Includes the weighted average common shares outstanding and assumes conversion of our Series A redeemable preferred stock and Series B preferred stock because both series of preferred stock were convertible at the option of the holders and were dilutive. Also includes the dilutive effect of the common stock warrant which was exercised upon the closing of our initial public offering; however, for the years ended December 31, 2002, 2001, and 2000, the warrant was anti-dilutive and was not included in those periods.
Our core business involves issuing non-standard personal automobile insurance policies. These policies, which are generally issued for the minimum limits of coverage required by state laws, provide coverage to drivers who cannot obtain insurance from standard carriers due to a variety of factors, including the lack of flexible payment plans, the failure to maintain continuous coverage, age, prior accidents, driving violations, occupation and type of vehicle. Customers in the non-standard market generally have higher average premiums for a comparable amount of coverage than customers who qualify for the standard market. The higher average premiums typically result from an increased frequency of losses, which is partially offset by the lower severity of losses resulting from lower limits of coverage. In some states, we produce personal automobile insurance policies for unaffiliated insurance companies
through our distribution system. We assume this business from unaffiliated insurers through reinsurance agreements and earn service fees for our agency, underwriting, policy administration and claims adjustment services performed for the unaffiliated insurers.
Through our premium finance subsidiaries, we finance the premiums on the majority of the insurance policies that we sell by lending to customers the premium due to the insurance company. We earn fees and interest income from our premium finance operations. These loans are backed by the unearned portion of the insurance premiums being financed, which is the portion of the loan attributable to future periods of coverage. We generally structure our payment plans and integrate our systems in an attempt to minimize principal losses on our premium finance loans.
We seek to attract customers by developing strong brand name recognition in our markets through our television advertising campaigns that emphasize our low down payment, flexible payment plans, convenient neighborhood locations and customer service. Our neighborhood offices serve as a network for both product delivery and payment collection. The majority of the policy applications are completed in the neighborhood sales offices, and most of our customers revisit these offices at least monthly to make their periodic payments.
Our business model provides our employee-agents with customer contact at the point of sale and when the customer returns to make periodic payments. This contact allows us to offer a variety of products in addition to our core product, non-standard personal automobile insurance. We provide term life insurance policies through our wholly-owned life insurance subsidiaries, as well as vehicle protection insurance, travel protection insurance and hospital indemnity insurance underwritten by unaffiliated insurers, for which we receive commission and service fee income. We also offer ancillary non-insurance products and services such as prepaid debit cards and, in select states, payday consumer loans.
premiums we earn from sales of direct and assumed non-standard personal automobile and term life insurance policies, which we refer to in this report as gross premiums, less the portion of those premiums that is ceded to other insurers, which we refer to in this report as ceded premiums, with the difference being what we refer to as net premiums;
We entered Virginia, our twelfth state, where we developed 9 sales offices over the course of the year. We also developed an additional 18 sales offices in Texas and 20 sales offices in Missouri.
During 2006, we expect to continue many of the initiatives that we started or were ongoing in 2005 including our continued expansions in Texas, Missouri, and Virginia, the implementation of two alternative distribution channels: Telephone Sales and Internet Sales in all of our markets, the introduction of the Direct Cash Advance program in Florida and Missouri, and the introduction of our motorcycle and personal watercraft policies in select states. In addition, we expect to enter two new states before the end of the year.
Reduction in Quota Share Reinsurance. We have eliminated our use of quota share reinsurance for policies written in 2006. During 2005, we retained 88.4% of gross premiums written and for 2006, we expect to retain nearly all of our gross premiums written with the exception of premiums ceded to our property catastrophe reinsurers.
Assumptions. Statements made in this section, including those concerning our anticipated growth, our estimated loss and expense ratios, and our anticipated return on average equity are forward-looking statements. Some important factors that must occur in order for us to achieve these results include:
increase in sales of insurance policies in Texas through the independent agencies that we acquired in 2005 and our developed neighborhood sales offices;
the successful transitions from offering monthly policies in Texas to offering six and/or twelve month policies that are supported by our premium finance subsidiary;
the absence of unfavorable judicial and regulatory developments relative to the automobile insurance industry;
Net Premiums Written. Net premiums written is the sum of direct premiums written and assumed premiums written less ceded premiums written. Ceded premiums written is the portion of our direct and assumed premiums that we transfer to our reinsurers in accordance with the terms of our reinsurance contracts based upon the risks they accept. See Note 7 to our audited consolidated financial statements included in this report. We use net premiums written, primarily in relation to gross premiums written, to measure the amount of business retained after cessions to reinsurers.
Expense Ratio. Expense ratio is the ratio (expressed as a percentage) of net operating expenses to premiums earned and measures a company’s operational efficiency in producing, underwriting and administering its insurance business. For statutory accounting purposes, operating expenses of an insurance company exclude investment expenses, and are reduced by other income. There is no such industry definition for determining an expense ratio for GAAP purposes. As a result, we apply the statutory definition to calculate our expense ratio on a GAAP basis. We reduce our operating expenses by ancillary income (excluding net investment income and realized gains (losses) on securities) to calculate our net operating expenses. Due to our historically high levels of reinsurance, we calculate our expense ratio on both a gross basis (before the effect of ceded reinsurance) and a net basis (after the effect of ceded reinsurance). Although the net basis is meaningful in evaluating our financial results that are net of ceded reinsurance, as reflected in our consolidated financial statements, we believe that the gross expense ratio better reflects the operational efficiency of the underlying business and is a better measure of future trends.
Insurance Losses and Loss Adjustment Expense Reserves. Insurance loss and loss adjustment expense reserves represent the estimated ultimate net cost of all unpaid reported and unreported losses incurred as of the date of our balance sheet. Estimating our loss and LAE reserves requires us to make significant judgments and use many assumptions. Months and sometimes years may elapse between the occurrence of an automobile accident covered by one of our policies, reporting of the accident to us and our payment of the claim. We record a liability for estimates of losses that will be paid for accidents that have been reported to us, which we refer to in this report as case reserves. In addition, since accidents are not always reported when they occur, we estimate liabilities for accidents that have occurred but have not been reported to us, which we refer to in this report as incurred but not reported, or IBNR reserves.
We are directly liable for loss and loss adjustment expenses under the terms of the insurance policies our insurance subsidiaries underwrite. Each of our insurance subsidiaries establishes a reserve for all of its unpaid losses and loss adjustment expenses, including case and IBNR reserves, and estimates for the cost to settle the claims. We rely primarily on historical loss experience in determining reserve levels, on the assumption that historical loss experience provides a good indication of future loss experience. Our internal actuarial staff reviews our insurance subsidiaries’ reserves quarterly for each year on a state and coverage level. We believe that our quarterly reviews allow for timely adjustments to reserves based on additional information. As part of these quarterly reviews, our actuarial staff performs various tests to estimate ultimate average severity and frequency of claims. Severity represents the average cost per claim and frequency represents the number of claims per policy. As part of the overall review, the staff then evaluates loss and LAE ratios by accident year by state and by coverage for reasonableness. Estimation of loss and LAE reserves is subject to variation as a result of factors such as inflation, claims settlement patterns, legislative activity and litigation trends. Also, we make key assumptions regarding future claims emergence, the number of claims to be closed in the future, the future impact of inflation, amounts that may be collected from subrogation or salvage and amount of claims that can be closed with or without payment. Changes in the assumptions we employ or our estimates associated with such assumptions could result in materially different amounts being reported as reserves. If necessary, we will increase or decrease the level of our reserves as experience develops or new information becomes known, in the period in which changes to the estimates are determined. Accordingly, the actual losses and loss adjustment expenses may differ materially from the estimates we have recorded. See “Business - Loss and Loss Adjustment Expense Reserves” for additional information.
include the duration and extent to which the fair value has been less than amortized cost, the reasons for the unrealized loss, including market conditions or changes in the financial condition of the issuer, and the Company’s ability and intent to hold the investment until maturity, or at least until there is a recovery in fair value. If an investment becomes other than temporarily impaired, such impairment is treated as a realized loss and the investment is adjusted to fair value. Realized investment gains and losses are recognized using the specific identification method.
Effect of Future Cancellations. The insurance policies that we write, through our insurance subsidiaries and on behalf of other insurers for which we receive a commission, are subject to being cancelled by the policyholder prior to the policy expiration date. As a result, we estimate the effect of future cancellations in determining the amount of commission and service fee income and ceding commissions that are recorded in our consolidated financial statements. We use historical cancellation rates that are updated quarterly to estimate future cancellations with the effect of any changes in our estimates being recorded in the period in which the change in the estimate is determined to be necessary. However, actual cancellations may differ materially from the cancellation estimates that we used. As of December 31, 2005, the reserve for return of commission and service fee income and return of ceding commissions was $5.0 million and $1.0 million, respectively.
Year Ended December 31, 2005 Compared to Year Ended December 31, 2004. During 2005, gross premiums written decreased $28.9 million or 6.0% to $453.0 million from $481.9 million in 2004. Over this same period, gross premiums earned, a function of gross premiums written over the current and prior periods, decreased to $461.6 million from $471.8 million. In 2005, Florida represented 49.4% of our business and accounted for $19.7 million of the decrease in gross premiums written with approximately $4.7 million of this decline related to our decision, in October 2004, to stop writing new business policies in the Miami market. Competition in the non-standard market has been intense. Overall, we believe that we remain very competitive in the market for our core customer; however, we believe that the increased advertising and a focus on the higher credit profiles of the nonstandard market by some of the national carriers has resulted in our gross written premium declines. Our hit ratio (the ratio of policies to quotes) remains very good, and we have been implementing a number of changes to our marketing in order to increase our quote calls. We are also in the process of implementing a more sophisticated pricing structure, which coupled with the convenience of being able to complete transactions over the phone or through the Internet, should help us compete in the upper tiers of the nonstandard market.
more than offset the decline in the average number of new policies written per month. A portion of the Florida growth was also attributable to slightly more than a 3% increase in average premiums per policy. The majority of the increases in gross premiums written in our other existing states were due primarily to growing renewal books of business. Gross premiums earned, a function of gross premiums written over the current and prior periods, increased to $471.8 million in 2004 from $394.9 million in 2003.
Year Ended December 31, 2005 Compared to Year Ended December 31, 2004. Net premiums written decreased 2.1% to $400.6 million in 2005 from $409.4 million in 2004. The ratio of net premiums written to gross premiums written increased to 88.4% in 2005 from 85.0% in 2004 as we continued to reduce our use of quota share reinsurance. We expect to eliminate our quota share reinsurance in 2006 and retain nearly all gross premiums written. Net premiums earned, a function of net premiums written over the current and prior periods, increased to $404.1 in 2005 from $372.5 million in 2004.
Ancillary income includes finance income, commission and service fee income and other income. Finance income primarily consists of interest, acquisition and service fees, and delinquency fees on the premium finance agreements related to the insurance policies we finance. Our agency and administrative subsidiaries produce and service non-standard personal automobile insurance business for other insurers from which we assume a portion of this business, and in some cases the entire premium, through reinsurance treaties. We receive service fees for agency, underwriting, policy administration, and claims adjusting services performed on behalf of these unaffiliated insurers. We also receive commission and service fee income on other insurance products produced for unaffiliated insurance companies on which we do not bear underwriting risk, including travel protection, vehicle protection and hospital indemnity insurance policies. Our business model allows us to generate a significant amount of ancillary income, which we measure as a percentage of gross earned premiums and as a percentage of our operating expenses. Our goal is to generate ancillary income in amounts that will offset a majority of our operating expenses. The following table summarizes the components of our ancillary income for the periods indicated.
Year Ended December 31, 2005 Compared to Year Ended December 31, 2004. Ancillary income decreased 6.7% to $91.2 million in 2005 from $97.8 million in 2004. This decrease is comprised of a $4.8 million decrease in premium finance income and a $1.8 million decrease in commission and service fee income. The decrease in finance income is related, in part, to the decline in gross premiums earned and the company’s decision in early 2005 to temporarily reduce the minimum down payment requirements in most states in an effort to increase premium production. In 2005, average down payments as a percentage of financed premium declined to 12.8% compared to 14.5% in 2004. As a result of this change, we experienced an increase in the provision for finance receivable losses to $10.3 million in 2005 from $7.3 million in 2004. As part of the Company’s efforts to achieve the optimal balance of maximum premium growth with minimal impact on finance income, the company re-assessed its pay plans and increased down payment requirements in select states in late 2005. The allowance for credit losses was 2.9% and 2.8% of gross finance receivables at the end of 2005 and 2004, respectively.
The decrease in commission and service fee income can be attributed to a $2.1 million reduction in fees earned for the administration of our assumed business in Texas due to the company’s decision to write more of its Texas business through one of its own insurance subsidiaries as opposed to a third party insurer. This change caused a corresponding reduction in operating expenses as assumed reinsurance commissions also decreased by $2.1 million. The remainder of the change included a $2.1 million increase in revenues from our consumer products, including our Direct prepaid Visa program and Direct Cash Advance, which was largely offset by lower commission and service fees related to a decline in the sale of ancillary insurance products.
Year Ended December 31, 2004 Compared to Year Ended December 31, 2003. Net investment income increased to $10.8 million in 2004 from $6.7 million in 2003 primarily as a result of a 65.0% increase in average invested assets to $298.5 million in 2004 from $180.9 million in 2003. Since our initial public offering in August 2003, we contributed $51.9 million of capital to our insurance companies in the second half of 2003 and made another $11.5 million of capital contributions during 2004. The proceeds from these capital contributions, coupled
Realized gains and losses on securities are principally affected by changes in interest rates, the timing of sales of investments and changes in credit quality of the securities we hold as investments and change in the market value of our trading portfolio.
Year Ended December 31, 2005 Compared to Year Ended December 31, 2004. For the year ended December 31, 2005, insurance losses and loss adjustment expenses increased to $305.8 million from $282.0 million in 2004, an increase of $23.8 million. This increase is generally consistent with the overall premium growth and increase in net business we retained. Our net loss ratio was 75.7% in both 2005 and 2004. During both 2005 and 2004, there was an unusually high level of catastrophic losses, which increased our annual loss ratios by approximately 0.8 points and 0.7 points, respectively.
Reserve Development. We perform an actuarial analysis of our loss reserves each quarter, which encompasses an analysis of developing loss experience from all coverages and states in which we operate. During 2005, we increased our estimate of incurred losses for prior accident years by approximately $6.8 million, which resulted in a 1.7 point increase in our 2005 loss ratio. Approximately $5.8 million of this increase was attributable to Florida where we experienced higher than expected ultimate severity trends in the personal injury protection (“PIP”) coverage, a portion of which related to the runoff of claims from the Miami market, and higher ultimate frequency and severity trends in the property damage coverage, largely associated with an increase in post-closing payments. Comparatively, during 2004 we increased our estimate of incurred losses for prior accident years by approximately $6.3 million, which also resulted in a 1.7 point increase in our 2004 loss ratio.
We have taken a number of actions to improve our overall loss trends in Florida and address the sources of adverse loss reserve development. In October 2004, we ceased writing new business policies in the Miami market due to the high levels of fraudulent activity, which has improved our Florida loss experience and reduced some of the volatility in the underlying claims data. During 2005, we replaced a third party bill review system that we had been using in our personal injury protection unit to identify duplicate bills and charges for procedures that did not correspond with the diagnosis, with an internally developed program that essentially performed the same review. By eliminating the outside vendor, we have been able to expedite the settlement process while saving the cost of the service and reducing interest costs. We also reinforced our claims closure guidelines to reduce the number and amount of post-closing payments on property damage claims by keeping those files, which have been specifically identified as having the potential for subrogation payments, open for a longer period of time. Finally, we continued to refine our actuarial reserving methodology for personal injury protection claims that started as part of our fourth quarter 2004 review. We believe that these changes have enabled us to expedite the settlement process, reduce certain loss adjustment expenses, and provide a more refined set of data to be used in our loss reserve analysis.
Reserve Development. As a result of our fourth quarter 2004 actuarial analysis, based upon adversely developing loss trends, we increased our estimate of ultimate incurred losses by approximately $11.2 million, including the related effect of a reduction in ceding commission. Our estimates of incurred losses for accidents that occurred in the first three quarters of 2004 increased by approximately $7.0 million. We considered these adverse trends in determining our estimates for incurred losses attributable to accidents that occurred during the fourth quarter of 2004, which we estimate these trends increased our reserves by approximately $2.0 million. During 2004, we increased our estimate of incurred losses for prior accident years by approximately $6.3 million, approximately $2.2 million of this was recorded during the fourth quarter.
The prior year development of $6.3 million resulted in a 1.7 point increase in our 2004 loss ratio. Our 2004 loss ratio would have been 74.0% excluding the impact of the adverse development relating to prior years. Approximately $4.5 million of this increase was attributable to higher than expected frequency and severity trends in the Florida personal injury protection (“PIP”) and property damage coverages that were partially offset by better than expected loss trends in bodily injury coverage. A significant component of the increase in PIP reserves was related to higher than expected reported frequency and closed with payment trends, which we believe was considerably affected by increased fraud activity in the Miami market. For example, we estimate that reported frequency on Florida PIP claims in the Miami market increased over 15.8% from the first quarter to the third quarter of 2004, while during the same period, the reported PIP frequency for the remainder of the Florida markets decreased by 7.3%. In addition to our development in Florida, we increased our prior year estimate of incurred losses in Tennessee by approximately $1.1 million. This increase was principally a result of increases to expected bodily injury frequency trends and increases to the expected average severity of property damage claims.
During 2003 and 2004, we endeavored to improve our personal injury protection loss trends in the Miami market, principally by adjusting rates and enhancing our claims SIU presence in the Miami market. In addition, we expected that our Miami results would benefit from some of the fraud prevention initiatives that were a part of the Florida Motor Vehicle Insurance Affordability Reform Act of 2003 (the “Act”). While these changes did, at times, appear to improve our trends, they were not sufficient to improve our loss ratio to our target. As a result, in October 2004, we decided to stop writing new business in the Miami market.
Year Ended December 31, 2005 Compared to Year Ended December 31, 2004. Operating expenses increased 24.5% to $141.9 million for the year ended December 31, 2005 from $114.0 million in 2004. The largest component of this increase related to ceded reinsurance commissions. The Company receives reinsurance commissions on the premiums ceded to its reinsurers, which represent the reinsurers reimbursement of underwriting expenses associated with the business they assume. These reinsurance commissions, which are included as a component of our net SGA Costs, decreased to $6.9 million in 2005 from $15.4 million in 2004 as we continued to reduce the level of premiums ceded to reinsurers. Gross operating expenses, which exclude the effect of ceded reinsurance commissions, increased $19.4 million or 15.0% during 2005. Approximately $8.7 million of this increase was attributable to our expansion states, including approximately $6.3 million in Texas and approximately $2.4 million of costs related to our sales office development in Missouri and Virginia. The primary drivers of the remaining expense increases included a $2.8 million increase in interest expense, generally caused by the interest on the new junior subordinated debentures and the higher interest rate environment; a $2.2 million increase in advertising costs in our core states; a $1.0 million increase in professional fees, primarily legal fees, and an overall increase in general corporate expenses.
Advertising costs in total increased to $13.2 million in 2005 from $8.5 million in 2004, with approximately $2.5 million of this increase related to our expansion states where there was minimal advertising in the prior year. The remainder of the increase related to our marketing initiatives in our existing states including an increase in costs related to more targeted television media buys, an upgrade in the quality of the ads, and the outsourcing of certain
creative components. We expect our advertising costs will continue to increase in 2006 to approximately $18 million as we continue to focus on many of these same initiatives and develop our grass roots marketing campaign. In 2006, we expect to allocate approximately $2.0 million toward the development of this strategy.
Year Ended December 31, 2004 Compared to Year Ended December 31, 2003. Operating expenses increased 40.9% to $114.0 million for the year ended December 31, 2004 from $80.9 million in 2003. The largest component of this increase related to ceded reinsurance commissions, which decreased to $15.4 million in 2004 from $33.7 million in 2003 as we reduced the level of premiums ceded to reinsurers. Gross operating expenses, which exclude the effect of ceded reinsurance commissions, increased $14.9 million or 13.0% during 2004. Approximately $5.4 million of this increase was attributable to our expansion states, primarily Texas, but it also includes some initial start up costs in Missouri and Virginia. In addition, our health insurance costs increased $3.1 million, our corporate insurance costs increased $1.2 million generally as a result of being a public company for a full year, and our expenses for accounting services increased by approximately $0.7 million largely associated with implementing and documenting our compliance with the Sarbanes-Oxley Act. The remaining increases related to general growth and expansion, which were partially offset by the savings we achieved by converting the cost structure of the 42-office Cash Register agency, which we acquired in November 2003, from a variable (commission-based) structure to the largely fixed cost structure provided by our business model in 2004.
We file a consolidated federal income tax return that includes all of our subsidiaries other than our two life insurance subsidiaries, which file separate federal income tax returns. The statutory rate used in calculating our tax provision was 35% and our effective tax rates for the years ended December 31, 2005, 2004 and 2003 were 37.5%, 36.6%, and 36.7%, respectively.
Our operating subsidiaries’ primary sources of funds are premiums received, finance income, commission and service fee income, investment income, borrowings under credit facilities and proceeds from the sale and redemption of investments. Funds are used to pay claims and operating expenses, to pay interest and principal repayments under the terms of our indebtedness for borrowed money, to purchase investments and to pay dividends to Direct General Corporation. We had positive cash flow from operations of approximately $61.1 million in 2005, $67.0 million in 2004 and $67.1 million in 2003. We expect our cash flows to be positive in both the short-term and reasonably foreseeable future.
Capital Raising - Trust Preferred Securities. In September 2005, Direct General Statutory Trust I (“DGST I”), a wholly owned unconsolidated subsidiary trust of the Company, issued 40,000 shares of preferred securities at $1,000 per share to outside investors and 1,238 shares of common securities to the Company, also at $1,000 per share. The sole assets of DGST I are $41.2 million of junior subordinated debentures issued by the Company. The debentures will mature on September 15, 2035 and are redeemable by the Company in whole or in part beginning on
Premium Finance Revolving Credit Facility. Our premium finance operations are supported by a revolving credit agreement with a group of banks. The size of the facility was $190.0 million, of which $150.0 million was outstanding at December 31, 2005, and it has a maturity of June 30, 2007. We would expect to continue the practice of periodically increasing the size of the facility to support the growth in premiums, however, there is the risk that our attempt to increase this revolving credit line facility would not be successful, in which case we would be forced to seek alternative methods of financing premiums.
Effective August 1, 2005, the Company entered into an interest rate swap under which the Company pays a fixed rate of 4.255% and receives 1 month Libor. This swap qualifies as a hedge under SFAS 133, and therefore the fair market value of this derivative instrument is reported as a separate component of shareholders’ equity on an after-tax basis. The pre-tax fair value of this derivative was an unrealized gain of $1.1 million at December 31, 2005. Payments associated with the swap were $0.1 million in the year ended December 31, 2005 and were reported in the income statement as interest expense. See Note 12 to our audited consolidated financial statements included in this report for further discussion on these derivative instruments.
As of December 31, 2005, the amount of unsecured reinsurance recoverables was $19.4 million or 8.2% of shareholders’ equity as compared to $24.5 million or 10.0% of shareholders’ equity at December 31, 2004. In addition, the largest unsecured recoverable from a single reinsurer was $8.7 million at December 31, 2005, which was due from Dorinco Reinsurance Company, a subsidiary of Dow Chemical, rated A- (Excellent) by A.M. Best.
We had total debt securities, cash, cash equivalents and short-term investments of $456.2 million as of December 31, 2005. The following table summarizes our debt securities, cash, cash equivalents and short-term investments as of the dates indicated.
Investment Strategy. We believe that our investment portfolio is highly liquid and consists substantially of readily marketable, investment-grade debt securities. We currently do not invest in equity securities or securities with exposure to foreign currency risk. Effective April 1, 2003, Bank One Investment Advisors and U.S. Bancorp Asset Management provide our investment portfolio management advisory services. Prior to March 31, 2003, our investment advisors were Deutsche Asset Management. These advisors operate under investment guidelines approved by our investment committee. These guidelines emphasize:
gross unrealized losses of $0.2 million. For the year ended December 31, 2005, “net realized (losses) gains on securities and other” included a net gain of $0.3 million related to the increase in the market value of open contracts.
Debt Securities. Our investment portfolio consists primarily of debt securities, all of 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 shareholders’ equity on an after-tax basis. As of December 31, 2005, the net unrealized loss on the fixed maturity portfolio was $7.2 million, comprised of gross unrealized gains of $0.7 million and gross unrealized losses of $7.9 million. At December 31, 2004, the fair value of our investment portfolio was equal to the amortized cost of the portfolio so there were no net unrealized gains or losses. The increase in net unrealized losses during 2005 was generally attributable to the increasing interest rate environment and not due to deterioration of the credit quality of the portfolio.
We monitor our investment results by comparing the total return on our portfolio of debt securities to the total return for a customized benchmark based on a blend of Lehman indices. Total return is comprised of interest income and the change in the fair value of the securities. Because we have a portion of our portfolio invested in the municipal obligations of Tennessee, Louisiana, and Mississippi in an effort to maximize the premium tax credits available to us, we separately evaluate the total return of our taxable and tax-exempt securities by comparing them to customized benchmarks for each investment class. During 2005, our portfolio yield lagged the customized benchmark primarily as a result of holding higher quality securities than the index. The total return on our portfolio of debt securities was 4.1% in 2005, 3.7% in 2004, and 3.7% in 2003.
The amortized cost and fair value of debt securities in our investment portfolio as of December 31, 2005, by contractual maturity, is shown below.
The Securities Valuation Office of the NAIC evaluates the bond investments of insurers for regulatory reporting purposes and assigns securities to one of six investment categories called “NAIC designations”. The NAIC designations generally parallel the credit ratings of the nationally recognized statistical rating organizations for marketable bonds. NAIC designations 1 and 2 include bonds considered to be investment grade, which are those rated “BBB-” or higher by Standard & Poor’s, a division of The McGraw-Hill Companies, Inc. NAIC designations 3 through 6 include bonds considered to be below investment grade, rated “BB+” or lower by S&P.
On a quarterly basis, we examine our investment portfolio for evidence of impairment. The assessment of whether such impairment has occurred is based on management’s evaluation, on an individual security basis, of the underlying reasons for the decline in fair value. In such cases, changes in fair value are discussed with our investment advisors and evaluated to determine the extent to which such changes are attributable to interest rates, market-related factors other than interest rates, as well as financial conditions, business prospects and other fundamental factors specific to the issuer. Declines attributable to issuer fundamentals are reviewed in further detail. When one of our securities has a decline in fair value that is determined to be other than temporary, we reduce the carrying value of such security to its current fair value as required by GAAP.
Cash and Cash Equivalents. Our balance in cash and cash equivalents was $64.5 million and $71.0 million as of December 31, 2005 and 2004, respectively. At December 31, 2005, cash and cash equivalents totaling approximately $9.0 million were held in reinsurance security trust accounts for the benefit of certain unaffiliated insurers in order to secure our assumed reinsurance obligations.
statements and assumptions relating to future growth, earnings, earnings per share and other financial performance measures, as well as management’s short-term and long-term performance goals;
statements relating to the anticipated effects on results of operations or financial condition from recent and expected developments or events;
The Company’s management carried out an evaluation, with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of its internal control over financial reporting as of December 31, 2005. The framework on which such evaluation was based is contained in the report entitled “Internal Control-Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission (the “COSO Report”). Based upon the evaluation described above under the framework contained in the “COSO Report”, the Company’s management concluded that the Company’s internal control over financial reporting was effective as of December 31, 2005.
In our opinion, management’s assessment that Direct General Corporation and Subsidiaries maintained effective internal control over financial reporting as of December 31, 2005, is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, Direct General Corporation and Subsidiaries maintained, in all material respects, effective internal control over financial reporting as of December 31, 2005, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Direct General Corporation and Subsidiaries as of December 31, 2005 and 2004, and the related consolidated statements of operations, shareholders’ equity and cash flows for each of the three years in the period ended December 31, 2005, and our report dated March 9, 2006 expressed an unqualified opinion thereon.
The preparation of financial statements requires management to make estimates and assumptions that affect amounts reported in the financial statements and accompanying notes. Such estimates and assumptions could change in the future as more information becomes known that could impact the amounts reported and disclosed herein.
Insurance losses and loss adjustment expense reserves represent the estimated ultimate net cost of all unpaid reported and unreported losses incurred through December 31. The loss and loss adjustment expense reserves are estimated on an undiscounted basis, using individual case-basis valuations and statistical analyses. Those estimates, which are reported net of anticipated salvage and subrogation, are subject to the effects of trends in loss severity and frequency. Although considerable variability is inherent in such estimates, management believes the loss and loss adjustment expense reserves are adequate. The estimates are continually reviewed and adjusted as necessary as experience develops or new information becomes known; such adjustments are included in current operations.
produce a level yield. Delinquency fees are earned when billed. Acquisition fees, net of directly related lending costs, are deferred and amortized into finance income over the remaining lives of the related loans. Upon cancellation of the underlying insurance policies, any uncollected earned interest or fees are charged off. The Company’s allowance for finance receivable losses is comprised of a reserve for uncollected finance acquisition fees and a provision for the write-off of premium finance balances (primarily realized but uncollected interest and fees), which is calculated using the historical level of finance receivable losses as a percentage of outstanding balances under the premium finance agreements.
Property and equipment is recorded at cost, net of accumulated depreciation. Depreciation is calculated using the straight-line method over the estimated useful lives of the respective assets, which are principally as follows: computer hardware and software (3-5 years), furniture and equipment (3-7 years), leasehold improvements (3-14 years based on the expected remaining life of the lease) and Company-owned buildings and related improvements (31.5 years). Property and equipment includes software developed and capitalized for internal use.
Goodwill represents the amount by which the cost of acquired net assets exceeds their related fair value. Other intangible assets includes the costs of specifically identifiable intangible assets, primarily licenses. In accordance with Financial Accounting Standards No. 142, the carrying value of goodwill and other intangible assets is reviewed annually or whenever events or changes in circumstances indicate that the carrying amount might not be recoverable. If the fair value of the operations to which goodwill relates is less than the carrying amount of those operations, including unamortized goodwill, the carrying amount of goodwill is reduced accordingly with a charge to expense. Based on its most recent analysis, the Company believes that no impairment of goodwill and other intangible assets exists at December 31, 2005.
The Company follows the provisions of Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees,” to account for its stock option activity in the financial statements. Using the intrinsic value method under APB No. 25, generally no compensation expense is recorded for employee options that are granted with an exercise price that equals or exceeds the market price at the date of grant. The disclosure provisions required by Statement of Financial Accounting Standards (SFAS) No. 123, “Accounting for Stock-Based Compensation” is provided in Note 10. Effective January 1, 2006, the Company adopted SFAS No. 123 (revised 2004) “Share Based Payments.” The impact of this pronouncement, which requires the Company to expense the cost resulting from all share-based payments in its financial statements, is provided in Note 18.
The fair value and gross unrealized losses of debt securities available for sale by length of time that individual securities have been in a continuous unrealized loss position at December 31, 2005 are as follows:
Depreciation expense was approximately $6,602,000, $5,601,000 and $4,472,000 in 2005, 2004 and 2003, respectively.
In December 2004, the Company entered into a $30,000,000 revolving credit facility with a consortium of banks. Under the terms of the credit facility the Company may periodically obtain advances until June 30, 2007. Interest is payable quarterly at a rate elected by the Company of either the base commercial rate of First Tennessee Bank, N.A., as “Agent”, or at 2.5% above LIBOR. Principal payments begin 18 months after advances under the credit facility reach $10,000,000 and will be determined based upon a five-year amortization schedule. The credit
The Company enters into various other credit agreements from time to time, primarily to finance the purchase of computer equipment and other assets. As of December 31, 2005, the Company has three of such credit agreements bearing interest at rates ranging from 4.50% to 4.60%. Principal and interest are payable monthly, with principal totaling $1,729,000, $649,000, and $631,000 due in 2006, 2007, and 2008, respectively. Notes in the amount of $1,900,000 are secured by computer equipment.
The Company is the beneficiary of letters of credit totaling approximately $2,446,000 and trust accounts totaling $3,352,000 in accordance with the terms of its reinsurance agreements. The letters of credit and trust accounts were unused at December 31, 2005. The largest unsecured reinsurance recoverable from a single reinsurer was $8,719,000 as of December 31, 2005, which was due from Dorinco Reinsurance Company, a subsidiary of Dow Chemical.
The Company’s agency subsidiaries and administrative service subsidiaries produce and administer personal automobile insurance business for other insurers. The Company receives service fees for its underwriting, policyholder administration and claims processing services. Administrative service fees earned, net of the related fronting fees and premium taxes, were approximately $7,891,000, $10,653,000 and $7,574,000 in 2005, 2004 and 2003 respectively, and are included in the caption commissions and service fee income in the Statements of Operations.
In March 2004, the Company completed a secondary offering whereby selling shareholders sold 3,314,015 shares of common stock. As a result of the exercise of the over-allotment option by the underwriters of the secondary offering, the Company issued and sold an additional 497,102 common shares in April 2004, which resulted in net proceeds to the Company (after deducting issuance costs) of $15,970,000.
During 2005, the Company repurchased 2,157,871 shares of its outstanding common stock for an aggregate price of approximately $40,075,000. Under prior approval by the Board of Directors, the Company has the discretionary authority to buyback up to an additional $10,000,000 of its outstanding common stock prior to the end of January 2007.
On November 25, 1996, the Company issued 1,776,588 shares of no par value convertible Series B preferred stock in a private placement offering at a price of $4.50 per share. During 1997 and 1998, a total of 301,656 additional Series B shares were issued as dividends resulting in a total number issued and outstanding at December 31, 2002 of 2,078,244. Each share of Series B preferred stock was converted into 1.119 shares of common stock in conjunction with the Company’s initial public offering in August 2003. Dividends on the Series B preferred stock were payable semiannually at an annual rate of 6% per share.
In April 2003, the Company’s board of directors adopted and the shareholders approved the 2003 Equity Incentive Plan (the “2003 Plan”). Under terms of the 2003 Plan, 1,680,000 shares of common stock are reserved and available for distribution. Under the 2003 Plan, incentive stock options and non-qualified stock options may be granted. Exercise provisions may vary, however, the term shall not exceed ten years from the date of grant.
As of December 31, 2005, the weighted average remaining contractual life of options outstanding under both plans is approximately eight years.
The Company follows the provisions of Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees,” to account for its employee stock option activity in the financial statements. The Company may grant incentive stock options that qualify for certain favorable tax treatment under Section 422 of the Internal Revenue Code of 1986. It may also grant stock options that do not qualify for such favorable tax treatment. The Company generally grants employee incentive stock options at an exercise price equal to the market price at the date of grant. Employee non-qualified stock options granted at less than the market price at the date of grant and non-qualified options granted to non-employees are expensed. During 2005, the Company recorded $100,000 of expense related to options granted to both employees and non-employees to purchase 115,000 shares at an exercise price of $31.00 per share that was less than the current market price at the time of grant. During the third quarter 2005, these non-qualified stock options were voluntarily surrendered by the grantees.
The Company’s statutory-basis financial statements of its insurance subsidiaries are prepared in accordance with accounting practices prescribed or permitted by the Department of Insurance in each state of domicile. Each state of domicile required that insurance companies domiciled in those states prepare their statutory basis financial statements in accordance with the NAIC Accounting Principles and Procedures Manual subject to any deviations prescribed or permitted by the insurance commissioner in each state of domicile. As of December 31, 2005 and 2004, the Company’s insurance subsidiaries did not have any prescribed or permitted accounting practices that differed from NAIC statutory accounting practices.
Statutory accounting practices differ from GAAP. Significant differences for the Company’s insurance subsidiaries were as follows:
The Company’s insurance subsidiaries are restricted by state insurance laws as to the amounts they may pay as dividends without prior approval from their respective state insurance departments. For 2006, $18,062,000 in dividends is available to be paid to the Company from insurance subsidiaries without prior approval. Property and casualty insurance and life insurance companies are subject to certain Risk-Based Capital (RBC) requirements as specified by the NAIC. Under those requirements, the amount of capital maintained by an insurance company is to be determined based on the various risk factors related to it. At December 31, 2005, each of the Company’s insurance subsidiaries exceeds the RBC requirements.
The table below summarizes the amounts included in the accompanying financial statements related to these derivatives:
commitments for leases having an initial or remaining term of more than one year are as follows at December 31, 2005:
Baton Rouge Facility. The Company currently leases a facility in Baton Rouge, Louisiana for its administrative and customer service center. This lease is scheduled to mature in April 2008. The Company plans to expand its administrative and customer service operations to support its future growth and, in conjunction with these plans, the Louisiana Local Government Environmental and Community Development Authority (“Authority”) will construct a new facility (“Facility”) and the Company will, in turn, lease the Facility from the Authority. On October 29, 2004, the Company and certain of its subsidiaries invested $10,000,000 in Louisiana Taxable Lease Revenue Bonds (“Bonds”) in order to provide the Authority with funds to finance the acquisition of land and the construction of the Facility. Under the terms of the agreements, the ownership of the Facility will transfer to the Company and the lease will expire upon the full repayment of all principal and interest related to the Bonds, which have a scheduled maturity of June 1, 2024. Construction of the Facility is expected to begin in the summer of 2006.
Litigation. The Company is named as defendant in various legal actions including four putative securities class actions filed in early 2005 and others arising in the ordinary course of business. Estimates of losses from legal actions pertaining to claims made under insurance policies underwritten by the Company are included in loss and loss adjustment expense reserves. The securities lawsuits are in the early stages and the ultimate outcome is uncertain. Management believes that the resolution of all other actions will not have a material adverse effect on the Company’s financial position or results of operations.
SEC Inquiry. The Company received a letter in March 2005 from the Securities and Exchange Commission (“SEC”) indicating that it is conducting an informal inquiry relating to the Company’s quarterly loss reserve analysis. The Company is fully cooperating with the SEC in response to its request for information.
Short-Term Investments and Other Invested Assets - The carrying values reported in the accompanying balance sheets for these financial instruments approximate their fair values.
The carrying values and fair values of certain of the Company’s financial instruments as of December 31 were as follows:
In August 2005, the Company acquired a property and casualty insurance company, the assets of which consist of debt securities and licenses to conduct property and casualty business in 38 states and the District of Columbia. The purchase price was $10,400,000, of which approximately $4,400,000 was allocated to the value of the licenses acquired.
Quarterly results of operations for 2005 and 2004 are summarized as follows:
The Company periodically reviews recent accounting pronouncements issued by the Financial Accounting Standards Board, American Institute of Certified Public Accountants, Emerging Issues Task Force, and Staff Accounting Bulletins issued by the United States Securities and Exchange Commission to determine the potential impact on the Company’s financial statements. Based on its most recent review, the Company has determined that the majority of these recently issued accounting standards either do not apply to the Company or will not have a material impact on its financial statements. However, in December 2004, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment, which will affect the manner in which the Company accounts for its share-based payment arrangements, including employee stock options. This pronouncement is effective for periods beginning after June 15, 2005. As disclosed in Note 10,