Insurance Underwriting owns and occupies a building located in Florida consisting of approximately 57,386 square feet.
Insurance Services leases facilities with an aggregate square footage of approximately 84,042 at three locations in two states. The latest expiration date of the existing leases is in May 2016.
Insurance Underwriting includes the following subsidiaries of the Company: Mendota Insurance Company ("Mendota"), Mendakota Insurance Company, Universal Casualty Company ("UCC"), Kingsway Amigo Insurance Company ("Amigo"), Kingsway Reinsurance Corporation and Kingsway Reinsurance (Bermuda) Ltd. Throughout this 2011 Annual Report, the term "Insurance Underwriting" is used to refer to this segment.
Insurance Underwriting principally offers personal automobile insurance to drivers who do not meet the criteria for coverage by standard automobile insurers. For the year ended December 31, 2011, non-standard automobile insurance accounted for 86.4% of the Company's gross premiums written.
Insurance Services includes the following subsidiaries of the Company: Assigned Risk Solutions Ltd. ("ARS"), Northeast Alliance Insurance Agency, LLC ("NEA") and KAI Advantage Auto, Inc. ("Advantage Auto"). Throughout this 2011 Annual Report, the term "Insurance Services" is used to refer to this segment.
Operating loss represents one measure of the pretax profitability of our segments and is derived by subtracting direct segment expenses from direct segment revenues. Revenues and expenses are presented in the consolidated statements of operations, but are not subtotaled by segment. However, this information is available in total and by segment in Note 22, "Segmented Information" to the Consolidated Financial Statements, regarding reportable segment information. The nearest comparable U.S. GAAP measure is loss before income tax benefit which, in addition to operating loss, includes net investment income, net realized gains on investments, gain (loss) on change in fair value of debt, other income, general and administrative expenses, restructuring costs, interest expense, amortization of other intangible assets, goodwill impairment, gain on buy-back of debt and consolidation of debt, and equity in net income of investee.
While net premiums earned is the related U.S. GAAP measure used in the consolidated statements of operations, gross premiums written is the component of net premiums earned that measures insurance business produced before the impact of ceding reinsurance premiums, but without respect to when those premiums will be recognized as actual revenue. We use this measure as an overall gauge of gross business volume in Insurance Underwriting with some indication of profit potential subject to the levels of our retentions, expenses and loss costs.
While net premiums earned is the related U.S. GAAP measure used in the consolidated statements of operations, net premiums written is the component of net premiums earned that measures the difference between gross premiums written and the impact of ceding reinsurance premiums, but without respect to when those premiums will be recognized as actual revenue. We use this measure as an indication of retained or net business volume in Insurance Underwriting. It provides some indication of profit potential subject to our expenses and loss costs.
The preparation of consolidated financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect application of policies and the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the year. Actual results could differ from these estimates. Estimates and their underlying assumptions are reviewed on an ongoing basis. Changes in estimates are recorded in the accounting period in which they are determined. The critical accounting estimates and assumptions in the accompanying consolidated financial statements include the provision for unpaid loss and loss adjustment expenses, valuation of fixed maturities and equity investments, valuation of deferred tax assets, valuation of other intangible assets and goodwill recoverability, deferred policy acquisition costs, and fair value assumptions for debt obligations.
A significant degree of judgment is required to determine amounts recorded in the consolidated financial statements for the provision for unpaid loss and loss adjustment expenses. The process for establishing the provision for unpaid loss and loss adjustment expenses reflects the uncertainties and significant judgmental factors inherent in predicting future results of both known and unknown loss events. As such, the process is inherently complex and imprecise and estimates are constantly refined. The process of establishing the provision for unpaid loss and loss adjustment expenses relies on the judgment and opinions of a large number of individuals, including the opinions of the Company's actuaries. Further information regarding estimates used in determining our provision for unpaid loss and loss adjustment expenses is discussed in the “Unpaid Loss and Loss Adjustment Expenses” section of Part I, Item 1 of this Annual Report and Note 12, "Unpaid Loss and Loss Adjustment Expenses," to the Consolidated Financial Statements.
During 2010, the Company moved responsibility for evaluating and setting the provision for unpaid loss and loss adjustment expenses to an internal process, with the objective of increasing consistency and accountability relating to variability of the provision. The provision is evaluated by the Company's actuaries with the results then shared with management, which is responsible for establishing the provision recorded in the consolidated balance sheets.
Because the establishment of the provision for unpaid loss and loss adjustment expenses is an inherently uncertain process involving estimates, current provisions may need to be updated. Adjustments to the provision, both favorable and unfavorable, are reflected in the consolidated statements of operations for the periods in which such estimates are updated. The Company's actuaries develop a range of reasonable estimates and a point estimate of unpaid loss and loss adjustment expenses. The actuarial point estimate is intended to represent the actuaries' best estimate and will not necessarily be at the mid-point of the high and low estimates of the range.
determining the necessary provision for declines in market value that are considered other-than-temporary based on the analyses performed; and
The Company did not recognize any impairment related to its fixed maturities or equity investments that was considered other-than-temporary for the years ended December 31, 2011 and 2010.
The provision for income taxes is calculated based on the expected tax treatment of transactions recorded in our consolidated financial statements. In determining our provision for income taxes, we interpret tax legislation in a variety of jurisdictions and make assumptions about the expected timing of the reversal of deferred income tax assets and liabilities and the valuation of deferred income tax assets.
A reconciliation of total segment net operating loss to net loss for the years ended December 31, 2011 and 2010 is presented in Table 1 below:
The decrease in premiums written and earned is due to significant reductions in premium volumes in the non-standard automobile line of business. Insurance Underwriting has withdrawn from a number of states, increased its rate adequacy in the states where
General and administrative expenses not allocated to segments were $12.9 million in 2011 compared to $34.5 million in 2010. The decrease is primarily due to $4.8 million of restructuring expenses recorded in 2010 (See Note 19, "Restructuring Charges" to the Consolidated Financial Statements for further details); $5.6 million more of insurance expense, including for Director's & Officer's coverage, recorded in 2010 than in 2011; $6.3 million more of professional fees, including outside legal and audit, recorded in 2010 than in 2011; and $3.5 million more of salaries and benefits expense recorded in 2010 than in 2011 reflective of the increased staffing and higher operating costs related to the Company's previous Canadian operations.
During 2010, the Company recorded a gain of $17.8 million related to the LROC preferred units held by KFS Capital as a result of the consolidation of KLROC Trust. The gain arose from the difference between the carrying value of the debt held by KLROC Trust and the fair value of the LROC preferred units held by KFS Capital. See Note 4, "Acquisitions" to the Consolidated Financial Statements for further details of the KLROC Trust consolidation.
Effective December 31, 2010, we obtained a 75.1% common equity interest in Atlas Financial Holdings, Inc., a financial services holding company. In 2011, we recorded $0.4 million in earnings from this investment. During 2010, the Company had no equity in net income from investees. See Note 7, "Investment in Investees" to the Consolidated Financial Statements for further details.
Table 2 below summarizes the fair value of investments, including cash and cash equivalents, at the dates indicated.
As at December 31 (in millions of dollars, except for percentages)
Market risk is the risk that we will incur losses due to adverse changes in interest or currency exchange rates and equity prices. Given our U.S. operations typically invest in U.S. dollar denominated instruments and our relatively insignificant investment in equity instruments, our primary market risk exposures in the investments portfolio are to changes in interest rates.
Credit risk is defined as the risk of financial loss due to failure of the other party to a financial instrument to discharge an obligation. Credit risk arises from our positions in term deposits, corporate debt instruments and government bonds.
Table 4 below summarizes the composition of the fair value of fixed maturities and short-term investments, excluding cash and cash equivalents, at December 31, 2011 and 2010, by rating as assigned by Standard and Poor's ("S&P") or Moody's Investors Service ("Moody's"). Fixed maturities consist of predominantly high-quality instruments in corporate and government bonds with approximately 99.0% of those investments rated 'A' or better at December 31, 2011. The 'not rated' category consists primarily of investments in money market and short-term instruments.
The Company did not incur impairment losses during 2011 or 2010 on investments for which a decline in market value was deemed to be other-than-temporary. Management performs a quarterly analysis of our investments portfolio to determine if declines in market value are other-than-temporary. Further information regarding our detailed analysis and factors considered in establishing an other-than-temporary impairment on an investment is discussed within the "Critical Accounting Estimates and Assumptions" section of MD&A.
The length of time individual investments may be held in an unrealized loss position may vary based on the opinion of the investment manager and their respective analyses related to valuation and to the various credit risks that may prevent us from recapturing the principal investment. In cases of individual investments with a maturity date where the investment manager determines that there is little or no risk of default prior to the maturity of a holding, we would elect to hold the investment in an unrealized loss position until the price recovers or the investment matures. In situations where facts emerge that might increase the risk associated with recapture of principal, the Company may elect to sell investments at a loss.
TABLE 6 Provision for unpaid loss and loss adjustment expenses - net of reinsurance recoverable
At December 31, 2011 and 2010, the gross provisions for unpaid loss and loss adjustment expenses for our commercial automobile business were $22.4 million and $28.5 million, respectively. The primary reason for the decrease in unpaid loss and loss adjustment expenses was due to accelerated closure of open claims at UCC combined with UCC's exit from the commercial automobile markets.
The purpose of liquidity management is to ensure that there is sufficient cash to meet all financial commitments and obligations as they fall due. The liquidity requirements of the Company's business have been met primarily by funds generated from operations, disposal of discontinued operations, investment maturities and income and other returns received on investments. Cash provided from these sources is used primarily for loss and loss adjustment expense payments, debt servicing and other operating expenses. The timing and amount of payments for loss and loss adjustment expenses may differ materially from our provisions for unpaid loss and loss adjustment expenses, which may create increased liquidity requirements.
During 2011, the net cash used in operating activities as reported on the consolidated statements of cash flows was $76.1 million. This use of cash can be explained primarily by the decrease of $54.5 million in the provision for loss and loss adjustment expenses and the decrease of $27.5 million in the unearned premium liability. This combined $82.0 million use of cash is the result of the previously explained decrease in the volume of business being written while at the same time the Company is still responsible for paying loss and loss adjustment expenses related to losses incurred during years when the volume of business written was significantly higher than it was in 2011. The gross premiums written in 2012 are not expected to decline to the extent of the past few years which should moderate the net cash used in operating activities.
In summary, as reported on the consolidated statements of cash flows, the Company's net decrease in cash and cash equivalents during 2011 was $55.1 million.
Throughout 2011 and 2010, the Company has continued to experience losses. The reduction in shareholders' equity as a result of these ongoing losses can detrimentally impact the Company's capital flexibility by triggering negative covenants in its trust indentures described above and/or limiting the dividend capacity of the operating subsidiaries. As of December 31, 2011, the Company's total debt-to-total capital and senior debt-to-total capital ratios were 33.4% and 21.8%, respectively. These ratios have been calculated based on the financial statements prepared in accordance with U.S. GAAP, under which the Company's shareholders' equity has materially improved primarily due to fair valuation of its debt. The debt was previously carried at amortized cost under Canadian GAAP.
The Company launched a debt buy-back initiative during 2009, pursuant to which it has retired a substantial amount of its outstanding debt. During 2011 and 2010, the Company repurchased zero and $73.5 million of par value, respectively, of senior notes maturing in 2014. During 2011 and 2010, the Company repurchased $11.4 million (C$10.8 million) and $69.8 million (C$71.4 million) of par value, respectively, of senior unsecured debentures maturing in 2012. For further detail related to the Company's debt, see "Debt" below and Note 13, "Debt" to the Consolidated Financial Statements.
These buy-backs have resulted in improved debt ratios as well as decreased debt servicing cost.
Our reinsurance subsidiaries, which are domiciled in Barbados and Bermuda, are required by the regulators in the jurisdictions in which they operate to maintain minimum capital levels. As of December 31, 2011, the capital maintained by Kingsway Reinsurance Corporation and Kingsway Reinsurance (Bermuda) Ltd. was in excess of the regulatory capital requirements in Barbados and Bermuda, respectively.
On July 10, 2007, a general partnership of the Company, Kingsway 2007 General Partnership, issued C$100.0 million Senior Unsecured Debentures at 6% due on July 11, 2012. These debentures bear interest at a fixed rate of 6% per annum payable semi-annually from the date of issuance until July 11, 2012. Interest payments are to be made on January 10 and July 10 in each year, commencing January 10, 2008. The net proceeds to the Company amounted to C$99.2 million. Kingsway 2007 General Partnership may redeem the debentures in whole at any time and in part from time to time at the issuer's option. The debentures are unconditionally guaranteed by the Company and KAI.
Pursuant to the debt buy-back initiative previously mentioned, Kingsway 2007 General Partnership has repurchased and retired most of the originally issued par value. As of December 31, 2011, only C$1.7 million par value of this issue remains outstanding as compared to C$12.5 million at December 31, 2010.
Pursuant to the debt buy-back initiative previously mentioned, KAI has repurchased and retired most of the originally issued par value, and, as of December 31, 2011 and 2010, only $27.0 million par value of this issue remains outstanding.
On July 14, 2005, KLROC Trust completed its public offering of C$78.0 million of 5.00% LROC preferred units due June 30, 2015, of which the Company was a promoter.
As a result of these acquisitions, the Company beneficially owns and controls 2,333,715 units, representing 74.8% of the issued and outstanding LROC preferred units. The Company has determined that the consolidated financial statements of KLROC Trust should be consolidated with the financial statements of the Company beginning July 23, 2010. Refer to Note 4, "Acquisitions" to the Consolidated Financial Statements for further discussion. As a result of consolidating KLROC Trust, the Company recorded a gain of $17.8 million during 2010 related to the LROC preferred units held by KFS Capital. The gain arose as a result of the effective settlement of the debt within the consolidated group and is equal to the difference between the carrying value of the debt held by KLROC Trust and the fair value of the LROC preferred units held by KFS Capital.
Consolidated Statements of Comprehensive Loss for the Years Ended December 31, 2011 and 2010
In our opinion, Kingsway Financial Services Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2011, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Kingsway Financial Services Inc. as of December 31, 2011 and 2010, and the related consolidated statements of operations, shareholders' equity, comprehensive income and cash flows for the years then ended and our report dated March 30, 2012 expressed an unqualified opinion thereon.
Effective July 1, 2011, the Company ceased to be a "foreign private issuer," as defined in Rule 3b-4 of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), and became subject to the rules and regulations under the Exchange Act applicable to domestic issuers. As a result, the Company is required to prepare and file this Annual Report on Form 10-K for the fiscal year ended December 31, 2011. Our Annual Reports were previously filed on Form 40-F.
The consolidated financial statements are prepared as of December 31, 2011 based on individual company financial statements at the same date. Accounting policies of subsidiaries have been aligned where necessary to ensure consistency with those of Kingsway. The consolidated financial statements include the following material subsidiaries, all of which are owned, directly or indirectly, with the jurisdiction of incorporation indicated in brackets: 1347 Advisors LLC ("1347 Advisors") (Delaware); 1347 Capital LLC (Delaware); Acadia GP, LLC (Delaware); Acadia Acquisition Partners, LP ("Acadia") (Delaware); Appco Finance Corporation (Pennsylvania); American Country Underwriting Agency Inc. (Illinois); ARM Holdings, Inc. (Illinois); Assigned Risk Solutions Ltd. (New Jersey); Auto Underwriters Holdings LLC (Delaware); Boston General Agency, Inc. (Texas); Hamilton Risk Management Company ("Hamilton") (Florida); Insurance Management Services Inc. (Florida); KAI Advantage Auto, Inc. ("Advantage Auto") (Illinois); KFS Capital LLC ("KFS Capital") (Delaware); Kingsway 2007 General Partnership (Delaware); Kingsway 2009 LLC (Delaware); Kingsway America II Inc. (Delaware); Kingsway America Inc. ("KAI") (Delaware); Kingsway America Agency Inc. (Illinois); Kingsway Amigo Insurance Company ("Amigo") (Florida); Kingsway General Insurance Company (Ontario); Kingsway LGIC Holdings, LLC (Delaware); Kingsway Linked Return of Capital Trust ("KLROC Trust") (Ontario); Kingsway Reinsurance (Bermuda) Ltd. (Bermuda); Kingsway Reinsurance Corporation (Barbados); Mattoni Insurance Brokerage, Inc. (Washington); Mendakota Insurance Company ("Mendakota") (Minnesota); Mendota Insurance Agency, Inc. (Texas); Mendota Insurance Company ("Mendota") (Minnesota); MIC Insurance Agency Inc. (Texas); Northeast Alliance Insurance Agency, LLC ("NEA") (Delaware); and Universal Casualty Company ("UCC") (Illinois).
Noncontrolling interests arise where the Company owns less than 100% of the voting rights and economic interests in a subsidiary and is initially recognized at the proportionate share of the identifiable net assets of the subsidiary at the acquisition date and is subsequently adjusted for the noncontrolling interests' share of the acquiree's net income (losses) and changes in capital. The effects of transactions with noncontrolling interests are recorded in shareholders' equity where there is no change of control.
The preparation of consolidated financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect application of policies and the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the year. Actual results could differ from these estimates. Estimates and their underlying assumptions are reviewed on an ongoing basis. Changes in estimates are recorded in the accounting period in which they are determined. The critical accounting estimates and assumptions in the accompanying consolidated financial statements include the provision for unpaid loss and loss adjustment expense, valuation of fixed maturities and equity instruments, valuation of deferred tax assets, valuation of other intangible assets and goodwill recoverability, deferred policy acquisition costs, and fair value assumptions for debt obligations.
The unrealized foreign currency translation gains and losses arising from available-for-sale financial assets are recognized in other comprehensive loss until realized, at which date they are reclassified to the consolidated statements of operations. Unrealized foreign currency translation gains and losses on certain interest bearing debt obligation carried at fair value are included in the consolidated statements of operations.
The purchase method of accounting is used to account for the acquisition of subsidiaries. The cost of an acquisition is measured as the fair value of the assets received, equity instruments issued and liabilities incurred or assumed at the date of exchange, plus costs directly attributable to the acquisition. Identifiable assets acquired and liabilities and contingent liabilities assumed in a business combination are measured initially at their fair values at the acquisition date, irrespective of the extent of any noncontrolling interest. The excess of the cost of an acquisition over the fair value of the Company's share of the identifiable net assets acquired is recorded as goodwill. If the cost of acquisition is less than the fair value of the net assets of the subsidiary acquired, the difference is recognized in the consolidated statements of operations. Noncontrolling interest in the net assets of consolidated entities are reported separately in shareholders' equity.
Dividends and interest income are included in net investment income. Investment income is recorded as it accrues.
At each reporting date, and more frequently when conditions warrant, management assesses its investment in investees for potential impairment. If management's assessment indicates that there is objective evidence of impairment, the investee is written down to its recoverable amount, which is determined as the higher of its fair value less costs to sell and its value in use.
Cash and cash equivalents include cash and investments with maturities of three months or less that are readily convertible into cash.
income is included in determining the realizable value of the deferred policy acquisition costs. The Company's deferred policy acquisition costs are reported net of ceding commissions.
Property and equipment are reported in the consolidated financial statements at cost. Depreciation of property and equipment has been provided using the straight-line method over the estimated useful lives of such assets. Repairs and maintenance are recognized in operations during the period incurred. Land is not depreciated. The useful lives range from 39 years for buildings, 5 to 39 years for leasehold improvements, 3 to 10 years for furniture and equipment, 3 to 5 years for computer hardware and 2 to 5 years for automobiles.
Unpaid loss and loss adjustment expenses represent the estimated liabilities for reported loss events, incurred but not yet reported loss events and the related estimated loss adjustment expenses, including investigation. Unpaid loss and loss adjustment expenses are determined using case-basis evaluations and statistical analyses, including insurance industry loss data, and represent estimates of the ultimate cost of all claims incurred through the balance sheet date. Although considerable variability is inherent in such estimates, management believes that the liability for unpaid loss and loss adjustment expenses is adequate. The estimates are continually reviewed and adjusted as necessary, and such adjustments are included in current operations and accounted for as changes in estimates.
Basic net loss per share is computed by dividing net loss by the weighted average number of common shares outstanding during the year. Diluted net loss per share is computed by giving effect to the potential dilution that could occur if stock options were exercised and converted into common shares during the year. Shares issued under restricted stock awards are included in basic shares upon issuance of the awards even though the vesting of shares will occur over time.
The fair values of the Company's investments in fixed maturities and equity investments, LROC preferred units, senior unsecured debentures and subordinated debt are estimated using a fair value hierarchy to categorize the inputs it uses in valuation techniques. The fair value of the Company's investment in investees is based on quoted market prices. Fair values for other investments approximate their unpaid principal balance. The carrying amounts reported in the consolidated balance sheets approximate fair value for cash, short-term investments and certain other assets and other liabilities because of their short-term nature.
In October 2010, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") 2010-26, Financial Services-Insurance (Topic 944): Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts. The amendments in ASU 2010-26 address diversity in practice regarding the interpretation of which costs relating to the acquisition of new or renewal insurance contracts qualify for deferral; they clarify which costs should be deferred and which costs should be expensed when incurred. The amendments in ASU 2010-26 become effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2011. The Company does not anticipate that the adoption of this standard will have a material impact on the Company.
In May 2011, the FASB issued ASU 2011-04, Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS. ASU 2011-04 provides identical guidance with concurrently issued IFRS 13, Fair Value Measurements. Most of the changes in the new standard are clarifications of existing guidance, but it expands the disclosures about fair value measurements. It will require the categorization by level of the fair value hierarchy for items that are not measured at fair value in the statement of financial position but for which the fair value is required to be disclosed. In addition, for fair value measurements categorized as Level 3 within the fair value hierarchy, the valuation processes and sensitivity of the fair value measurements to changes in unobservable inputs shall be disclosed. This standard is effective for interim and annual periods beginning after December 15, 2011, and should be applied prospectively. Early adoption is not permitted. Other than enhanced disclosure requirements, the Company does not anticipate that the adoption of the new standard will have a material impact on the Company.
In June 2011, the FASB issued ASU 2011-05, Comprehensive Income (Topic 220): Presentation of Comprehensive Income. ASU 2011-05 will require companies to present the components of net income and comprehensive income in either one or two consecutive financial statements. Companies will no longer be permitted to present the components of other comprehensive income as part of the statement of changes in shareholders' equity. Reclassifications from other comprehensive income must be presented in both the consolidated statement of operations and the consolidated statement of other comprehensive income. This standard is effective for interim and annual periods beginning after December 15, 2011, and should be applied retrospectively. Early adoption is permitted. The Company does not anticipate that the adoption of ASU 2011-05 will have a material impact on the consolidated financial statements. In December 2011, the FASB issued ASU 2011-12, Comprehensive Income (Topic 220): Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income in Accounting Standards Update No. 2011-05 . The amendments in ASU 2011-12 delay the effective date of certain provisions in ASU No. 2011-05 that relate to reclassification items until such time as the FASB has time to re-deliberate the presentation of those items. All other provisions of ASU No. 2011-05 take effect on the date originally noted in that ASU.
On January 4, 2010, KAI acquired certain assets of Itasca Financial, LLC ("Itasca"), a property and casualty insurance industry advisory firm, owned and controlled by Mr. Larry G. Swets. Jr., a former director and current Chief Executive Officer and President of the Company. The consideration for the assets purchased was equal to $1.5 million cash and one million restricted common shares of the Company, payable in three annual installments. The purchase price of the Itasca assets was subject to adjustment at the end of the installment period. In 2011, purchase price adjustments were finalized, resulting in total goodwill of $2.8 million related to the purchase. The Company tested the Itasca goodwill for recoverability at December 31, 2011 and determined that the carrying value of the Itasca goodwill exceeded its fair value, which resulted in an impairment charge. Refer to Note 10, "Goodwill and Intangible Assets" for further discussion.
Effective June 30, 2010, the Company acquired 100% of JBA Associates, Inc. ("JBA") for approximately $16.3 million. JBA is a managing general agency based in New Jersey that specializes in assigned risk automobile insurance. The acquisition allows the Company to benefit from its institutional knowledge of non-standard automobile and assigned risk business and expand in the agency market. Goodwill of $0.5 million was recognized related to the purchase and an intangible asset of $12.0 million was
The following table summarizes the estimated fair value of the assets acquired and liabilities assumed at the date of acquisition of JBA.
KLROC Trust is an investment trust established under the laws of the Province of Ontario and is governed by a Declaration of Trust dated May 12, 2005, amended July 14, 2005. KLROC Trust was created to provide holders with exposure to a promissory note issued by KAI, an affiliate of the Company.
KLROC Trust commenced operations on July 14, 2005 and raised C$78.0 million through the issuance of 3,120,000 preferred units ("LROC preferred units") at C$25 per LROC preferred unit. In order to achieve its investment objectives, KLROC Trust used the net proceeds of C$74.1 of its initial public offering to subscribe for and purchase all of the limited partnership units of KL Limited Partnership ("KL LP"). In turn, KL LP used these proceeds for the payment of its purchase obligations under a forward purchase agreement which KL LP entered into with the Bank of Nova Scotia ("the Counterparty"). Such proceeds were invested by the Counterparty in KN Trust.
Beginning in 2009, KFS Capital, an affiliate of the Company, began purchasing LROC preferred units. The LROC preferred units purchased at that time were accounted for as available-for-sale investments. As of June 30, 2010, the Company held 833,715 LROC preferred units representing 26.7% of the issued and outstanding LROC preferred units; therefore, the Company was not obligated to consolidate KLROC Trust. In July 2010, the Company purchased an additional 1,500,000 LROC preferred units and now beneficially owns and controls 74.8% of the issued and outstanding LROC preferred units. The Company has determined that the consolidated financial statements of KLROC Trust, which financial statements include the accounts of the other aforementioned entities, should be consolidated with the financial statements of the Company beginning July 23, 2010. As a result of consolidating KLROC Trust, the Company recorded a gain of $17.8 million in the third quarter of 2010 related to the LROC preferred units held by KFS Capital. The gain arose from the difference between the carrying value of the debt held by KLROC Trust and the fair value of the LROC preferred units held by KFS Capital.
American Service Insurance Company ("American Service"), American Country Insurance Company ("American Country"), Southern United Fire Insurance Company ("Southern United"), Walshire Assurance Company ("Walshire"), Zephyr Insurance Company, Inc. ("Zephyr"), Avalon Risk Management Inc. (“Avalon”), and Jevco Insurance Company ("Jevco") have been classified as discontinued operations and the results of their operations are reported separately for all periods presented.
At the date of disposition, the investments, other non-cash assets and total liabilities of American Country, American Service and Southern United were $154.0 million, $85.1 million and $168.4 million, respectively.
The Pennsylvania Insurance Department ("DOI") challenged the disposition of Lincoln General which led to litigation with the DOI. On October 17, 2011, the Company reached a settlement and release ending all legal disputes with the DOI and also completed the previously announced acquisition of a minority interest in Walshire. At closing, Kingsway also obtained releases from Walshire, Lincoln General and the charities.
In total, the Company reported a loss from discontinued operations relating to Walshire, net of taxes, of zero and $2.7 million for the years ended December 31, 2011 and 2010, respectively.
At the date of disposition, the investments, other non-cash assets and total liabilities of Jevco were $909.4 million, $248.7 million and $913.6 million, respectively.
assessing the company's ability and intent to hold these investments at least until the investment impairment is recovered.
The Company has reviewed currently available information regarding investments with estimated fair values that are less than their carrying amounts and believes that these unrealized losses are not other-than-temporary and are primarily due to temporary
market and sector-related factors rather than to issuer-specific factors. The Company does not intend to sell those investments, and it is not likely that it will be required to sell those investments before recovery of its amortized cost.
Equity in net income of investees was $0.4 million and zero for the years ended December 31, 2011 and 2010, respectively. The Company also recognized a decrease to shareholders' equity of $1.5 million for the Company's pro rata share of its investees' accumulated other comprehensive loss.
The Company acquired its investment in Oak Street in the fourth quarter of 2011. Summarized financial information for Oak Street at December 31, 2011 is presented below:
The maximum amount of return commission, which would have been due to reinsurers if they or the Company had canceled all of the Company's reinsurance, with the return of the unearned premium, is as follows at December 31, 2011:
The amounts of assumed premiums written were $12.1 million and $12.7 million for the years ended December 31, 2011 and December 31, 2010, respectively. The amounts of assumed premiums earned were $12.5 million and $14.9 million for the years ended December 31, 2011 and 2010, respectively.
Goodwill is assessed for impairment on an annual basis and at any other time if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting segment below its carrying amount. Any potential impairment is identified by comparing the fair value of a reporting unit to its carrying value. If the fair value of the reporting segment exceeds its carrying value, goodwill is considered not to be impaired. If the carrying value of the reporting segment exceeds its fair value, a more detailed goodwill impairment assessment must be undertaken. A goodwill impairment charge is recognized to the extent that, at the reporting unit level, the carrying value of goodwill exceeds the implied fair value.
The Company recorded goodwill of $2.8 million related to the Itasca acquisition (see Note 4, "Acquisitions" for further discussion), which was not associated with the Company's two reportable segments as identified in Note 22, "Segmented Information". The Company concluded that the carrying amount of goodwill related to the Itasca acquisition exceeded its fair value and, therefore, was not recoverable. As a result, the Company recorded a non-cash goodwill impairment charge of $2.8 million relating to the Itasca goodwill in the consolidated statements of operations during 2011. The determination that the fair value of goodwill was less than its carrying value resulted primarily from a decline in the quoted value of Kingsway's common stock as compared to the book value per share of the Company at December 31, 2011.
ARS, which is part of Insurance Services, has goodwill of $0.5 million. Based on this review, the Company concluded that the estimated fair value of ARS exceeds the carrying value of the reporting unit at December 31, 2011. Accordingly, the Company concluded that the goodwill associated with ARS was recoverable at December 31, 2011.
The insurance licenses intangible assets have indefinite useful lives and are not amortized. The agent relationships intangible asset was being amortized over a five-year term based on the pattern in which the economic benefits of the intangible asset was expected to be consumed. The renewal rights intangible assets, recognized related to the acquisitions of NEA and ARS, were being amortized on a straight-line basis over 10 to 15 years. Effective January 1, 2011, the renewal rights intangible assets were deemed to have indefinite useful lives and, therefore, are no longer being amortized. Amortization of intangible assets was $0.1 million and $4.4 million for the years ended December 31, 2011 and 2010, respectively.
Other factors include the continually evolving and changing regulatory and legal environment, actuarial studies, professional experience and expertise of the Company's claims departments' personnel and independent adjusters retained to handle individual claims, the quality of the data used for projection purposes, existing claims management practices including claims handling and settlement practices, the effect of inflationary trends on future loss settlement costs, court decisions, economic conditions and public attitudes.
During 2011 and 2010, the Company repurchased $11.4 million (C$10.8 million) and $69.8 million (C$71.4 million) of par value, respectively, of this offering and realized a gain of $0.6 million in 2011 and $2.8 million in 2010. As of December 31, 2011 C$1.7 million par value of this issue remains outstanding as compared to C$12.5 million par value outstanding at December 31, 2010.
Both of these senior unsecured debentures contain negative covenants in their trust indentures placing limitations and restrictions over certain actions without the prior written consent of the indenture trustees. Included in the negative covenants is the limitation on the incurrence of additional debt in the event that the total debt-to-total capital ratio or the senior debt-to-total capital ratio exceeds 50% or 35%, respectively. The total debt is calculated on a pro-forma basis taking into account the issuance of additional debt. The debentures also include covenants limiting the issuance and sale of voting stock of restricted subsidiaries, the payment of dividends or any other payment in respect of capital stock of the Company, or the retirement of debt subordinate to the debentures covered by the trust indentures if, after giving effect to such payments as described in the trust indentures, the total debt-to-total capital ratio exceeds 50%. As of December 31, 2011, the Company's total debt-to-capital and senior debt-to-capital ratios were 33.4% and 21.8%, respectively.
During the first quarter of 2011, the Company gave notice to its trustees of its intention to exercise its voluntary right to defer interest payments for up to 20 quarters, pursuant to the contractual terms of its outstanding indentures, which permit interest deferral. This action does not constitute a default under the Company's indentures or any of its other debt indentures. At December 31, 2011, deferred interest payable of $3.8 million is included in accounts payable and accrued liabilities in the consolidated balance sheets. The cash interest due in 2016 is subject to changes in LIBOR over the deferral period.
On July 10, 2007, Kingsway 2007 General Partnership issued a five-year C$100.0 million debt obligation due on July 11, 2012 with fixed semi-annual C$3.0 million interest payments. Kingsway 2007 General Partnership's risk management objective was to lock in the cash flow requirements on this debt obligation in U.S. dollar terms which is the currency in which its cash inflows are received, thus mitigating exposure to variability in expected future cash flows. In order to meet this objective, Kingsway 2007 General Partnership had entered into a cross-currency swap with Bank of Nova Scotia to swap U.S. dollar cash flows into Canadian dollar cash flows providing the Company with the required Canadian dollar funds each semi-annual period and upon maturity to settle the senior debenture offering interest payments. The swap transaction had been designated as a cash flow hedge. Any changes in the fair value of the hedging instruments were recorded in other comprehensive income (loss) until the hedged item affects the consolidated statement of operations.
On June 2, 2009, the Company discontinued the swap transaction which was designated as a cash flow hedge. When a cash flow hedge is discontinued, any cumulative adjustment to the hedging instrument that had been recorded through other comprehensive income (loss) is recognized in the consolidated statements of operations over the remaining term of the hedged item. The amount of loss recorded in other comprehensive income at the time of the discontinuance of the cash flow hedge was $6.2 million before tax of which $1.3 million and $3.6 million has been reclassified to other income in the consolidated statements of operations for the years ended December 31, 2011 and 2010, respectively. As of December 31, 2011, zero remains in other comprehensive income (loss) to be reclassified to the consolidated statements of operations in 2012.
The U.S. operating loss carryforward amounts disclosed above contain consolidated and separate company operating loss carryforwards, the most significant of which is the KAI Tax Group operating loss carryforward of approximately $777.8 million. In addition, there are operating loss carryforwards relating to the operations in Barbados in the amount of $84.8 million, which losses will expire by 2018.
The following table sets forth the reconciliation of numerators and denominators for the basic and diluted loss per share computation for the years ended December 31, 2011 and 2010:
The exercise price is based on the market value of the shares at the time the option is granted. In general, the options vest evenly over a three or four-year period and are exercisable for periods not exceeding 10 years.
The intrinsic value of a stock option grant is the difference between the current market price for the Company's common shares and the exercise price of the option. The aggregate intrinsic values for the stock options outstanding at December 31, 2011 and 2010 were zero for each year. The aggregate intrinsic values for stock options exercisable at December 31, 2011 and 2010 were zero for each year.
The following tables summarize information about stock options outstanding as of December 31, 2011 and December 31, 2010:
Exercise prices are stated as per the terms of the option.
At December 31, 2011 and December 31, 2010, the number of options exercisable was 509,000 and 236,417, respectively, with weighted average prices of C$6.85 and C$16.86, respectively.
The fair value of the options granted was estimated at the date of grant using the Black-Scholes option pricing model with the following weighted-average assumptions:
management's opinion the above pro forma adjustments are not necessarily a reliable single measure of the fair value of the Company's employee stock options.
In May 2008, the Company implemented a deferred share unit ("DSU") program. The purpose of the DSU program was to promote a greater alignment of interests between members of the Board of Directors and the shareholders of the Company. DSUs were credited to an account maintained for each director by the Company. The number of DSUs to be credited was determined by dividing the amount of the director's remuneration to be deferred into DSUs on that date by the closing TSX share price on that day.
The Company maintains a defined contribution plan in the United States. for all of its qualified employees including the employees of all subsidiaries. Qualifying employees can choose to voluntarily contribute up to 60% of their annual earnings subject to an overall limitation of $16,500 in each of 2011 and 2010. The Company matches an amount equal to 50% of each participant's contribution, limited to contributions up to 5% of a participant's earnings.
The contributions for the plan vest based on years of service with 100% vesting after five years of service. The Company's contribution is expensed as paid and for the years ended December 31, 2011 and 2010 totaled $0.7 million and $0.6 million, respectively. All Company obligations to the plans were fully funded as of December 31, 2011.
There were no options exercised during the years ended December 31, 2011 and 2010.
Segment revenues for the years ended December 31, 2011 and 2010 were:
In 2010, in addition to a previously agreed annual retainer of $0.2 million, the Board of Directors decided to pay an additional retainer of $0.2 million to the Chairman of the Board. The additional payments to the Chairman of the Board were due to his increased workload with respect to various matters confronting the Company.
The Company provided a letter of guarantee to a third-party for customs bonds reinsured by Lincoln General. This guarantee may require the Company to compensate the third-party if Lincoln General is unable to fulfill its obligations relating to the customs bonds. The Company's expense under this contingency is not determinable and no liability is reflected in the consolidated financial statements at December 31, 2011.
Fixed maturities and short-term investments with an estimated fair value of $18.2 million and $16.6 million were on deposit with state and provincial regulatory authorities at December 31, 2011 and 2010, respectively. Also, from time to time, the Company pledges investments to third-parties to collateralize liabilities incurred under its policies of insurance. The amount of such pledged investments was $32.1 million and $28.3 million at December 31, 2011 and 2010, respectively. Collateral pledging transactions are conducted under terms that are common and customary to standard collateral pledging and are subject to the Company's standard risk management controls.
In the normal course of business, the Company receives collateral on certain business transactions to reduce its exposure to credit risk. The amount of such pledged securities was $0.5 million and $0.9 million at December 31, 2011 and 2010, respectively. The Company is normally permitted to sell or repledge the collateral it receives under terms that are common and customary to standard collateral holding and are subject to the Company's standard risk management controls.
In the United States, a risk-based capital ("RBC") formula is used by the National Association of Insurance Commissioners ("NAIC") to identify property and casualty insurance companies that may not be adequately capitalized. The NAIC requires that capital and surplus not fall below 200% of the authorized control level as defined under the RBC statutes. As of December 31, 2011, all of the Company's U.S. insurance subsidiaries are above the required RBC levels.
As of December 31, 2010, UCC's RBC was 160%. UCC entered into a voluntary runoff and prepared a comprehensive plan which it filed with the Illinois Department of Insurance in April 2011. The comprehensive plan was approved by the Illinois Department of Insurance in June 2011. UCC has been in compliance with the plan since its approval.
The Company's reinsurance subsidiaries, which are domiciled in Barbados and Bermuda, are required by the regulators in the jurisdictions in which they operate to maintain minimum capital levels. As of December 31, 2011, the capital maintained by Kingsway Reinsurance Corporation and Kingsway Reinsurance (Bermuda) Ltd. was in excess of the regulatory capital requirements in Barbados and Bermuda, respectively.
The Company's insurance subsidiaries prepare statutory basis financial statements in accordance with accounting practices prescribed or permitted by the Departments of Insurance in states in which they are domiciled. "Prescribed" statutory accounting practices include state laws, regulations and general administrative rules, as well as a variety of publications of the NAIC. "Permitted" statutory accounting practices encompass all accounting practices that are not prescribed. Such practices may differ from state to state, may differ from company to company within a state, and may change in the future. The Company and its subsidiaries have no material differences between accounting practices set forth in the NAIC Practices and Procedures Manual and prescribed practices in each insurer's state of domicile.
The Company's insurance subsidiaries are required to report results of operations and financial position to insurance regulatory authorities based upon statutory accounting practices ("SAP"). The more significant differences between SAP and U.S. GAAP are as follows:
Under SAP, available-for-sale investments in fixed maturities are generally carried at amortized cost while U.S. GAAP requires available-for-sale fixed maturities to be carried at fair value, with unrealized gains or losses reported as a separate component of shareholders' equity, net of applicable deferred taxes.
Statutory capital and surplus, statutory net loss and maximum dividend potential for the Company's insurance subsidiaries are:
Dividends paid by insurance subsidiaries are restricted by regulatory requirements of the insurance departments in the subsidiaries' state of domicile. The maximum amount of dividends that can be paid to shareholders by insurance companies without prior approval of the domiciliary state insurance commissioner is generally limited to the greater of (i) 10% of a company's statutory capital and surplus at the end of the previous year or (ii) 100% of the company's net income for the previous year. The combined maximum dividend in the table above represents the amount that can be paid by Mendakota, a wholly owned subsidiary of Mendota, to Mendota. At this time, however, none of UCC, Mendota, and Amigo is able to pay dividends to the Company without regulatory approval due to their negative unassigned surplus positions.
On February 21, 2012, the Company and its subsidiary, 1347 Capital LLC, announced that the Company has signed a definitive agreement to acquire the tangible and intangible assets and liabilities of a specialty insurance business in a highly structured transaction for total consideration consisting of cash at closing, future contingent payments and common equity in the newly formed entity. The transaction, which is subject to customary closing conditions including regulatory approval, is expected to close during the second quarter of 2012.