We lease space in the office building which houses our principal place of business, located at 3333 Lee Parkway, Suite 1200, Dallas, Texas 75219. The property is in good condition and consists of approximately 52,000 square feet. Our Southeast region leases office space in Miami, Florida of approximately 28,100 square feet and our Southwest region leases office space in Phoenix, Arizona of approximately 4,800 square feet both of which are in good condition. We own no real estate properties.
Continued settlement of runoff claims in an orderly manner. We also sold a former subsidiary (General Agents), which is not utilized in the nonstandard personal automobile business, in a transaction in which the Company realized a net gain of $4.6 million.
As of December 31, 2008, the statutory surplus was $89.8 million, after a $5.0 million dividend paid to GAN, compared to $96.0 million as of December 31, 2007. The unpaid claims and claim adjustment expenses stood at $75.5 million and $74.7 million at December 31, 2008 and 2007, respectively, of which unpaid claims and claim adjustment expenses attributable to ongoing nonstandard personal automobile lines was $66.0 million and $55.7 million, respectively.
Index to Financial Statements The Company believes that the improved C & CAE ratio for nonstandard personal auto insurance discussed below is the result of numerous factors, including the improvements in pricing and underwriting, upgrades of claims systems, procedures and personnel, and actions to closely monitor and address emerging claims trends. The Company believes that it should be able to achieve additional improvement in this C & CAE ratio, subject to the significant risks and uncertainties identified in this report (see ITEM 1A. Risk Factors).
We believe rate increases, selective reduction in the agency force and the effects of the slowing economy are the main reasons for the decrease in gross premiums written and net premiums earned for the comparative years. The decrease in the C & CAE ratio in 2008 from the 2007 periods was primarily due to a smaller amount of unfavorable development for claims occurring in prior accident years on the nonstandard personal auto lines and improvement in the 2008 accident periods as compared to the 2007 accident periods.
Index to Financial Statements Net investment income decreased $1,473,000 (16)% in 2008 primarily due to the decrease in Bonds available for sale, which provide higher returns than Short-term investments and the decline in interest rates. At December 31, 2008, Bonds available for sale comprised 57% of Investments versus 73% at December 31, 2007. The return on average investments was 4.4% in 2008 versus 5.0% in 2007.
The Company recorded net realized losses of $6,313,000 in 2008 and net realized gains of $4,629,000 in 2007. Approximately $5,671,000 of the net realized losses in 2008 related to write downs for other-than-temporary declines in fair value of various investments, including approximately $3,950,000 from auction preferred securities backed by preferred stock of Fannie Mae and Freddie Mac that are included in preferred stock (see note 3 of Notes to Consolidated Financial Statements which appear in Item 8 of this Annual Report). The net realized gains in 2007 were primarily due to the sale of General Agents. See “Significant Corporate Transactions - Sale of General Agents.” Variability in the timing of net realized capital gains and losses should be expected.
New business and the entry into new territories and product lines, associated with the Company’s growth beginning in 2005, has generally produced higher claims and greater uncertainty in determining reserves than more seasoned in-force business; see ITEM 1A. Risk Factors. The unfavorable development for prior accident years for nonstandard personal auto in 2008 is primarily the result of actual and projected increases in severity associated with bodily injury liability. The Company’s growth and the associated risks and uncertainties (see ITEM 1A. Risk Factors) made it difficult to estimate ultimate claims liabilities, and the unfavorable development occurred as the Company revised previous estimates to reflect current claims data. The unfavorable development for prior accident years includes approximately $993,000 recognized in 2008 relating to “extra-contractual” claims, in which claimants seek to recover amounts significantly in excess of applicable policy limits. In 2007, the Company incurred several “extra-contractual” claims of approximately $2,051,000 primarily related to prior accident years (see ITEM 1A. Risk Factors - “Litigation may adversely affect our financial condition, results of operations and cash flows”).
Index to Financial Statements Claims for “extra-contractual” liability arise when a claim is originally denied or the claimant asserts that a claim has been handled inappropriately, and the claimant further asserts that such denial or allegedly inappropriate response was improper or in “bad faith.” In such cases, which tend to arise in cases involving serious injury or death, it is not unusual for the amount of the claim to exceed by a substantial amount the policy limits that would otherwise be applicable. When the Company becomes aware of such a potential claim, it typically consults with outside counsel and, if appropriate, seeks to settle the claim on terms as favorable as possible in light of all the relevant circumstances. The amounts required for settlement of such claims, and the potential award if a case cannot be settled on acceptable terms, vary widely depending on the specific facts of the claim, the applicable law and other factors.
We believe it is reasonably likely that our loss costs could increase or decrease by 2% from current estimates, as remaining claims are recorded and resolved. Loss costs reflect the incurred loss per unit of exposure and are the product of frequency and severity. A 2% increase or decrease in our loss costs would result in unfavorable or favorable development of $7.5 million (based on C & CAE incurred as of December 31, 2008). This estimate of sensitivity is informational only, is not a projection of future results and does not take into account possible effects of extraordinary litigation events (such as class action claims).
Policy acquisition costs include commissions, premium taxes, marketing and underwriting expenses and the amortization of the premium deficiency. The expenses are charged to operations over the period in which the related premiums are earned. The decrease of $5,962,000 (17)% in 2008 was primarily due to decreases in commission, marketing expenses and the amortization of the premium deficiency for expected underwriting losses on the South Central business that was recorded in deferred policy acquisitions costs in 2007. Commissions decreased primarily as a result of the decline in premiums. The decrease in marketing expenses occurred primarily as a result of reducing the number of territory managers by expanding individual territory manager’s geographical area in order to become more efficient. Commissions are paid to the independent agents based upon premium writings. The marketing expenses are primarily salaries, telephone and travel expenses of our territory managers who oversee the efforts of the agents within a geographical area. Their time is focused on the supervision, relationship management and support of existing agents and recruiting new agents, as well as actively soliciting new business from these agents. Accordingly, these costs vary with and are primarily related to the acquisition of new and renewal insurance policies. The ratio of Policy acquisition costs to Net premiums earned was 17% and 18% for 2008 and 2007, respectively.
Underwriting and operating expenses increased $1,024,000 (3%) in 2008 from 2007 primarily due to an increase in software amortization and software maintenance. Underwriting and operating expenses as a percent of Net premiums earned and Agency revenues were 17% for 2008 and 15% for 2007. The increase in the ratio was due to the expense increases and the decline in premium earned.
The decrease in interest expense of $922,000 (22)% is primarily due to the decline in the 3-month London Interbank Offered Rate for U.S. dollar deposits (“LIBOR”) during 2008.
The Company recorded deferred tax expense in 2007 as a result of increasing the valuation allowance for Deferred Federal income tax asset. The Company considered it appropriate to increase the valuation allowance, see “Liquidity and Capital Resources - Net Operating Loss Carryforwards.”
As of December 31, 2008 and 2007, the net deferred tax asset before valuation allowance was $32,397,000 and $28,951,000 and the valuation allowance was $29,905,000 and $28,699,000, respectively. The Company does not record a tax valuation allowance relating to the net unrealized losses on investments, excluding equity securities because it is more likely than not that these losses would reverse or be used in future periods. The Company has the ability and it is the Company’s intent to fully recover the principal, which could require the Company to hold these securities until their maturity; therefore, the Company considers the impairment to be temporary.
The primary sources of the insurance subsidiary’s liquidity are funds generated from insurance premiums, net investment income and maturing investments. The short-term investments and cash are intended to provide adequate funds to pay claims without selling fixed maturity investments. At December 31, 2008, the insurance subsidiary held short-term investments and cash that the insurance subsidiary believes is at adequate liquidity for the payment of claims and other short-term commitments.
Index to Financial Statements With regard to liquidity, the average duration of the investment portfolio is approximately 2.0 years. The fair value of the fixed maturity portfolio at December 31, 2008 was $7,331,000 below amortized cost, before taxes see note 2 and note 18 of Notes to Consolidated Financial Statements which appear in Item 8 of this Annual Report). Various insurance departments of states in which the Company operates require the deposit of funds to protect policyholders within those states. At December 31, 2008 and 2007, the balance on deposit for the benefit of such policyholders totaled $5,447,000 and $5,218,000, respectively.
Net cash provided by operating activities was $15,625,000 for 2008 versus cash used for operating activities of $18,277,000 for 2007. The change in cash as a result of operating activities between the periods was primarily attributable to a lower C & CAE paid ratio in 2008 than in 2007.
The Company has performed a detailed review of the securities in the investment portfolio and has recorded approximately $5,671,000 in Net realized losses on certain securities that were considered other than temporarily impaired. The Company, at this time based upon information currently available and management’s evaluation and intent to hold securities to maturity if necessary to recover the cost, expects to recover the net unrealized loss of $4,839,000 (net of tax effects) and considers this impairment to be temporary.
Ceded unpaid C & CAE decreased as a result of the settlement of claims subject to the excess casualty and quota share reinsurance agreements. This balance represents unpaid C & CAE which have been ceded to reinsurers under the Company’s various reinsurance agreements, other than the reserve reinsurance cover agreement. These amounts are not currently due from the reinsurers but could become due in the future when the Company pays the claim and requests reimbursement from the reinsurers.
The reserve estimates were made by our in-house actuarial staff. An analysis provided by an independent actuarial firm was used to corroborate the reserve selections made by the in-house actuarial staff.
Accounts payable increased primarily due to increases in return premiums due policyholders, Florida hurricane assessments and bonuses payable based on production.
Note payable decreased as a result of the Company paying the principal balance down to $900,000 in November in conjunction with an amendment to the credit agreement (see note 5 of Notes to Consolidated Financial Statements which appear in Item 8 of this Annual Report).
Treasury stock increased as a result of the Company’s purchase of its Common Stock; see PART II, ITEM 5, “Market for Registrant’s Common Equity, Related Shareholders Matters and Issuer Purchases of Equity Securities.”
The discussion and analysis of the Company’s financial condition and results of operations are based upon the Company’s consolidated financial statements, which have been prepared in accordance with GAAP. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates under different assumptions or conditions.
Critical accounting policies are defined as those that are reflective of significant judgments and uncertainties, and potentially result in materially different results under different assumptions and conditions. The Company’s critical accounting policies are described below. For a detailed discussion on the application of these and other accounting policies, see note 1 of Notes to Consolidated Financial Statements which appears in Item 8 of this Annual Report.
Level 1 - Unadjusted quoted prices for identical assets or liabilities in active markets that the Company has the ability to assess.
Level 3 - Valuations based on models where significant inputs are not observable. The unobservable inputs reflect the Company’s own estimates as to the assumptions that market participants would use.
The Company receives pricing from independent pricing services, and these are compared to prices available from sources accessed through the Bloomberg Professional System. The number of available quotes varies depending on the security, generally we obtain one quote for Level 1 investments, one to three quotes for Level 2 investments and one to two quotes, if available, for Level 3 investments. If there is a material difference in the prices obtained, further evaluation is made. Market prices and valuations from sources such as the Bloomberg system, TRACE and dealer offerings are used as a check on the prices obtained from the independent pricing services. Should a material difference exist, then an internal valuation is made. This occurs primarily with mortgage backed securities where the matrix pricing methodology used by the independent pricing service is too broad in its categorizations. This often involves differences in reasonable prepayment assumptions or significant differences in performance among issuers. In some cases, other external observable inputs such as credit default swap levels are used as input in the fair value analysis.
All broker-dealer quotations obtained are non-binding. For short-term investments classified as Level 1 and Level 2, the Company uses prices provided by independent pricing services. The preferred stock classified as Level 3 are all auction rate preferred shares, and the Company used broker-dealer quotes which are non-binding.
1. The Company obtains a price from an independent pricing service.
4. In order to determine the proper SFAS No. 157 classification for each instrument, the Company obtains from its independent pricing service the pricing procedures and inputs used to price the instrument. The Company analyzes this information, taking into account asset type, rating and liquidity, to determine what inputs are observable and unobservable in order to determine the proper SFAS No. 157 level. For those valued internally, a determination is made as to whether all relevant inputs are observable or unobservable in order to classify correctly.
Deferred policy acquisition costs are principally commissions, premium taxes, marketing expenses and some underwriting expenses which are deferred. Policy acquisition costs are principally commissions, premium taxes, marketing expenses, some underwriting expenses and the change in deferred policy acquisition costs that are charged to operations over the period in which the related premiums are earned. The Company utilizes investment income when assessing recoverability of deferred policy acquisition costs. A premium deficiency and a corresponding charge to income is recognized if the sum of the expected claims and claim adjustment expenses, unamortized acquisition costs and maintenance costs exceeds related unearned premiums and anticipated investment income. At December 31, 2007, a premium deficiency of $623,000, net of anticipated investment income, was recognized against Deferred policy acquisition costs for expected underwriting losses on the South Central business. At December 31, 2008, there was no premium deficiency that was required to be recognized.
Goodwill represents the excess of purchase price over fair value of net assets acquired. The goodwill recorded is related to the 1998 acquisition of the Lalande Group. In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets,” goodwill is not amortized but rather is subject to an annual impairment test, or earlier if certain factors are present, based on its estimated fair value. Therefore, impairment losses could be recorded in future periods. These procedures require GAN to estimate the fair value of the reporting unit, compare the results to its carrying value and record the amount of any shortfall as an impairment charge. GAN performed this test as of December 31, 2008 and 2007, using a variety of methods, including estimates of future discounted cash flows. The test results indicated that there was no impairment loss at December 31, 2008 or 2007.
In addition to the factors described above that are generally applicable to property and casualty insurers, our ability to estimate claims reserves accurately is subject to risks and uncertainties arising out of the recent history and growth of the Company. These factors are discussed in more detail in Item 1A of this Annual Report, “Risk Factors.” The following are particularly significant factors that limit our ability, as compared with a more mature insurer with a larger and more stable book of business, to estimate claims reserves accurately:
Our growth required additional personnel resources, including management and technical underwriting, claims and servicing personnel, relationships with agents and vendors with whom we have not previously done business, and additional dependence on operating systems and technology. As a result, we often do not have as much reliable historical information about costs and trends in claims as would an insurer with more experience in the markets in which we have grown.
In analyzing claims data for the fourth quarter of 2007, it became apparent that the underlying accident quarter data reflected variances from historical patterns and required further analysis. Based on that analysis, we made adjustments to account for these variances, as follows:
The law of large numbers applies to selecting development patterns; i.e. the confidence of a point estimate is improved by increasing the amount of data used to develop the estimate; however, the data must be reasonably homogeneous, and exhibit little variation over time. Changes associated with the assumptions listed above affect the homogeneity of our data, and the variance associated with the loss development factors derived from the data. This implies that the variance around our point estimate has increased over time, or that the confidence interval around our point estimate has widened over time. This in turn implies there is greater volatility associated with our point estimate and we attempted to take this uncertainty into consideration with our estimates for the fourth quarter of 2007 and for 2008.
We utilize somewhat different processes for the estimation of reserves in the runoff line and in the nonstandard personal automobile business.
For our runoff lines, however, the remaining number of claims has declined to the point that conventional actuarial methods are of less utility than during the period in which the number of active claims provided more complete statistical data. Accordingly, during 2008 we ceased using conventional actuarial methods in our estimates for runoff claims and relied exclusively on evaluations of individual claim files. This methodology is not used for our personal lines business.
Traditionally, use of multiple methodologies produces a cluster of estimates with modest dispersion in the indicated possible outcomes. However, due to the changes the Company has experienced as outlined above, use of the methodologies cited above produced conflicting results and wider bands of indicated possible outcomes. Such bands do not necessarily constitute a range of outcomes, nor do we calculate a range of outcomes. If there is a significant variation in the results generated by different actuarial methodologies, our actuarial staff further analyzes the data using additional techniques. These processes may include making adjustments to the key assumptions underlying the methodologies, using additional generally accepted actuarial estimation methodologies, and applying actuarial judgment.
As noted above in the discussion of the methodologies we use in setting reserves for our runoff business, the decline in the number of outstanding claims has made traditional actuarial techniques less useful in determining our estimated liabilities, and the estimates for runoff claims have been based primarily on case-by-case evaluations by the claims department of developments in individual claim files. Accordingly, we generally do not depend on assumptions about historical claims development in making these estimates, and it would not be feasible to devise any means of testing the sensitivity of our estimates.
In determining our reserve estimates for nonstandard personal automobile insurance, for each financial reporting date we record our best estimate, which is a point estimate, of our overall unpaid claims and CAE for both current and prior accident years. Because the underlying processes require the use of estimates and professional actuarial judgment, establishing claims reserves is an inherently uncertain process. As our experience develops and we learn new information, our quarterly reserving process may produce revisions to our previously reported claims reserves, which we refer to as “development,” and such changes may be material. We recognize favorable development when we decrease our previous estimate of ultimate C & CAE, which results in an increase in net income in the period recognized. We recognize unfavorable development when we increase our previous estimate of ultimate losses, which results in a decrease in net income in the period recognized. Accordingly, while we record our best estimate, our claims reserves are subject to potential variability.
Index to Financial Statements As of December 31, 2008 and 2007, the net deferred tax asset before valuation allowance was $32,397,000 and $28,951,000, and the valuation allowance was $29,905,000 and $28,699,000, respectively. The Company does not record a tax valuation allowance relating to the net unrealized losses on investments, excluding stocks, because it is more likely than not that these losses would reverse or be utilized in future periods. The Company has the ability and it is the Company’s intent to fully recover the principal, which could require the Company to hold these securities until their maturity; therefore, the Company considers the impairment to be temporary.
The Company has evaluated tax contingencies in accordance with FIN No. 48. At December 31, 2008 and 2007, the Company does not have any uncertain tax positions.
In May 2008, the FASB issued SFAS No. 162, “The Hierarchy of Generally Accepted Accounting Principles” (“No. 162”). SFAS No. 162 identifies the sources of accounting principles and the framework for selecting the principles to be used in the preparation of financial statements of nongovernmental entities that are presented in conformity with GAAP in the United States (“the GAAP hierarchy”). The current GAAP hierarchy is set forth in the AICPA Statement on Auditing Standards No. 69, “The Meaning of Present Fairly in Conformity with Generally Accepted Accounting Principles” (“SAS No. 69”). The FASB believes the GAAP hierarchy should be directed to entities because it is the entity (not its auditors) that is responsible for selecting accounting principles for financial statements that are presented in conformity with GAAP. Accordingly, the FASB concluded that the GAAP hierarchy should reside in the accounting literature established by the FASB and has issued SFAS No. 162 to achieve the results. SFAS No. 162 is effective 60 days following the SEC’s approval of the Public Company Accounting Oversight Board amendments to SAS No. 69. We do not expect the adoption of SFAS No. 162 to have an impact on our consolidated financial position, results of operations or cash flows.
In December 2007, the FASB issued SFAS No. 141 (revised 2007), “Business Combinations” (“No. 141(R)”). SFAS No. 141(R) changes the accounting for acquisitions specifically eliminating the step acquisition model, changing the recognition of contingent consideration from being recognized when it is probable to being recognized at the time of acquisition, disallowing the capitalization of transaction costs and changes when restructurings related to acquisitions can be recognized. This statement applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. We will adopt this statement for acquisitions consummated after its effective date and for deferred tax adjustments for acquisitions completed before its effective date.
Index to Financial Statements In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities-Including an amendment of Statement No. 115” (“No. 159”). SFAS No. 159 permits a company to choose, at specified election dates, to measure at fair value certain eligible financial assets and liabilities that are not currently required to be measured at fair value. The specified election dates include, but are not limited to, the date when an entity first recognizes the item, when an entity enters into a firm commitment or when changes in the financial instrument causes it to no longer qualify for fair value accounting under a different accounting standard. An entity may elect the fair value option for eligible items that exist at the effective date. At that date, the difference between the carrying amounts and the fair values of eligible items for which the fair value option is elected should be recognized as a cumulative effect adjustment to the opening balance of retained earnings. The fair value option may be elected for each entire financial instrument, but need not be applied to all similar instruments. Once the fair value option has been elected, it is irrevocable. Unrealized gains and losses on items for which the fair value option has been elected will be reported in earnings. SFAS No. 159 is effective as of the beginning of fiscal years that begin after November 15, 2007. Upon our adoption and subsequent to that date of SFAS No. 159 effective January 1, 2008, we elected not to fair value financial instruments and certain other items under SFAS No. 159. Therefore, this statement had no impact on our consolidated financial position, results of operations or financial condition.
Index to Financial Statements In June 2006, the FASB issued FIN 48, “Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109, Accounting for Income Taxes.” FIN 48 prescribes a comprehensive financial statement model of how a company should recognize, measure, present, and disclose uncertain tax positions that the Company has taken or expects to take in its income tax returns. Guidance is also provided on derecognition, classification, interest and penalties, interim accounting, and disclosure. FIN 48 requires that only income tax benefits that meet the “more likely than not” recognition threshold be recognized or continue to be recognized on the effective date. Initial derecognition amounts would be reported as a cumulative effect of a change in accounting principle, as an adjustment to the opening balance of retained earnings for the 2007 fiscal year. FIN 48 applies to all tax positions and is effective for the Company beginning in fiscal year 2007. The adoption of FIN 48 did not affect the Company’s consolidated financial position, results of operations or financial condition and no cumulative effect adjustment was required to the January 1, 2007 balance of accumulated deficit.
These forward-looking statements reflect our current views, but they are based on assumptions and are subject to risks, uncertainties, and other variables which you should consider in making an investment decision, including, in addition to the terms discussed under “PART I. ITEM 1A. Risk Factors” of this document, (a) current and future economic conditions and uncertainties and disruptions in financial markets that may materially and adversely affect our business, operations, capital and liquidity, (b) the unpredictability of governmental actions affecting financial institutions and other financial firms and/or rating agencies, (c) operational risks and other challenges associated with growth into new and unfamiliar markets and states, (d) adverse market conditions, including heightened competition, (e) factors considered by A.M. Best in the rating of our insurance subsidiary, and the acceptability of our current rating, or a future rating, to agents and customers, (f) the Company’s ability to adjust and settle its runoff business on terms consistent with our estimates and reserves, (g) the adoption or amendment of legislation and regulations, uncertainties in the outcome of litigation and adverse trends in litigation, (h) inherent uncertainty arising from the use of estimates and assumptions in decisions about pricing and reserves, (i) the effects on claims levels resulting from natural disasters and other adverse weather conditions, (j) the availability of reinsurance and our ability to collect reinsurance recoverables, (k) the availability and cost of capital, which may be required in order to implement the Company’s strategies, and (l) limitations on the our ability to use net operating loss carryforwards.
The following Consolidated Financial Statements are on pages 64 through 109:
The following Consolidated Financial Statements Schedules are on pages 110 through 120: