As of December 31, 2012, we leased an aggregate of 434,249 square feet of office space in various locations throughout the United States. The office space includes a lease for 56,875 aggregate square feet of office space in a common building in Burr Ridge, Illinois, and our Burr Ridge lease term expires in November 2016. Effective November 2012, we subleased 38,341 square feet of the common building in Burr Ridge through November 2016. We lease 56,888 square feet of office space in Addison, Texas, and our Addison lease term expires in March 2015. We also have two leases of 55,186 aggregate square feet of office space in Baton Rouge, Louisiana.
One Baton Rouge lease is for 51,792 square feet of office space with a term that expires in January 2020. The second Baton Rouge lease is for 3,394 square feet of office space with a term that expires in July 2014. We also have offices in Chicago, Dallas and Plymouth, Michigan, which have 4,003, 2,619 and 1,705 square feet, respectively. In addition, we have 199 owned retail stores that presently lease space on an individual basis at various locations in the states in which we do business. None of these individual retail store leases are material to our operations.
As of December 31, 2012, our subsidiaries included insurance companies licensed to write insurance policies in 39 states, underwriting agencies, retail agencies with 199 owned stores and a relationship with one unaffiliated underwriting agency. Affirmative Insurance Company of Michigan, USAgencies Casualty Insurance Company, Inc. (Casualty) and USAgencies Direct Insurance Company (Direct) are wholly-owned subsidiaries of Affirmative Insurance Company (AIC), a wholly-owned subsidiary of Affirmative Insurance Group, Inc., a wholly-owned subsidiary of Affirmative Insurance Holdings, Inc. (Holdings). In November 2012, Insura Property and Casualty Insurance Company (formerly a wholly-owned subsidiary of AIC) was merged into AIC and Direct was sold from AIC to Casualty. We are currently active in offering insurance directly to individual consumers through retail stores in 9 states (Louisiana, Texas, Illinois, Alabama, Missouri, Indiana, South Carolina, Kansas and Wisconsin) and distributing our own insurance policies through our owned retail stores and approximately 5,400 independent agents or brokers in 8 states (Louisiana, Texas, Illinois, Alabama, California, Missouri, Indiana and South Carolina). In March 2011, we discontinued writing new business in the state of Michigan, and in June 2011 we discontinued writing renewals. In May 2010, we discontinued writing new and renewal policies in the state of Florida. In July 2010, we discontinued writing new and renewal insurance polices in New Mexico.
We incurred losses from operations over the last four years, including a net loss of $51.9 million for the year ended December 31, 2012. Losses over this time period were primarily due to underwriting losses, significant revenue declines and expenses declining less than the amount of revenue declines and goodwill impairments. The loss from operations was the result of prior pricing issues in some states in which we have taken significant pricing and underwriting actions to address profitability, losses from states that we have exited, such as Florida and Michigan, and goodwill impairment charges as a result of such losses. As a result of declining performance, we have breached the leverage ratio covenant under the senior secured credit facility as of September 30, 2012; however, the lenders for the facility agreed to waive such event of default. We breached the leverage, interest coverage and risk-based capital ratio covenants (“Financial Covenants”) as of December 31, 2012, and the lenders for the facility have agreed to temporarily forbear from exercising their rights and remedies under the facility until the earlier of June 1, 2013, or the occurrence of a further event of default under the facility from the quarterly covenants. If we are unable to achieve compliance with the Financial Covenants as of June 1, 2013, or obtain an extension of the lenders’ forbearance or a waiver of any non-compliance, the lenders will be able to declare all amounts outstanding under the facility to be immediately due and payable. Even if we are compliant with the Financial Covenants or, if not compliant, obtain additional forbearance or waivers from our lenders, there is still substantial uncertainty that we will be able to refinance or extend the maturity of the senior secured facility when it expires in January 2014. If our lenders declare the amounts outstanding under our senior secured credit facility to be immediately due and payable or we are unable to refinance or extend the maturity of the senior secured facility when it expires in January 2014, it would have a material adverse effect on our operations and our creditors and stockholders.
We are pursuing various actions to address these issues including, but not limited to, refinancing of our debt, obtaining additional financing or entering into certain transactions, such as sales of assets or operations.
The preparation of our consolidated financial statements in conformity with GAAP requires us to make estimates and assumptions when applying our accounting policies. Critical accounting policies are defined as those that are reflective of significant judgments and uncertainties, and potentially result in materially different results under different assumptions and conditions. Our critical accounting policies are described below. For a detailed discussion on the application of these and other accounting policies, see Note 3 of Notes to Consolidated Financial Statements which appears in Item 8 of this Annual Report.
Reserving for unpaid losses and loss adjustment expenses. On a quarterly basis at the end of each financial reporting period, we record our best estimate of our overall reserve for both current and prior accident years. The amount recorded represents the remaining amount we expect to pay for all covered losses that occurred, including unreported, through the current financial statement date, as well as the amount we expect to expend for all claim settlement expenses. The overall reserve for losses and loss adjustment expenses estimate that we record is the difference between (1) our point estimate of the ultimate loss and ultimate loss adjustment expenses, and (2) the amount of losses and loss adjustment expenses paid through the current financial statement date. Our point estimate of ultimate loss consists of a point estimate for incurred but not reported (IBNR) losses and case reserves. The point estimate of ultimate loss adjustment expenses consists of a separate point estimate for adjusting and other expenses and for defense and cost containment expenses.
We utilize different processes to determine our best estimate for unpaid losses and unpaid loss adjustment expenses. We establish a standard system-generated case loss reserve that varies by state, program, coverage and, in some instances for certain coverages, elapsed time since date of loss or if the claim is in litigation. The only variation to this methodology for setting case loss reserves exists in the instance where we believe our financial exposure for a particular loss event is significant and in fact may approach or be equal to our policy limits. In these instances, we will establish a case loss reserve to reflect our view regarding the potential cost of this exposure to us. The system automatically adjusts the case loss reserves downward in the event a partial payment is made and a claim remains open. We will re-adjust the case loss reserves in an instance where a partial payment is made if we believe the facts of the claim justify a different reserve. This activity is generally limited to our personal injury protection coverage, where we have a significant amount of this type of activity, the settlement time is longer than for our normal business and the types of losses do not lend themselves to an average reserve methodology.
We estimate IBNR losses and ultimate loss adjustment expenses quarterly using detailed statistical analyses and judgment, including adjustment for deviations in trends caused by internal and external variables that may affect the resulting reserves. The underlying processes require the use of estimates and informed judgment, and as a result the establishment of loss and loss adjustment expenses reserves is an inherently uncertain process. The following generally accepted actuarial loss and loss adjustment expenses (LAE) reserving methodologies are used in our analysis:
Paid Loss Development - We use historical loss or loss adjustment expense payments over discrete periods of time to estimate future losses or loss adjustment expense. Paid development methods assume that the pattern of paid losses or loss adjustment expense occurring in past periods will recur for losses or loss adjustment expense occurring in subsequent periods.
Incurred Bornhuetter/Ferguson - We use a combination of incurred development methods and expected loss and loss adjustment expense methods. Expected loss ratio methods are based on the assumption that ultimate losses vary proportionately with premiums. Expected loss and loss adjustment expense ratios are typically developed based upon the information used in pricing and are multiplied by the total amount of premiums earned to calculate ultimate loss and loss adjustment expense which is then proportionately added to the actual incurred to date.
Valuation of goodwill and other intangible assets. We evaluate goodwill for impairment annually as of September 30, or more frequently if events or circumstances indicate that the carrying value may not be recoverable. We report under a single reporting segment and, as such, the goodwill analysis is measured at the
Consistent with prior assessments, our fair value was determined using an internally developed discounted cash flow method. Management made significant assumptions and estimates about the extent and timing of future cash flows, growth rates, and discount rates that represent unobservable inputs into the valuation methodologies used to calculate fair value. A discount rate of 19% was used at September 30, 2012, which we believed adequately reflected an appropriate risk-adjusted discount rate based on our overall cost of capital and company-specific risk factors related to cash flow, debt covenants compliance, and regulatory risk, as discussed in Note 2. The cash flows were estimated over a significant future period of time, which made those estimates and assumptions subject to a high degree of uncertainty. Based upon the results of the assessment, we concluded that the carrying value of goodwill was fully impaired as of September 30, 2012. In step two of the goodwill impairment analysis, we determined the fair values of our assets and liabilities (including any unrecognized intangible assets) as if we had been acquired in a business combination. Determining the implied fair value of goodwill was judgmental in nature and involved the use of significant estimates and assumptions. The resulting implied fair value of goodwill was compared to the carrying value of goodwill, resulting in the write-off of the remaining goodwill balance of $23.4 million.
In October 2010, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2010-26, Financial Services-Insurance (Topic 944). ASU 2010-26 modified the definitions of the type of costs that can be capitalized in the successful acquisition of new and renewal insurance contracts. ASU 2010-26 requires incremental direct costs of successful contract acquisition as well as certain costs related to underwriting, policy issuance and processing, medical and inspection and sales force contract selling for successful contract acquisition to be capitalized. These incremental direct costs and other costs are those that are essential to the contract transaction and would not have been incurred had the contract transaction not occurred. We retrospectively adopted ASU 2010-26 on January 1, 2012. The cumulative effect of the adoption was a decrease of shareholders’ equity by $11.3 million, net of tax, as of January 1, 2011.
ASU 2011-08, Intangibles-Goodwill and Other (Topic 350): Testing Goodwill for Impairment, permits an entity to make a qualitative assessment of whether it is more likely than not that a reporting unit’s fair value is less than its carrying amount before applying the two-step goodwill impairment test. Additionally, if the carrying amount of a reporting unit is zero or negative, the second step of the impairment test shall be performed to measure the amount of the impairment loss, if any, when it is more likely than not that a goodwill impairment exists. In considering whether it is more likely than not that a goodwill impairment exists, a qualitative assessment will be performed. If an entity concludes it is not more likely than not that the fair value of a reporting unit is less than its carrying amount, it need not perform the two-step impairment test. This standard is effective for interim and annual goodwill impairment tests performed for fiscal years beginning after December 15, 2011. The adoption of this standard did not have an impact on our consolidated financial position, results of operations or cash flows.
ASU 2011-05, Comprehensive Income (Topic 220):Presentation of Comprehensive Income, requires companies to present the components of net income and comprehensive income in either one or two consecutive financial statements. Companies will no longer be permitted to present the components of other comprehensive income as part of the statement of changes in stockholders’ equity. This standard is effective for interim and annual periods beginning after December 15, 2011, and should be applied retrospectively. The adoption of this standard did not impact our consolidated financial position, results of operations or cash flows.
In July 2012, the FASB issued ASU 2012-02, Intangibles-Goodwill and Other (Topic 350): Testing Indefinite-Lived Intangible Assets for Impairment. This ASU gives entities testing indefinite-lived intangible assets for impairment the option first to assess qualitative factors to determine whether the existence of events and circumstances indicates that it is more likely than not that the indefinite-lived intangible asset is impaired. If, after assessing the totality of events and circumstances, an entity concludes that it is not more likely than not that the indefinite-lived intangible asset is impaired, the entity is not required to take further action. However, if an entity concludes otherwise, a quantitative impairment test is required. This guidance is effective for annual and
interim impairment tests beginning January 1, 2013, with early adoption permitted. We will adopt this standard on January 1, 2013 and do not believe the adoption will have a material effect on our consolidated financial position, results of operations or cash flows.
In the independent agency distribution channel and the unaffiliated underwriting agency distribution channel, the effect of competitive conditions is the same as in our 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 parties instead of our products. We believe that we are generally competitive in the markets we serve, and we constantly evaluate our products relative to those of other carriers.
For 2012, we had a net loss of $51.9 million, which included a goodwill impairment charge of $23.4 million. For 2011, we had a net loss of $162.6 million, which included a goodwill impairment charge of $140.1 million and losses from our Michigan business of $14.7 million. For 2010, we had a net loss of $86.9 million.
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 in our retail stores. We earn commission income and fees in our retail distribution channel for sales of third-party insurance policies. The following represents gross premiums written produced by our retail agencies (in thousands):
In our independent agency distribution channel, gross premiums written for 2012 increased $13.8 million, or 24.7%, compared with 2011 primarily due to increases in our Texas business. In our independent agency distribution channel, gross premiums written for 2011 decreased $92.9 million, or 62.4%, compared with 2010. The 2011 decrease was primarily due to the suspension of new business production from unprofitable independent agent relationships, which included our withdrawal from the Michigan market, as well as our pricing and underwriting actions.
Gross premiums written by our unaffiliated underwriting agencies for 2012 increased $2.9 million, or 19.4%, compared with 2011. Gross premiums written by our unaffiliated underwriting agencies for 2011 decreased $5.7 million, or 27.6%, compared with 2010.
Total net premiums written for 2012 increased $29.4 million, or 20.8%, compared with 2011. The increase was primarily due to the increase in gross written premium and the termination of a quota-share reinsurance agreement on January 1, 2012. This contract, put in place effective January 1, 2011, terminated on a cut-off basis and resulted in the return of $11.8 million of ceded unearned premium, net of $4.3 million of deferred ceding commissions during the year ended December 31, 2012. Total net premiums written for 2011 decreased $140.9 million, or 50.0%, compared with 2010.
We assume reinsurance from a Texas county mutual insurance company (the county mutual) whereby we have assumed 100% of the policies issued by the county mutual for business produced by our owned general agents.
Effective October 1, 2010, we entered into a quota-share reinsurance agreement with a third-party reinsurance company ceding 40% of premiums and losses on policies in-force in all states other than Michigan on October 1, 2010 and policies written through December 31, 2010 on a run-off basis. Written premiums ceded under this agreement totaled $60.8 million through December 31, 2012. This contract was commuted effective November 30, 2012.
The amount of recoveries pertaining to reinsurance contracts that were deducted from losses and loss adjustment expenses incurred during 2012, 2011 and 2010 was approximately $49.8 million, $40.6 million and $75.2 million, respectively. The amount of loss reserves and unearned premium we would remain liable for in the event our reinsurers are unable to meet their obligations was as follows (in thousands):
We entered into an excess of loss reinsurance contract effective August 1, 2010 that provides coverage for individual losses in excess of $100,000 up to $1 million primarily to reduce our exposure to no-fault medical losses in Michigan. This contract terminated July 31, 2011 on a run-off basis. In addition, we entered into a reinsurance agreement effective June 1, 2012 (as we have previously done on an annual basis) to provide coverage for catastrophic events that may involve multiple insured losses.
Net Investment Income and Other Income. Net investment income includes income on our portfolio of debt securities and net rental income from our investment in real property. Net investment income for 2012 decreased $1.9 million, or 37.8%, compared with 2011. The decrease was primarily due to a 52.1% decrease in total average invested assets to $76.3 million during 2012 from $159.4 million during 2011, which was partially offset by a $0.3 million increase in income from our investment in real estate. The average investment yield was 1.9% (2.0% on a taxable equivalent basis) in 2012, compared with 2.3% (2.4% on a taxable equivalent basis) in 2011.
In the first quarter of 2010, we began to reposition our investment portfolio by decreasing our exposure to tax-exempt investments. The repositioning was completed in the second quarter of 2010. We sold $123.6 million of available-for-sale securities during 2010 for a net realized gain of $1.6 million.
At December 31, 2012, our fixed-income investments were invested in the following: corporate debt securities 40.6%; FDIC-insured certificates of deposit 27.8%; U.S. Treasury and government agencies securities 24.0%; and states and political subdivisions securities 7.6%. The average quality of our portfolio was AA- at December 31, 2012. We attempt to mitigate interest rate risk by managing the duration of our fixed-income portfolio to the duration of our reserves. As of December 31, 2012, the effective duration of our fixed-income investment portfolio was 1.1 years.
Losses and Loss Adjustment Expenses. Losses and loss adjustment expenses for 2012 decreased $25.8 million, or 18.7%, compared with 2011. Losses and loss adjustment expenses for 2011 decreased $175.0 million, or 56.0%, compared with 2010.
The decrease in the 2012 accident year resulted from the confluence of a number of initiatives. During 2012, we realized the full benefit of our new multi-variate pricing model in our four largest states, implemented pricing and underwriting changes and our continuing improvements in our claims process. The combination of these improvements has allowed us to start growing in the fourth quarter while keeping our losses at levels lower than 2011.
In 2011, the percentage of calendar year losses and loss adjustment expense to net premiums earned (the loss ratio) was 78.0% compared with 93.8% in 2010. The accident year loss ratio for 2011 decreased 13.7 points compared with the current 2010 accident year loss ratio of 88.8%. The decline in the loss ratio for 2011
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. During 2010, we experienced frequency indications that were flat compared to prior year selections and severity trends for liability business that were significantly higher than in the past. In a period of stable premium rates, these trends would have resulted in deteriorating loss ratios.
The following table presents the development of reserves for unpaid losses and loss adjustment expenses from 2002 through 2012 for our insurance company subsidiaries, net of reinsurance recoveries or recoverables. The first line of the table presents the reserves at December 31 for each indicated year. This represents the estimated amounts of losses and loss adjustment expenses for claims arising in that year and all prior years that are unpaid at the balance sheet date, including losses incurred but not reported to us. The upper portion of the table presents the cumulative amounts subsequently paid as of successive years with respect to those claims. The lower portion of the table presents an update of the estimated amount of the previously recorded reserves based upon the experience as of the end of each succeeding year. The estimates are revised as more information becomes known about the payments, frequency and severity of claims for individual years. A redundancy (deficiency) exists when the reestimated reserves at each December 31 is less (greater) than the prior reserve estimate. The cumulative redundancy (deficiency) depicted in the table, for any particular calendar year, represents the aggregate change in the initial estimates over all subsequent calendar years.
Our historical net liabilities for losses and loss adjustment expenses are impacted by our 100% quota-share reinsurance contract with VFIC. For the years 2002 and 2003 we reinsured 100% of business written or assumed by our insurance companies to VFIC. The following table summarizes the development of reserves for unpaid losses and loss adjustment expenses (in thousands):
The adverse prior period development taken in 2012 was primarily due to an increase in the estimated severity for Louisiana bodily injury claims in 2011. The gross cumulative redundancy in 2010 was primarily due to a reduction of Michigan case reserves for 2010 due to revised estimates of losses. The gross cumulative deficiency in 2009 increased as a result of revised case reserves on our Michigan business due to increased estimates of ultimate losses.
Deferred policy acquisition costs represent the deferral of expenses that we incur related to successful contract acquisition of new business or renewal of existing business. Policy acquisition costs, consisting of primarily commission expenses and premium taxes, are initially deferred and then charged against income ratably over the
ASU 2010-26, Financial Services-Insurance (Topic 944), modifies the definitions of the type of costs that can be capitalized in the successful acquisition of new and renewal insurance contracts. ASU 2010-26 requires incremental direct costs of successful contract acquisition as well as certain costs related to underwriting, policy issuance and processing, medical and inspection and sales force contract selling for successful contract acquisition to be capitalized. These incremental direct costs and other costs are those that are essential to the contract transaction and would not have been incurred had the contract transaction not occurred. We adopted this guidance on January 1, 2012 using retrospective application.
Net expenses, defined as the sum of selling, general and administrative expenses and depreciation and amortization less commission income and fees, as a percentage of net premiums earned (the net expense ratio) increased to 31.0% in 2012 compared with 29.7% in 2011. The increase was primarily due to an 18.6% decrease in net premiums earned and a 13.2% decrease in selling, general and administrative expenses, which were partially offset by a 9.4% decrease in commission income and fees. Net expenses as a percentage of net premiums earned (the net expense ratio) increased to 29.7% in 2011 compared with 27.3% in 2010. The increase was primarily due to a 47.0% decrease in net premiums earned and a 32.9% decrease in selling, general and administrative expenses, which were partially offset by an 18.7% decrease in commission income and fees. The following table sets forth the components of the net expenses and the computation of the net expense ratios (in thousands):
Interest Expense. Interest expense for 2012 decreased $1.8 million, or 8.5%, compared with 2011. This decrease was due to decreases in the average debt outstanding, in the amortization of debt discount and in interest expense on the lease obligation entered into in May 2010. In 2012, we repaid $3.5 million of the senior secured facility. Amortization of debt discount was $4.1 million in 2012, compared with $4.5 million in 2011.
Income Taxes. Income tax expense for 2012 was $0.3 million as compared to an income tax benefit of $9.0 million in 2011. Income tax expense for 2012 represents increasing deferred tax liabilities arising from timing differences on goodwill and other intangible assets.
Income tax benefit for 2011 was $9.0 million as compared to expense of $1.7 million for 2010. The income tax benefit was related to the reduction of deferred tax liabilities from the goodwill and other intangible asset impairment charges.
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 year-end or the insurance company’s net income for the preceding year, in each case determined in accordance with statutory accounting practices. In addition, dividends may only be paid from unassigned earnings and an insurance company’s remaining surplus must be both reasonable in relation to its outstanding liabilities and adequate to its financial needs. As of December 31, 2012, our insurance companies could not pay ordinary dividends to us without prior regulatory approval due to a negative unassigned surplus position of Affirmative Insurance Company. However, as mentioned previously, our non-insurance company subsidiaries provide adequate cash flow to fund their own operations.
In 2010, we entered into a capital lease obligation related to certain computer software, software licenses, and hardware currently used by and on the books of Affirmative Insurance Company. The lease term was 60 months and the lease obligation was fully secured with FDIC-insured certificates of deposit. On October 17, 2012, we received notice from one of the lessors (Lessor) under a capital lease obligation that, based upon Lessor’s claim of an alleged default under the terms of the applicable lease and security agreements, it elected to
The Illinois Insurance Code includes a reserve requirement that an insurer maintain an amount of qualifying investments, as defined, at least equal to the lesser of $250.0 million or 100% of its adjusted loss reserves and loss adjustment expenses reserves, as defined. As of December 31, 2011, Affirmative Insurance Company (AIC) was deficient in meeting the qualifying investments requirement by $18.9 million, but submitted a plan to cure such deficiency to the Illinois Department of Insurance by September 30, 2012, which was approved and through various actions AIC was deemed by the Illinois Department of Insurance to be in compliance with the reserve requirement as of September 30, 2012. As of December 31, 2012, AIC was deficient in meeting the qualifying investments requirement by $16.5 million. We submitted a plan to cure the deficiency as of June 30, 2013 which includes a number of actions. The Illinois Department of Insurance has not yet responded to the plan. If the Illinois Department of Insurance does not approve AIC’s proposed plan or if AIC is not compliant as of the plan date of June 30, 2013, the Director of the Illinois Department of Insurance could deem AIC to be in hazardous financial condition and could take one or more of the remedial actions authorized by law for such a condition. Such action by the Illinois Department of Insurance would have a material adverse affect on our operations and the interests of our creditors and stockholders. Such action by the Illinois Department of Insurance also would trigger a further event of default under our senior secured credit facility allowing our lenders to declare all amounts outstanding under the facility to be immediately due and payable, and if such amounts were declared immediately due and payable by the lenders, it would have a material adverse effect on our operations and the interests of our creditors and stockholders.
On February 28, 2012, we exercised our right to defer interest payments on selected Notes Payable beginning with the scheduled interest payment due in March 2012 and continuing for a period of up to five years. The affected notes are associated with obligations to our unconsolidated trusts. The outstanding balance of the affected notes was $56.7 million as of December 31, 2012. We will continue to accrue interest on the principal during the extension period and the unpaid deferred interest will also accrue interest. Deferred interest will be due and payable at the expiration of the extension period.
We believe that existing cash and investment balances, as well as cash flows generated from operations, and other actions taken by the Company will be adequate to meet our liquidity needs, planned capital expenditures and the debt service requirements of the senior secured credit facility and notes payable, during the 12-month period following the date of this report at both the holding company and insurance company levels. For the year ended December 31, 2012, our net cash used in operations was $48.8 million. We believe that this amount will be significantly reduced in 2013 due to our exit from the Michigan business and premium production increasing. The runoff of the Michigan business and previous decline in insurance premiums had a substantial impact on the net cash used in operations during the year ended December 31, 2012. Cash provided by investing activities of $65.9 million was utilized to fund operating cash needs for the year ended December 31, 2012. 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 2014 expiration of our senior secured credit facility.
Repayment of the full $8.0 million will be on a first out basis, payable in full, on or prior to January 17, 2014, with priority over all other amounts outstanding under the senior secured credit facility. The incremental term loan lenders retained $2.5 million, representing original issue discount.
As of December 31, 2012, a non-cash closing fee of $550,000 was recorded in other liabilities, and subsequently added to the principal amount of the incremental term loan as of January 1, 2013.
The incremental term loan lenders have the right to retain a financial advisor to assess the financial, operational and regulatory condition of the Company.
Indebtedness under the baskets for qualified additional subordinated debt and Affirmative Premium Finance Company was eliminated. We did not have any such debt.
In addition, we paid a 0.25% fee to all lenders that approved the March 2011 amendment.
(1) As of December 31, 2012, we leased an aggregate of approximately 434,249 square feet of office space for our agencies, insurance companies and retail stores in various locations throughout the United States. These amounts represent our minimum future operating lease commitments.
(6) The payout pattern for reserves for losses and loss adjustment expenses is based upon historical payment patterns and does not represent actual contractual obligations. The timing and amount ultimately paid can and will vary from these estimates.
The Company incurred losses from operations over the last four years, including a net loss of $51.9 million for the year ended December 31, 2012. The Company’s losses over this time period were primarily due to underwriting losses, significant revenue declines and expenses declining less than the amount of revenue declines and goodwill impairments. The loss from operations was the result of prior pricing issues in some states in which the Company has taken significant pricing and underwriting actions to address profitability, losses from states that the Company has exited, such as Florida and Michigan, and goodwill impairment charges as a result of such losses. As a result of declining performance, the Company breached the leverage ratio covenant under the senior secured credit facility as of September 30, 2012; however, the lenders for the facility agreed to waive such event of default. The Company breached the leverage, interest coverage and risk-based capital ratio covenants (“Financial Covenants”) as of December 31, 2012, and the lenders for the facility have agreed to temporarily forbear from exercising their rights and remedies under the facility until the earlier of June 1, 2013, or the occurrence of a further event of default under the facility from the quarterly covenants. If the Company is unable to achieve compliance with the Financial Covenants as of June 1, 2013, or obtain an extension of the lenders’ forbearance or a waiver of any non-compliance, the lenders will be able to declare all amounts outstanding under the facility to be immediately due and payable. Even if the Company is compliant with the Financial Covenants or, if not compliant, obtains additional forbearance or waivers from its lenders, there is still substantial uncertainty that the Company will be able to refinance or extend the maturity of the senior secured facility when it expires in January 2014. If the Company’s lenders declare the amounts outstanding under our senior secured credit facility to be immediately due and payable or the Company is unable to refinance or extend the maturity of the senior secured facility when it expires in January 2014, it would have a material adverse effect on our operations and our creditors and stockholders.
hazardous financial condition and could take one or more of the remedial actions authorized by law for such a condition. Such action by the Illinois Department of Insurance would have a material adverse affect on the Company’s operations and the interests of its creditors and stockholders. Such action by the Illinois Department of Insurance also would trigger a further event of default under the Company’s senior secured credit facility allowing the Company’s lenders to declare all amounts outstanding under the facility to be immediately due and payable, and if such amounts were declared immediately due and payable by the lenders it would have a material adverse effect on the Company’s operations and the interests of its creditors and stockholders.
Investments • Investment securities consist of debt securities, and are recorded at fair value on the consolidated balance sheet. These investments are classified as available-for-sale, based on management’s intent and ability to hold to maturity. Unrealized gains and losses are recorded in accumulated other comprehensive
Management evaluates goodwill for impairment by comparing the fair value of the Company as a whole to its carrying value as of the measurement date. To determine the fair values, management used the market approach based on comparable publicly traded companies in similar lines of business and the income approach based on estimated discounted future cash flows. Cash flow assumptions consider historical financial performance; recent financial performance; the Company’s financial forecast, and other relevant factors.
Affirmative Insurance Holdings Statutory Trust II (“Trust II”), is an unconsolidated trust subsidiary, for the sole purpose of issuing $25.0 million trust preferred securities in 2005. Trust II used the proceeds from the sale of these securities and the Company’s initial capital contribution to purchase $25.8 million of subordinated debt securities from the Company. The debt securities are the sole assets of Trust II, and the payments under the debt securities are the sole revenues of Trust II. The Company’s initial capital contribution consisted of the purchase of 774,000 common securities issued by Trust II for $774 thousand, which represented 3% of the total dollar amount of subordinated debentures issued.
Commission income - Commission income and related policy fees, written for third-party insurance companies, are recognized, net of an allowance for estimated policy cancellations, 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. The allowance for estimated third-party cancellations is periodically evaluated and adjusted as necessary.
Fee Income - Policy origination fees, agency fees and installment fees compensate the Company for the costs of providing installment payment plans, as well as late payment, policy cancellation, policy rewrite and
reinstatement fees. Policy origination fees are recognized over the underlying policy terms. Other fees are recognized when services are provided. Premium finance and origination fees are recognized over the term of the finance contracts.
Stock-Based Compensation • Compensation cost is measured based on the grant-date fair value of an award utilizing the assumptions discussed in Note 18. Compensation cost is recognized for financial reporting purposes on a straight-line basis over the period in which the employee is required to provide service in exchange for the award.
The following table illustrates the effect of adopting ASU 2010-26 in the consolidated balance sheets (in thousands):
ASU 2011-08, Intangibles-Goodwill and Other (Topic 350): Testing Goodwill for Impairment, permits an entity to make a qualitative assessment of whether it is more likely than not that a reporting unit’s fair value is less than its carrying amount before applying the two-step goodwill impairment test. Additionally, if the carrying amount of a reporting unit is zero or negative, the second step of the impairment test shall be performed to measure the amount of the impairment loss, if any, when it is more likely than not that a goodwill impairment exists. In considering whether it is more likely than not that a goodwill impairment exists, a qualitative assessment will be performed. If an entity concludes it is not more likely than not that the fair value of a reporting unit is less than its carrying amount, it need not perform the two-step impairment test. This standard is effective for interim and annual goodwill impairment tests performed for fiscal years beginning after December 15, 2011. The adoption of this standard did not have an impact on the Company’s consolidated financial position, results of operations or cash flows.
ASU 2011-05, Comprehensive Income (Topic 220): Presentation of Comprehensive Income, requires companies to present the components of net income and comprehensive income in either one or two consecutive financial statements. Companies are no longer permitted to present the components of other comprehensive income as part of the statement of changes in stockholders’ equity. This standard is effective for interim and annual periods beginning after December 15, 2011, and should be applied retrospectively. The adoption of this standard did not impact the Company’s consolidated financial position, results of operations or cash flows.
ASU 2011-04, Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs, provides identical guidance with concurrently issued International Financial Reporting Standard (IFRS) 13, Fair Value Measurements. Most of the changes in the new standard are clarifications of existing guidance, but it expands the disclosures about fair value measurements, and requires the categorization by level of the fair value hierarchy for items that are not measured at fair value in the statement of financial position, but for which the fair value is required to be disclosed, which would consist of the Company’s debt, cash and cash equivalents, and fiduciary and restricted cash. In addition, for fair value measurements categorized as Level 3 within the fair value hierarchy, the valuation processes and sensitivity of the fair value measurements to changes in unobservable inputs shall be disclosed. This standard is effective for interim and annual periods beginning after December 15, 2011, and should be applied prospectively. The adoption of this standard did not impact the Company’s consolidated financial position, results of operations or cash flows.
In July 2012, the FASB issued ASU 2012-02, Intangibles-Goodwill and Other (Topic 350): Testing Indefinite-Lived Intangible Assets for Impairment. This ASU gives entities testing indefinite-lived intangible assets for impairment the option first to assess qualitative factors to determine whether the existence of events and circumstances indicates that it is more likely than not that the indefinite-lived intangible asset is impaired. If, after assessing the totality of events and circumstances, an entity concludes that it is not more likely than not that the indefinite-lived intangible asset is impaired, the entity is not required to take further action. However, if an entity concludes otherwise, a quantitative impairment test is required. This guidance is effective for annual and interim impairment tests beginning January 1, 2013, with early adoption permitted. Management does not believe the adoption of this standard will have a material effect on the Company’s consolidated financial position, results of operations or cash flows.
The following table summarizes the Company’s available-for-sale securities in an unrealized loss position at December 31, 2012 and 2011, the estimated fair value and amount of gross unrealized losses, aggregated by investment category and length of time those securities have been continuously in an unrealized loss position (in thousands):
At December 31, 2012 and 2011, investments in fixed-maturity securities with an approximate carrying value of $7.1 million and $10.2 million, respectively, were on deposit with regulatory authorities as required by insurance regulations.
In 2010, the Company entered into a quota-share reinsurance agreement with a third-party reinsurance company ceding 40% of premiums and losses on policies in-force in certain states on October 1, 2010 and policies written through December 31, 2010 on a run-off basis. The Company receives provisional ceding commission which may be adjusted based on the fully-developed loss ratio of the reinsured policies. Written premiums ceded under this agreement totaled $60.8 million through December 31, 2012. This agreement was commuted effective November 30, 2012.
In 2011, the Company entered into an additional quota-share agreement with a third-party reinsurance company under which the Company ceded 10% of business produced in Louisiana, Alabama, Texas and Illinois from September 1, 2011 through December 31, 2011. At December 31, 2011, this contract converted to a 40% quota-share reinsurance contract on the in-force business for the applicable states throughout 2012. Written premiums ceded under this agreement totaled $82.0 million during the year ended December 31, 2012. Written premiums ceded under this agreement totaled $104.9 million since inception through December 31, 2012. This agreement was extended under the same terms through March 31, 2013. In March 2013, the Company entered into a new quota-share agreement with this third-party reinsurance company effective March 31, 2013, which the Company cedes 40% for the same four states as the expiring agreement and 100% of business originated through the Texas county mutual. This agreement is through December 31, 2013 but has automatic one-year renewals unless either party provides notice of intent not to renew within 75 days.
In June 2012, the Company entered into a reinsurance agreement with third-party reinsurers which provides $5.0 million in excess of the first $3.0 million of losses coverage for catastrophic events that may involve multiple insured losses.
In February 2012, the Company entered into a one-year excess of loss reinsurance contract with third-party reinsurers which provides coverage for individual losses in excess of $100,000 up to $1.0 million.
Under certain of the Company’s reinsurance transactions, the Company has received ceding commissions. The ceding commission rate varies based on loss experience. The estimates of loss experience are continually reviewed and adjusted, and the resulting adjustments to ceding commissions are reflected in current operations. Ceding commissions recognized, reflected as a reduction of selling, general and administrative expenses, were as follows (in thousands):
The amount of loss reserves and unearned premium the Company would remain liable for in the event its reinsurers are unable to meet their obligations were as follows (in thousands):
The Michigan Catastrophic Claims Association (MCCA) is the mandatory reinsurance facility that covers no-fault medical losses above a specific retention amount in Michigan. For policies effective in 2011 and 2010, the retention amount was $0.5 million. For policies effective July 1, 2009 to June 30, 2010, the retention amount was $0.5 million. For policies effective July 1, 2008 to June 30, 2009, the retention amount was $0.4 million. As a writer of personal automobile policies in the state of Michigan, the Company ceded premiums and claims to the MCCA. Funding for MCCA comes from assessments against active automobile insurers based upon their proportionate market share of the state’s automobile liability insurance market. Insurers are allowed to pass along this cost to Michigan automobile policyholders.
The table below presents the ceded premiums written and ceded loss and loss adjustment expenses to the MCCA (in thousands):
The table below presents the total amount of receivables due from reinsurers as of December 31, 2012 and 2011 (in thousands):
VIG indemnified the Company 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, 2012, all such unaffiliated reinsurers had A.M. best ratings of A- or better. The Company had reinsurance recoverable from VIG of $2.5 million and $2.8 million as of December 31, 2012 and 2011, respectively.
Premium finance receivables (related to policies of both the Company and third-party carriers) were as follows at December 31, 2012 and 2011 (in thousands):
Premium finance receivables are secured by the underlying unearned policy premiums for which the Company obtains assignment from the policyholder in the event of non-payment. When a payment becomes past due, the Company cancels the underlying policy with the insurance carrier and receives the unearned premium to clear unpaid principal and interest. The loan is closed by writing off any uncollected amounts or refunding any overpayment to the customer. An insignificant amount of finance receivables are past due in excess of thirty days. Losses due to non-realization of premium finance receivables were $0.4 million and 0.2% of total premiums financed for 2012, $0.6 million and 0.4% of total premiums financed for 2011 and $0.7 million and 0.4% of total premiums financed for 2010.
Amortization of deferred policy acquisition costs was $(32.1) million for 2010. At December 31, 2010, the Company determined a premium deficiency existed and recorded a $0.5 million reduction of deferred acquisition costs.
The Company completed its annual goodwill and indefinite lived intangible asset impairment analysis as of September 30, 2011. Based upon the results of the assessment, the Company concluded that the carrying values of goodwill and other intangible assets were not impaired as of September 30, 2011. Due to prior period adverse loss development on the Company’s Michigan business recorded in the fourth quarter of 2011 and recent negative premium production trends, the Company revised its five-year forecast and updated its discounted cash
The fair value of goodwill presented below is not necessarily indicative of the amounts the Company might realize in actual market transactions. The carrying amount and fair value for goodwill is summarized as follows (in thousands):
Indefinite-lived intangible assets primarily consist of trade names. In measuring the fair value of these intangible assets, the Company utilizes the relief-from-royalty method. This method assumes that trade names have value to the extent that their owner is relieved of the obligation to pay royalties for the benefits received from them. This method requires an estimate of future revenue for the related brands, the appropriate royalty rate and the weighted average cost of capital. This analysis indicated an impairment of indefinite-lived intangible assets of $0.2 million as of September 30, 2012. There was no impairment of indefinite-lived intangible assets as of December 31, 2011. Impairment of intangible assets is recorded in goodwill and other intangible assets impairment on the consolidated statements of operations.
The Company’s long-term debt instruments and balances outstanding at December 31, 2012 and 2011 were as follows (in thousands):
The $30.9 million notes payable due 2035 are redeemable in whole or in part by the Company. The notes adjust quarterly to the three-month LIBOR rate plus 3.60%. The interest rate as of December 31, 2012 was 3.91%.
In November 2012, a new class of loans under the senior secured credit facility was created allowing for an incremental term loan. The incremental term loan has the following characteristics:
Repayment of the full $8.0 million will be on a first out basis, payable in full, on or prior to January 17, 2014, with priority over all other amounts outstanding under the senior secured credit facility. The incremental term loan lenders retained $2.5 million, representing non-cash original issue discount, which is amortized over the term of the incremental term loan using the effective interest method.
A $60,000 principal payment is due as of March 31, 2013 and $40,000 is due each quarter end for the remainder of 2013. The remaining balance is due at maturity.
The incremental term loan lenders retained a financial advisor to assess the financial, operational and regulatory condition of the Company.
Indebtedness under the baskets for qualified additional subordinated debt and Affirmative Premium Finance Company was eliminated. The Company did not have any such debt.
A provision was added allowing for the acquisition of $30 million of subordinated debt if the proceeds are used as a capital contribution to the regulated insurance entities.
In addition, the Company paid a 0.25% fee to all lenders that approved the March 2011 amendment.
In accordance with ASC 470-50 Debt Modifications and Extinguishments, for both the 2012 and 2011 amendments, the Company evaluated the present value of the cash flows under the terms of the amended credit agreement to determine if they were at least 10 percent different from the present value of the remaining cash flows under the terms of the existing credit agreement. It was determined that the terms of both the 2012 and 2011 amendments were not substantially different and therefore should not be accounted for as a debt extinguishment. For the 2012 amendment, fees paid to other parties of approximately $0.5 million were expensed as incurred. The non-cash closing fee of $0.55 million was capitalized and recorded in other liabilities as of December 31, 2012 and added to the principal amount of the incremental term loan as of January 1, 2013. The closing fee is amortized over the term of the incremental term loan. For the 2011 amendment, lender consent fees of approximately $0.3 million were capitalized and are amortized, along with remaining unamortized debt issuance costs from the March 2009 debt modification, over the remaining term of the senior secured credit facility. Fees paid to other parties of approximately $0.7 million were expensed as incurred in 2011.
The following table summarizes the Company’s senior secured credit facility and incremental term loan scheduled payments (in thousands):
The principal amount of the term loan is payable in quarterly installments, with the remaining balance due on the seventh anniversary of the closing of the facility. The Company is also required to make additional annual principal payments that are to be calculated based upon the Company’s financial performance during the preceding fiscal year after deducting voluntary prepayments made during the year. The Company does not expect to have an additional required principal payment due March 2013. In addition, certain events, such as the sale of material assets or the issuance of significant new equity, necessitate additional required principal repayments.
Estimated future lease payments for the years ending December 31 (in thousands):
Tax effects of temporary differences that give rise to significant portions of the Company’s deferred tax assets and deferred tax liabilities at December 31, 2012 and 2011 were as follows (in thousands):
In 2006, the Company entered into an IT outsourcing contract with a data processing services provider under which the Company outsourced substantially all of its IT operations, including the Company’s data center, field support and application management. The initial term of the agreement was ten years, although it may be terminated for convenience by the Company at any time upon six month’s notice after the first two years, subject to the payment of certain stranded costs and other termination fees. In October 2012, the Company amended its Master Service Agreement with a third party whereby the Company assumed responsibility for managing substantially all of its IT operations, including data center and applications management at an annual cost of $6.1 million. In addition, the Company contracted with a third party to provide network infrastructure services for $1.2 million annually. The Company’s IT outsourcing expenses were $11.2 million, $13.0 million and $14.2 million for the years ended December 31, 2012, 2011 and 2010, respectively.
As of December 31, 2012, the Company leased office space for its agencies, insurance companies and retail stores in various locations throughout the United States. The Company’s operating lease rental expenses were $8.8 million, $7.8 million and $9.1 million for the years ended December 31, 2012, 2011 and 2010, respectively.
Net loss per common share is based on the weighted average number of shares outstanding. Diluted weighted average shares is calculated by adjusting basic weighted average shares outstanding by all potentially dilutive stock options and restricted stock. Stock options outstanding of 2,407,000, 1,748,000 and 1,235,900 for the years ended December 31, 2012, 2011 and 2010, respectively, were not included in the computation of diluted earnings per share because there was a loss from continuing operations in the respective periods.
The following table sets forth the reconciliation of numerators and denominators for the basic and diluted earnings per share computation for each of the years ended December 31, 2012, 2011 and 2010 (in thousands, except per share amounts):
In May 2004, the Company’s board of directors adopted and its stockholders approved the 2004 Stock Incentive Plan (2004 Plan) to enable the Company to attract, retain and motivate eligible employees, directors and consultants through equity-based compensatory awards, including stock options, stock bonus awards, restricted and unrestricted stock awards, performance stock awards, stock appreciation rights and dividend equivalent rights. The maximum number of shares of common stock reserved for issuance under the 2004 Plan, as amended, is 3,000,000, subject to adjustment to reflect certain corporate transactions or changes in the Company’s capital structure. At December 31, 2012, 410,194 shares were reserved for future grants under the 2004 Plan.
Stock Options • The Company used the modified Black-Scholes model to estimate the fair value of employee stock options on the date of grant utilizing the assumptions noted below. The risk-free rate is based on the U.S. Treasury bill yield curve in effect at the time of grant for the expected term of the option. The expected term of options granted represents the period of time that the options are expected to be outstanding. The expected volatility assumption is derived from the historical volatility of the Company’s common stock over the most recent period commensurate with the estimated expected life of the Company’s stock options, adjusted for periods of significant volatility not expected to recur. The dividend yield was based on expected dividends at the time of grant.
The stock options outstanding and exercisable at December 31, 2012 had aggregate intrinsic values of zero as the aggregate exercise price was greater than the aggregate market value. No stock options were exercised during 2012, 2011 or 2010.
The Company’s insurance company subsidiaries are subject to risk-based capital standards and other minimum capital and surplus requirements imposed under applicable state laws, including the laws of their state of domicile. The risk-based capital standards, based upon the Risk-Based Capital Model Act, adopted by the National Association of Insurance Commissioners (NAIC), require the Company’s insurance company subsidiaries to report their results of risk-based capital calculations to state departments of insurance and the NAIC. Failure to meet applicable risk-based capital requirements or minimum statutory capital requirements could subject the Company to further examination or corrective action imposed by state regulators, including limitations on the Company’s writing of additional business, state supervision or liquidation. Any changes in existing risk-based capital requirements or minimum statutory capital requirements may require the Company to increase its statutory capital levels. At December 31, 2012, and 2011, each of the Company’s insurance subsidiaries maintained a risk-based capital level that was in excess of an amount that would require any corrective actions. Effective January 1, 2012, the NAIC revised the Risk-Based Capital Model Act to include a risk-based capital trend test as another manner under which the company action level could be triggered and will be applied as of December 31, 2012. The test is applicable when an insurance company has a risk-based capital ratio between 200% and 300% and a combined ratio of more than 120%. Each of the Company’s insurance subsidiaries was in compliance with risk-based capital trend test requirements as of December 31, 2012.
State insurance laws restrict the ability of the Company’s 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 year-end or the insurance company’s net income for the preceding year, in each case determined in accordance with statutory accounting practices. In addition, dividends may only be paid from unassigned earnings and an insurance company’s remaining surplus must be both reasonable in relation to its outstanding liabilities and adequate to its financial needs. As of December 31, 2012, the Company’s insurance companies could not pay ordinary dividends to the Company without prior regulatory approval due to a negative unassigned surplus position of Affirmative
Refer to Note 2 regarding going concern and noncompliance with the Illinois Insurance Code.
Where possible, the Company utilizes quoted market prices to measure fair value. For assets and liabilities that have quoted market prices in active markets, the Company uses the quoted market prices as fair value and includes these prices in the amounts disclosed in Level 1 of the hierarchy. When quoted market prices in active markets are unavailable, the Company determines fair values based on independent external valuation information obtained from independent pricing services, which utilize various models and valuation techniques based on a range of inputs including pricing models, quoted market prices of publicly traded securities with similar duration and yield, time value, yield curve, prepayment speeds, default rates and discounted cash flows. In most cases, these estimates are determined based on independent third-party valuation information, and the amounts are disclosed as Level 2 or Level 3 of the fair value hierarchy depending on the level of observable market inputs. Additional pricing services are used as a comparison to ensure that realistic fair values are used in pricing the investment portfolio.
The following table provides information as of December 31, 2011 about the Company’s financial assets measured at fair value on a recurring basis (in thousands):
Fair value measurements for assets in Level 3 for the year ended December 31, 2012 were as follows (in thousands):
The Company did not have any transfers between Levels 1 and 2 during the years ended December 31, 2012 or 2011.