As of the year ended December 31, 2006, we leased an aggregate of approximately 543,851 square feet of office space for our agencies, insurance companies and retail stores in various locations throughout the United States.
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 financial data as of December 31, 2006, 2005, 2004, 2003 and 2002 and for the years then ended from our audited consolidated financial statements. The results for past accounting periods are not necessarily indicative of the results to be expected for any future accounting period.
Insurance companies, which possess the regularity authority and capital necessary to issue insurance policies;
As of December 31, 2006, our subsidiaries included three insurance companies licensed to write insurance policies in 36 states, four underwriting agencies and five retail agencies with 158 owned retail stores (16 of which are located in leased space within supermarkets owned by a major supermarket chain under an agreement signed in late 2005) and 33 franchised retail store locations serving 11 states. The acquisition of USAgencies, effective January 1, 2007, will increase our operations by two insurance companies and 92 additional owned retail stores.
In November 2005, with a change in controlling ownership, we changed our board of directors and, subsequently, some members of senior management including the chief executive officer and the chief financial officer. The former senior management, with extensive experience in managing underwriting agencies and retail agencies, monitored the business on the basis of several segments consisting of an “agency” segment that was comprised of our underwriting and retail agencies, an “insurance” segment for the insurance companies and a “corporate” segment. The current senior management determined that with the significantly increased retention by the insurance companies of the business produced by the underwriting agencies, the company should be analyzed as an integrated insurance company beginning January 1, 2006. Given the homogeneity of our products, the regulatory environments in which we operate, the nature of our customers and our distribution channels, we now monitor, control and manage our business lines as an integrated entity offering non-standard personal automobile insurance products through multiple distribution channels. Accordingly, the segment information previously viewed by the former management is no longer used to monitor the company and we have no segment information to disclose. Our previously reported historical consolidated financial results represent the integrated entity currently analyzed by management, so no additional or adjusted historical disclosures are required in order to reflect this change in management’s business analysis.
As part of our corporate strategy, we treat our owned retail stores as though they are independent agents, encouraging them to sell to their individual customers whatever products are most appropriate and affordable for those customers. We believe that this offers our retail customers the best combination of service and value, developing stronger customer loyalty and improving customer retention. In practice, this means that in our owned retail stores, the relative proportion of the sales of our own insurance products as compared to the sales of the third-party policies will vary depending upon the competitiveness of our insurance products in the marketplace during the period. Recently, we have experienced a significant shift in this ratio towards third-party insurance carriers as we have enhanced our technology making it easier for our owned retail stores to sell third-party products. Overall, applications for third-party carriers represented 41% of our retail applications for the year ended December 31, 2006 as compared to 30% for the prior year. This reflects our intention of maintaining the margins in our owned insurance carriers, even at the cost of business lost to other third-party carriers.
In the independent agency distribution channel and the unaffiliated underwriting agencies distribution channel, the effect of competitive conditions is the same as in our owned retail store distribution channel. As in our retail stores, independent agents (either working directly with us or through unaffiliated underwriting agencies) not only offer our products but also offer their customers a selection of products by third-party carriers. Therefore our insurance products must be competitive in pricing, features, commission rates and ease of sale or the independent agents will sell the products of those third-party insurance carriers instead of our products. We believe
For our owned insurance carriers, one measurement of our performance is the level of gross premiums written and a second measurement is the relative proportion of premiums written through our three distribution channels. The following table displays our gross premiums written by distribution channel for the years ended December 31, 2006, 2005, and 2004 (dollars in thousands):
Total gross premiums written for the year ended December 31, 2006 were $286.2 million, a decrease of $35.0 million, or 10.9% as compared to $321.2 million for the same period in 2005. In our retail distribution channel, gross premiums written consist of premiums written for our affiliated insurance carriers’ products only and do not include premiums written for third-party insurance carriers. We only earn commission income and fees in our retail distribution channel for sales of third-party insurance policies. Gross premiums written in our retail distribution channel were $86.8 million, a decrease of $29.7 million, or 25.5%, as compared to $116.4 million in the prior year, primarily due to the decrease in premiums written for our affiliated insurance carriers’ products relative to policies written for unaffiliated insurance companies. Our retail strategy is to operate our owned stores as an independent agency, allowing us to provide customers with the choice of the best combination of pricing and features from among both our own insurance products and those of third-party insurers. Under current market conditions, gross premiums written by our insurance companies through our retail channel have decreased while policies written through third-parties have increased. The impact can be seen in the increase in our third-party commission income as discussed below.
The following table displays our gross premiums written by state for the years ended December 31, 2006 and December 31, 2005 (dollars in thousands):
Commission Income and Fees. Another measurement of our performance is the relative level of production of commission income and fees. Commission income and fees consists of three principal types, including (a) the commission income and fees earned by our underwriting agencies on insurance business that is not written or retained by us, (b) policy, installment and agency fees earned for business written or assumed by our insurance companies both through independent agents and our retail agencies and (c) the commission income earned on sales of unaffiliated (third-party) insurance companies’ products sold by our retail agencies. These various types of commission income and fees are impacted in different ways by the corporate decisions we make in pursuing our corporate strategy.
If existing estimates of the ultimate liability for losses and related loss adjustment expenses are lowered, then that favorable development is recognized in the subsequent period in which the reserves are reduced. This has the effect of benefiting that subsequent period, when the aggregate losses and loss adjustment expenses (reflecting the favorable development related to previously reported earned premiums) are reduced relative to that period’s earned premium. Although the favorable development must be included in that subsequent period’s financial statements, it is appropriate for measurement purposes to compare only the losses and loss adjustment expenses related to any specific period’s earned premiums in evaluating performance during that particular period.
Consolidation Process. Our agencies sell non-standard automobile insurance policies that are issued by our own insurance carriers as well as third-party carriers. For the policies issued by our own insurance carriers, our insurance companies pay our agencies a commission. Our insurance companies recognize earned premium and
Effective December 31, 2003, VIG sold to us two insurance companies - AIC and Insura - and also transferred to us all future economic interest in VIG’s non-standard personal automobile insurance business through a series of reinsurance transactions. We accounted for our acquisition of these insurance companies at their underlying carrying amounts in a manner similar to a pooling of interests in accordance with SFAS No. 141, and our historical consolidated financial statements have been presented to reflect our historical results of operations and the historical results of AIC and Insura on a combined basis. Prior to December 31, 2003, our insurance companies ceded 100% of their premiums, losses and loss adjustment expenses to VFIC. Accordingly, our insurance companies’ historical statements of operations prior to January 1, 2004 do not include any of the premiums, losses or loss adjustment expenses on policies written by our insurance companies.
Change in Management. In the fourth quarter of 2006, we completed a separation and non-competition agreement with a former executive that resulted in severance expense of $739,000. Also in 2006, we expensed $885,000 in amortization on non-competition agreements completed in 2005 and $133,000 as the final installment on a retained executive search contract initiated in 2005. In the fourth quarter of 2005, we completed separation and non-competition agreements with three former executives that resulted in expenses incurred in 2005 of $3.0 million, including $2.7 million in severance, $122,000 in amortization related to non-competition agreements, and $200,000 incurred for a retained search for a replacement executive.
IT issues and initiatives. On October 16, 2006, we entered into a master services agreement with Accenture under which we will outsource substantially all of our IT operations to Accenture, including our data center, field support and application management. The initial term of the agreement is ten years, although it may be terminated for convenience by us at any time upon six months’ notice after the first two years, subject to the payment of certain stranded costs and other termination fees. We believe that over time this arrangement will create a stronger technology platform to support our business by consolidating our data centers into one professionally managed location and improving our overall IT infrastructure.
Receivable from VIG. In the fourth quarter of 2006, we determined that the recovery of the $7.2 million in other assets, reflecting an uncollateralized receivable from VFIC, was uncertain due to, among other things, the regulatory liquidation of VFIC, the recently disclosed financial condition of VFIC and related entities and our creditor status in the liquidation proceedings. We increased our reserve for doubtful accounts by $7.2 million to recognize the current uncertain status of the recovery.
Relocation to new Chicago-area offices. During 2006, we entered into a ten-year operating lease for new corporate office facilities in Burr Ridge, Illinois that replaced the existing lease for office space in Bedford Park, Illinois, which lease terminated effective December 31, 2006. We began the relocation effort on December 31, 2006. The Burr Ridge property was first occupied and in use in the first week of January 2007. During the construction of the leasehold improvements, which began in September 2006, we expensed a monthly lease expense as required by GAAP even though no cash payments were required until December 2006. This resulted in lease expense that was in excess of historical and future lease expense levels because we continued to incur simultaneous lease expense for the Bedford Park facility for the period of September through December 2006. In addition, the relocation resulted in the incurrence of moving costs, expenditure for the repair and clean-up of the vacated Bedford Park building and the write-off of unamortized leasehold improvements at that location. In total we expensed $788,000 in connection with the Chicago office relocation in 2006.
In 2004 and 2005 we acquired one retail agency, currently operating in Florida, and one underwriting agency, currently operating in Michigan. Both 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.
IPA. On July 19, 2005, we acquired the assets of IPA, an underwriting agency with operations in Michigan. IPA generates approximately $20 million in premiums annually.
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. VIG’s non-standard personal automobile insurance business had net premiums earned of $167.4 million for the year ended December 31, 2003. We determined that this restructuring of VIG’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.
Revenue recognition. Our consolidated revenues are derived principally from premiums, commissions, fees, investment income and investment gains and losses. Premiums are earned over the life of a policy on a pro rata basis. Unearned premiums represent that portion of premiums written that is applicable to the unexpired terms of policies in force
We receive commissions for policies that are written through our underwriting agencies or are sold by our retail agencies. These policies are subject to cancellation by the policyholder prior to the policy expiration date. We estimate the future cancellations in determining the amount of commission income and fees that is recorded in our consolidated financial statements. Our allowance for policy cancellations, presented as deferred revenue in our consolidated balance sheet, is periodically evaluated and adjusted as necessary. All commission and policy fee revenue and our related allowance for policy cancellations from our insurance companies are eliminated in consolidation.
Fee income includes policy origination fees, agency 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.
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.
AIC and Insura from VFIC under the reinsurance agreement. Accordingly, AIC, Insura and VFIC entered into a Security Fund Agreement effective September 1, 2004. On August 30, 2005 AIC received a letter from VFIC’s President that irrevocably confirmed VFIC’s duty and obligations under the Security Fund Agreement to provide security sufficient to satisfy VFIC’s gross obligations under the reinsurance agreement (the “VFIC Trust”). Currently the VFIC Trust holds $23.1 million to collateralize the $20.2 million gross recoverable from VFIC. In June, 2006, the Texas Department of Insurance placed VFIC, along with several of its affiliates, into rehabilitation and subsequently into liquidation. Due to VFIC’s liquidation status, AIC is working through certain procedures to effect its right to withdraw funds from the VFIC Trust. AIC has been working with the Special Deputy Receiver (the “SDR”) and his staff on this matter since VFIC was placed into liquidation. To date, the SDR has not taken issue with the validity of the VFIC Trust; however, we currently are negotiating with the SDR the manner in which the funds will be withdrawn from the VFIC Trust, which must then be approved by the Special Master of the Receivership Court.
As of December 31, 2005, we separately included $7.2 million in other assets that was related to a receivable due from VIG as part of the transfer of the insurance companies to us at December 31, 2003. The $7.2 million was not included in the gross recoverable at December 31, 2005. We continue to believe that this receivable is due from VIG and have instituted appropriate legal proceedings to recover the full amount thereof. However, a loss for $7.2 million was included in selling, general and administrative expenses in the fourth quarter of 2006 when we set up a reserve equal to the full amount of the receivable. We established this reserve due to our uncertainty as to the collectibility of the receivable in light of the significant amount of claims made against VIG and VFIC as of December 31, 2006 in their bankruptcy and liquidation proceeding, respectively, and our creditor status in those proceedings.
At December 31, 2006, $18.4 million was included in reserves for losses and loss adjustment expenses that reflect the amounts owed from AIC and Insura under reinsurance agreements with the VIG affiliated companies, including Hawaiian Insurance and Guaranty Company, Ltd. Affirmative established a trust account to collateralize this payable, which currently holds $23.1 million in securities (the “AFIC Trust”). The AFIC Trust has not been drawn upon the SDR in Texas or the SDR in Hawaii. The SDRs will likely negotiate similar terms for withdrawal of funds from the AFIC trust as those agreed to in regards to the VFIC Trust.
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 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, 2006, we had $23.9 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, 2006, we determined that there was no premium deficiency.
Reserving for unpaid losses and loss adjustment expenses. We maintain reserves in the amount of the estimated ultimate liability for unpaid losses and loss adjustment expenses related to incurred claims and our estimate of unreported claims. Management’s estimation of the ultimate liability for unpaid losses and loss adjustment expenses is based on projections developed by our actuaries using analytical methodology commonly used in the property-casualty insurance industry. The liabilities stated for unpaid claims and for expenses of investigation and adjustment of unpaid claims are based on the following: (1) the accumulation of estimates of individual claims for losses reported prior to the close of the accounting period; (2) estimates received from ceding companies, reinsurers and insurance pools and associations; (3) estimates of unreported losses based on past experience; (4) estimates based on past experience of expenses for investigating and adjusting claims; and (5) estimates of subrogation and salvage collections. We periodically adjust our losses and loss adjustment expense reserves for changes in product mix, underwriting standards, loss cost trends and other factors. Our losses 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
Valuation of investments. Our investments are recorded at fair value, which is 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 publicly traded investments. We do not adjust the carrying value of any investment unless management determines that its value is other-than temporarily-impaired.
Commission income and fees consists of (a) the commission income and fees earned by our underwriting agencies on business that is not written or retained by us, (b) policy, installment and agency fees earned for business written or assumed by our insurance companies (affiliated) both through independent agents and our retail agencies and (c) the commissions and agency fees earned on sales of unaffiliated (third-party) insurance companies’ products sold by our retail agencies. The table below displays the components of consolidated commission income and fees earned for the two years ended December 31, 2006 and December 31, 2005 (dollars in thousands):
on business that our insurance companies retain against our agencies’ expenses. Therefore, when we retain a higher percentage of our written premiums, we eliminate a greater portion of our agencies’ commission income and fees.
Net investment income for the year ended December 31, 2006 was $8.8 million, an increase of $3.1 million, or 54.1%, compared to $5.7 million for the same period in 2005. The increase was primarily a result of a 5.2% increase in total invested assets to $221.8 million at December 31, 2006 from $210.8 million at December 31, 2005 and the 32.0% increase in 2005 from $159.7 million at December 31, 2004. The increase in invested assets is primarily the result of increased cash flows from insurance operations. The average investment yield was 3.7% (5.3% on a taxable equivalent basis) for the year ended December 31, 2006 as compared to 3.3% (4.5% on a taxable equivalent basis) for the year ended December 31, 2005. This increase is primarily the result of the higher interest rates available for new investments in 2006.
Losses and loss adjustment expenses for the year ended December 31, 2006 were $185.3 million, a decrease of $5.9 million, or 3.1%, as compared to $191.2 million for the same period in 2005. The decrease was primarily due to favorable loss development in the current period as compared to loss estimates made in previous periods. For the year ended December 31, 2006, our overall loss and loss adjustment expense ratio was 64.3% as compared to 64.2% for the prior year. The increase in our overall loss and loss adjustment expense ratio is primarily due to less favorable loss development in the current year on prior years’ business than we experienced in the prior year. The impact from the favorable loss ratio development on our losses and loss adjustment expense ratio was 3.9% for the year ended December 31, 2006 as compared to 5.0% for the same period in the prior year. The following table displays the impact of favorable loss development on prior years’ business on our overall loss and loss adjustment expense ratio for the years ended December 31, 2006 and December 31, 2005:
Selling, general and administrative expenses for the year ended December 31, 2006 were $150.5 million, a decrease of $3.3 million, or 2.1%, as compared to $153.8 million for the same period in 2005. As shown in the table below, the largest component of total selling, general and administrative expenses is the cost of policy acquisition (amortization of deferred policy acquisition costs). Policy acquisition costs, primarily commissions, premium taxes and underwriting expenses related to issuing a policy, are deferred and charged against income ratably over the remaining service periods of the policies produced. Accordingly, amortization of deferred policy acquisition costs is correlated with earned premium. In 2006, the amortization of deferred policy acquisition costs was 25.6% of earned premium as compared to 25.2% in the prior year. The following
table displays the change in capitalized deferred acquisition costs as well as the impact that amortization of the deferred acquisition costs has on selling, general and administrative expenses:
Significant costs that impact comparability of selling, general and administrative expenses for the year ended December 31, 2006 as compared to the prior year were approximately $16.6 million. These items include $7.2 million for the increase to our reserve for doubtful accounts for the uncertainty of collecting a receivable due from VIG, $6.5 million of IT transition expenses related to Accenture and other outsourcing costs, $0.8 million in severance for a former executive, $0.4 million in severance for IT due to the transition, $0.8 million for costs related to the Chicago office relocation, $0.7 million in costs related to an acquisition that ultimately was not completed, $0.1 million for the final installment on a retained executive search contract initiated in 2005 and $0.1 million in costs due to the early termination of a lease for office space in Michigan. Other selling, general and administrative expenses for the year ended December 31, 2006, including these events, were $76.7 million and $60.1 million excluding the unusual adjustments in 2006. Total selling, general and administrative expenses excluding expenses for the significant events as a percentage of earned premiums were 46.5% for the year ended December 31, 2006 as compared to 52.3% on the reported basis.
In 2006: executive severances - $0.8 million and CEO recruiting fees - $0.1 million In 2005: executive severances - $2.7 million and CEO recruiting fees - $0.2 million
Includes: $0.4 million due to IT outsourcing; Burr Ridge office move - $0.8 million; Michigan office lease termination - $0.1 million; and cost of unsuccessful acquisition - $0.7 million
Other selling, general and administrative expenses for the year ended December 31, 2006 were $37.4 million, a decrease of $11.2 million, or 23.1%, as compared to $48.6 million for the prior year. The decrease in other selling, general and administrative expenses was primarily due to decreased salary and related expenses due to a reduction in workforce, as well as a reduction in advertising and repairs and maintenance expenses.
The following table displays components of our expense ratio calculation for the years ended December 31, 2006 and 2005:
Income tax expense for the year ended December 31, 2006 was $2.7 million, or an effective rate of 21.3%, as compared to income tax expense of $9.8 million, or an effective rate of 34.0% for the same period in 2005. The decrease in our effective rate is primarily due to both an increased level of, and a relative proportion of, tax exempt income, which has a favorable tax impact. Net investment income represented 70.7% of our income before income taxes in 2006 as compared to 19.9% in 2005. The decrease in our effective rate is unusual and due in large part to the unusual costs in 2006. We anticipate that our future effective tax rates will be in the range of 34-38%, more similar to the 2005 tax rate.
Minority interest, net of income taxes, for the year ended December 31, 2006 was $81,000 as compared to $672,000 in the prior year. The decrease is due to our purchase of the remaining 27.0% interest in our Florida underwriting agency from the minority holders in March 2006. We now own 100% of this underwriting agency.
Total commission income and fees for the year ended December 31, 2005 were $79.6 million, a decrease of $47.1 million, or 37.2%, as compared to $126.7 million for the same period in 2004. This decrease is primarily related to our increased retention of business written and assumed by our insurance companies. In our agencies, we earn commission income and fees that are based on premiums earned in the current period but written in both current and prior periods. In consolidation, we eliminate our agencies’ commission income and fees based on business that our insurance companies retain against our agencies’ expenses. Therefore, when we retain a higher percentage of our written premiums, we eliminate a greater portion of our agencies’ commission income and fees.
Significant events that impact comparability of selling, general and administrative for the year ended December 31, 2005 as compared to the prior year included $2.7 million in severance for three former executives, $2.4 million for the write-off of the BRT enterprise system and $0.2 million incurred for a retained search for a replacement executive. Other selling, general and administrative expenses for the year ended December 31, 2005 were $78.6 million and $73.4 million excluding the unusual adjustments in 2005, or 49.3% of earned premium. There were no expenses of a similar nature incurred in the fiscal year ended December 31, 2004.
Our expense ratio for the year ended December 31, 2005 increased to 26.3%, as compared to 13.2% in the prior year. The expense ratio calculation treats all commission income and fees as a reduction in the dividend, with the divisor consisting of earned premium only. Therefore, the increase in our expense ratio is due, in part, to the increased retention of premiums written by our insurance companies resulting in an increased amount of commission income fees being eliminated in consolidation, thereby reducing the amount of the revenue offset against expenses. As mentioned above, our commission income and fees decreased $47.1 million in 2005 to $79.6 million from $126.7 million in 2004 as a result of the elimination entries related to our increased retention of business produced. The following table displays components of our expense ratio calculation for the years ended December 31, 2005 and 2004:
Minority interest net of income taxes, for the year ended December 31, 2005 was $672,000 as compared to $804,000 for the year ended December 31, 2004. The decrease in minority interest was a result of lower earnings from our Florida underwriting agency, where our ownership interest was 73.0% for the periods presented.
State insurance laws restrict the ability of our insurance company subsidiaries to declare stockholder dividends. These subsidiaries may not make an “extraordinary dividend” until 30 days after the applicable commissioner of insurance has received notice of the intended dividend and has not objected in such time or until the commissioner has approved the payment of the extraordinary dividend within the 30-day period. In most states, an extraordinary dividend is defined as any dividend or distribution of cash or other property whose fair market value, together with that of other dividends and distributions made within the preceding 12 months, exceeds the greater of 10.0% of the insurance company’s surplus as of the preceding December 31 or the insurance company’s net income for the 12-month period ending the preceding December 31, in each case determined in accordance with
statutory accounting practices. In addition, an insurance company’s remaining surplus after payment of a dividend or other distribution to stockholder affiliates must be both reasonable in relation to its outstanding liabilities and adequate to its financial needs. In 2007, our insurance companies may pay up to $11.1 million in ordinary dividends to us without prior regulatory approval. However, the maximum dividend capacity is not immediately available in 2007 due to the dividend payment of $11.5 million by our insurance company subsidiaries in December 2006. For the year ended December 31, 2005, our insurance company subsidiaries paid us $5.0 million in dividends.
We believe that existing cash and investment balances, as well as new cash flows generated from operations and other credit facilities 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 other than the debt service requirements of the senior term credit agreement completed on January 31, 2007 to fund the acquisition of USAgencies.
On January 31, 2007, we completed our acquisition of USAgencies. Pursuant to the terms of a Purchase and Sale Agreement, effective as of October 12, 2006 (the “Purchase Agreement”), among the Company and the unit holders (the “Sellers”) of USAgencies, we acquired all of the issued and outstanding membership interests of USAgencies from the Sellers for an aggregate purchase price of approximately $196.3 million in cash after giving effect to deductions based on the estimated indebtedness and book value of USAgencies and the estimated expenses of the transaction (the “Purchase Price”). $20.0 million of the Purchase Price was deposited into an escrow fund to satisfy any indemnification obligations of the Sellers under the Purchase Agreement. The Purchase Price is subject to a post-closing adjustment based on the actual indebtedness and book value of USAgencies and the actual expenses of the transaction, in each case as finally determined within a specified period following closing.
Consists primarily of rental obligations under real estate leases related to our retail operations and our corporate offices.
From time to time, we and our subsidiaries are subject to random compliance audits from federal and state authorities regarding various operations within our business that involve collecting and remitting taxes in one form or another. Recently, two of our owned underwriting agencies were subject to a sales and use tax audit conducted by the State of Texas. The examiner for the State of Texas has now completed his audit report and delivered an audit assessment to us. The examiner’s report asserts that, for the period from January 2002 to December 2005, we should have collected and remitted approximately $2.9 million in sales tax derived from claims services performed by our underwriting agencies for policies sold by these underwriting agencies and issued by Old American County Mutual Insurance Company, an unaffiliated insurance company, through a fronting arrangement. Our insurance companies reinsured 100% of these policies. The assessment includes an additional $412,000 for accrued interest and penalty for a total assessment of $3.3 million. We believe that these services are not subject to sales tax, are vigorously contesting the assertions made by the state, and are exercising all available rights and remedies available to us. On October 19, 2006, we responded to the assessment by filing petitions with the Comptroller of Public Accounts for the State of Texas requesting a redetermination of the tax due and a hearing to present written and oral evidence and legal arguments to contest the imposition of the asserted taxes. As a result of the timely filing of these petitions, an administrative appeal process has commenced and the date for payment is delayed until the completion of the
We have audited the accompanying consolidated balance sheet of Affirmative Insurance Holdings, Inc. and subsidiaries as of December 31, 2006, and the related consolidated statements of operations, stockholders’ equity and comprehensive income, and cash flows for the year ended December 31, 2006. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audit.
We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control Over Financial Reporting appearing under Item 9A, that Affirmative Insurance Holdings, Inc. and its subsidiaries (the Company) maintained effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.
In our opinion, management’s assessment that the Company maintained effective internal control over financial reporting as of December 31, 2006, is fairly stated, in all material respects, based on criteria established in Internal Control - Integrated Framework issued by COSO. Also, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control - Integrated Framework issued by COSO.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet of the Company as of December 31, 2006, and the related consolidated statements of operations, stockholders’ equity and comprehensive income, and cash flows for the year ended December 31, 2006, and our report dated March 16, 2007 expressed an unqualified opinion on those consolidated financial statements.
Affirmative Insurance Holdings, Inc., formerly known as Instant Insurance Holdings, Inc., was incorporated in Delaware on June 25, 1998. We are a distributor and producer of non-standard personal automobile insurance policies and related products and services for individual consumers in targeted geographic areas. Our subsidiaries include three insurance companies, four underwriting agencies, five retail agencies with 158 owned stores (16 of which are located in leased space within supermarkets owned by a major supermarket chain under an agreement signed in late 2005) and 33 franchise store locations as of December 31, 2006. Our underwriting agencies utilize approximately 3,200 independent agencies to sell the policies that they administer. In addition, we have two unaffiliated underwriting agencies producing business for our insurance companies through approximately 4,200 independent agencies. We are currently active in offering insurance directly to individual consumers through retail stores in 8 states (Illinois, Texas, Missouri, Indiana, South Carolina, Florida, Kansas and Wisconsin) and distributing our own insurance policies through independent agents in 9 states (Illinois, Texas, Missouri, Indiana, South Carolina, Florida, California, Michigan and New Mexico). Our growth has been achieved principally as a result of the acquisition of six retail and/or underwriting agencies in 2001 and 2002.
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 VIG 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 VIG. On June 1, 2005, we purchased 2,000,000 of our shares of common stock from VIG at a price of $14.00 per share. In May and June, 2006, we purchased 302,400 shares of our common stock in open market purchases at an average price of $13.67 per share.
On June 14, 2005, VIG and VFIC entered into a stock purchase agreement with New Affirmative LLC (“New Affirmative”), J.C. Flowers I LP and Delaware Street Capital Master Fund for the sale by VIG and VFIC of 5,218,228 shares of our common stock (“Stock Purchase Agreement”). New Affirmative was formed for the purpose of acquiring, holding, voting and disposing of the shares of our common stock acquired in connection with the Stock Purchase Agreement and any shares of our common stock that New Affirmative may acquire in the future. At the time of the agreement, New Affirmative was (i) 50% owned by DSC AFFM, LLC (“DSC AFFM”), an entity controlled by DSC AFFM Manager LLC (“DSC Manager”), the sole managing member of DSC AFFM, and Andrew G. Bluhm, the managing member of DSC Manager, and (ii) 50% owned by Affirmative Investment LLC (“Affirmative Investment”), an entity owned, in part, by the Enstar Group, Inc., and controlled by Affirmative Associates LLC (“Affirmative Associates”), the sole managing member of Affirmative Investment, and J. Christopher Flowers, the sole member and manager of Affirmative Associates. Simultaneously with the closing of the transactions contemplated by the Stock Purchase Agreement: (1) DSC AFFM contributed 1,459,699 shares of our common stock which were previously acquired in open market transactions by members of DSC AFFM and subsequently contributed to DSC AFFM, to New Affirmative and (2) Affirmative Investment contributed 1,183,000 shares of our common stock, previously acquired by it in open market transactions, to New Affirmative. VIG completed the sale to New Affirmative on August 30, 2005.
On August 31, 2006, DSC AFFM and Affirmative Investment consummated the transactions contemplated by a purchase agreement, dated August 4, 2006, pursuant to which DSC AFFM sold to Affirmative Investment all of the membership units of New Affirmative owned by DSM AFFM. As a result, Affirmative Investment now owns 100% of New Affirmative. As of December 31, 2006, New Affirmative owned 7,860,927 shares, or approximately 51.2% of our outstanding common stock.
Management believes the accompanying consolidated financial statements are representative of our costs of doing business on a stand-alone basis. The accompanying consolidated statements of operations include charges for expenses allocated to us by VIG for various services through 2004. These charges were based upon specific identification when available or were allocated based upon estimated usage. Management believes the methods used to identify and allocate these costs are reasonable.
We conduct regular reviews to assess whether the amortized cost of our investments are impaired and if any impairment is other than temporary. Factors considered by us in assessing whether an impairment is other than temporary include the credit quality of the investment, the duration of the impairment, our ability and intent to hold the investment until recovery and overall economic conditions. If we determine that the value of any investment is other than temporarily impaired, we record a charge against earnings in the amount of the impairment and the investment is adjusted to fair value.
We account for our equity interest in unconsolidated subsidiaries under the equity method of accounting. Under the equity method of accounting, we record our proportionate share of the income (losses), net of income taxes in our consolidated statements of operations. As of December 31, 2006 and 2005, our equity investment and related income in unconsolidated subsidiaries was zero.
We are required to report our results of operations and financial position to insurance regulatory authorities based upon statutory accounting practices (“SAP”). One significant difference between SAP and GAAP is that under SAP 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 as required by GAAP. 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 dividends from insurance companies. A second significant difference is that under SAP, certain assets are designated as “nonadmitted” and are charged directly to unassigned surplus, whereas under GAAP, such assets are included in the balance sheet net of an appropriate valuation reserve. A third significant difference between SAP and GAAP is that under SAP, investments are carried at amortized book value and under GAAP, investments are carried at fair value.
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, 2006, we had $23.9 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 losses and loss adjustment expenses, unamortized acquisition costs, and maintenance costs exceeds related unearned premiums and anticipated investment income. At December 31, 2006, 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.
Property and equipment is stated at cost, less accumulated depreciation, and consists primarily of computer and telephone equipment, furniture and fixtures and leasehold improvements. Depreciation is computed for property and equipment, excluding leasehold improvements, using the straight-line method over the estimated useful lives of our assets, typically ranging from three to five years. Leasehold improvements are depreciated using the straight-line method over the shorter of the useful life or the remainder of the lease term.
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.
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 that is applicable to the unexpired terms of policies in force. Premiums receivable are recorded net of an estimated allowance for uncollectible amounts.
Commission income - Commission income and related policy fees, written for affiliated and unaffiliated insurance companies, are recognized at the date the customer is initially billed or as of the effective date of the insurance policy, whichever is later. Commissions on premium endorsements are recognized when premiums are processed. Our allowance for policy cancellations, presented as deferred revenue in our consolidated balance sheet, is periodically evaluated and adjusted as necessary. All commission and policy fee revenue and our related allowance for policy cancellations from our insurance companies are eliminated in consolidation.
Fee Income - Fee income includes policy origination fees, agency 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. 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. 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 according to the guidelines of SOP 98-7, Deposit Accounting for Insurance and Reinsurance Contracts that do not Transfer Insurance Risk. Under Deposit Accounting, excess deposit liabilities are recorded as income based on a percentage of actual paid losses, if the estimated deposit liabilities are less than the recorded deposit liabilities. We believe we have properly accounted for all of our reinsurance contracts (Note 6).
We utilize various advertising mediums such as yellow pages, television and radio campaigns and print advertisements. We account for advertising costs in accordance with Statement of Position 93-7 (“SOP 93-7”), Reporting on Advertising Costs. SOP 93-7 requires all advertising costs not meeting the criteria for direct response advertising be expensed as incurred or at the first time the advertising takes place. Our advertising process does not meet the criteria for direct response advertising and therefore we expense all advertising costs as incurred or at the first time the advertising takes place.
We adopted SFAS 123R on January 1, 2006 using the modified prospective method and, accordingly, prior periods have not been restated because of the adoption. We recognize stock-based payment expense using the straight-line method. For the year ended December 31, 2006, we have recognized approximately $595,000 before income taxes ($468,000 after income taxes) in stock-based payment expense under the requirements of SFAS 123R (Note 18).
In November 2005, with a change in controlling ownership, we changed our board of directors and, subsequently, some members of senior management including the chief executive officer and the chief financial officer. The former senior management, with extensive experience in managing underwriting agencies and retail agencies, monitored the business on the basis of several segments consisting of an “agency” segment that was comprised of our underwriting and retail agencies, an “insurance” segment for the two insurance companies and a “corporate” segment. The current senior management has determined that with the significantly increased retention by the insurance companies of the business produced by the underwriting agencies, the Company should be analyzed as an integrated insurance company beginning January 1, 2006. Given the homogeneity of our products, the regulatory environments in which we operate, the nature of our customers and our distribution channels, we now monitor, control and manage our business lines as an integrated entity offering non-standard personal automobile insurance products through multiple distribution channels. Accordingly, the segment information previously viewed by the former management is no longer used to monitor the company and we have no segment information to disclose. Our previously reported historical consolidated financial results represent the integrated entity currently analyzed by management, so no additional or adjusted historical disclosures are required in order to reflect this change in management’s business analysis.
In July 2006, FASB Interpretation (FIN) No. 48, Accounting for Uncertainty in Income Taxes - An Interpretation of FASB Statement No. 109 (’FIN 48”), was issued. FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements with FASB Statement No. 109, Accounting for Income Taxes. FIN 48 also prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return, as well as providing guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006 with earlier application permitted as long as the enterprise has not yet issued financial statements, including interim financial statements, in the period of adoption. We have evaluated the requirements of FIN 48 and expect that the adoption of FIN 48 will have no material impact on our future financial statements.
In September 2006, the FASB issued Statement No. 157, Fair Value Measurements (“SFAS 157”), which defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles (“GAAP”) and expands disclosures about fair value measurements. This statement applies under other accounting pronouncements that require or permit fair value measurements, the FASB having previously concluded in those accounting pronouncements that fair value is the relevant measurement attribute. Accordingly, this statement does not require any new fair value measurements. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. Earlier application is encouraged, provided that the reporting entity has not yet issued financial statements for the fiscal year, including financial statements for an interim period within that fiscal year. We have not evaluated the requirements of SFAS 157 and have not yet determined if SFAS 157 will have a material impact on our future financial statements.
In February 2007, the FASB issued Statement No. 159, Establishing the Fair Value Option for Financial Assets and Liabilities (“SFAS 159”), which includes an amendment to FASB No. 115, Accounting for Certain Investments in Debt and Equity Securities (“SFAS 115”). SFAS 159 permits entities to choose to measure many financial instruments and certain other items at fair value. The objective is to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. This statement is expected to expand the use of fair value measurement, which is consistent with the FASB’s long-term measurement objectives for accounting for financial instruments. This statement applies to all entities and most of the provisions of this statement apply only to entities that elect the fair value option. However, the amendment to FAS 115 applies to all entities with available-for-sale and trading securities. SFAS 159 is effective for fiscal years beginning after November 15, 2007, with early adoption permitted for an entity that has also elected to apply the provisions of SFAS 157, Fair Value Measurements. An entity is prohibited from retrospectively applying SFAS 159, unless it chooses early adoption. SFAS 159 also applies to eligible items existing at November 15, 2007 (or early adoption). We have not evaluated the requirements of SFAS 159 and have not yet determined if SFAS 159 will have a material impact on our future financial statements.
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. Our investment committee reviewed our investment portfolio in December 2005 and decided to realign a portion of our investment portfolio in order to better align our portfolio with our historical claims life. We determined that the identified securities would not fully recover prior to the expected sale date, therefore the securities were deemed other-than-temporarily impaired in December 2005 when the decision to sell was made. The identified securities were in compliance with our investment guidelines prior to the review by the Investment Committee. The amortized cost, gross unrealized gains (losses) and estimated fair value of our investments at December 31 are as follows (dollars in thousands):
As of December 31, 2005, the $210.3 million in fixed maturities includes $135.2 million in securities that had been identified by the investment committee of the board of directors as securities to be sold. The $135.2 million reflects the fair market value of such securities after $1.7 million in losses were recognized in December 2005.
Major categories of net investment income for the years ended December 31 are summarized as follows (dollars in thousands):
Proceeds from sales, maturities, and principal receipts of bonds were $398.1 million, $7.8 million, and $20.6 million for the years ended December 31, 2006, 2005, and 2004, respectively.
Gross realized gains and losses on investments for the years ended December 31 are summarized as follows (dollars in thousands):
any unrealized losses represent an other-than-temporary impairment based on our evaluation of available evidence as of December 31, 2006.
As of December 31, 2006, we have available for income tax purposes approximately $15.6 million in federal net operating loss carryforwards (“NOLs”), which may be used to offset future taxable income.
We initially recorded a valuation allowance of $7.1 million for NOLs that were generated prior to the acquisition of a greater than 50% voting interest in our company, as these NOLs are subject to a number of acquisition related limitations. The NOLs 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. We established a valuation allowance for the full amount of these NOLs as part of VIG’s purchase accounting of greater than 50% voting interest in our company as VIG determined they would not be able to realize these NOLs. Our separation from VIG has allowed us to evaluate these NOLs based on our expected taxable income and if we believe we will generate taxable income in future years to utilize these NOLs, the reversal of the valuation allowance and applicable tax benefits will reduce our goodwill balance related to the VIG acquisition. We were able to complete our evaluation of these NOLs in the fourth quarter of 2005 and determined that our beginning NOL balance was incorrectly calculated by VIG by approximately $3.1 million due to incorrect assumptions regarding tax utilization limitations. The additional NOL increased our NOL carryforward and valuation allowance to approximately $10.2 million. In addition, during our review, we further determined that we will generate taxable income in future years to utilize our NOLs and reversed our valuation allowance and reduced our goodwill balance related to the VIG acquisition in the amount of $10.2 million, the total value of our NOLs as determined by our analysis.
The $4.4 million of other intangible assets acquired was allocated to brand name, which is not subject to amortization.
Effective May 1, 2006, our quota-share reinsurance agreement with FolksAmerica where we ceded 25% of business produced by Space Coast, our Florida underwriting agency was terminated.
renewal policies written by the VIG insurance company subsidiaries through a 100% quota share reinsurance agreement, whereby AIC will assume 100% of the underwriting results of the VIG insurance subsidiaries related to non-standard personal automobile polices produced by our underwriting agencies.
The amounts included in our balance sheets for the unpaid losses and loss adjustment expenses and unearned premium we would remain liable for in the event our reinsurers are unable to meet their obligations at December 31 are as follows (dollars in thousands):
At December 31, 2006, $18.4 million was included in reserves for losses and loss adjustment expenses that reflect the amounts owed from AIC and Insura under reinsurance agreements with the VIG affiliated companies, including Hawaiian. AIC established the AFIC Trust to collateralize this payable, which currently holds $23.054 million in securities (the “AFIC Trust”). The AFIC Trust has not been drawn upon the SDR in Texas or the SDR in Hawaii. The SDRs will likely negotiate similar terms for withdrawal of funds from the AFIC trust as those agreed to in regards to the VFIC Trust.
Effective May 1, 2006, our quota-share reinsurance agreement with FolksAmerica where we ceded 25% of business produced by Space Coast, our Florida underwriting agency, was terminated.
AIC is a party to a 100% quota share reinsurance agreement with Hawaiian, which is ultimately a wholly-owned subsidiary of VIG. On November 4, 2004, 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 ; and professional negligence as to the defendants Prompt Insurance Services, Paul Ruelas, and Anthony David Medina. SCJ, Prompt Insurance Services, Paul Ruelas, and Anthony David Medina are not affiliated with AIC. The plaintiff sought 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 $35.0 million. AIC, as a party to a 100% quota share reinsurance agreement, is sharing in the defense of this matter.
On August 8, 2005, we were served a copy of plaintiff’s Second Amended Complaint, which added a cause of action for fraud and deceit against all defendants, and a cause of action for negligent misrepresentation against Hawaiian and SCJ.
Effective August 1, 2005, we entered into novation agreements with several unaffiliated reinsurers who participated in a quota share reinsurance agreement in which we also participated. Pursuant to these agreements, we were substituted in place of these reinsurers assuming all rights, interests, liabilities and obligations related to the original quota share reinsurance agreement. As a result of these novation agreements, our participation in the original reinsurance agreement increased from 5% to 100% effective August 1, 2005. In consideration for our assumption of their liabilities, these reinsurers agreed to pay us an amount equal to their share of the liabilities under the original quota share agreement as of July 31, 2005. We received cash in the amount of $14.2 million in relation to this novation. The terms of this reinsurance agreement did not meet the risk transfer requirements according to FAS 113; therefore, this contract was accounted for as deposits according to the guidelines of SOP 98-7, “Deposit Accounting for Insurance and Reinsurance Contracts that do not Transfer Insurance Risk”. Under deposit accounting, the deposit liability should be adjusted based on the adjusted amount and timing of the cash flows. Changes in the carrying amount of the deposit liability should be reported as income or expense as appropriate. For the years ended December 31, 2006 and 2005, we have recognized $683,000 and $476,700, respectively, in income related to this novation. As of December 31, 2006, $635,000 is included in deferred revenue.
Effective October 1, 2005, we entered into commutation agreements with several unaffiliated reinsurers who participated in a quota share reinsurance agreement in which we were the direct writer. Pursuant to these agreements, we were substituted in place of these reinsurers assuming all rights, interests, liabilities and obligations related to the original quota share reinsurance agreement. In consideration for our assumption of their liabilities, these reinsurers agreed to pay us an amount equal to their share of the liabilities under the original quota share agreement as of September 30, 2005. As of December 31, 2005, we had received $4.5 million in relation to this commutation.
In the fourth quarter of 2006, management determined that a reclassification would provide improved presentation for the liability for reserves for loss adjustment expenses that had previously been classified as deferred revenue liability. We reduced our consolidated deferred revenue liability for the year ended December 31, 2005 while increasing our reserve for losses, loss adjustment expenses and deposits. This reclassification resulted in an adjustment to our statements of cash flows for the years ended December 31, 2005 and 2004. However, the reclassification does not affect “net cash provided by operating activities” because the reclassification was between two components of “net cash provided by operating activities”. The reclassification as of December 31, 2005 and December 31, 2004 was $16.0 million and $5.8 million, respectively and has been reflected in the table above.
We evaluate impairment of goodwill and indefinite life intangibles in our agency reporting unit, as the insurance company reporting unit has no associated goodwill or indefinite life intangibles. Goodwill impairment is based upon (1) the historical financial performance of the unit; (2) the most recent financial performance of the unit;
The following table represents our anticipated intangible amortization over the next five years, assuming no future acquisitions, (dollars in thousands):
The changes in the carrying amount of goodwill as of December 31, 2006 and 2005 and for the years ended December 31, 2006 and 2005 are as follows (dollars in thousands):
As of December 31, 2006, other adjustments to goodwill are for contingent purchase consideration on certain acquisitions.
Property and equipment is stated at cost, less accumulated depreciation, and consists primarily of computer and telephone equipment, furniture and fixtures and leasehold improvements. Excluding leasehold improvements, depreciation is computed using the straight-line method over the estimated useful lives of the assets, typically ranging from three to five years. Leasehold improvements are depreciated over the shorter of the useful life or the remainder of the lease term.
We have provided various services for VIG and its subsidiaries, including underwriting, premium processing, and claims processing. Accordingly, for the years ended December 31, the accompanying consolidated statements of operations reflect income from these services as follows (dollars in thousands):
As part of the terms of the acquisition of AIC and Insura, VIG 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, 2006, all such unaffiliated reinsurers had A.M. Best ratings of “A−” or better.
We lease six of our Insure One retail stores in Chicago, Illinois from ATR Investments, LLC or entities controlled by ATR Investments. The former president of our retail division, Alan T. Rasof, is the sole owner and manager of ATR Investments. These six leases have terms ranging from 3 to 4 years and expiration dates ranging
State insurance laws restrict the ability of our insurance company subsidiaries to declare stockholder dividends. These subsidiaries may not make an “extraordinary dividend” until 30 days after the applicable commissioner of insurance has received notice of the intended dividend and has not objected in such time or until the commissioner has approved the payment of the extraordinary dividend within the 30-day period. In most states, an extraordinary dividend is defined as any dividend or distribution of cash or other property whose fair market value, together with that of other dividends and distributions made within the preceding 12 months, exceeds the greater of 10.0% of the insurance company’s surplus as of the preceding December 31 or the insurance company’s net income for the 12-month period ending the preceding December 31, in each case determined in accordance with statutory accounting practices. In addition, an insurance company’s remaining surplus after payment of a dividend or other distribution to stockholder affiliates must be both reasonable in relation to its outstanding liabilities and adequate to its financial needs. In 2007, our insurance companies may pay up to $11.1 million in ordinary dividends
to us without prior regulatory approval. However, the maximum dividend capacity is not immediately available in 2007 due to the dividend payment of $11.5 million by our insurance company subsidiaries in December 2006.
On June 1, 2005, our newly formed trust subsidiary, Affirmative Insurance Holdings Statutory Trust II (“Trust Subsidiary II”), completed a private placement of $25.0 million of 30 year floating rate trust preferred securities. Simultaneously, we borrowed $25.0 million from Trust Subsidiary II and the net proceeds from this borrowing, along with cash from operations, were used to purchase the 2.0 million shares of our common stock as discussed in Note 16. The trust preferred securities, which can be redeemed in whole or in part by the issuer after five years, bear an initial interest rate of 7.792% until June 15, 2010, at which time they will adjust quarterly to the 90-day LIBOR rate plus 355 basis points. As of December 31, 2006 the note balance was $25.8 million.
Employee agreements. We have entered into employment agreements with our key executive officers, Kevin R. Callahan, Chief Executive Officer, Mark E. Pape, Executive Vice President and Chief Financial Officer; M. Sean McPadden, Executive Vice President and Robert A. Bondi, Executive Vice President and Chief Operating Officer. These agreements grant these individuals the right to receive certain benefits, including base salary, should the executives be terminated other than for cause.
Operating leases. As of the year ended December 31, 2006, we leased an aggregate of approximately 543,851 square feet of office space for our agencies, insurance companies and retail stores in various locations throughout the United States.
The following table identifies our contractual obligations by payment due period as of December 31, 2006 (dollars in thousands):
Affirmative Insurance Holdings, Inc. and Affirmative Insurance Company v. Nance, Meadows, Saeger, Wright and Does 1-10: Affirmative Insurance Holdings, Inc. and Affirmative Insurance Company (referred to herein collectively as “Affirmative”) brought action against certain officers and directors of Vesta Fire Insurance Corporation and its parents and/or subsidiaries, including, Hopson B. Nance, E. Murray Meadows, Paul H. Saeger, Jr., Fred H. Wright, and Does 1-10 in the United States District Court of the Northern District of Alabama, Southern Division, on December 28, 2006, for negligent misrepresentation, fraud, tortuous interference with contractual relations, breach of fiduciary duty, negligence and conversion. The details of such allegations are set forth in the petition. The case involves an action by Affirmative to recover $7.2 million of Affirmative’s funds used improperly by Defendants to satisfy a debt of one of Vesta Insurance Group, Inc.’s subsidiaries. Among the requested relief, Affirmative seeks judgment against the Defendants for $7.2 million, plus prejudgment interest and punitive damages. This matter subsequently was transferred to the U.S. Bankruptcy Court for the Northern District of Alabama for pre-trial proceedings in connection with the bankruptcy proceeding of Vesta Insurance Group, Inc. We are vigorously prosecuting the claims against the defendants and are exercising all available rights and remedies against them.
On August 6, 2004, we entered into a credit agreement (the “Credit Agreement”) with The Frost National Bank, effective July 30, 2004, which provided us with a senior secured credit facility. On August 7, 2006, we entered into a Fourth Amendment to our Credit Agreement dated July 30, 2004, which amended certain provisions of the Credit Agreement. The Fourth Amendment extended the term to July 30, 2008, modified certain affirmative and negative covenants, and increased the revolving commitment to $20.0 million. Under this credit facility, the maximum amount available to us from time to time was $20.0 million, which may include up to $20.0 million under a two-year revolving line of credit, up to $10.0 million in five-year term loans and up to $10.0 million in five-year stand-by letters of credit. The borrowings under our credit facility would accrue interest based on the 90-day LIBOR rate plus 150 basis points and we would pay letter of credit fees based on an annual rate of 75 basis points. Our obligations under the credit facility were guaranteed by our material operating subsidiaries (other than our insurance companies) and were secured by a first lien security interest on all of our assets and the assets of our material operating subsidiaries (other than our insurance companies), including a pledge of 100% of the stock of AIC. The credit facility contained certain financial covenants, which included combined ratio, risk-based capital requirement, fixed charge coverage ratio, consolidated net worth and consolidated net income requirements and other restrictive covenants governing distributions and management changes. The proceeds were available to issue letters of credit securing our obligations under reinsurance agreements, to fund general working capital for our agency operations, capital surplus for our insurance companies and to finance acquisition activities. During 2005, we executed letters of credit under this credit facility of approximately $2.3 million to collateralize an assumed reinsurance contract with certain of our reinsurers, all of which were released on December 1, 2005. Total fees were approximately $13,000.
Under the terms of our Credit Agreement, we were required to file our Annual Report on Form 10-K on or before March 31, 2006. Frost Bank waived, for a certain period of time, our compliance with the above covenant of the Credit Agreement, and we filed our Annual Report on Form 10-K within the waiver period. All other terms of the Credit Agreement are unaffected by this waiver.
As of December 31, 2006, there were no outstanding loan amounts due under the above mentioned credit facility, and we were in compliance with all of our financial and other restrictive covenants.
limitations, minimum fixed charge coverage ratios and a minimum consolidated net worth requirement, as well as other restrictive covenants.
Concurrently with entering into the Facility, the Company borrowed $200.0 million (the “Borrowing”) under the term loan portion of the Facility to finance its acquisition of USAgencies and to pay related costs and expenses. The principal amount of the Borrowing is payable in quarterly installments of $500,000, with the remaining balance due on the seventh anniversary of the closing of the Facility. Beginning in 2008, we are also required to make additional annual principal repayments that are to be calculated based upon our financial performance during the preceding fiscal year. In addition, certain events, such as the sale of material assets or the issuance of significant new equity, necessitate additional required principal repayments. As of March 14, 2007, we have no borrowings under the revolving portion of the Facility.
On March 12, 2004, we issued 39,944 shares of our common stock to LBL Partners, Ltd., a minority stockholder, at a purchase price of $9.76 per share, for aggregate consideration of $389,967 in cash.
On March 12, 2004, we issued 19,623 shares of our common stock to Thomas E. Mangold, our former 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.
On July 9, 2004, we completed our initial public offering of our common stock. We issued 4,420,000 additional shares of our common stock and VIG sold 3,750,000 shares of our common stock that they owned, at an initial public offering price of $14 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 VIG. Our net proceeds from the offering were $65.3 million, after deducting our estimated offering expenses. We contributed $64.3 million of the net proceeds to our insurance companies in order to increase their statutory surplus. This additional capital allowed us to reduce our reinsurance purchases and retain more gross premiums. The remaining $1.0 million of net proceeds were held for general corporate purposes.
On June 1, 2005, we purchased 2,000,000 shares of treasury stock from VIG for $14.00 per share. We recorded the purchase at cost. The purchase was funded with the proceeds from our new trust preferred securities, as discussed in Note 13, and with cash from operations.
In November 2005, we issued 623,610 shares of our common stock to Thomas E. Mangold upon the exercise of options. In addition, we purchased 50,963 shares of stock from Thomas E. Mangold for $14.63 per share, which was market value on the date of the transaction.
On May 9, 2006, the board of directors approved a share repurchase program for up to $15.0 million of our common stock over the subsequent 12 months. From time to time, repurchases may be made in the open market or through privately negotiated transactions at the discretion of management based on management’s assessment of market conditions and other relevant factors. We expect to fund the purchases initially through internally available funds. In May and June 2006, we repurchased a total of 302,400 shares of our common stock at an average cost of $13.67 per share.
In June 2006, we issued 5,300 shares of our common stock upon the exercise of options.
In November 2006, we issued 25,000 shares of restricted stock to Robert A. Bondi, Executive Vice President and Chief Operations Officer, which vests ratably over five years. Total compensation recorded for the year ended December 31, 2006 was approximately $7,000.
SFAS 123R permits us to adopt its requirements using one of two methods:
1. A “modified prospective” method in which compensation cost is recognized beginning with the adoption date (a) based on the requirements of SFAS 123R for all share-based compensation payments granted after the adoption date and (b) based on the requirements of SFAS 123 for all awards granted to employees prior to the adoption date that remain unvested on the adoption date.
price of each stock option granted under the 2004 Plan may be paid in cash or in other forms of consideration in certain circumstances, including shares of common stock, deferred payment arrangements or pursuant to cashless exercise programs. A stock option award may provide that if shares of our common stock are used to pay the exercise price, an additional option will be granted to the participant to purchase that number of shares used to pay the exercise price. Generally, stock options are not transferable except by will or the laws of descent and distribution, unless the board or committee provides that a nonqualified stock option may be transferred.
As permitted by SFAS 123R, we used the modified Black-Scholes model to estimate the value of employee stock options on the date of grant that used the assumptions noted below. The risk-free rate for periods within the contractual life of the options is based on the U.S. Treasury yield curve in effect at the time of grant. The expected term of each option is based on our estimate that all individuals granted stock options would have an average holding period of two years after the vesting before any of the vested options are exercised. We expect all grantees to exercise their options within two years after each individual tranche’s vesting date within the single option grant. Expected volatilities are based on historical volatilities of our common stock. The dividend yield was based on expected dividends at the time of grant.
Stock option compensation expense is the estimated fair market value of options granted and amortized on a straight-line basis over the requisite service period for each separately vesting portion of the award. The weighted average estimated fair value of stock options granted during the twelve month period ended December 31, 2006 was $2.33.
As of December 31, 2006, there was $2.8 million of total unrecognized compensation cost related to nonvested stock option compensation expense and $1.7 million of unrecognized compensation cost for nonvested restricted stock compensation expense that will be recognized over the remaining requisite service periods.
The majority of our commission income 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.
that we administer. In 2006, no one independent agency accounted for more than 3.1% of the gross written premiums produced by our affiliated and unaffiliated underwriting agencies, and only two independent agencies accounted for more than 1% of these gross written premiums.
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 applicable state of domicile. Each state of domicile requires that insurance companies domiciled in those states prepare their statutory-basis financial statements in accordance with the
The condensed financial information of the parent company, Affirmative Insurance Holdings, Inc. only as of December 31, 2006 and 2005, and for the years ended December 31, 2006, 2005, and 2004 is presented as follows:
On March 6, 2007, we announced that Alan T. Rasof resigned as the president of our retail division. We had no employment agreement with Mr. Rasof.