross written premiums underwriting division presented james river group inc subsidiaries notes consolidated financial statements years ended december 2006 2005 2004 19 segment information continued company business one broker crc insurance services inc generated 501 million direct written premiums excess surplus insurance segment representing 171 consolidated direct written premiums 201 excess surplus insurance segment’s direct written premiums year ended december 31 2006 company agency contracts various branches within aforementioned broker loss broker aggregate could material adverse effect company excess surplus insurance segment company believe loss single branch would material adverse effect company excess surplus insurance segment broker generated 100 direct written premiums excess surplus insurance segment year ended december 31 2006 approximately 50 million 113 workers’ compensation insurance segment’s direct written premiums year ended december 31 2006 generated one agency sia group inc loss agency could material adverse effect workers’ compensation insurance segment agency generated 100 direct written premiums workers’ compensation insurance segment year ended december 31 2006 20 fair value carrying values fair values financial instruments summarized fair values fixed maturity securities equity securities determined using quoted market prices securities traded public market prices using bid closing prices securities traded public marketplace fair values cash equivalents approximate carrying values due shortterm maturity fair values senior debt junior subordinated debt approximate carrying values due floating interest rate structure inherent instruments james river group inc subsidiaries notes consolidated financial statements years ended december 2006 2005 2004 21 statutory matters dividend restrictions state insurance laws regulations prescribe accounting practices determining statutory net income capital surplus insurance companies addition state regulators may permit statutory accounting practices differ prescribed practices statutory accounting practices prescribed permitted regulatory authorities sap company’s insurance subsidiaries differ united states generally accepted accounting principles gaap principal differences sap gaap relate financial statements company’s insurance subsidiaries policy acquisition costs expensed incurred sap whereas deferred amortized gaap b certain assets admitted purposes determining surplus sap c classification carrying amounts investments certain securities different sap gaap criteria providing asset valuation allowances methodologies used determine amount thereof different sap gaap combined net income statutory capital surplus minimum required statutory capital surplus determined accordance statutory accounting practices insurance subsidiaries december 31 2006 2005 2004 years ended summarized follows insurance statutes insurance subsidiaries’ states domicile limit amount dividends may pay annually company without first obtaining regulatory approval generally limitations based statutory net income preceding year 100 statutory surplus end preceding year maximum amount dividends available company insurance subsidiaries 2007 without regulatory approval 327 million however insurance regulators broad powers prevent reduction statutory surplus inadequate levels could refuse permit payment dividends riskbased capital rbc requirements promulgated national association insurance commissioners require propertycasualty insurers maintain minimum capitalization levels determined based formulas incorporating various business risks insurance subsidiaries december 31 2006 insurance subsidiaries’ adjusted capital surplus exceeds authorized control level rbc james river group inc subsidiaries notes consolidated financial statements years ended december 2006 2005 2004 22 subsequent events february 13 2007 company’s board directors declared cash dividend 015 per share common stock payable march 30 2007 shareholders record march 15 2007 23 unaudited selected quarterly financial data following summary unaudited quarterly results operations net income loss third quarter 2005 reflected 175 million aftertax losses hurricanes katrina rita james river group inc subsidiaries schedule summary investments related parties s1 james river group inc schedule ii condensed financial information registrant parent company balance sheets see accompanying notes s2 james river group inc subsidiaries schedule ii condensed financial information registrant parent company statements operations see accompanying notes s3 james river group inc subsidiaries schedule ii condensed financial information registrant parent company statements cash flow see accompanying notes s4 james river group inc subsidiaries schedule ii condensed financial information registrant parent company notes condensed financial statements years ended december 31 2006 2005 2004 1 accounting policies organization james river group inc company delawaredomiciled holding company organized purpose acquiring managing insurance entities basis presentation accompanying condensed financial statements prepared using equity method equity method investment consolidated subsidiaries stated cost plus equity undistributed earnings consolidated subsidiaries since date acquisition condensed financial statements read conjunction company’s consolidated financial statements estimates assumptions preparation condensed financial statements conformity united states generally accepted accounting principles requires management make estimates assumptions affect amounts reported condensed financial statements accompanying disclosures estimates inherently subject change actual results may ultimately differ estimates 2 senior debt may 26 2004 company issued 150 million unsecured floating rate senior debentures due april 29 2034 unless accelerated earlier indenture see note 9 consolidated financial statements james river group inc subsidiaries description senior debentures 3 junior subordinated debt company arranged sale trust preferred securities trust preferred securities james river capital trust james river capital trust ii james river capital trust iii trust collectively trusts delaware statutory trusts sponsored whollyowned company trust used proceeds sale trust preferred securities purchase company’s floating rate junior subordinated debentures issued trust indenture see note 10 consolidated financial statements james river group inc subsidiaries description junior subordinated debentures 4 commitments contingent liabilities company leases certain office space operating leases expire 2008 2010 subject renewal options market rates prevailing time renewal rental expense leases 214000 69000 68000 years ended december 31 2006 2005 2004 respectively december 31 2006 future minimum payments noncancelable operating leases follows thousands s5 james river group inc subsidiaries schedule ii condensed financial information registrant parent company notes condensed financial statements years ended december 31 2006 2005 2004 4 commitments contingent liabilities continued company subleased certain office space 2008 amounts received sublease 150000 s6 s7 index exhibits number exhibit 31 third amended restated certificate incorporation incorporated herein reference exhibit 31 company’s current report form 8k dated august 12 2005 file 00051480 32 form third amended restated bylaws incorporated herein reference exhibit 32 company’s current report form 8k dated august 12 2005 file 00051480 41 specimen stock certificate representing james river group inc common stock par value 00l per share incorporated reference exhibit 41 company’s registration statement form s1 file 333124605 42 form warrant relating series b convertible preferred stock incorporated reference exhibit 42 company’s registration statement form s1 file 333124605 43 registration rights agreement dated january 21 2003 among james river group inc certain stockholders named therein incorporated reference exhibit 46 company’s registration statement form s1 file 333124605 44 indenture dated may 26 2004 james river group inc wilmington trust company trustee relating floating rate senior debentures due 2034 incorporated reference exhibit 48 company’s registration statement form s1 file 333124605 45 indenture dated may 26 2004 james river group inc wilmington trust company trustee relating floating rate junior subordinated debentures due 2034 incorporated reference exhibit 49 company’s registration statement form s1 file 333124605 46 amended restated declaration trust james river capital trust dated may 26 2004 among james river group inc trustees defined therein holders time undivided beneficial interests james river capital trust incorporated reference exhibit 410 company’s registration statement form s1 file 333124605 47 preferred securities guarantee agreement dated may 26 2004 james river group inc guarantor wilmington trust company preferred guarantee trustee benefit holders defined therein james river capital trust incorporated reference exhibit 411 company’s registration statement form s1 file 333124605 48 indenture dated december 15 2004 james river group inc wilmington trust company trustee relating floating rate junior subordinated deferrable interest debentures due 2034 incorporated reference exhibit 412 company’s registration statement form s1 file 333124605 49 amended restated declaration trust james river capital trust ii dated december 15 2004 among james river group inc trustees defined therein administrators named therein holders time undivided beneficial interests james river capital trust ii incorporated reference exhibit 413 company’s registration statement form s1 file 333124605 410 guarantee agreement dated december 15 2004 james river group inc guarantor wilmington trust company guarantee trustee benefit holders defined therein time capital securities james river capital trust ii incorporated reference exhibit 414 company’s registration statement form s1 file 333124605 411 indenture dated june 15 2006 james river group inc wilmington trust company trustee relating floating rate junior subordinated deferrable interest debentures due 2036 412 amended restated declaration trust james river capital trust iii dated june 15 2006 among james river group inc trustees defined therein administrators named therein holders time undivided beneficial interests james river capital trust iii 413 guarantee agreement dated june 15 2006 james river group inc guarantor wilmington trust company guarantee trustee benefit holders defined therein time capital securities james river capital trust iii 101 james river group inc 2003 incentive plan incorporated reference exhibit 101 company’s registration statement form s1 file 333124605 102 first amendment james river group inc 2003 incentive plan incorporated reference exhibit 102 company’s registration statement form s1 file 333124605 103 second amendment james river group inc 2003 incentive plan incorporated reference exhibit 103 company’s report form 10q quarter ended september 30 2006 file 00051480 104 form nonqualified option grant certificate pursuant james river group inc 2003 incentive plan incorporated reference exhibit 103 company’s registration statement form s1 file 333124605 105 form nonqualified option grant certificate entities pursuant james river group inc 2003 incentive plan incorporated reference exhibit 104 company’s registration statement form s1 file 333124605 106 form incentive stock option grant certificate employees pursuant james river group inc 2003 incentive plan incorporated reference exhibit 105 company’s registration statement form s1 file 333124605 107 james river group inc 2005 incentive plan incorporated reference exhibit 106 company’s registration statement form s1 file 333124605 108 first amendment james river group inc 2005 incentive plan incorporated reference exhibit 104 company’s report form 10q quarter ended september 30 2006 file 00051480 109 employment agreement dated effective november 15 2002 james river group inc j adam abram incorporated reference exhibit 107 company’s registration statement form s1 file 333124605 number exhibit 1010 amendment employment agreement dated september 4 2003 james river group inc j adam abram incorporated reference exhibit 108 company’s registration statement form s1 file 333124605 1011 second amendment employment agreement dated effective august 12 2005 james river group inc j adam abram incorporated reference exhibit 109 company’s report form 10k 2005 fiscal year file 00051480 1012 employment arbitration agreement dated effective november 2 2002 james river management company inc michael p kehoe incorporated reference exhibit 109 company’s registration statement form s1 file 333124605 1013 employment arbitration agreement dated effective october 1 2003 stonewood insurance management company inc c kenneth mitchell incorporated reference exhibit 1010 company’s registration statement form s1 file 333124605 1014 amendment employment agreement dated effective october 1 2003 stonewood insurance management company inc c kenneth mitchell incorporated reference exhibit 102 company’s report form 10q quarter ended september 30 2006 file 00051480 1015 employment agreement dated effective april 29 2005 james river group inc michael oakes incorporated reference exhibit 1011 company’s registration statement form s1 file 333124605 1016 summary offer letter amended james river group inc michael e crow incorporated reference exhibit 1013 company’s report form 10k 2005 fiscal year file 00051480 1017 employment agreement dated effective may 31 2006 james river group inc gregg davis incorporated reference exhibit 101 company’s current report form 8k dated june 6 2006 file 00051480 1018 summary consulting agreement richard w wright incorporated reference exhibit 1014 company’s report form 10k 2005 fiscal year file 00051480 1019 form indemnification agreement james river group inc directors executive officers incorporated reference exhibit 1014 company’s registration statement form s1 file 333124605 1020 stock purchase agreement dated april 3 2003 james river group inc american empire surplus lines insurance company incorporated reference exhibit 1015 company’s registration statement form s1 file 333124605 1021 reinsurance agreement effective january 1 2002 fidelity excess surplus insurance company american empire surplus lines insurance company incorporated reference exhibit 1016 company’s registration statement form s1 file 333124605 number exhibit 1022 amendment reinsurance agreement effective january 1 2002 fidelity excess surplus insurance company american empire surplus lines insurance company incorporated reference exhibit 1017 company’s registration statement form s1 file 333124605 1023 guarantee agreement dated june 30 2003 james river group inc great american insurance company incorporated reference exhibit 1018 company’s registration statement form s1 file 333124605 1024 trust account agreement effective march 12 2003 among american empire surplus lines insurance company provident bank fidelity excess surplus insurance company incorporated reference exhibit 1019 company’s registration statement form s1 file 333124605 1025 net quota share reinsurance contract effective january 1 2005 among james river insurance company subscribing reinsurers named therein incorporated reference exhibit 1020 company’s registration statement form s1 file 333124605 statement computation per share earnings included note 2 consolidated financial statements item 8 “financial statements supplementary data” report form 10k subsidiaries james river group inc consent independent registered public accounting firm 311 certification chief executive officer pursuant section 302 sarbanesoxley act 2002 312 certification chief financial officer pursuant section 302 sarbanesoxley act 2002 321 certification chief executive officer pursuant section 906 sarbanesoxley act 2002 322 certification chief financial officer pursuant section 906 sarbanesoxley act 2002 denotes compensatory plan arrangement company officer director exhibit included pursuant item 601 b4iii v regulation sk company provide copy securities exchange commission upon request item 15 exhibits financial statement schedules documents filed part report financial statements financial statement schedules listed accompanying index consolidated financial statements schedules filed part report exhibits listed accompanying index exhibits filed part report b exhibits see item 15a c schedules see item 15a schedules provision made applicable accounting regulations securities exchange commission required related instructions inapplicable therefore omitted signatures pursuant requirements section 13 15d securities exchange act 1934 amended registrant duly caused report signed behalf undersigned thereunto duly authorized pursuant requirements securities exchange act 1934 amended report signed following persons behalf registrant capacities dates indicated index consolidated financial statements schedules report independent registered public accounting firm board directors james river group inc audited accompanying consolidated balance sheets james river group inc subsidiaries december 31 2005 2004 related consolidated statements operations changes stockholders’ equity cash flows three years period ended december 31 2005 audits also included financial statement schedules listed index item 15c financial statements schedules responsibility company’s management responsibility express opinion financial statements based audits conducted audits accordance auditing standards public company accounting oversight board united states standards require plan perform audit obtain reasonable assurance whether financial statements free material misstatement engaged perform audit company’s internal control financial reporting audits included consideration internal control financial reporting basis designing audit procedures appropriate circumstances purpose expressing opinion effectiveness company’s internal control financial reporting accordingly express opinion audit also includes examining test basis evidence supporting amounts disclosures financial statements assessing accounting principles used significant estimates made management evaluating overall financial statement presentation believe audits provide reasonable basis opinion financial statements referred present fairly material respects consolidated financial position james river group inc subsidiaries december 31 2005 2004 consolidated results operations cash flows three years period ended december 31 2005 conformity united states generally accepted accounting principles also opinion related financial statement schedules considered relation basic financial statements taken whole present fairly material respects information set forth therein ernst young llp richmond virginia february 13 james river group inc subsidiaries consolidated balance sheets see accompanying notes james river group inc subsidiaries consolidated balance sheets continued see accompanying notes james river group inc subsidiaries consolidated statements operations see accompanying notes james river group inc subsidiaries consolidated statements changes stockholders’ equity thousands except share data see accompanying notes james river group inc subsidiaries consolidated statements cash flows see accompanying notes james river group inc subsidiaries notes consolidated financial statements years ended december 31 2005 2004 2003 thousands except share data 1 accounting policies organization james river group inc subsidiaries referred company delawaredomiciled holding company organized september 2002 purpose acquiring managing insurance entities consolidated financial statements include results james river group inc following whollyowned subsidiaries respective dates inception acquisition applicable james river insurance company james river insurance ohiodomiciled excess surplus lines insurance company authorized write business 48 states district columbia james river management company inc provides management services james river insurance potomac risk services inc potomac formed 2004 provide surplus lines brokerage services potomac operating activities 2004 2005 stonewood insurance company stonewood insurance north carolinadomiciled workers’ compensation insurance company licensed november 2003 write insurance north carolina stonewood insurance licensed write insurance south carolina december 2005 stonewood insurance management company inc provides management services stonewood insurance stonewood insurance began writing insurance january 1 2004 basis presentation consolidated financial statements notes prepared accordance united states generally accepted accounting principles insurance company subsidiaries vary respects statutory accounting practices prescribed permitted various state insurance departments significant intercompany transactions balances eliminated prior july 1 2003 company developmentstage company certain reclassifications prior year amounts made conform 2005 presentation reclassifications effect net income loss stockholders’ equity cash flow operating activities prior years specifically 4639 previously classified shortterm investments consolidated balance sheet december 31 2004 reclassified cash equivalents assets highly liquid investments maturities threemonths less date purchase consolidated statement cash flows reflects reclassification 9420 previously classified shortterm investments december 31 2003 cash equivalents preparation consolidated financial statements conformity united states generally accepted accounting principles requires management make estimates assumptions affect amounts reported consolidated financial statements accompanying disclosures estimates inherently subject change actual results may ultimately differ estimates james river group inc subsidiaries notes consolidated financial statements years ended december 31 2005 2004 2003 thousands except share data 1 accounting policies continued investments securities classified ‘‘availableforsale’’ carried fair value unrealized gains losses securities net deferred taxes reported separate component accumulated comprehensive income loss company securities classified ‘‘heldtomaturity’’ ‘‘trading’’ fair value generally represents quoted market value prices securities traded public marketplace prices analytically determined using bid closing prices securities traded public marketplace premiums discounts mortgagebacked securities assetbacked securities amortized accrued using constant yield method considers anticipated prepayments date purchase extent estimated lives securities change result changes estimated prepayment rates adjustments included net investment income using retrospective method realized investment gains losses determined specific identification basis company evaluates investments regularly determine whether declines value otherthantemporary company determines security experienced otherthantemporary impairment loss recognized realized investment loss factors company considers evaluating whether otherthantemporary impairment occurred include amount percentage fair value amortized cost length time fair value amortized cost credit quality ratings security special emphasis securities downgraded investment grade company also considers intent ability hold security sufficient period time allow recovery value shortterm investments reported cost include investments readily convertible known amounts cash maturities 12 months less upon acquisition company cash equivalents company considers highly liquid investments maturities three months less date purchase cash equivalents premiums earned pro rata basis terms policies generally 12 months portion premiums written applicable unexpired terms policies force recorded unearned premiums receivable agents’ balances premiums receivable agents’ balances carried face value net allowance doubtful accounts approximates fair value allowance doubtful accounts represents estimate amounts considered uncollectible based company’s assessment collectibility receivables past due allowance doubtful accounts 485 86 december 31 2005 december 31 2004 respectively bad debt expense 444 2005 86 2004 0 2003 receivables written allowance doubtful accounts totaled 45 2005 0 2004 2003 account balances charged allowance means collection exhausted potential recovery considered remote james river group inc subsidiaries notes consolidated financial statements years ended december 31 2005 2004 2003 thousands except share data 1 accounting policies continued deferred policy acquisition costs vary primarily related production insurance business deferred principal costs deferred commissions agents certain policy underwriting issue costs net ceding commissions related reinsurance ceded amortization policy acquisition costs charged expense proportion premium earned estimated policy life extent unearned premiums existing policies adequate cover related costs expenses deferred policy acquisition costs charged earnings company considers anticipated investment income determining whether premium deficiency exists reserve losses loss adjustment expenses reserve losses loss adjustment expenses lae represents estimated ultimate cost reported unreported losses lae incurred unpaid balance sheet date company discount reserve losses lae reserve losses lae estimated using individual casebasis valuations statistical analyses estimates subject effects trends loss severity frequency management limited historical loss information available making loss reserve estimates company utilized two primary actuarial methods arrive loss reserve estimates one primary methods utilizes management’s initial expected loss ratio losses lae incurred net earned premiums expected reporting patterns losses based insurance industry data company’s actual reported losses lae estimate reserve primary method estimates reserve applying expected loss ratio net earned premiums line business management generally selected actuarial method yields highest reserve line business best estimate management believes practice using higher two methods appropriate since company limited historical experience two primary actuarial methods utilize industry data losses company’s casualty business often take number years develop company writes difficult classes business typically meet risk criteria standard carriers estimating reserve losses lae hurricanes katrina wilma occurred 2005 management used case reserve estimates based information obtained site inspections companys adjustors terms coverage provided policies management estimated reserves incurred reported claims hurricanes katrina wilma using judgment based assessment property insurance exposures path storms december 31 2005 aggregate reserve losses lae sum results selected actuarial method line business plus reserve losses lae associated hurricanes katrina wilma estimated described although management believes reserve losses lae reasonable possible company’s actual incurred losses lae conform assumptions inherent determination reserves specifically company’s actual ultimate loss ratio could differ management’s initial expected loss ratio company’s actual reporting patterns losses could differ expected reporting patterns based industry data accordingly ultimate settlement losses related lae may vary significantly estimates included company’s financial statements estimates reviewed continually management adjusted necessary experience develops new information becomes known adjustments included current operations james river group inc subsidiaries notes consolidated financial statements years ended december 31 2005 2004 2003 thousands except share data 1 accounting policies continued reinsurance certain premiums losses ceded insurance companies various excess loss quota share reinsurance contracts company enters reinsurance contracts limit exposure large losses provide additional capacity growth reinsurance premiums commissions losses lae reinsured business accounted basis consistent used accounting original policies issued terms reinsurance contracts reinsurance recoverables prepaid reinsurance premiums reported assets amounts payable reinsurers receivable reinsurers netted right offset exists company receives ceding commissions connection certain ceded reinsurance ceding commissions recorded reduction operating expenses income taxes deferred tax assets net applicable valuation allowance deferred tax liabilities provided future tax consequences attributable temporary differences financial statement carrying amounts assets liabilities respective tax bases deferred tax assets liabilities measured using enacted tax rates expected apply taxable income years temporary differences expected recovered settled intangible insurance assets company accounts intangible assets accordance financial accounting standards board fasb statement 142 goodwill intangible assets statement 142 management determined company’s intangible assets indefinite life statement 142 requires intangible assets indefinite useful lives capitalized tested impairment least annually evaluating whether impairment intangible asset management determines fair value intangible asset compares resulting fair value carrying value intangible asset carrying value exceeds fair value intangible asset written fair value impairment reported earnings property equipment net property equipment reported cost less accumulated depreciation depreciated principally straightline basis estimated useful lives generally three ten years depreciable assets james river group inc subsidiaries notes consolidated financial statements years ended december 31 2005 2004 2003 thousands except share data 1 accounting policies continued stock options company grants stock options employees directors fixed number shares exercise price equal greater fair value shares date grant company accounts stock option grants using intrinsic value method prescribed accounting principles board opinion 25 accounting stock issued employees apb opinion 25 accordingly recognizes compensation expense stock option grants purposes pro forma disclosures required fasb statement 123 accounting stock based compensation statement 123 estimated value options amortized expense options vesting period awards issued prior may 3 2005 date company filed initial form s1 securities exchange commission minimum value method used determine value awards issued may 3 2005 fair value method used following table summarizes effect net income loss earnings loss per share expense recognition james river group inc subsidiaries notes consolidated financial statements years ended december 31 2005 2004 2003 thousands except share data 1 accounting policies continued recent accounting pronouncements december 16 2004 fasb issued fasb statement 123 revised 2004 sharebased payment statement 123r revision statement 123 supersedes apb opinion 25 amends fasb statement 95 statement cash flows statement 123r requires sharebased payments employees including grants stock options recognized financial statements based fair values statement 123r pro forma disclosure longer alternative financial statement recognition stock option awards made company adopts statement 123r company adopt statement 123r january 1 2006 awards issued prior may 3 2005 company uses minimum value method calculate pro forma disclosures required statement 123 company adopts statement 123r january 1 2006 continue account portion awards outstanding prior may 3 2005 using provisions apb opinion 25 related interpretive guidance awards issued may 3 2005 awards modified repurchased cancelled date company uses fair value method calculate pro forma disclosures required statement 123 company adopts statement 123r january 1 2006 begin recognizing expense associated awards consolidated statement operations award’s remaining vesting period using modified prospective method compensation expense 2006 associated options granted subsequent may 3 2005 expected approximately 900 amount terms fair values awards issued future uncertain full impact adoption statement 123r company’s financial statements known time november 2005 fasb issued fsp fas 1151 meaning otherthantemporary impairment application certain investments fsp 1151 addresses determination investment considered impaired whether impairment otherthantemporary measurement impairment loss fsp also includes accounting considerations subsequent recognition otherthantemporary impairment requires certain disclosures unrealized losses recognized otherthantemporary impairments fsp 1151 amends fasb statement 115 accounting certain investments debt equity securities nullifies certain requirements eitf 031 meaning otherthantemporary impairments application certain investments fsp 1151 effective reporting periods beginning december 15 2005 company believes existing policies recognizing otherthantemporary impairments consistent guidance fsp 1151 therefore adoption fsp 1151 expected material impact company’s consolidated balance sheet results operations james river group inc subsidiaries notes consolidated financial statements years ended december 31 2005 2004 2003 thousands except share data 2 acquisition june 30 2003 company acquired outstanding stock fidelity excess surplus insurance company fidelity cash purchase price totaling 28929 including 84 acquisition costs incurred fidelity’s results operations july 1 2003 forward included accompanying consolidated statements operations company’s primary reason acquiring fidelity obtain regulatory approvals write insurance excess surplus lines basis large number states purchase price allocation regulatory approvals resulted intangible insurance assets 4184 condensed balance sheet disclosing values assigned assets liabilities acquired company acquisition date follows june 30 2003 fidelity certain insurance liabilities ceded parent american empire surplus lines insurance company american empire reinsurance agreement reinsurance agreement june 30 2003 immediately prior closing reinsurance agreement amended fidelity ceded liabilities resulting direct assumed business written june 30 2003 american empire reinsurance agreement amended secured trust agreement fidelity american empire trust agreement guarantee great american insurance company affiliate american empire fidelity changed name james river insurance company july 2003 james river group inc subsidiaries notes consolidated financial statements years ended december 31 2005 2004 2003 thousands except share data 3 earnings loss per share earnings loss per share years ended december 31 2004 2003 reflect 10 1 split company’s common stock effective august 9 2005 connection company’s initial public offering beginning period james river group inc subsidiaries notes consolidated financial statements years ended december 31 2005 2004 2003 thousands except share data 4 investments company’s investments availableforsale securities summarized follows james river group inc subsidiaries notes consolidated financial statements years ended december 31 2005 2004 2003 thousands except share data 4 investments continued amortized cost fair value investments fixed maturity securities december 31 2005 summarized contractual maturity follows actual maturities may differ securities borrowers right call prepay obligations without penalties following table shows company’s gross unrealized losses fair value aggregated investment category length time individual securities continuous unrealized loss position james river group inc subsidiaries notes consolidated financial statements years ended december 31 2005 2004 2003 thousands except share data 4 investments continued majority unrealized losses fixed maturity securities interest rate related two fixed maturity securities unrealized losses december 31 2005 fair values greater 93 amortized cost rated investment grade standard poor’s received equivalent rating another nationally recognized rating agency december 31 2005 company held 343 securities unrealized loss position total fair value 304302 gross unrealized losses 5320 none fixed maturity securities unrealized losses ever missed delinquent scheduled principal interest payment december 31 2005 977 fixed maturity security portfolio rated ‘‘a−’’ better standard poor’s received equivalent rating another nationally recognized rating agency fourth quarter 2005 management concluded one two securities portfolio rated investment grade standard poor’s fixed maturity security issued finance company united states automobile manufacturer experienced impairment otherthantemporary accordingly company realized impairment write 92 security conclusion due primarily difficult operational industry issues facing issuer fact security downgraded investment grade investment grade two nationally recognized rating agencies fourth quarter 2005 appear imminent events transactions would cause value security increase significantly foreseeable future security company’s portfolio rated investment grade unrealized loss 72 december 31 2005 management concluded security experienced otherthantemporary impairment december 31 2005 management also concluded none availableforsale securities unrealized losses december 31 2005 experienced otherthantemporary impairment determining securities unrealized losses december 31 2005 experienced otherthantemporary impairment management considered company’s ability intent hold securities sufficient amount time allow recovery value james river group inc subsidiaries notes consolidated financial statements years ended december 31 2005 2004 2003 thousands except share data 4 investments continued major categories company’s net investment income summarized follows company’s realized gains losses investments summarized follows following table summarizes change company’s gross unrealized gains losses investment type december 31 2005 2004 investments fair value 9049 9405 respectively deposit state insurance departments satisfy regulatory requirements james river group inc subsidiaries notes consolidated financial statements years ended december 31 2005 2004 2003 thousands except share data 5 deferred policy acquisition costs analysis deferred policy aquisition costs follows 6 intangible insurance assets intangible insurance assets consist authority write insurance excess surplus lines basis 40 states district columbia acquired fidelity acquisition 2003 intangible assets arise regulatory approvals granted various state insurance departments write insurance business respective states nonlicensed basis insurance authorities granted routinely renewed little cost provided insurer complied rules regulations cash flows related regulatory approvals transact insurance business expected continue indefinitely management concluded intangible assets indefinite life impairment write recognized 2005 2004 2003 7 property equipment net property equipment consists following james river group inc subsidiaries notes consolidated financial statements years ended december 31 2005 2004 2003 thousands except share data 8 reserve losses loss adjustment expenses following table provides reconciliation beginning ending reserve balances losses lae net reinsurance gross amounts reported consolidated balance sheet foregoing reconciliation shows 4908 redundancy developed 2005 reserve losses lae held december 31 2004 favorable reserve development consisted 5433 favorable development excess surplus insurance segment offset 525 adverse development workers’ compensation insurance segment excess surplus insurance segment favorable development included 2484 favorable development casualty lines 2004 accident year 2351 favorable development property lines 2004 accident year 593 favorable development casualty lines 2003 accident year workers’ compensation insurance segment reserve development consisted 696 adverse development related company’s share north carolina involuntary workers’ compensation pool’s 2004 accident year results offset 171 favorable development direct business written workers’ compensation insurance segment 2004 accident year foregoing reconciliation also shows 156 redundancy developed 2004 reserve losses lae held december 31 2003 company provided insurance coverage could reasonably expected produce material levels asbestos claims activity addition company believe exposed environmental liability claims specifically underwritten priced environmental exposure asbestos environmental exposure policies issued fidelity prior july 1 2003 subject reinsurance agreement trust agreement james river group inc subsidiaries notes consolidated financial statements years ended december 31 2005 2004 2003 thousands except share data 9 reinsurance company’s insurance subsidiaries remain liable policyholders reinsurers unable meet contractual obligations applicable reinsurance agreements minimize exposure significant losses reinsurance insolvencies company evaluates financial condition reinsurers monitors concentrations credit risk company’s reinsurance contracts generally require reinsurers authorized reinsurers state insurance regulations experience rating downgrades specified levels rating agencies fund share company’s ceded outstanding losses lae reserves typically use irrevocable unconditional letter credit december 31 2005 company reinsurance recoverables unpaid losses 110514 reinsurance recoverables paid losses 11544 2093 companys reinsurance recoverables december 31 2005 companies best ratings ‘‘a’’ excellent better collateralized letters credit trust agreement american empire december 31 2005 reinsurance recoverables paid unpaid losses three reinsurers 23979 12869 8102 representing approximately 368 total balance reinsurance recoverables american empire totaled 2800 representing approximately 23 total balance reinsurance recoverables outstanding december 31 2005 december 31 2005 prepaid reinsurance premiums three reinsurers totaled 5393 4297 4088 representing approximately 532 balance company entered quota share reinsurance contract effective january 1 2005 transfers portion risk related certain propertycasualty insurance business written james river insurance 2005 reinsurers exchange portion direct written premiums business transferring risk reinsurers also reduced amount capital required support insurance operations james river insurance quota share reinsurance contract company receives ceding commission equal 25 ceded earned premium pays reinsurance margin equal 45 ceded earned premium reinsurers receive margin loss position contract ceding commission reduced certain circumstances based underwriting results company entitled additional profit contingent commission amount equal reinsurers’ profits margin company earn additional profit contingent commission 2005 based underwriting results business ceded treaty company maintains funds held account credited interest rate 375 annually funds held account shown liability accompanying consolidated balance sheets december 31 2005 balance account 21992 funds held account balance represents excess ceded earned premium interest credited ceded paid losses lae company’s ceding commission reinsurers’ margin assets supporting funds held liability segregated restricted contract loss ratio cap 115 means company cannot cede losses excess 115 ceded earned premiums reinsurers 2005 ceded earned premiums related quota share reinsurance treaty 40000 ceded losses lae 36458 reinsurance ceding commissions 9725 reinsurers’ margin 0 terms trust agreement see note 2 american empire must maintain assets current fair value greater equal ultimate net aggregate losses recoverable reinsurance agreement addition affiliate american empire great american insurance company irrevocably unconditionally guaranteed performance american empire obligations reinsurance agreement amended trust agreement december 31 2005 fair value assets trust totaled 4076 james river group inc subsidiaries notes consolidated financial statements years ended december 31 2005 2004 2003 thousands except share data 9 reinsurance continued reinsurance activity summarized follows assumed earned premiums percentage net earned premiums 24 year ended december 31 2005 0 years ended december 31 2004 2003 10 senior debt may 26 2004 james river group inc issued 15000 unsecured floating rate senior debentures senior debt due april 29 2034 unless accelerated earlier indenture senior debt redeemable holder subject sinking fund requirements net proceeds company totaled 14508 used provide capital company’s insurance subsidiaries additional working capital company interest accrues quarterly payable arrears per annum rate threemonth libor determination date defined indenture plus 385 senior debt redeemable prior stated maturity option company whole part may 15 2009 b entirety time prior may 15 2009 upon occurrence continuation certain tax event generally defined change united states tax law whereby interest payable company longer deductible federal income tax purposes terms indenture generally provide long senior debt outstanding neither company subsidiaries may • assume permit exist indebtedness secured encumbrance capital stock company subsidiaries senior debt • issue sell transfer otherwise dispose shares securities convertible warrants rights options subscribe purchase shares capital stock subsidiary company compliance covenants indenture december 31 2005 interest payable included accrued expenses accompanying consolidated balance sheets james river group inc subsidiaries notes consolidated financial statements years ended december 31 2005 2004 2003 thousands except share data 11 junior subordinated debt james river group inc arranged sale trust preferred securities trust preferred securities james river capital trust james river capital trust ii trust collectively trusts delaware statutory trusts sponsored whollyowned company trust created solely purpose issuing trust preferred securities accordance fasb interpretation 46 consolidation variable interest entities interpretation arb 51 trusts consolidated company financial statements trust used proceeds sale trust preferred securities purchase company’s floating rate junior subordinated debentures junior subordinated debt issued trust indenture collectively indentures junior subordinated debt sole asset trust preferred securities sole liabilities trust company purchased outstanding common stock trusts company’s investment trusts included assets accompanying consolidated balance sheets following table summarizes nature terms junior subordinated debt trust preferred securities interest trust preferred securities interest paid company trusts junior subordinated debt payable quarterly arrears per annum rate threemonth libor determination date defined indentures plus margin described table company right defer interest payments junior subordinated debt five years without triggering event default trust preferred securities subject mandatory redemption like amount upon repayment junior subordinated debt stated maturity date b contemporaneously optional prepayment junior subordinated debt company conjunction special event defined c five years issue date contemporaneously optional prepayment whole part junior subordinated debt company provided full irrevocable unconditional guarantee payments amounts due trust preferred securities indentures contain certain organizational covenants company compliance december 31 2005 interest payable included accrued expenses accompanying consolidated balance sheets james river group inc subsidiaries notes consolidated financial statements years ended december 31 2005 2004 thousands except share data 12 capital stock common stock may 3 2005 company filed registration statement form s1 securities exchange commission purpose making initial public offering common stock company’s registration statement declared effective august 8 2005 august 9 2005 company increased number authorized shares common stock 2000000 100000000 affected 10 1 split company’s common stock shareholders record date common stock share per share amounts restated give retroactive effect stock split immediately prior closing initial public offering august 12 2005 company’s outstanding series convertible preferred stock series preferred stock series b convertible preferred stock series b preferred stock including shares representing accrued unpaid dividends converted 9956413 shares common stock conversion preferred stock dividends effect decreasing retained earnings 9909 increasing common stock 11 increasing additional paidin capital 9898 gross proceeds sale 4444000 shares common stock initial public offering price per share 1800 totaled 79992 costs associated initial public offering included 5600 underwriting costs 995 issuance costs august 26 2005 underwriters initial public offering exercised overallotment option additional 666600 shares common stock issued 1800 initial public offering price per share gross proceeds transaction 11999 underwriting costs 840 company pay cash dividends common stockholders 2005 2004 2003 following table summarizes number shares common stock issuable reserved future issuance december 31 2005 convertible preferred stock august 9 2005 company set number authorized shares preferred stock preferred stock 5000000 series b convertible preferred stock january 15 2003 company designated 85000 shares preferred stock series preferred stock january 21 2003 issued shares gross proceeds transaction totaled 8500 company incurred syndication costs 61 june 20 2003 company designated 500000 shares preferred stock series b preferred stock june 30 2003 issued shares gross proceeds transaction totaled 50000 september 4 2003 company’s board approved increase number shares designated series b preferred stock 500000 shares 700000 shares extended series b preferred stock offering connection extended series b preferred stock offering company issued 200000 series b preferred stock shares october 31 2003 form 191450 series b preferred stock shares 8550 series b preferred stock units series b units series b unit consists one james river group inc subsidiaries notes consolidated financial statements years ended december 31 2005 2004 thousands except share data 12 capital stock continued convertible preferred stock continued series b preferred stock share one warrant purchase 175 shares common stock exercise price 1000 per share common stock subject adjustment warrants see note 13 gross proceeds transaction totaled 20000 may 5 2004 company increased number shares designated series b preferred stock 700000 713500 extended series b preferred stock offering connection offering company issued 13500 series b preferred stock shares gross proceeds transaction totaled 1350 company incurred syndication costs 233 series b preferred stock offerings holders series preferred stock series b preferred stock entitled cumulative noncompounding dividends rate 60 per annum percentage preferred stock purchase price prior initial public offering preferred dividends declared immediately prior closing company’s initial public offering august 12 2005 company’s outstanding preferred stock including shares representing accrued unpaid dividends converted 9956413 shares common stock series preferred stock liquidation preference amount disclosed face balance sheet december 31 2004 varies proceeds received series preferred stock primarily due 100 per share purchase price 50 per share conversion price 13 stock options warrants 2005 company adopted 2005 incentive plan key employees directors third party service providers generally consultants agents advisors independent contractors involved marketing selling company’s securities eligible receive share awards subject individual annual aggregate award limits form options share appreciation rights restricted share awards units performance shares units sharebased awards well cashbased awards maximum number shares available issuance participants 2005 incentive plan 1691075 options granted 2005 issued 2005 incentive plan 2003 company adopted 2003 incentive plan 2003 incentive plan certain directors officers key employees eligible granted various stockbased awards additional awards made 2003 incentive plan james river group inc subsidiaries notes consolidated financial statements years ended december 31 2005 2004 thousands except share data 13 stock options warrants continued information concerning stock option plan summarized following table summarizes certain stock option information exercise price december 31 2005 currently options vest four year period commencing date grant exercisable ten years following date grant certain options immediately vest event change control company purposes pro forma information required statement 123 value options granted estimated date grant using black scholes option pricing model grants 2005 company’s initial public offering minimum value option pricing model grants 2004 2003 following assumptions black scholes option pricing model minimum value option pricing model developed use estimating fair value traded options vesting restrictions fully transferable addition option valuation models require input highly subjective assumptions including expected stock price volatility company’s stock options characteristics significantly different traded options changes subjective input assumptions materially affect fair value estimate management’s opinion existing models necessarily provide reliable single measure fair value stock options james river group inc subsidiaries notes consolidated financial statements years ended december 31 2005 2004 thousands except share data 13 stock options warrants continued minimum value option pricing model used grants 2004 2003 consider expected stock price volatility valuing options granted black scholes option pricing model used 2005 grants considers expected stock price volatility valuing options granted company became publicly traded august 2005 sufficient historical stock price information available company estimate stock price volatility result company utilized stock price volatility data similar propertycasualty companies period initial public stock offerings basis determining expected stock price volatility use valuing company’s 2005 stock option grants weighted average value options issued 2005 2004 2003 determined described 831 221 201 respectively part extended series b preferred stock offering company issued 8550 series b units series b unit consists one series b preferred share one warrant purchase 175 shares common stock exercise price 1000 per share common stock subject adjustment vesting period associated exercise warrants expire october 31 2013 compensation expense 524 recognized warrants 2003 representing value 6129 per warrant fair value warrants estimated using minimum value pricing model following assumptions riskfree interest rate 423 dividend yield 000 expected stock price volatility 000 expected life warrants ten years james river group inc employment agreement president chief executive officer terms agreement president granted certain circumstances options purchase common stock equal 50 total number shares common stock securities convertible common stock offered us future equity financing transactions time company raised aggregate 250000 equity exercise price options issued equal per share fair market value companys common stock closing date equity offering 14 income taxes company files consolidated federal income tax return subsidiaries consolidated financial statements december 31 2003 company net operating loss carryforwards 4686 net operating loss carryforwards used offset taxable income year ended december 31 2004 company’s effective income tax rate pretax income loss differs prevailing corporate federal income tax rate summarized follows james river group inc subsidiaries notes consolidated financial statements years ended december 31 2005 2004 thousands except share data 14 income taxes continued significant components net deferred tax asset current prevailing tax rate summarized follows management periodically reviews need valuation allowance related deferred tax assets prior 2004 management established tax valuation allowance equal total deferred tax assets net existing deferred tax liabilities current income tax expense 2004 management concluded likely company would realize entire deferred tax asset management based conclusion primarily fact company generated taxable income inceptiontodate basis sufficient exhaust company’s net operating loss carryforwards created startup phase valuation allowance established company’s deferred tax assets december 31 2005 2004 components changes deferred tax valuation allowance recorded follows james river group inc subsidiaries notes consolidated financial statements years ended december 31 2005 2004 thousands except share data 15 operating expenses operating expenses consist following 16 employee benefits company offers savings plans savings plans qualify section 401k internal revenue code participants may contribute certain percentages pretax salary savings plans subject statutory limitations company matches employee contributions rate 100 maximum contribution 6 participant’s earnings subject certain statutory limits years ended december 31 2005 2004 2003 company’s expense associated savings plans totaled 540 386 167 respectively 17 related party transactions january 2003 company entered consulting agreement chairman board directors pursuant agreement chairman received annual fee 60 exchange services capacity chairman board directors services august 2005 consulting agreement terminated immediately following initial public offering company entered new consulting agreement whereby chairman receive annual fee 40 consulting services agreement may terminated either party 90 days written notice expenses related agreement totaled 52 2005 60 years ended december 31 2004 2003 part 2003 series b preferred stock offerings company loaned total 2565 employees directors purchase shares respective transactions notes annual interest rate 45 reported accompanying consolidated balance sheets reduction stockholders’ equity april 2005 2020 outstanding loans extended directors executive officers repaid full additional 10 repaid third quarter 2005 leaving 535 loans outstanding december 31 2005 interest notes years ended december 31 2005 2004 2003 totaled 52 117 55 respectively recorded income accompanying statements operations beginning 2003 company contracted two investment advisory firms manage company’s investment portfolio member company’s board directors partner one firms company contracts years ended december 31 2005 2004 2003 company incurred expenses 89 44 2 respectively firm fees charged agreement firm comparable fees charged company’s investment advisory service provider james river group inc subsidiaries notes consolidated financial statements years ended december 31 2005 2004 thousands except share data 18 commitments contingent liabilities company leases certain office space operating leases expire various times subject renewal options market rates prevailing time renewal rental expense leases 650 514 252 years ended december 31 2005 2004 2003 respectively december 31 2005 future minimum payments noncancelable operating leases follows company party various lawsuits arising ordinary course operations company believes ultimate resolution matters materially impact financial position results operations 19 comprehensive income loss following table summarizes components comprehensive income loss james river group inc subsidiaries notes consolidated financial statements years ended december 31 2005 2004 thousands except share data 20 segment information company three reportable segments separately managed business unit ‘‘excess surplus insurance’’ segment primarily offers commercial excess surplus lines liability property products ‘‘workers’ compensation insurance’’ segment offers workers’ compensation insurance coverages ‘‘corporate other’’ segment consists certain management treasury activities james river group inc interest expense associated company’s senior debt junior subordinated debt accounting policies reportable segments described summary significant accounting policies segment revenues reportable segment consist net earned premiums net investment income realized investment gains losses income segment profit loss reportable segment measured underwriting profit loss generally defined net earned premiums less losses lae operating expenses insurance segments segment results reported prior effects intercompany reinsurance pooling agreement company’s insurance subsidiaries james river group inc subsidiaries notes consolidated financial statements years ended december 31 2005 2004 thousands except share data 20 segment information continued following table reconciles underwriting profit loss insurance segments individual segment consolidated income taxes company 13 underwriting divisions 12 excess surplus insurance segment one workers’ compensation insurance segment underwriting division focuses specific industry group coverage direct written premiums underwriting division presented james river group inc subsidiaries notes consolidated financial statements years ended december 31 2005 2004 thousands except share data 20 segment information continued company business one broker generated 46658 direct written premiums excess surplus insurance segment representing 197 consolidated direct written premiums 225 excess surplus insurance segment’s direct written premiums year ended december 31 2005 company agency contracts various branches within aforementioned broker loss broker aggregate could material adverse effect company excess surplus insurance segment company believe loss single branch would material adverse effect company excess surplus insurance segment broker generated 100 direct written premiums excess surplus insurance segment year ended december 31 2005 approximately 3228 110 workers’ compensation insurance segment’s direct written premiums year ended december 31 2005 generated one agency loss agency could material adverse effect workers’ compensation insurance segment agency generated 100 direct written premiums workers’ compensation insurance segment year ended december 31 2005 21 fair value carrying values fair values financial instruments summarized fair values fixed maturity securities equity securities determined using quoted market prices securities traded public market prices using bid closing prices securities traded public marketplace fair values cash equivalents approximate carrying values due shortterm maturity fair values senior debt junior subordinated debt approximate carrying values due floating interest rate structure inherent instruments 22 statutory matters dividend restrictions state insurance laws regulations prescribe accounting practices determining statutory net income capital surplus insurance companies addition state regulators may permit statutory accounting practices differ prescribed practices statutory accounting practices prescribed permitted regulatory authorities sap company’s insurance subsidiaries differ accounting principles generally accepted united states gaap principal differences sap gaap relate financial statements company’s insurance subsidiaries james river group inc subsidiaries notes consolidated financial statements years ended december 31 2005 2004 thousands except share data 22 statutory matters dividend restrictions continued policy acquisition costs expensed incurred sap whereas deferred amortized gaap ii certain assets admitted purposes determining surplus sap iii classification carrying amounts investments certain securities different sap gaap iv criteria providing asset valuation allowances methodologies used determine amount thereof different sap gaap combined net income statutory capital surplus minimum required statutory capital surplus determined accordance statutory accounting practices insurance subsidiaries december 31 2005 2004 2003 years ended summarized follows insurance statutes insurance subsidiaries’ states domicile limit amount dividends may pay annually company without first obtaining regulatory approval generally limitations based statutory net income preceding year 100 statutory surplus end preceding year maximum amount dividends available company insurance subsidiaries 2006 without regulatory approval 14508 riskbased capital rbc requirements promulgated national association insurance commissioners require propertycasualty insurers maintain minimum capitalization levels determined based formulas incorporating various business risks insurance subsidiaries december 31 2005 insurance subsidiaries’ adjusted capital surplus exceeds authorized control level rbc 23 unaudited selected quarterly financial data following summary unaudited quarterly results operations james river group inc subsidiaries notes consolidated financial statements years ended december 31 2005 2004 thousands except share data 23 unaudited selected quarterly financial data continued james river group inc subsidiaries schedule summary investments related parties s1 james river group inc schedule ii condensed financial information registrant parent company balance sheets see accompanying notes s2 james river group inc subsidiaries schedule ii condensed financial information registrant parent company statements operations see accompanying notes s3 james river group inc subsidiaries schedule ii condensed financial information registrant parent company statements cash flow see accompanying notes s4 james river group inc subsidiaries schedule ii condensed financial information registrant parent company notes condensed financial statements years ended december 31 2005 2004 thousands 1 accounting policies organization james river group inc company delawaredomiciled holding company organized purpose acquiring managing insurance entities basis presentation condensed financial statements notes prepared accordance united states generally accepted accounting principles accompanying condensed financial statements prepared using equity method equity method investment consolidated subsidiaries stated cost plus equity undistributed earnings loss consolidated subsidiaries since date acquisition condensed financial statements read conjunction companys consolidated financial statements estimates assumptions preparation condensed financial statements conformity accounting principles generally accepted united states requires management make estimates assumptions affect amounts reported condensed financial statements accompanying disclosures estimates inherently subject change actual results may ultimately differ estimates 2 senior debt may 26 2004 company issued 15000 unsecured floating rate senior debentures due april 29 2034 unless accelerated earlier indenture see note 10 consolidated financial statements james river group inc subsidiaries description senior debentures 3 junior subordinate debt company arranged sale trust preferred securities trust preferred securities james river capital trust james river capital trust ii trust collectively trusts delaware statutory trusts sponsored whollyowned company trust used proceeds sale trust preferred securities purchase companys floating rate junior subordinated debentures issued trust indenture see note 11 consolidated financial statements james river group inc subsidiaries description junior subordinated debentures 4 commitments contingent liabilities company leases certain office space operating lease expires 2008 subject renewal options market rates prevailing time renewal rental expense leases 69 68 44 years ended december 31 2005 2004 2003 respectively december 31 2005 future minimum payments noncancelable operating lease follows s5 james river group inc subsidiaries schedule iii supplementary insurance information thousands s6 index exhibits denotes compensatory plan arrangement company officer director