The following tables provide selected historical consolidated financial and operating data of Affirmative Insurance Holdings, Inc. 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, 2004 and 2003 and for the years ended December 31, 2004, 2003 and 2002 from our audited consolidated financial statements included in this report. We derived our selected historical consolidated financial data for the year ended December 31, 2001 from our audited consolidated financial statements not included in this report. We derived our selected historical consolidated financial data for the year ended December 31, 2000 from our unaudited consolidated statements of operations and balance sheets 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.
On December 28, 2001, Vesta increased its ownership interest in us to 92% of the voting power of our capital stock. At that time, we adopted push down accounting. Our statements of operations data for the years ended December 31, 2001 and 2000 are presented above on our historical basis, as push down accounting was not appropriate prior to December 28, 2001 and no material adjustments exist for the period from December 28, 2001 to December 31, 2001. In addition, our balance sheet data as of December 31, 2000 are presented above on our historical basis as push down accounting was not appropriate prior to December 28, 2001. See Note 2 to our consolidated financial statements included in this report.
Prior to acquiring our insurance companies effective December 31, 2003, our operations were comprised of our non-standard personal automobile insurance underwriting and retail agency operations. The business written by the insurance companies we acquired from Vesta was 100% reinsured by Vesta Fire in accordance with a quota share reinsurance agreement. As a result of this internal reinsurance, the historical financial statements of Affirmative Insurance Company and Insura included only certain revenues, primarily policy fees that were not ceded to Vesta Fire.
In the third quarter of 2000, we discontinued the insurance underwriting operations related to our original business concept of underwriting non-standard personal automobile insurance policies sold exclusively through a centralized call center sales force directly to consumers responding to radio, television and Internet advertising, as well as through the solicitation of customers of a national check cashing chain. At that time, we made a strategic decision to focus our operations on building and acquiring our underwriting and retail agency businesses.
We are an insurance holding company engaged in underwriting, servicing and distributing non-standard automobile insurance policies and related products and services to individual consumers in highly targeted geographic areas. Our subsidiaries include two insurance companies, four underwriting agencies and five retail agencies with 169 owned and 42 franchised retail store locations. We offer our products and services in 11 states, including Texas, Florida, Illinois and California. Since 2000, our growth has been achieved principally as a result of the acquisition and integration of six retail and/or underwriting agencies in 2001, 2002 and 2004.
The historical financial results of the NSA Business for the years ended December 31, 2003 and 2002 have been included in footnotes to Vesta’s audited financial statements not included in this report.
Vesta’s ownership. On December 21, 2000, Vesta acquired common and convertible preferred stock representing approximately 52% of our voting stock on a fully diluted basis. On December 28, 2001, Vesta acquired additional common and convertible preferred stock representing an additional approximately 40% of our voting stock. When purchase transactions result in an entity becoming wholly-owned or majority-owned, a new basis for the purchased assets and liabilities must be presented, representing the concept of “push-down accounting.” We determined that Vesta’s costs of acquiring us should be “pushed down” in order to establish a new accounting basis in our separate financial statements. In recognition of Vesta’s approximately 92% ownership position in us, we adopted push down accounting to reflect Vesta’s cost basis in us effective December 28, 2001. The principal adjustments that were made to adopt push down accounting were to record goodwill of $18.5 million and to adjust the various elements of stockholders’ equity, including retained deficit, related to Vesta’s ownership percentage.
Acquisitions. In 2001, 2002 and 2004, we acquired six retail and/or underwriting agencies currently operating in seven states. Effective December 31, 2003, we acquired our two insurance companies from Vesta. Descriptions of each of these acquisitions are provided below. With the exception of the December 31, 2002 InsureOne transaction and the acquisition of our insurance companies, all of these transactions were accounted for as purchases and the purchase price was allocated to the assets purchased based on their fair values at the time of acquisition.
• Space Coast. On October 1, 2001 we purchased a 74.5% ownership interest in Space Coast Holdings, Inc., the parent company of Space Coast Underwriters Insurance Agency, Inc., a Florida-based underwriting agency. At the time of our acquisition, the remaining 25.5% ownership of Space Coast was held by the management of Space Coast. Following the transaction, the management of Space Coast exercised options and increased its ownership percentage to 27.0%, with our ownership percentage decreasing to 73.0%.
• American Agencies and Harbor. On January 1, 2002, we acquired American Agencies General Agency, Inc., as well as certain non-standard personal automobile insurance assets of Harbor Insurance Group, Inc. As part of the transaction, the assets and business operations of Harbor Insurance Group, Inc. were transferred to American Agencies General Agency, Inc. The combined American Agencies operation is an underwriting agency that underwrites and services non-standard personal automobile insurance policies sold by independent agencies in the states of Texas and New Mexico.
• Driver’s Choice. On August 1, 2002, we purchased Driver’s Choice Insurance Services, LLC, a South Carolina-based underwriting agency and retail agency operation.
Reinsurance transaction with Vesta. Effective December 31, 2003, Vesta restructured its internal reinsurance arrangements relating to non-standard personal automobile insurance policies to transfer to our insurance companies all of the future economic interest in the NSA Business. Under this transaction, which was effected through a quota share reinsurance agreement, Vesta Fire retained all loss and loss adjustment expense reserves as of December 31, 2003 related to these policies and remains liable to indemnify us for any losses and allocated loss adjustment expenses associated with these policies that occurred on or prior to December 31, 2003. The NSA Business had net premiums earned of $167.4 million for the year ended December 31, 2003. We determined that this restructuring of Vesta’s internal reinsurance did not constitute a business combination within the meaning of SFAS No. 141 and, accordingly, our historical consolidated statements of operations included in this report do not reflect any underwriting results on these policies during the periods presented.
Fee income includes policy origination fees and installment fees to compensate us for the costs of providing installment payment plans, as well as late payment, policy cancellation, policy rewrite and reinstatement fees. We recognize policy origination fees over the premium earning period of the underlying policies and recognize all other fees on a collected basis.
Accounting and Reporting for Reinsurance. Pursuant to SFAS No. 113, “Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts,” we are required to review the contractual terms of all our reinsurance purchases to ensure compliance with that statement. The statement establishes the conditions required for a contract with a reinsurer to be accounted for as reinsurance and prescribes accounting and reporting standards for those contracts. For all reinsurance transactions, immediate recognition of gains is precluded unless our liability to our policyholders is extinguished. Contracts that do not result in the reasonable possibility that the reinsurer may realize a significant loss from the insurance risk assumed generally do not meet the conditions for reinsurance accounting and must be accounted for as deposits.
SFAS No. 113 also requires us to disclose the nature, purpose and effect of reinsurance transactions, including the premium amounts associated with reinsurance assumed and ceded. It also requires disclosure of concentrations of credit risk associated with reinsurance receivables and prepaid reinsurance premiums. We believe we have properly accounted for all of our reinsurance contracts.
Recoverability of assets. Our financial statements include as assets amounts we either: (1) expect to collect from third parties, particularly reinsurance recoverables; or (2) expect to benefit from in future periods, particularly deferred acquisition costs. In establishing these amounts, we have made significant judgments and estimates regarding the ultimate realization of each asset. Specifically, we have made critical assumptions and judgments in establishing assets for reinsurance recoverables on paid losses and deferred policy acquisition costs. Changes in assumptions, judgments or estimates we have made with respect to each of these assets would directly impact our financial results and financial condition.
Reinsurance recoverable on paid and incurred losses. We cede premiums and losses to reinsurers under quota share reinsurance agreements. Although a reinsurer is liable for losses to the extent of the coverage which it assumes, our reinsurance contracts do not discharge our insurance companies from primary liability to each policyholder for the full amount of the applicable policy. Consequently our insurance companies remain obligated to pay claims in accordance with the terms of the policies regardless of whether a reinsurer fulfills or defaults on its obligations under the related reinsurance agreement.
At December 31, 2004, we had recorded $75.4 million as amounts recoverable from reinsurers, including $10.3 million net recoverable from Vesta Fire. Our reinsurance agreement with Vesta Fire allow us and Vesta Fire to offset amounts due to one another under the agreement. Vesta Fire is currently rated “B” (Fair) by A.M. Best. According to our reinsurance agreement, if Vesta Fire’s A.M. Best financial strength rating remains below “B+” we have the right to require Vesta Fire to provide a letter of credit or establish a trust account to collateralize the net amounts due to us from Vesta Fire under the reinsurance agreement. On July 27, 2004, we notified Vesta to establish a trust account collateralizing the net amount due to us, due to the fact that Vesta Fire’s A.M. Best rating was below a “B+” after the consummation of our initial public offering. We have $8.9 million currently in a trust account and have requested Vesta to increase the collateral held in this account to $10.3 million to fully collateralize the net amount due to us as of December 31, 2004.
Deferred policy acquisition costs. Deferred policy acquisition costs represent the deferral of expenses that we incur acquiring new business or renewing existing business. Policy acquisition costs, primarily commissions, premium taxes and underwriting and agency expenses related to issuing a policy are deferred and charged against income ratably over the terms of the related policies. At December 31, 2004, we had $19.1 million of deferred policy acquisition costs. Management regularly reviews the categories of acquisition costs that are deferred and assesses the recoverability of this asset. A premium deficiency and a corresponding charge to income is recognized if the sum of the expected losses and loss adjustment expenses, unamortized acquisition costs and maintenance costs exceeds related unearned premiums and anticipated investment income. At December 31, 2004, we determined that there was no premium deficiency.
our loss and loss adjustment expense reserves for changes in product mix, underwriting standards, loss cost trends and other factors. Our loss and loss adjustment expense reserves may also be impacted by factors such as the rate of inflation, claims settlement patterns, litigation and legislative activities. Unpaid losses and loss adjustment expenses have not been reduced for our reinsurance recoverables. Changes in estimates of the liabilities for unpaid losses and loss adjustment expenses are reflected in the consolidated statement of operations in the period in which determined. Ultimately, our actual losses and loss adjustment expenses may differ materially from the estimates we have recorded. As previously noted, our historical financial statements include the effects of a 100% quota share reinsurance contract with our affiliate, Vesta Fire. Accordingly, we retain none of the underwriting risks associated with the reserves established at December 31, 2003 for our insurance companies.
Statutory accounting practices. The Company is required to report its results of operations and financial position to Insurance Departments of Insurance based upon Statutory accounting practices (“SAP”). Certain key differences under SAP, unlike GAAP are as follows: the Company is required to expense all sales and other policy acquisition costs as they are incurred rather than capitalizing and amortizing them over the expected life of the policy. The immediate charge off of sales and acquisition expenses and other conservative valuations under SAP generally cause a lag between the sale of a policy and the emergence of reported earnings. Because this lag can reduce the Company’s gain from operations on a SAP basis, it can have the effect of reducing the amount of funds available for dividend from insurance companies.
Valuation of investments. Our investments are recorded at fair value and are typically based on publicly available quoted prices. From time to time, the carrying value of our investments may be temporarily impaired because of the inherent volatility of publically traded investments. We do not adjust the carrying value of any investment unless management determines that its value is other than temporarily impaired.
Agency segment. Our agency segment is comprised of our underwriting agencies and our retail agencies. Our underwriting agencies primarily design, distribute and service policies that are issued or reinsured by our insurance companies. Our retail agencies primarily sell non-standard personal automobile insurance policies that are issued or reinsured by our insurance companies and administered by our underwriting agencies. However, both our underwriting agencies and retail agencies do business with unaffiliated third parties. During 2004, our underwriting agencies also administered the nonstandard personal automobile insurance policies of one unaffiliated insurance company.
Our underwriting agencies appoint both unaffiliated independent agencies and our retail agencies to distribute insurance policies to individual customers. In the year ended December 31, 2004, our underwriting agencies were responsible for a total of $299.1 million of gross premiums written, $177.6 million, or 59.4%, of which were distributed through independent agencies, and $121.5 million, or 40.6%, of which were distributed through our retail agencies.
Our retail agencies earn commissions and fees from the sale of non-standard personal automobile insurance policies administered by our underwriting agencies, which are substantially eliminated in consolidation, as well as commissions and fees from the sale of other insurance policies and products of unaffiliated
• commissions generated by our underwriting agencies from designing, distributing, servicing and selling insurance policies issued or reinsured by our insurance companies and by unaffiliated insurance companies;
• commissions generated by our retail agencies from selling insurance policies issued by unaffiliated insurance companies;
• policy acquisition fees, installment and late payment fees, and fees from the sale of ancillary products; and
• claims processing fees paid to our underwriting agencies for the administration of claims for policies issued or reinsured by our insurance companies and by an unaffiliated insurance company.
• other costs of producing and administering business, including advertising costs, the costs of administering policies and the costs of claims administration.
Insurance company segment. The historical financial results of our insurance companies prior to 2004, only included certain revenues, primarily policy fees, that were not ceded to Vesta Fire. Beginning January 1, 2004, our revenues also include premiums and investment income and our expenses also include losses and loss adjustment expenses. Therefore, beginning January 1, 2004, the financial results of our insurance companies are primarily dependent on: (1) the amount of premiums we collect, which is dependent on rate, volume and retention levels; (2) the investment income we earn by collecting and investing premiums in advance of paying claims, as well as the investment income we earn on investments related to the statutory surplus that we maintain in our insurance companies to support the premiums that we underwrite; (3) the losses and other costs we incur to adjust and pay claims submitted by individuals we have insured; (4) the cost of reinsurance programs; and (5) the expenses we incur for policy acquisition and to operate our insurance companies.
Subject to regulatory approval, premium rates are generally within our control and we continuously monitor and seek to adjust rates as appropriate. With respect to volume, our ability to increase the amount of written premium retained by our insurance companies is largely dependent on the statutory leverage of our insurance companies, generally expressed as the amount of net written premiums relative to statutory surplus. Statutory surplus is defined as total assets less total liabilities of our insurance companies in accordance with statutory accounting principles. We have historically operated with a limited amount of statutory surplus and as a result have utilized reinsurance to maintain our statutory leverage at a level we believe is acceptable.
For the years ended December 31, 2003 and 2002 our insurance companies’ revenues consisted primarily of policy fees, comprised primarily of origination and installment fees charged to our policyholders, and a small amount of investment income earned on invested assets and realized gains and losses. Beginning January 1, 2004, our insurance companies’ revenues include:
• net investment income we earn on our invested assets, together with realized gains and losses on our investments; and
• policy acquisition fees, including commissions and fees paid to our underwriting agencies and unaffiliated underwriting agencies and premium taxes, less ceding commissions that we receive under reinsurance contracts; and
• operating and general expenses, which include general and administrative expenses and other expenses.
Comparison of the Year Ended December 31, 2004 to December 31, 2003
Total expenses for the year ended December 31, 2004 were $247.2 million, an increase of $174.1 million, or 237.9%, as compared to total expenses of $73.2 million for the prior year. The increase in total expenses was principally due to increases in expenses related to our retention of premiums that were previously ceded to Vesta.
Pre-tax income for the year ended December 31, 2004 was $41.5 million, an increase of $10.6 million, or 34.5%, as compared to $30.8 million for the prior year. Increases in pre-tax were due improved pre-tax income in both the agency and insurance company segments.
For the year ended December 31, 2004, the loss in our equity interest in unconsolidated subsidiaries net of income taxes was $913,000 as compared to $348,000 in the prior year. This investment was made in July of 2003 and the increase in the loss relates to recording the equity interest for a full year in 2004 as compared to a half year in 2003, as well as our decision to write-down the remainder of this investment in the fourth quarter of 2004.
Commissions for the year ended December 31, 2004 were $95.2 million, an increase of $14.1 million, or 17.4%, as compared to commissions of $81.1 million in the prior year. We earned commissions in both our underwriting agencies and retail agencies. Commissions in our underwriting agencies, which include both provisional and profit sharing commissions, for the year ended December 31, 2004 were $88.5 million, an increase of $14.3 million, or 19.3%, as compared to $74.2 million in the prior year.
Profit sharing commissions for the year ended December 31, 2004 were $12.4 million, and increase of $5.6 million as compared to profit sharing commissions of $6.8 million for the prior year. The increase in profit sharing commissions was the result of favorable loss ratio development in prior treaty years for business produced by our underwriting agencies. We have not recognized any profit sharing commission on treaties that incepted during 2004.
• Commission expenses for the year ended December 31, 2004 were $27.9 million, an increase of $4.1 million, or 17.2%, as compared to $23.8 million for the prior year. The increase in commission expenses is principally due to increases in written premium volume produced by certain underwriting agencies as well as an increase caused by the acquisition of a book of business in 2004. In addition to increases in premiums produced, the average commission rate increased from 15.1% to 15.6% during the year. This increase results from changes in the geographic distribution of our policies produced as well as increases in commission rates in certain geographic areas in response to existing market conditions. The commission rates we pay independent agents are established based on prevailing market conditions.
• Employee compensation and benefit expenses for the year ended December 31, 2004 were $58.2 million, an increase of $1.1 million, or 1.8%, as compared to $57.1 million in the prior year. The increase in employee compensation and benefit expenses was primarily due to an increase in overall headcount during 2004 which contributed to an increase of $2.0 million, offset by decreases from prior years in performance-based compensation and severance related expenses of $968,000.
• Operating expenses for the year ended December 31, 2004 were $49.3 million, an increase of $8.3 million, or 20.1%, as compared to $41.1 million in the prior year. The increase in operating expenses was primarily a result of increases in operational expenses such as fronting fees, premium taxes and claims processing expenses of $2.9 million due to the increased premiums produced by our underwriting agencies, increased advertising expenditures of $1.4 million, increases in legal and professional fees of $2.7 million associated with various legal projects as well as expenses related to our ongoing litigation with a former employee.
Insurance company segment. Total revenues for the year ended December 31, 2004 were $225.1 million, an increase of $214.9 million as compared to total revenues of $10.2 million for the prior year. The increase in total revenues was principally due our retention of gross premiums written in our insurance companies following the termination of the reinsurance agreements with Vesta, which allowed us to start retaining premiums beginning January 1, 2004 that were previously ceded to Vesta.
Loss and loss adjustment expenses for the year ended December 31, 2004 were $129.0 million as compared to zero for the prior year. Our loss and loss adjustment expense ratio for the year ended December 31, 2004 was 57.9%. The increase in our loss and loss adjustment expenses was due to our termination of reinsurance agreements with Vesta.
Interest expenses for the year ended December 31, 2004 was $588,000, as compared to interest expense of $821,000 for the prior year. The interest expense in 2004 and 2003 is primarily attributable to interest payments on a note payable related to the Harbor Insurance Group, Inc. acquisition, which began in January of 2003 when the final determination of the contingent purchase price was made. The balance of this note was repaid in the third quarter of 2004.
Comparison of the Year Ended December 31, 2003 to December 31, 2002
Total expenses for the year ended December 31, 2003 were $73.2 million, an increase of $10.8 million, or 17.3%, as compared to total expenses of $62.4 million for the prior year.
Income tax expense for the year ended December 31, 2003 was $11.0 million, or an effective tax rate of 35.8%, as compared to income tax expense for the year ended December 31, 2002 of $8.6 million, or an effective tax rate of 37.4%.
For the year ended December 31, 2003, minority interest net of income taxes was $403,000 as compared to $703,000 in the prior year.
Provisional commissions for our underwriting agencies for the year ended December 31, 2003 were $67.4 million, an increase of $5.3 million, or 8.5%, as compared to the provisional commissions of $62.1 million for our underwriting agencies during the prior year. The $67.4 million in provisional commissions recorded in 2003 were favorably impacted by a $2.4 million reduction in a deferred revenue accrual. Excluding the impact of this adjustment, provisional commission for the year ended December 31, 2003 would have increased $2.9 million or 4.7%, as compared to the prior year. The remaining increase in provisional commissions resulted from an increase in average commission rate to 24.5% in 2003 from 22.0% in 2002 and a $1.9 million increase due to recording a full year of commissions for Driver’s Choice, which was acquired on August 1, 2002. These increases were partially offset by a $3.7 million reduction resulting from a decline in the gross premiums written produced by our other underwriting agencies. The increase in the provisional commission rate in 2003, as compared to 2002, was due to improved contractual commission rates negotiated by our underwriting agencies. For the year ended December 31, 2003, gross premiums written produced by our underwriting agencies were $275.2 million, a decrease of $7.4 million, or 2.6%, as compared to $282.6 million in the prior year. The principal reason for the decline in gross premiums written produced by our underwriting agencies was a $14.2 million decrease resulting from re-pricing and re-underwriting activities in our underwriting agencies, partially offset by a $7.5 million increase from recording a full year of gross premiums written for Driver’s Choice, which we acquired on August 1, 2002.
Profit-sharing commissions for the year ended December 31, 2003 were $6.8 million, an increase of $5.8 million as compared to profit-sharing commissions of $1.0 million for the prior year. The increase in profit-sharing commissions was principally a result of positive loss ratio development for business produced by our InsureOne, American Agencies and A-Affordable underwriting agencies as compared to provisional loss ratios.
Policy and other fees for the year ended December 31, 2003 were $38.5 million, an increase of $1.3 million, or 3.5%, as compared to policy and other fees of $37.2 million for the prior year. The $38.5 million recorded in policy and other fees in 2003 were unfavorably impacted by a $1.2 million increase in a deferred revenue accrual. Excluding the impact of this adjustment, policy and other fees for the year ended December 31, 2003 would have increased $2.5 million, or 6.7%, as compared to prior year. The remaining increase in policy and other fees during 2003 as compared to 2002 was principally due to increased installment billing fees in our underwriting agencies in Texas.
Total expenses for the year ended December 31, 2003 were $125.6 million, an increase of $6.2 million, or 5.2%, as compared to total expenses of $119.4 million in the prior year.
• Commission expenses for the year ended December 31, 2003 were $23.8 million, a decrease of $3.3 million, or 12.3%, as compared to $27.2 million for the prior year. The reduction in commission expenses is principally due to a decline in average commission rate to 15.1% in 2003 from 16.7% during the prior year. This decline resulted from changes in the geographic distribution of our policies produced and reductions in commission rates in certain geographic areas in response to existing market conditions. We do not anticipate that we will lower commission rates further in 2004. The commission rates we pay independent agents are established based on prevailing market conditions and we do not feel that the decrease in commission rates will affect the amount of policies that we sell in these markets.
• Employee compensation and benefit expenses for the year ended December 31, 2003 were $57.1 million, an increase of $2.4 million, or 4.4%, as compared to $54.7 million in the prior year. The increase in employee compensation and benefit expenses was primarily due to an increase in performance-based compensation of $2.1 million and $1.5 million additional
expense from recording a full year of expense for Driver’s Choice.
Pretax income for the year ended December 31, 2003 was $20.9 million, an increase of $8.6 million, or 69.5%, as compared to pretax income of $12.3 million in the prior year. For the year ended December 31, 2003 the pretax margin was 14.2%, an increase from the 9.3% pretax margin recorded in the prior year.
Insurance company segment. Total revenues for the year ended December 31, 2003 were $10.2 million, a decrease of $872,000, or 7.9%, as compared to total revenues of $11.1 million for the prior year. The decrease in total revenues in 2003 was principally due to a reduction in policy and other fees as a result of a decrease in the volume of non-standard personal automobile business of InsureOne written by our insurance companies. For the year ended December 31, 2003 policy and other fees were $9.6 million, a decrease of $1.1 million, or 10.4%, as compared to $10.7 million of policy and other fees in the prior year. Prior to December 31, 2003, our insurance companies were a party to a reinsurance agreement with Vesta Fire pursuant to which they ceded 100% of premiums, losses and loss adjustment expenses to Vesta Fire and retained all policy fees.
For the year ended December 31, 2003, pretax income was $10.8 million, a decrease of $963,000, or 8.2%, as compared to pretax income of $11.7 million in the prior year. The decrease in pretax income was principally a result of lower policy fees in 2003 as compared to prior year.
Net cash provided by financing activities was $85.9 million for the year ended December 31, 2004, as compared to net cash used in financing activities of $5.4 million for the year ended December 31, 2003 and $1.0 million for the year ended December 31, 2002. The increase in cash provided by financing activities for the year ended December 31, 2004 compared to the prior year was principally due from the proceeds of the issuance of common stock following our initial public offering, proceeds from our note payable in association with the issuance of trust preferred securities from our statutory subsidiary and the issuance of as well as increase in principal repayments on a note. The increase in cash used in financing activities for the year ended December 31, 2003 compared to the prior year was principally due to an increase in principal repayments on a note.
We believe that existing cash and investment balances, as well as new cash flows generated from operations and our available credit facility will be adequate to meet our capital and liquidity needs during the 12-month period following the date of this report at both the holding company and insurance company levels. We do not currently know of any events that could cause a material increase or decrease in our long-term liquidity needs. If such events materialize, we will identify the source and disclose our plan of action to remedy any deficiency.
Initial Public Offering. We completed our initial public offering of our common stock effective July 9, 2004. We issued 4,420,000 additional shares of our common stock and Vesta sold 3,750,000 shares of our common stock that they owned, at an initial public offering price of $14.00 per share. On July 26, 2004, our underwriters exercised their option to purchase an additional 663,000 shares from us, and an additional 562,500 shares from Vesta. The combined net proceeds to us from these transactions was approximately $65.3 million, of which $64.3 million was contributed to our insurance companies in order to increase their policyholder’s surplus.
The following table identifies our commitments and notes payable by payment due period as of December 31, 2004:
(1) Consists primarily of payments due in 2005 related to the asset purchase of Insure One Independent Agency, LLC.
(3) The payout pattern for reserves for loss and loss adjustment expense is based upon historical payment patterns and do not represent actual contractual obligations. The timing and amount ultimately paid can and will vary from these estimates.
We believe that interest rate risk and credit risk are the two types of market risk to which we are principally exposed.
A.M. Best financial strength rating remains below “B+” we have the right to require Vesta Fire to provide a letter of credit or establish a trust account to collateralize the net amounts due to us from Vesta Fire under the reinsurance agreement. On July 27, 2004, we notified Vesta to establish a trust account collateralizing the net amount due to us, due to the fact that Vesta Fire’s A.M. Best rating was below a “B+”. We have $8.9 million currently in a trust account and have requested Vesta to increase the collateral held in this account to $10.3 million to fully collateralize the net amount due to us as of December 31, 2004.
As part of the terms of the acquisition of Affirmative Insurance Company and Insura, Vesta has indemnified us for any losses due to uncollectible reinsurance related to reinsurance agreements entered into with unaffiliated reinsurers prior to December 31, 2003. As of December 31, 2004, all such unaffiliated reinsurers had A.M. Best ratings of “A-” or better.
To the Board of Directors and Stockholders’ of Affirmative Insurance Holdings, Inc.:
In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations, stockholders’ equity and comparative income and cash flows present fairly, in all material respects, the financial position of Affirmative Insurance Holdings, Inc. and its subsidiaries at December 31, 2004 and 2003, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2004 in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
Deferred policy acquisition costs represent the deferral of expenses that we incur acquiring new business or renewing existing business. Policy acquisition costs, consisting of primarily commission, premium taxes, underwriting and agency expenses, are deferred and charged against income ratably over the terms of the related policies. At December 31, 2004, we had $19.1 million of deferred policy acquisition costs. We regularly review the categories of acquisition costs that are deferred and assess the recoverability of this asset. A premium deficiency, and a corresponding charge to income is recognized, if the sum of the expected loss and loss adjustment expenses, unamortized acquisition costs, and maintenance costs exceeds related unearned premiums and anticipated investment income. At December 31, 2004, we determined that there was no premium deficiency. Amounts received as expense allowances on reinsurance contracts that represent reimbursement of acquisition costs are recorded as reductions of deferred acquisition costs.
Premium income - Premium, net of premiums ceded, is earned over the life of a policy on a pro rata basis. Unearned premiums represent that portion of premiums written which is applicable to the unexpired terms of policies in force. Premiums receivable are recorded net of an estimated allowance for uncollectible amounts.
The following table illustrates the effect on our net income and net income per share if we had applied SFAS 123 to stock-based compensation (in thousands, except per share amounts):
Effective December 31, 2003, we acquired Affirmative Insurance Company and Insura Property & Casualty Insurance Company (“Insura”) from a subsidiary of Vesta in exchange for 3,408,382 shares of our common stock (Note 6).
Effective December 31, 2003, we paid a ceding commission to Vesta of 1,471,984 shares of our common stock in a reinsurance transaction where we assumed the unearned premium of the in-force non-standard personal automobile business of Vesta (Note 7).
On September 30, 2002, we redeemed $8.1 million of notes payable to Vesta plus accrued interest of $0.6 million, in exchange for 1,140,522 shares of our common stock.
In December 2004, the FASB issued SFAS No. 123R (“SFAS 123R”), Share-Based Compensation, which is a revision of FASB Statement No. 123, Accounting for Stock-Based Compensation, and supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees, and its related implementation guidance. SFAS 123R focuses primarily on accounting for transactions in which an entity obtains employee services in share-based payment transactions. This statement requires a public entity to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award (with limited exceptions). That cost will be recognized over the period during which an employee is required to provide service in exchange for the award, the requisite service period. No compensation cost is recognized for equity instruments for which employees do not render the requisite service. SFAS 123R is effective for public entities that do not file as small business issuers as of the beginning of the first interim or annual reporting period that begins after June 15, 2005. We anticipate adopting the provisions of SFAS 123R in July 2005. We are currently evaluating the requirements and the potential impact of SFAS 123R and have not yet determined if SFAS 123R will have a material impact on our future operations.
Proceeds from sales, maturities, and principal receipts of bonds were $20.6 million, $5.0 million, and $1.5 million for the years ended December 31, 2004, 2003, and 2002, respectively.
Gross realized gains and losses for the years ended December 31 are summarized as follows (dollars in thousands):
The following table shows our investments with gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position at December 31, 2004 (dollars in thousands):
As of December 31, 2004, we have available for income tax purposes approximately $20.4 million in federal net operating loss carryforwards (“NOL’s”), which may be used to offset future taxable income. We initially recorded a valuation allowance of $7.3 million for NOLs that were generated prior to the acquisition of a greater than 50% voting interest in our company, as these NOL’s are subject to a number of acquisition related limitations. The NOL’s generated prior to December 2000 are subject to annual limitation prescribed by the Internal Revenue Code Section 382 and losses generated prior to December 2001 are subject to separate return year (“SRLY”) limitations. Accordingly, we established a valuation allowance for the full amount of these NOL’s as part of purchase accounting. Should we generate taxable income in future years to utilize these NOL’s, the reversal of the valuation allowance and applicable tax benefits will reduce our goodwill balance related to the Vesta acquisition.
In accordance with SFAS No. 141 (“SFAS 141”), Business Combinations, the exchange of equity interests between entities under common control is recorded at the underlying carrying amounts and the transaction was accounted for in a manner similar to a pooling of interests. Pursuant to the pooling of interests accounting treatment, our financial statements have been presented to reflect our results of operations and InsureOne on a combined basis effective January 1, 2002, the date Vesta acquired InsureOne. Summarized below is an allocation of assets and liabilities acquired (dollars in thousands):
Prior to December 31, 2003, Affirmative Insurance Company and Insura ceded their premiums to Vesta pursuant to an internal 100% quota share reinsurance contract. As a result of this internal reinsurance, the historical financial statements of Affirmative Insurance Company and Insura include only certain revenues, primarily fee income that was not ceded to Vesta.
Effective December 31, 2003, Affirmative Insurance Company assumed the remaining non-standard personal automobile policies issued by Vesta. This transaction involved the termination of the internal reinsurance contract with Vesta subsidiaries on a “cut off” basis, meaning that Vesta as reinsurer retained its loss and loss adjustment expense reserves as of December 31, 2003 and remains liable for any losses incurred on or prior to December 31, 2003 on policies issued by the other Vesta affiliated insurance companies as well as any subsequent development of loss and loss adjustment reserves related to those losses, while simultaneously entering into a 100% quota share reinsurance treaty with Affirmative Insurance Company. As a result, we assumed unearned premiums of $35.9 million related to this business as of December 31, 2003.
We have entered into a quota share reinsurance agreement effective January 1, 2004 under which we assumed a portion of the business produced by our Texas-based American Agencies underwriting agency and written by Old American. We assumed 5.0% of the gross premiums written in 2004. This contract continues in force until terminated by us or the ceding company at any December 31 with not less than 90 days’ prior notice. We terminated this agreement effective December 31, 2004 on a run-off basis.
All of our quota share reinsurance agreements contain provisions for sliding scale commissions, under which the commission paid to us varies with the loss ratio results under each contract. The effect of this feature in the quota share reinsurance agreements is to limit the reinsurers aggregate exposure to loss and thereby reduce the ultimate cost to us as the ceding company. These features also have the effect of reducing the amount of protection relative to the quota share amount of premiums ceded by us. Before entering into these reinsurance agreements, and based on our prior operating history, we concluded that each agreement met the risk transfer test of SFAS No. 113 (“SFAS 113”) Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts as the reinsurers assume significant risk and have a reasonable possibility of significant loss.
We recorded in our financial statements $67.4 million of goodwill, $14.7 million of indefinite life intangible assets and $3.7 million of intangible assets having estimated lives of between two and 20 years. We expect $38.4 million of our goodwill and other intangible assets to be fully deductible for tax purposes.
A summary of property and equipment at December 31, 2004 and 2003 is as follows (dollars in thousands):
Any failure by one of our insurance company subsidiaries to meet the applicable risk-based capital or minimum statutory capital requirements imposed by the laws of Illinois or other states where we do business could subject it to further examination or corrective action imposed by state regulators, including limitations on our writing of additional business, state supervision or liquidation. Any changes in existing risk-based capital requirements or minimum statutory capital requirements may require us to increase our statutory capital levels, which we may be unable to do. As of December 31, 2004, each of our insurance company subsidiaries maintained a risk-based capital level in excess of an amount that would require any corrective actions on our part.
State insurance laws limit the ability of our insurance company subsidiaries to pay dividends and require our insurance company subsidiaries to maintain specified minimum levels of statutory capital and surplus. In addition, for competitive reasons, our insurance companies need to maintain financial strength rating which require us to maintain minimum capital and surplus requirements in those subsidiaries. Without regulatory approval, the aggregate maximum amount of dividends that can be paid in 2005 to us by our insurance company subsidiaries is approximately $13.9 million.
We have entered into employment agreements with our key executive officers, Thomas E. Mangold, Chief Executive Officer, President and Chairman of the Board of Directors; Timothy A. Bienek, Executive Vice President and Chief Financial Officer; M. Sean McPadden, Executive Vice President and Katherine C. Nolan, Executive Vice President. These agreements grant these individuals the right to receive certain benefits, including base salary, should the executives be terminated other than for cause.
We were the subject of a purported class action in South Carolina alleging that we improperly denied coverage for losses resulting from the operation of insured vehicles by undisclosed “permissive use drivers”. The non-standard personal automobile policies in question were issued by a subsidiary of Vesta and were sold through Driver’s Choice, one of our underwriting agencies. The plaintiff sought injunctive relief and contract reformation, as well as an unspecified amount of compensatory and punitive damages, costs and interest based on claims for breach of contract, bad faith, fraud and negligence. This matter was settled in 2005 for an immaterial amount.
On December 19, 2002 we adopted through a stockholders’ unanimous consent an amended and restated Company certificate of incorporation to eliminate the Series A, C, D and E preferred stock previously established by resolution of the board of directors, subject to the prior conversion of all shares of such series into shares of our common stock. We converted all of our outstanding preferred stock to 3,103,708 shares of our common stock on December 19, 2002.
On March 12, 2004, we issued 19,623 shares of our common stock to Thomas E. Mangold, our Chief Executive Officer, at a purchase price of $9.76 per share, for aggregate consideration of $191,576 in cash. We believe that the fair value of our common stock issued to Mr. Mangold was higher than our historical carrying value we assigned to our shares of common stock for this transaction. In light of our proposed public offering, we used a projected public valuation model to determine the estimated fair value of the common shares issued to Mr. Mangold. Based on the projections, we recorded $44,000 of compensation expense in 2004.
Options to purchase 849,004 shares of common stock at prices ranging from $7.59 to $9.49 were outstanding at December 31, 2002 but were not included in the computation of diluted earnings per share because the inclusion would result in an anti-dilutive effect in periods where the option exercise price exceeded the average estimated market price per share for the period.
We apply the intrinsic value method to account for the 1998 and 2004 Plans and, accordingly, no compensation expense has been recognized in the accompanying consolidated financial statements. The fair value of each option is estimated on the date of grant using the Black-Scholes option pricing model using the following assumptions:
We have reflected the requirements of SFAS 131 for the years ended December 31, 2004, 2003 and 2002 in the following tables for our three operating segments: agency segment, insurance segment, and corporate segment.
Our insurance subsidiaries are required to file statutory-basis financial statements with state insurance departments in all states where they are licensed. These statements are prepared in accordance with accounting practices prescribed or permitted by the State of Illinois Department of Insurance. Effective January 1, 2001, each state of domicile required that insurance companies domiciled in those states prepare their statutory-basis financial statements in accordance with the National Association of Insurance Commissioners Accounting Principles and Procedures Manual subject to any deviations prescribed or permitted by the insurance commissioner in each state of domicile.
There have been no significant changes in our internal controls over financial reporting that occurred during our last fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
The information relating to this Item 11 is incorporated by reference to the Proxy Statement for our 2005 Annual Meeting of Stockholders, which will be filed with the Securities and Exchange Commission no later than 120 days after December 31, 2004.
The information relating to this Item 12 is incorporated by reference to the Proxy Statement for our 2005 Annual Meeting of Stockholders, which will be filed with the Securities and Exchange Commission no later than 120 days after December 31, 2004.
Form of Registration Rights Agreement between Affirmative Insurance Holdings, Inc. and Vesta Insurance Group, Inc. (incorporated by reference to Exhibit 4.2 to Amendment No. 2 to our Registration Statement on Form S-1 filed with the SEC on May 27, 2004, File No. 333-113793).
Affirmative Insurance Holdings, Inc. 2004 Stock Incentive Plan (incorporated by reference to Exhibit 10.2 to Amendment No. 2 to our Registration Statement on Form S-1 filed with the SEC on May 27, 2004, File No. 333-113793).
Employment Agreement between Affirmative Insurance Holdings, Inc. and Thomas E. Mangold (incorporated by reference to Exhibit 10.3 to Amendment No. 2 to our Registration Statement on Form S-1 filed with the SEC on May 27, 2004, File No. 333-113793).
Employment Agreement between Affirmative Insurance Holdings, Inc. and M. Sean McPadden (incorporated by reference to Exhibit 10.4 to Amendment No. 2 to our Registration Statement on Form S-1 filed with the SEC on May 27, 2004, File No. 333-113793).
Employment Agreement between Affirmative Insurance Holdings, Inc. and Timothy A. Bienek (incorporated by reference to Exhibit 4.2 to Amendment No. 2 to our Registration Statement on Form S-1 filed with the SEC on May 27, 2004, File No. 333-113793).
Amended and Restated 100% Quota Share Reinsurance Contract between the Shelby Insurance Company, Affirmative Insurance Company, Insura Property & Casualty Insurance Company and Vesta Fire Insurance Corporation, with Addendum No. 1 thereto, effective December 31, 2003 (incorporated by reference to Exhibit 10.7 to our Registration Statement on Form S-1 filed with the SEC on March 22, 2004, File No. 333-113793).
100% Quota Share Reinsurance Contract between Vesta Fire Insurance Corporation, Vesta Insurance Corporation, Insura Property & Casualty Insurance Company, Shelby Casualty Insurance Company, The Hawaiian Insurance & Guaranty Company, Ltd. and Affirmative Insurance Company, effective December 31, 2003 (incorporated by reference to Exhibit 10.8 to our Registration Statement on Form S-1 filed with the SEC on March 22, 2004, File No. 333-113793).
Addendum No. 2 to the Amended and Restated 100% Quota Share Reinsurance Contract between Affirmative Insurance Company, Insura Property & Casualty Insurance Company and Vesta Fire Insurance Corporation, dated May 10, 2004 (incorporated by reference to Exhibit 10.17 to Amendment No. 2 to our Registration Statement on Form S-1 filed with the SEC on May 27, 2004, File No. 333-113793).
Credit Facility between Affirmative Insurance Holdings, Inc. and The Frost National Bank (incorporated by reference to Exhibit 10.1 to our Quarterly Report on Form 10-Q for the period ended September 30, 2004 filed with the SEC on November 15, 2004, File No. 000-50795).
Certification of the Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
Pursuant to the requirements of Sections 13 or 15(d) of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the registrant and in the capacities indicated below.
Affirmative Insurance Holdings, Inc., (“we”, “us”, “our”) is an insurance holding company and is engaged in underwriting, servicing and distributing nonstandard automobile insurance policies and related products and services to individual consumers in highly targeted geographic areas. As of December 31, 2004, our subsidiaries included two insurance companies licensed to write insurance policies in 32 states, four underwriting agencies and five retail agencies with 169 owned retail store locations and 42 franchised retail store locations serving seven states. We offer our products and services in 11 states, including Texas, Illinois, California and Florida. Our growth has been achieved principally as a result of the acquisition and integration of six retail and/or underwriting agencies in 2001 and 2002. We were formerly known as Instant Insurance Holdings, Inc., and we incorporated in Delaware on June 25, 1998.
As discussed in Note 6, we purchased certain operations from Vesta in 2002 and 2003 that are accounted for herein in a manner similar to a pooling of interests. Therefore, the results of these operations are included in the historical results for all periods presented.
Cash and cash equivalents are highly liquid investments with an original maturity of ninety days or less and include principally money market funds, repurchase agreements, and other bank deposits.
In our capacity as an insurance agency, we collect premiums from insureds and, after deducting our authorized commissions, remit these premiums to the appropriate insurance companies. Unremitted insurance premiums are held in a fiduciary capacity until disbursed by us. In certain states where we operate, the use of investment alternatives for these funds are regulated by various state agencies. We invest these unremitted funds only in cash and money market accounts and report such amounts as restricted cash on our consolidated balance sheets. We report the unremitted liability of these funds as amounts due reinsurers on our consolidated balance sheets. Interest income earned on these unremitted funds is reported as investment income in our consolidated statements of operations.
Investment securities are classified as available for sale and reported at fair value, generally based on quoted market prices, with unrealized gains and losses excluded from earnings and reported as a separate component of stockholders’ equity, net of deferred income taxes.
We collect premiums from insureds and after deducting our authorized commissions; we remit these premiums to the appropriate insurance and reinsurance companies. Our obligation to remit these premiums is recorded as amounts due reinsurers in our consolidated balance sheet.
Effective July 9, 2004, the date of our initial public offering, we have terminated our tax allocation agreement with Vesta and will file separate federal income tax returns on a go forward basis. Prior to July 9, 2004, we were included in the consolidated income tax return with Vesta. Our provision for income taxes is recorded as if we filed a separate federal income tax return. Deferred federal income taxes reflect the future tax differences between the tax basis of assets and liabilities and amounts recorded for financial reporting purposes. Recorded amounts will be adjusted to reflect changes in income tax rates for the period in which the change is enacted.
On May 25, 2004 we completed a stock split of 13.17 shares per one share of common stock effected through a stock dividend. All references to common shares, share prices, per share amounts, and stock plans have been restated retroactively in this report for our stock split.
Fee Income - Fee income includes policy origination fees and installment fees to compensate us for the costs of providing installment payment plans, as well as late payment, policy cancellation, policy rewrite and reinstatement fees. We recognize policy origination fees over the premium earning period of the underlying policies and recognize all other fees on a collected basis.
On December 31, 2002, we acquired a 100% ownership in InsureOne Independent Insurance Agency, LLC. and an 80% ownership in InsureOne Insurance Agency, LLC, from a subsidiary of Vesta for 2,355,019 shares of our common stock (Note 6).
Our investment portfolio consists of fixed income securities, which are classified as available-for-sale and are carried at fair value with unrealized gains and losses reported in our financial statements as a separate component of stockholders’ equity on an after-tax basis. The amortized cost, gross unrealized gains (losses) and estimated fair value of our investments at December 31 are as follows (dollars in thousands):
Expected maturities may differ from contractual maturities because certain borrowers may have the right to call or prepay obligations with or without penalties. Our amortized cost and estimated fair value of fixed income securities at December 31, 2004 by contractual maturity are as follows (dollars in thousands):
Tax effects of temporary differences that give rise to significant portions of our deferred tax assets and deferred tax liabilities at December 31, 2004 and 2003 are as follows (dollars in thousands):
On May 7, 2003, we acquired the remaining 20% interest in InsureOne Independent Agency, LLC that we did not own for $10.3 million. We accounted for this acquisition as a purchase and accordingly, our purchase price was allocated to the assets purchased based upon their fair values at the time of acquisition. We recorded $7.0 million in goodwill for this acquisition and $2.0 million of other intangible assets acquired which was allocated to two separate non-compete agreements, which are being amortized over 36 and 44 months.
• Illinois, Indiana, Missouri . This agreement covers all business written through our underwriting agencies in these states from January 1, 2004 and continues in force until terminated by us or our reinsurers at any December 31 with not less than 90 days’ prior notice. We ceded 60.0% of gross premiums written for the first six months of 2004, and effective July 1, 2004, we reduced the amount of business we cede to our reinsurers on all business written through our underwriting agencies in these states from 60.0% to 20.0% for the second half of 2004. We terminated this agreement effective December 31, 2004 on a run-off basis. This agreement contains a loss corridor where the company remains liable for 100% of the losses between a loss ratio of 72.0% and 77.0%. This agreement also contains a provision that limits reinsurers liability to a loss ratio of 100.0%. The effect of these features in this agreement is to limit the reinsurers aggregate exposure to loss and thereby reduce the ultimate cost to us as the ceding company. These features also have the effect of reducing the amount of protection relative to the quota share amount of premiums ceded by us. While we do not receive pro rata protection relative to the amount of premiums ceded, the amount of such protection is significant, as determined in accordance with guidance under both statutory accounting practices and GAAP. The reinsurance under this agreement is provided by Hannover Re, which reinsures 50% of the premiums we ceded, Swiss Re, which reinsures 20.83% of the premiums we ceded, and AXA Re, which reinsures 29.17% of the premiums we ceded. Hannover Re, Swiss Re, and AXA Re are rated “A”, “A+”, and “A-”, respectively, by A.M. Best.
We entered into a quota share reinsurance agreement effective January 1, 2004 under which we will assume a portion of the business produced by our Texas-based A-Affordable underwriting agency and written by Old American County Mutual Fire Insurance Company. We assumed 25.0% of the gross premiums written in the first six months of 2004 and effective July 1, 2004 we have increased our participation on business produced by our Texas-based A-Affordable underwriting agency from 25.0% to 70.0% for the second half of 2004. We terminated this agreement effective December 31, 2004 on a run-off basis.
Other intangible assets at December 31, 2004 and 2003 are as follows (dollars in thousands):
The following table represents our anticipated intangible amortization over the next five years (dollars in thousands):
On January 30, 2003, we converted $13.2 million of our consideration due for acquisitions into a note payable. The note carried interest at 9.0 % annually. The note required an initial payment of $1.4 million followed by monthly payments of $440,000 through August 2005. During 2004, this note was paid in full. As of December 31, 2003, the note balance was $9.8 million.
We currently lease approximately 462,000 square feet of retail location and underwriting agency locations under differing operating lease obligations. Total rent expense for the years ended December 31, 2004 and 2003 was $7.3 million and $5.5 million, respectively.
The following table identifies our commitments and notes payable by payment due period as of December 31, 2004 (dollars in thousands):
We and our subsidiaries are named from time to time as defendants in various legal actions arising in the ordinary course of our business and arising out of or related to claims made in connection with our insurance policies, claims handling and employment related disputes. The plaintiffs in some of these lawsuits have alleged bad faith or extra-contractual damages and some have claimed punitive damages. We believe that the resolution of these legal actions will not have a material adverse effect on our financial position or results of operations.
On November 4th, 2004, The Hawaiian Insurance & Guaranty Company, Ltd. (“Hawaiian”) was named among a group of four other named defendants and twenty unnamed defendants in a complaint filed in the Superior Court of the State of California for the County of Los Angeles alleging causes of action as follows: enforcement of coverage under Hawaiian’s policy of an underlying default judgment plaintiff obtained against Hawaiian’s former insured, who was denied a defense in the underlying lawsuit due to his failure to timely pay the Hawaiian policy premium; ratification and waiver of policy lapse and declaratory relief against Hawaiian; breach of implied covenant of good faith and fair dealing against Hawaiian with the plaintiff as the assignee of the insured; intentional misconduct as to the defendant SCJ Insurance Services; and professional negligence as to the defendants Prompt Insurance Services, Paul Ruelas, and Anthony David Medina. The plaintiff is seeking to enforce an underlying default judgment obtained against Hawaiian’s insured on September 24, 2004 in the amount of $35,000,643, and additional bad faith damages including punitive damages in the amount of $35,000,000.
Affirmative Insurance Company, a wholly owned subsidiary of Affirmative, is a party to a 100% quota share reinsurance agreement with Hawaiian and is sharing in the defense of this matter. Hawaiian is ultimately a wholly-owned subsidiary of Vesta Insurance Group, Inc. which is a 42.9% stockholder of Affirmative. The other named defendants SCJ Insurance Services, Prompt Insurance Services, Paul Ruelas, and Anthony David Medina are unaffiliated persons to Affirmative.
On March 12, 2004, we issued 19,886 shares of our common stock to Vesta Insurance Group, Inc. in connection with the exercise of warrants, with an exercise price of $0.08 per share, which were originally purchased by Vesta in 2000.
Expected term of option: 1998 Plan 5 years, 2004 Plan 10 years
The majority of our commissions and fees are directly related to the premiums written from policies sold to individuals located in eleven states. Accordingly, we could be adversely affected by economic downturns, natural disasters, and other conditions that may occur from time-to-time in these states, which may not as significantly affect more diversified competitors.
In 2004, our affiliated and unaffiliated underwriting agencies utilized approximately 6,800 independent agencies and 169 owned retail stores and 42 franchised retail stores to sell the policies that we administer. In 2004, no one independent agency accounted for more than 2.9% of the gross written premiums produced by our affiliated and unaffiliated underwriting agencies, and only four independent agencies accounted for more than 1% of these gross written premiums.
Capital lease obligation - The fair value of capital lease obligation approximates carrying value as the explicit interest rate of lease obligations approximates current interest rates.
The following is a summary of our unaudited quarterly consolidated results of operations for the years ended December 31, 2004 and 2003: