The following tables provide selected historical consolidated financial and operating data of Direct General as of the dates and for the periods indicated. In conjunction with the data provided in the following tables and in order to more fully understand our historical consolidated financial and operating data, you should also read “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and the accompanying notes included in this report. We derived our selected historical consolidated financial data as of December 31, 2006 and 2005 and for the years ended December 31, 2006, 2005 and 2004 from our audited consolidated financial statements included in this report. We derived our selected historical consolidated financial data as of December 31, 2004, 2003 and 2002 and for the years ended December 31, 2003 and 2002 from our audited consolidated financial statements not included in this report. The results for past accounting periods are not necessarily indicative of the results to be expected for any future accounting period.
Net premiums written is the sum of direct premiums written and assumed premiums written less ceded premiums written. Ceded premiums written is the portion of our direct and assumed premiums that we transfer to our reinsurers in accordance with the terms of our reinsurance contracts based upon the risks they accept. See Note 7 to our audited consolidated financial statements included in this report.
Gross revenues is the sum of direct premiums written and assumed premiums written (which we refer to in this report as gross premiums written) plus other revenues including finance income, commission and service fee income, and net investment income (excluding net realized gains (losses) on securities). We consider gross revenues to be a non-GAAP financial measure and have provided, in “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Measurement of Results”, an explanation of why we believe gross revenues is a financial measure that is useful to management and investors and a reconciliation of gross
The Company corrected the recorded liability for unearned policy fees as of January 2004 during 2006 and restated the January 1, 2004 Balance Sheet, which affected total assets, total liabilities, total stockholders’ equity and book value per share as previously reported for 2005 and 2004. See Note 1 to our audited consolidated financial statements.
We are a provider of non-standard personal automobile insurance, premium finance and other insurance and non-insurance products and services. Our operations are primarily concentrated in the southeastern part of the United States. Our business model integrates our insurance, premium finance and agency subsidiaries. Our model also emphasizes the distribution of our products and services through neighborhood sales offices staffed by employee-agents as opposed to commissioned agents. The expansion of our neighborhood sales offices in selected states includes the use of independent insurance agencies, which we generally have options to acquire in the future.
Our business model provides our employee-agents with customer contact at the point of sale and when the customer returns to make periodic payments. This contact allows us to offer a variety of products in addition to our core product, non-standard personal automobile insurance. We provide term life insurance policies through our wholly-owned life insurance subsidiaries, as well as vehicle protection insurance and hospital indemnity insurance underwritten by unaffiliated insurers, for which we receive commission and service fee income. We also offer ancillary non-insurance products and services such as prepaid debit cards and, in select states, payday consumer loans.
interest and fees earned on the financing of insurance policies; and
commission and service fee income that we earn in connection with the sales and servicing of insurance products underwritten by other insurers and other income; and
interest expense primarily related to our premium finance revolving credit facility and debentures payable
Gross Revenues (a non-GAAP financial measure). Gross revenues is the sum of gross premiums written plus ancillary income (finance income and commission and service fee income) and net investment income (excluding net realized gains (losses) on securities). We use gross revenues as the primary measure of the underlying growth of our revenue streams from period to period. Gross revenues are reconciled to total revenues in the “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Results of Operations.”
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect amounts reported in the financial statements. As more information becomes known, these estimates and assumptions could change, thus having an impact on the amounts reported in the future. We view the estimates and assumptions used in establishing our reserves for losses and loss adjustment expenses, valuation of investments, the estimates of future policy cancellations used in determining the amounts recorded as commissions and service fees and establishing the allowance for finance receivable losses as our critical accounting policies.
Our reserve for insurance losses and loss adjustment expenses is comprised of case and IBNR reserves, which include an estimate for the costs to settle our claims. A description of the process we use to establish our reserves is provided below.
IBNR reserves. We rely primarily on historical loss experience in determining our IBNR reserve levels, on our assumption that historical loss experience provides a good indication of future loss experience. Our internal actuarial staff reviews our insurance subsidiaries’ reserves quarterly for each accident quarter by state and coverage. We typically evaluate three different policy coverages for each state: bodily injury (coverage for medical claims to any injured party); property damage (coverage for damage to a third party’s property); and physical damage (coverage for comprehensive, collision, rental and towing in conjunction with our insured’s vehicle). In addition, we separately evaluate our policy coverage for personal injury protection (“PIP”) in the two states where PIP is a
required coverage, Florida and Kentucky. We believe that our quarterly reviews allow us to make timely adjustments to reserves to reflect new or changed facts and information that we receive. As part of these quarterly reviews, our actuarial staff estimates the ultimate average severity and frequency of claims for each coverage. Severity represents the average cost per claim and frequency represents the number of claims per policy.
Our actuarial analysis of loss reserves by state and coverage involves numerous actuarial methods including the following:
The actuarial staff reviews the output from each of these methods giving consideration to current trends in frequency, severity, changes in claims closing patterns, post-closing payments, salvage and subrogation collections, and many other factors for each of the coverages within each state. Periodically, there may be extenuating circumstances that may cause certain methods to be more credible than others. In those instances, we may discount the results of certain models in favor of the output of more reliable models. For example, the Incurred Loss Development method and Incurred Bornhuetter/Ferguson method may not provide credible results in those periods where we make adjustments to our automated case reserves. These adjustments could artificially distort the results of these models if historical development trends are applied to the incurred data, which would cause us to place more reliance on the paid models and Claims Closure models. Conversely, when we make changes to claims staffing and processing, it could produce unintended changes in the historical settlement patterns that would cause the output from the paid models to be less reliable. In those instances where we may be understaffed, we could experience delays in claims settlement, which could inadvertently lead to an underestimation of ultimate losses under the paid models if the historical development patterns are applied. Alternatively, when there is an acceleration of claims payments, the paid models could produce inflated estimates of ultimate losses by applying historical development patterns. Therefore, in those periods where there have been changes in claims staffing or processing, we tend to place more reliance on the output from the Incurred models.
The actuarial selections of ultimate incurred losses are independently determined on an individual coverage basis for each state using the actuaries’ best judgment considering the current trends in the underlying data, the credibility of the results from the various models, and other factors described above. We do not use a weighted average of the output to determine the selected reserve and, because reserves are set at the individual coverage level within each state, we do not establish a countrywide range of reserves. Due to limited historical data in states we have recently entered, we utilize the factors of other states with similar coverages, limits, and claims handling processes to determine the ultimate incurred losses for these states.
Investments. The Company’s entire portfolio of debt securities is classified as “available-for-sale” and reported at fair value. This gives the Company the flexibility to sell its available-for-sale securities in response to changes in interest rates, risk/reward characteristics, liquidity needs, or other economic factors.
Effect of Future Cancellations. The insurance policies that we write through our insurance subsidiaries are subject to being cancelled by the policyholder prior to the policy expiration date. As a result, we estimate the effect of future cancellations in determining the amount of commission and service fee income that is recorded in our consolidated financial statements. We use historical cancellation rates that are updated quarterly to estimate future cancellations with the effect of any changes in our estimates being recorded in the period in which the change in the estimate is determined to be necessary. However, actual cancellations may differ materially from the cancellation estimates that we used. As of December 31, 2006, the reserve for return of commission and service fee income was $5.1 million.
Allowance for Finance Receivable Losses. Losses on finance receivables include an estimate of future credit losses on premium finance accounts. Credit losses on premium finance accounts occur when the unearned premiums received from the insurer upon cancellation of a financed policy are inadequate to pay the balance of the premium finance account. The majority of these shortfalls result in the write-off of unrealized interest and premium finance acquisition fees. We review historical trends of such losses relative to finance receivable balances to develop estimates of future losses. However, actual write-offs may differ materially from the write-off estimates that we used. As of December 31, 2006, the allowance for finance receivable losses was $6.8 million.
The table below summarizes certain operating results and key measures we use in monitoring and evaluating our operations. The information provided is intended to summarize and supplement information contained in our consolidated financial statements and to assist the reader in gaining a better understanding of our results of operations.
Year Ended December 31, 2005 Compared to Year Ended December 31, 2004. Net income decreased 27.8% to $39.0 million in 2005, compared to net income of $54.0 million in 2004. The most significant factors contributing to the decrease in net income during 2005 included higher operating costs, largely associated with our expansions in Texas, Missouri, and Virginia, higher advertising and interest costs, and a higher level of catastrophe losses. Additionally, while ancillary income declined, it was partially offset by more than a 30% increase in investment income as a result of the increase in average invested assets and higher yields. There was minimal impact of realized gains and losses on securities and other during either 2005 or 2004.
The declines in gross premiums written in most of our other existing states were primarily related to the competitive environment. However, we also experienced a 19.2% decline in Louisiana which we partially attributed to the impact of Hurricane Katrina. We believe that the displacement of a portion of the Louisianan population not only resulted in a premium decline in 2005, but we believe that the 2006 volumes in Louisiana were also impacted.
Year Ended December 31, 2005 Compared to Year Ended December 31, 2004. Net premiums written decreased 2.1% to $400.6 million in 2005 from $409.4 million in 2004. The ratio of net premiums written to gross premiums written increased to 88.4% in 2005 from 85.0% in 2004 as we continued to reduce our use of quota share reinsurance. We expect to eliminate our quota share reinsurance in 2006 and retain nearly all gross premiums written. Net premiums earned, a function of net premiums written over the current and prior periods, increased to $404.1 million in 2005 from $372.5 million in 2004.
majority of our operating expenses. The following table summarizes the components of our ancillary income for the periods indicated.
Year Ended December 31, 2006 Compared to Year Ended December 31, 2005. Ancillary income decreased 1.9% to $89.5 million in 2006 from $91.2 million in 2005. This decrease is comprised of a $0.5 million decrease in premium finance income and a $1.2 million decrease in commission and service fee income. The decrease in finance income is primarily related to the decrease in gross premiums earned. The allowance for credit losses was 2.9% of gross finance receivables at the end of both 2006 and 2005.
Year Ended December 31, 2005 Compared to Year Ended December 31, 2004. Ancillary income decreased 6.7% to $91.2 million in 2005 from $97.8 million in 2004. This decrease is comprised of a $4.8 million decrease in premium finance income and a $1.8 million decrease in commission and service fee income. The decrease in finance income is related, in part, to the decline in gross premiums earned and the Company’s decision in early 2005 to temporarily reduce the minimum down payment requirements in most states in an effort to increase premium production. In 2005, average down payments as a percentage of financed premium declined to 12.8% compared to 14.5% in 2004. As a result of this change, we experienced an increase in the provision for finance receivable losses to $10.3 million in 2005 from $7.3 million in 2004. As part of the Company’s efforts to achieve the optimal balance of maximum premium growth with minimal impact on finance income, the Company re-assessed its pay plans and increased down payment requirements in select states in late 2005. The allowance for credit losses was 2.9% and 2.8% of gross finance receivables at the end of 2005 and 2004, respectively.
The decrease in commission and service fee income can be attributed to a $2.1 million reduction in fees earned for the administration of our assumed business in Texas due to the Company’s decision to write more of its Texas business through one of its own insurance subsidiaries as opposed to a third party insurer. This change caused a corresponding reduction in operating expenses as assumed reinsurance commissions also decreased by $2.1 million. The remainder of the change included a $2.1 million increase in revenues from our consumer products, including our Direct prepaid Visa program and Direct Cash Advance, which was largely offset by lower commission and service fees related to a decline in the sale of ancillary insurance products.
Our investment portfolio is generally highly liquid and consists substantially of readily marketable, investment-grade debt securities. Net investment income is primarily comprised of interest earned on these securities, net of related investment expenses.
Year Ended December 31, 2006 Compared to Year Ended December 31, 2005. Net investment income increased to $19.0 million in 2006 from $14.7 million in 2005 primarily as a result of a 15.4% increase in average invested assets to $413.3 million in 2006 from $358.2 million in 2005. The increase in average invested assets is primarily the result of the cash flows from operations. The average investment yield increased to 4.6% in 2006 from 4.1% in 2005 primarily as the result of the higher interest rates available for new investments in 2006.
Year Ended December 31, 2005 Compared to Year Ended December 31, 2004. Net investment income increased to $14.7 million in 2005 from $10.8 million in 2004 primarily as a result of a 20.0% increase in average invested assets to $358.2 million in 2005 from $298.5 million in 2004. The increase in average invested assets is primarily the result of the cash flows from operations. The average investment yield increased to 4.1% in 2005 from 3.7% in 2004 primarily as the result of the higher interest rates available for new investments in 2005.
The Company also has a trading portfolio primarily consisting of futures contracts, swaps, and other derivative instruments. In 2006, we also realized gross gains of $0.8 million and gross losses of $0.6 million on closed contracts in this trading portfolio, as compared to 2005 where we realized gross gains of $2.6 million and gross losses of $1.9 million. This represents a speculative investment and does not represent a hedge; accordingly, all open contracts are marked to market with the change in market values included in “net realized (losses) gains on securities and other” in our consolidated statement of operations. The net unrealized gain (loss) on open contracts decreased to a $0.1 million gain in 2006 from a $0.2 million gain in 2005. The 2006 net gain was comprised of gross unrealized gains of $0.3 million and gross unrealized losses of $0.2 million. For the year ended December 31, 2006, “net realized (losses) gains on securities and other” included a net loss of $0.1 million related to the change in the market value of open contracts.
The Company also has a trading portfolio primarily consisting of futures contracts, swaps, and other derivative instruments. In 2005, we also realized gross gains of $2.6 million and gross losses of $1.9 million on closed contracts in this trading portfolio, as compared to 2004 where we realized gross gains of $2.4 million and gross losses of $2.2 million. This represents a speculative investment and does not represent a hedge; accordingly, all open contracts are marked to market with the change in market values included in “net realized (losses) gains on securities and other” in our consolidated statement of operations. The net unrealized gain (loss) on open contracts increased to a $0.2 million gain in 2005 from a $0.1 million loss in 2004. The 2005 net gain was comprised of gross
Year Ended December 31, 2006 Compared to Year Ended December 31, 2005. For the year ended December 31, 2006, insurance losses and loss adjustment expenses increased to $320.8 million from $305.8 million in 2005, an increase of $15.0 million. This increase is generally consistent with the overall premium growth and increase in net business we retained. Our net loss ratio was 75.5% and 75.7% in 2006 and 2005. respectively. During 2006, weather-related losses increased our loss ratio by approximately 0.4 points, primarily as a result of tornadoes and hailstorms that hit Tennessee and Texas in the spring. Comparatively, there was an unusually high level of catastrophic losses, which increased our annual loss ratios by approximately 0.8 points in 2005.
During 2005, we increased our estimate of incurred losses for prior accident years by approximately $6.8 million, which resulted in a 1.7 point increase in our 2005 loss ratio. Approximately $3.8 million of this increase was attributable to the Florida PIP coverage, where we experienced an increase in expected ultimate severity, a portion of which related to the runoff of claims from the Miami market. We increased our estimate of ultimate severity for PIP by approximately 4.8% related to the 2004 accident year based upon additional paid loss data obtained during 2005. An additional $2.0 million of increase in prior years’ reserves related to the property damage coverage in Florida where we experienced a shift in claims settlement patterns that resulted in an increase in post-closing payments. The majority of the reserve development for both coverages was paid in the current year. Comparatively, during 2004 we increased our estimate of incurred losses for prior accident years by approximately $6.3 million, which also resulted in a 1.7 point increase in our 2004 loss ratio.
Operating expenses include SGA costs, advertising and interest expense. These expenses include the amortization of policy acquisition and maintenance costs that are net of ceding commissions, costs associated with generating ancillary income and other revenues and corporate overhead. Our business model emphasizes the use of
Advertising costs in total increased to $13.2 million in 2005 from $8.5 million in 2004, with approximately $2.5 million of this increase related to our expansion states where there was minimal advertising in the prior year. The remainder of the increase related to our marketing initiatives in our existing states including an increase in costs related to more targeted television media buys, an upgrade in the quality of the ads, and the outsourcing of certain creative components.
We are organized as a holding company system with all of our operations being conducted by our wholly-owned insurance, premium finance, agency, administrative and consumer product subsidiaries. Accordingly, Direct General Corporation receives cash through loans from banks, issuance of equity securities, subsidiary dividends and other transactions. We may use the proceeds from these sources to contribute to the capital of our insurance subsidiaries and premium finance company in order to support premium growth, to repurchase our common stock, to retire our outstanding indebtedness, to pay interest, dividends, and taxes, and for other business purposes. We operate under an Intercompany Tax Allocation Agreement whereby our eligible subsidiaries compute tax provisions as if filing separate returns based on taxable income. Each subsidiary’s resulting provision (or credit) will be currently payable to (or receivable from) Direct General Corporation.
Capital Raising - Secondary Offering. In March 2004, we completed a secondary offering whereby selling shareholders sold 3,314,015 shares of common stock. As a result of the exercise of the over-allotment option by the underwriters of the secondary offering, we issued and sold an additional 497,102 common shares in April 2004, which resulted in net proceeds to us (after deducting issuance costs) of approximately $16.0 million. During 2004, we used approximately $11.5 million of the proceeds to increase our investment in our insurance subsidiaries. The remaining proceeds have not been permanently deployed to date and generally have been used to reduce the amount outstanding under the premium finance revolving credit facility described below.
Common Stock Repurchase. During 2005, the Company repurchased 2,157,871 shares of its outstanding common stock for an aggregate price of approximately $40.1 million. However, no common stock repurchases were made in 2006.
The obligations of the Company under the junior subordinated debentures represent full and unconditional guarantees by the Company of DGST I’s obligations for the preferred securities. Dividends on the preferred securities are cumulative, payable quarterly in arrears and are deferrable at the Company’s option for up to five years. The dividends on these securities are the same as the interest on the debentures. The Company cannot pay dividends on its common stock during such deferments.
Amounts outstanding under this facility were $143.0 million and $150.0 million as of December 31, 2006 and 2005, respectively. The average balances outstanding under this facility were $109.50 million in 2006 and $112.8 million in 2005. Interest on the facility is payable quarterly. The weighted average interest rate in effect was 7.0% in 2006 and 5.2% in 2005. The loan is principally secured by our finance receivables of our premium finance subsidiaries and is guaranteed by Direct General Corporation. See Note 6 to our audited consolidated financial statements included in this report for further discussion regarding our current outstanding debt.
Effective August 1, 2005, the Company entered into an interest rate swap under which the Company pays a fixed rate of 4.255% and receives 1 month Libor. This swap qualifies as a hedge under SFAS 133, and therefore the fair market value of this derivative instrument is reported as a separate component of shareholders’ equity on an after-tax basis. The pre-tax fair value of this derivative was an unrealized gain of $1.1 million at December 31, 2006, substantially the same as December 31, 2005. Payments associated with the swap were net receipts of $0.4 million and net payments of $0.1 million in the year end December 31, 2006 and 2005 respectively. These amounts were reported in the income statement as interest expense. See Note 12 to our audited consolidated financial statements included in this report for further discussion on these derivative instruments.
Contractual Obligations. The following table summarizes estimated payments under our contractual obligations as of December 31, 2006.
As of December 31, 2006, the amount of unsecured reinsurance recoverables was $6.0 million or 2.3% of shareholders’ equity as compared to $19.4 million or 8.2% of shareholders’ equity at December 31, 2005. All unsecured recoverables are with reinsurers with ratings of at least A (Excellent) by A.M. Best.
We had total debt securities, cash, cash equivalents and short-term investments of $494.5 million as of December 31, 2006. The following table summarizes our debt securities, cash, cash equivalents and short-term investments as of the dates indicated.
Our investment strategy recognizes our need to maintain capital adequate to support our insurance operations. Our investment objectives also include maximizing the benefit from premium tax credits. Certain of the states in which we do business provide relief from premium taxes to the extent we maintain qualifying investments in those states and their municipalities. As a result, historically a significant amount of debt securities in our
portfolio were comprised of tax-exempt obligations of the states of Louisiana, Mississippi and Tennessee, in order to maximize these premium tax credits.
We realized a net pretax gain on the sale of securities of $0.3 million in 2006. Comparatively, we realized pretax net losses of $0.9 million in 2005. Most of these sales occur when we reposition our portfolio for changes in market conditions, to reallocate the portfolio among various asset classes and other factors. The weighted average book yield of the portfolio was 4.6% for 2006, 4.1% for 2005 and 3.9% for 2004. The weighted average life of our investment portfolio was 4.4 years at both December 31, 2006 and 2005.
We monitor our investment results by comparing the total return on our portfolio of debt securities to the total return for a customized benchmark based on a blend of Lehman indices. Total return is comprised of interest income and the change in the fair value of the securities. Because we have a portion of our portfolio invested in the municipal obligations of Tennessee, Louisiana, and Mississippi in an effort to maximize the premium tax credits available to us, we separately evaluate the total return of our taxable and tax-exempt securities by comparing them to customized benchmarks for each investment class. During 2006, our portfolio yield lagged the customized benchmark primarily as a result of holding higher quality and shorter duration securities than the index. The total return on our portfolio of debt securities was 5.0% in 2006, 4.1% in 2005, and 3.7% in 2004.
The amortized cost and fair value of debt securities in our investment portfolio as of December 31, 2006, by contractual maturity, is shown below.
As of December 31, 2006, the impact of an immediate 100 basis point increase in market interest rates on our debt securities portfolio would have resulted in an estimated decrease in fair value of 4.4%, or approximately $16.1 million. As of the same date, the impact of an immediate 100 basis point decrease in market interest rates on our debt securities portfolio would have resulted in an estimated increase in fair value of 4.4%, or approximately $16.1 million.
The Company’s management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Rule 13a-15(f) under the Exchange Act. The Company’s internal control structure was designed to provide reasonable assurance that the Company’s transactions have been accurately recorded to permit the preparation of its financial statements in accordance with generally accepted accounting principles.
We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control Over Financial Reporting, that Direct General Corporation and Subsidiaries maintained effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control- Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Direct General Corporation and Subsidiaries’ management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the company’s internal control over financial reporting based on our audit.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Direct General Corporation and Subsidiaries as of December 31, 2006 and 2005, and the related consolidated statements of operations, shareholders’ equity and cash flows for each of the three years in the period ended December 31, 2006, and our report dated March 14, 2007 expressed an unqualified opinion thereon.
We have audited the accompanying consolidated balance sheets of Direct General Corporation and Subsidiaries as of December 31, 2006 and 2005, and the related consolidated statements of operations, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2006. Our audits also included the financial statement schedules listed in the index at Item 15(a). These financial statements and schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Direct General Corporation and Subsidiaries as of December 31, 2006 and 2005 and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2006 in conformity with U.S. generally accepted accounting principles. Also in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information set forth therein.
The Company finances the majority of the insurance policies sold under a variety of payment plans. Finance income consists of interest, installment fees, acquisition and service fees, and delinquency fees. Finance income, other than delinquency fees, is recognized using the interest (actuarial) method or similar methods that
The Company’s insurance agencies receive commission income on the sale of ancillary insurance products offered by non-affiliated insurance companies. Commissions are generally recognized into income when the ancillary insurance policies are issued, net of a provision for return commissions on anticipated cancellations. The commissions received are calculated as a straight percentage of premiums produced and are not contingent upon achieving volume, profitability or other financial goals.
The Company receives service fees for agency, underwriting, policy administration, and claims adjusting services performed on behalf of other insurance companies for insurance policies produced through the Company’s insurance agency subsidiaries. Service fees are recorded net of the related fronting fees and premium taxes and are recognized as the services are performed, less amounts necessary to cover future processing and administrative costs.
The Company’s investment portfolio is primarily exposed to interest rate risk and to a lesser extent market and credit risk. The fair value of our portfolio is directly impacted by changing interest rates, market conditions and financial conditions of the issuer. The Company examines its portfolio on at least a quarterly basis for evidence of impairment with a particular emphasis on those securities with unrealized losses that satisfy certain conditions. Some of the factors that the Company considers in evaluating a security for other than temporary impairment include the duration and extent to which the fair value has been less than amortized cost, the reasons for the unrealized loss, including market conditions or changes in the financial condition of the issuer, and the Company’s ability and intent to hold the investment until maturity, or at least until there is a recovery in fair value. If an investment becomes other than temporarily impaired, such impairment is treated as a realized loss and the investment is adjusted to fair value. Realized investment gains and losses are recognized using the specific identification method.
Property and equipment is recorded at cost, net of accumulated depreciation. Depreciation is calculated using the straight-line method over the estimated useful lives of the respective assets, which are principally as follows: computer hardware and software (3-5 years), furniture and equipment (3-7 years), leasehold improvements (3-14 years based on the expected remaining life of the lease) and Company-owned buildings and related improvements (32 years). Property and equipment includes software developed and capitalized for internal use.
Deferred tax assets and liabilities are established for temporary differences between the financial reporting basis and the tax basis of assets and liabilities, at the enacted tax rates expected to be in effect when the temporary differences reverse. The principal assets and liabilities that generate these temporary differences are unearned premiums, loss and loss adjustment expense reserves, deferred policy acquisition costs, and non-deductible provisions for returns and allowances for finance losses. The effect of a tax rate change is recognized in income in the period of enactment. State income taxes are included in income tax expense.
A valuation allowance for deferred tax assets is provided for all or some portion of the deferred tax asset when it is more likely than not that an amount will not be realized. An increase or decrease in a valuation allowance that results from a change in circumstances that causes a change in judgment about the realizability of the related deferred tax asset is included in income. The Company believes its deferred tax assets are fully realizable at December 31, 2006.
Effective January 1, 2006, the Company adopted SFAS No. 123 (revised 2004) “Share Based Payments.” The impact of this pronouncement, which requires the Company to expense the cost resulting from all share-based payments in its financial statements, is provided in Note 18. Prior to 2006, the Company followed the provisions of Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees,” to account for its stock option activity in the financial statements. Using the intrinsic value method under APB No. 25, generally no compensation expense is recorded for employee options that are granted with an exercise price that equals or exceeds the market price at the date of grant. The disclosure provisions required by Statement of Financial Accounting Standards (SFAS) No. 123, “Accounting for Stock-Based Compensation” is provided in Note 10.
As of December 31, 2006, there were 463 securities with gross unrealized losses for more than 12 months and 88 securities with gross unrealized losses for less than 12 months. The Company has determined that all of the unrealized losses in the table above were temporary. There were no fundamental issues with any of these securities and the Company has the ability and intent to hold the securities until there is a recovery in fair value. There were no securities with unrealized losses of greater than 10% of book value.
Realized losses on investments in 2005 include a $15,000 write-down on a security that was determined to have an other-than-temporary decline in fair value. There were no such write-downs in 2006.
At December 31, 2006, investments carried at market value of $13,950,000 and cash of approximately $2,056,000 were on deposit with regulatory authorities. Additionally, investments carried at market value of $3,485,000 were pledged to an unaffiliated insurer to secure our assumed reinsurance obligations.
Finance receivables, net of unearned interest, unearned acquisition fees and deferred costs for the years ended December 31 were:
Finance receivables are collateralized by the unearned premiums of the related insurance policies. These finance receivables have an average remaining contractual maturity of approximately six months, with the longest contractual maturity being approximately eleven months.
The Company also leases certain computer equipment under capital lease arrangements. Depreciation expense on capitalized equipment leases during 2006, 2005 and 2004 was $475,000, $491,000 and $414,000 respectively, and related accumulated depreciation as of December 31, 2006 and 2005, was $4,314,000 and $3,839,000, respectively.
The Company has maintained a revolving credit facility with a consortium of banks to fund the working capital needs of the Company’s premium finance operations since 1994. Under the terms of the current facility, interest is payable quarterly at a rate elected by the Company of either the base commercial rate of First Tennessee Bank, N.A., as “Agent”, or at 1.5% to 2.0% above LIBOR, depending on the Company’s “Loan Amount to Net Worth” ratio (as defined in the agreement). At December 31, 2006, the weighted average rate in effect was 7.55%. The loan is principally secured by premium finance receivables.
During 2006, the Company and its banks agreed to various amendments of this credit facility that collectively extended the maturity to June 30, 2009, approved the proposed merger with Elara Holdings, Inc. and Elara Merger Corporation, and increased the credit facility to $195,000,000 effective January 1, 2007. At December 31, 2006, the Company may borrow up to $180,000,000 and the unused amount was $37,000,000.
The revolving credit facility contains covenants which, among other matters 1) limit the Company’s ability to incur or guarantee indebtedness, merge, consolidate and acquire or sell assets without bank approval; 2) require the Company to satisfy certain financial ratios, including those related to net worth, debt-to-equity, and profitability; and 3) restrict the payment of cash dividends on common stock. As of December 31, 2006, the Company was in compliance with all covenants related to the credit agreement.
In September 2005, Direct General Statutory Trust I (“DGST I”), a wholly owned unconsolidated subsidiary trust of the Company, issued 40,000 shares of preferred securities at $1,000 per share to outside investors and 1,238 shares of common securities to the Company, also at $1,000 per share. The sole assets of DGST I are $41,238,000 of junior subordinated debentures issued by the Company. The debentures will mature on September 15, 2035 and are redeemable by the Company in whole or in part beginning on September 15, 2010, at which time the preferred securities are callable. The debentures pay a fixed rate of 7.915% until September 15, 2010, after which the rate becomes variable.
The Company cedes certain premiums and risks of loss to other insurance companies under quota share, excess of loss, and catastrophe forms of reinsurance agreements. The ceded reinsurance agreements provide the Company with increased capacity to write additional business while limiting its exposure to loss within its capital resources. The Company evaluates the financial condition of its reinsurers and monitors various credit risks to minimize its exposure to significant losses from reinsurer insolvencies. The Company remains obligated for amounts ceded in the event that the reinsurers do not meet their obligations.
The Company is the beneficiary of letters of credit totaling approximately $2,404,000 and trust accounts totaling $95,000 in accordance with the terms of its reinsurance agreements. The letters of credit and trust accounts were unused at December 31, 2006. The largest unsecured reinsurance recoverable from a single reinsurer was $2,339,000 as of December 31, 2006, which was due from Dorinco Reinsurance Company, a subsidiary of Dow Chemical.
The Company’s agency subsidiaries and administrative service subsidiaries produce and administer personal automobile insurance business for other insurers. The Company receives service fees for its underwriting, policyholder administration and claims processing services. Administrative service fees earned, net of the related fronting fees and premium taxes, were approximately $6,046,000, $7,891,000 and $10,653,000 in 2006, 2005 and 2004 respectively, and are included in the caption commissions and service fee income in the Statements of Operations.
In March 2004, the Company completed a secondary offering whereby selling shareholders sold 3,314,015 shares of common stock. As a result of the exercise of the over-allotment option by the underwriters of the secondary offering, the Company issued and sold an additional 497,102 common shares in April 2004, which resulted in net proceeds to the Company (after deducting issuance costs) of $15,971,000. From the proceeds of this offer, Direct General Corporation used $11,500,000 to increase its investment in insurance subsidiaries and approximately $600,000 to increase the capitalization of its non-insurance subsidiaries in 2004.
During 2005, the Company repurchased 2,157,871 shares of its outstanding common stock for an aggregate price of approximately $40,075,000.
In April 2003, the Company’s board of directors adopted and the shareholders approved the 2003 Equity Incentive Plan (the “2003 Plan”). Under terms of the 2003 Plan, 1,651,200 shares of common stock are reserved and available for distribution. Under the 2003 Plan, incentive stock options and non-qualified stock options may be granted. Exercise provisions may vary, however, the term shall not exceed ten years from the date of grant.
Effective January 1, 2006, the Company adopted the provisions of the Financial Accounting Standards Board Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment, which was issued in December 2004 and is effective for periods beginning after June 15, 2005. This statement requires the Company to expense the cost resulting from all share-based payment arrangements, including employee stock options, in its financial statements. The Company adopted the provisions of this statement using the modified prospective approach. This approach requires that compensation expense to be recorded for all unvested stock options and restricted stock that exist upon adoption of the statement as they vest. New stock options that are granted are recognized as expense in the financial statements based on their fair values at the grant date. The Company recorded pre-tax compensation expense of $1,285,000 for 2006.
The Company’s statutory-basis financial statements of its insurance subsidiaries are prepared in accordance with accounting practices prescribed or permitted by the Department of Insurance in each state of domicile. Each state of domicile required that insurance companies domiciled in those states prepare their statutory basis financial statements in accordance with the NAIC Accounting Principles and Procedures Manual subject to any deviations prescribed or permitted by the insurance commissioner in each state of domicile. As of December 31, 2006 and 2005, the Company’s insurance subsidiaries did not have any prescribed or permitted accounting practices that differed from NAIC statutory accounting practices.
The Company’s insurance subsidiaries are restricted by state insurance laws as to the amounts they may pay as dividends without prior approval from their respective state insurance departments. For 2007, $19,854,000 in dividends is available to be paid to the Company from insurance subsidiaries without prior approval. Property and casualty insurance and life insurance companies are subject to certain Risk-Based Capital (RBC) requirements as specified by the NAIC. Under those requirements, the amount of capital maintained by an insurance company is to be determined based on the various risk factors related to it. At December 31, 2006, each of the Company’s insurance subsidiaries exceeds the RBC requirements.
The Company maintains a $195,000,000 variable rate revolving credit agreement with a group of banks (Note 6), which subjects the Company to exposures from fluctuations in interest rates under the agreement. Effective August 1, 2005, the Company purchased an interest rate swap with a notional amount of $50,000,000 which has been designated as a hedge of variable cash flows associated with that portion of the revolving credit agreement. This derivative instrument requires monthly settlements whereby the Company pays a fixed rate of 4.255% and receives 30-day LIBOR rate, reset monthly. The derivative expires on August 2, 2010.
Litigation. The Company is named as defendant in various legal actions including a consolidated federal securities class action, a consolidated federal shareholder derivative action, and a consolidated state shareholder derivative action filed in early 2005 and other lawsuits arising in the ordinary course of business. Estimates of losses from legal actions pertaining to claims made under insurance policies underwritten by the Company are included in loss and loss adjustment expense reserves. The parties have reached tentative settlement agreements in the pending class and derivative action lawsuits. Management believes that the resolution of all other actions will not have a material adverse effect on the Company’s financial position or results of operations.
Finance Receivables, Net - Fair value of finance receivables, which approximates carrying value, was estimated using projected cash flows, discounted at the weighted-average rates currently being offered for similar finance receivables. Cash flows were based on contractual payment terms adjusted for delinquencies and losses.
Notes payable - The notes payable are primarily floating-rate instruments and their carrying value approximates their fair value.
Debentures payable - The fair values for these financial instruments were estimated using projected cash flows, discounted at rates currently being offered for similar financial instruments.
During January 2005, the Company acquired certain assets of All American General Agency, Inc., operating primarily under the name AMCO, and the assets of two other insurance agencies, collectively operating through 82 sales offices in the state of Texas. The assets acquired included customer records and renewal rights and the operating assets of the sales offices used to conduct their agency business. The total purchase price, the majority of which was recorded as goodwill, was $5,560,000.
The Company periodically reviews recent accounting pronouncements issued by the Financial Accounting Standards Board, American Institute of Certified Public Accountants, Emerging Issues Task Force, and Staff Accounting Bulletins issued by the United States Securities and Exchange Commission to determine the potential impact on the Company’s financial statements. Based on its most recent review, the Company has determined that the majority of these recently issued accounting standards either do not apply to the Company or will not have a material impact on its financial statements.
In June 2006, the FASB issued Financial Accounting Standards Board Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (“FIN 48”), an interpretation of FASB Statement of Financial Accounting Standards No. 109 “Accounting for Income Taxes” (“SFAS No. 109”). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with SFAS No. 109. The interpretation prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax provision taken or expected to be taken in a tax return. Also, the interpretation provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. The adoption of FIN 48 will be effective for fiscal periods beginning after December 15, 2006. The Company does not expect that the adoption of FIN 48 will have a material impact on the financial statements of the Company.
On December 4, 2006, the Company entered into a definitive merger agreement with Elara Holdings, Inc., or Elara, an affiliate of Calera Capital and TPG Capital (formerly known as Fremont Partners and Texas Pacific Group respectively), and Elara Merger Corporation, pursuant to which Elara agreed to acquire all of the Company’s outstanding stock (the “Elara Merger”). Upon completion of the Elara Merger, the Company’s shareholders will receive $21.25 in cash for each share of the Company’s common stock they hold, a 28.71% premium to the closing price of $16.51 on December 4, 2006. The total value of the Elara Merger, including debt, is approximately $629,200,000. Our Board of Directors has approved the transaction and on March 8, 2007, our stockholders voted to approve the merger. The merger is subject to customary conditions, including approval from the relevant state insurance and finance commissioner or banking or similar department prior to the acquisition. All required filings have been made.