Includes after tax net realized gains from securities transactions of $48,000, $1,261,000, $1,353,000, $1,352,000 and $2,822,000 for 2005, 2004, 2003, 2002 and 2001, respectively.
In 2005 the Company recorded net income of $8,872,000 compared to net income of $5,509,000 in 2004. In 2005 a decrease in the deferred tax valuation allowance of $3,616,000 was recorded. Gross premiums written in 2005 were $112.6 million compared to $43.8 million in 2004. Operationally, the Company made substantial investments throughout the year to build a long term franchise in the nonstandard personal automobile insurance industry, including significant expenditures to expand the long term processing and servicing capacity of our new operating center in Dallas and marketing initiatives to accelerate the growth of our agency distribution network and customer base. While these investments enabled the Company to expand premiums written and operating capabilities in pursuit of its long term business expansion plan, these investments, along with the generally higher claims ratios associated with the new business diminished operating profits during 2005.
In the first quarter of 2006, the Company sought to improve its capital structure with the issuance of $25 million of 30-year subordinated debentures which enabled the Company to redeem its outstanding Series A Preferred stock due in January, 2011. See “Capital Transactions - 2006 Subordinated Debentures.” The Company’s rapid growth, however, continues to place demands on the overall capital adequacy of the Company and, in support of expected future growth, the Company may seek to further increase the capital capacity of the insurance subsidiaries in future periods. We continue to caution that the financial and operational risks and uncertainties associated with our capital plan and the execution of our business plan, including those risks identified in “PART I. ITEM 1A. Risk Factors” of this document, are significant and could potentially alter our business plan in the future.
The sources of revenues for the Company in 2005 were premiums written on nonstandard personal auto risks, net investment income from the investment portfolio of the Company and fee income from the insurance agency operations.
The Company only writes nonstandard personal auto insurance and has no current plans to write any other lines of insurance. The Company’s current vision is to grow this business in target states to establish a broader and more geographically diversified earnings base. Significant growth at higher levels of operating leverage could enable the Company to materially increase its profitability, if it is able to achieve that growth with favorable profit margins, but is also has the potential to cause material and adverse effects on our financial condition and results if not profitably managed.
As the Company expands its infrastructure and builds its capabilities to carry out its growth strategy, it incurred expenditures in 2005 and expects to incur expenditures in 2006 in amounts greater than in previous periods. These expenditures include but are not limited to: hiring, relocation and incremental office space and wage and benefit costs, including costs for qualified additional personnel, furniture, fixtures, equipment, software and systems, additional marketing costs, such as agency compensation incentives, advertising and promotional expenses, including the Daytona Prototype Series racing team sponsorship; and non-cash expenses associated with the Company’s 2005 Long-Term Incentive Compensation Plan.
The Company continues to settle and reduce its inventory of commercial lines claims. At December 31, 2005, there were 149 claims associated with the Company’s runoff book outstanding, compared to 264 as of December 31, 2004. Due to the long tail and litigious nature of these claims, the Company anticipates it will take a substantial number of years to complete the adjustment and settlement process with regard to existing claims and the additional claims it expects to receive in the future from its past business writings. Most of the remaining claims are in suit and the Company’s future results may or may not be impacted either negatively or positively based on its ability to settle the remaining claims and new anticipated claims within its established reserve level.
Net investment income increased 59% in 2005 primarily due to the 24% increase in investments and the increase in Bonds available for sale, which provide higher returns than Short-term investments. At December 31, 2005 Bonds available for sale comprised 46% of Investments versus 20% at December 31, 2004. The increase in investments was due to funds received from the rights offering and positive cash flows from operations.
Agency revenues increased $5,204,000 in 2005 and $1,387,000 in 2004 as a direct result of the increase in writings. Beginning in the fourth quarter of 2005, policy fees were no longer recorded as Agency revenues, they were recorded as premiums and recognized over the period of the policy.
Other income has decreased in 2005 and 2004 as a result of the continued runoff of the commercial auto claims under the reserve reinsurance cover agreement. This item is primarily comprised of recognition of the deferred reinsurance gain from the reserve reinsurance cover agreement. At December 31, 2005, $462,000 remained to be recognized in Other income in the future.
During the fourth quarter of 2005, the Company recorded a deferred tax benefit as a result of a reduction in the valuation allowance for Deferred Federal income taxes. Because of continued increasing levels of taxable operating income and continued positive expectations for the future, the Company considered it proper to reduce the valuation allowance.
In August, 2005, the Company completed a rights offering which raised approximately $14.6 million in net proceeds. Approximately 97% of the maximum shares of Common Stock available through the rights offering were exercised. There was no over-subscription privilege in connection with this offering.
As a result of the recapitalization in January, 2005, the rights offering in August, 2005 and the one-for-four reverse split of Common Stock in November, 2005 the number of shares of Common Stock outstanding decreased from 21,169,736 as of December 31, 2004 to 20,225,574 shares as of December 31, 2005. GMSP now owns approximately 33% of the outstanding Common Stock, Mr. Stallings owns approximately 22% and Mr. Reis and First Western collectively own approximately 11%.
In January, 2006 a wholly-owned subsidiary, GAINSCO Capital Trust I, issued $25 million of 30-year capital securities. The capital securities require quarterly payments of interest at a floating interest rate equal to the 3-month LIBOR (London interbank offered rate for U.S. dollar deposits) plus a margin of 3.85%. The capital securities will mature on March 31, 2036 and are redeemable at the Company’s option beginning after March 31, 2011, in whole or in part, at the liquidation amount of $1,000 per capital security. Taken together, the Company’s obligations provide a full, irrevocable and unconditional guarantee of payments of distributions and other amounts due on the capital securities, subject to the subordination provisions of the agreements.
The following table sets forth, as of December 31, 2005 our actual consolidated capitalization, and our pro forma consolidated capitalization reflecting the sale of the Subordinated debentures. This table includes the net proceeds of approximately $23.6 million, after deducting the offering discount, the Placement Agent’s fee and other estimated offering expenses.
Reflects use of approximately $18.5 million of net proceeds to redeem the redeemable preferred stock.
GAN provides administrative and financial services for its wholly owned subsidiaries. GAN needs cash during 2006 primarily for administrative expenses and interest on the subordinated debentures and the note payable. The Company received approximately $3.1 million in net proceeds as a result of the 2005 recapitalization in January, 2005. The Company raised approximately $14.6 million in net proceeds as a result of it rights offering completed in August, 2005. The Company subsequently contributed $16 million from holding company cash and the proceeds of the rights offering to the surplus of General Agents. The primary source of cash to meet other obligations is statutorily permitted dividend payments from its insurance subsidiary, General Agents, an Oklahoma corporation. Statutes in Oklahoma restrict the payment of dividends by the insurance company to the available surplus funds. The maximum amount of cash dividends that General Agents may declare without regulatory approval in any 12-month period is the greater of net income for the 12-month period ended the previous December 31 or ten percent (10%) of policyholders’ surplus as of the previous December 31. For 2006, the maximum amount of cash dividends that General Agents may pay without regulatory approval is approximately $5,947,000. In addition, we entered into a credit arrangement with a commercial bank which can be used to provide for holding company funds. GAN believes the cash available from its credit facility and statutory dividend should be sufficient to meet its expected obligations for 2006.
As a result of losses in prior years, as of December 31, 2005 the Company has net operating loss carryforwards for tax purposes aggregating $68,750,000. These net operating loss carryforwards of $20,480,000, $33,950,000, $13,687,000 and $633,000, if not utilized, will expire in 2020, 2021, 2022 and 2023, respectively. The tax benefit of the net operating loss carryforwards is $23,375,000, which is calculated by applying the Federal statutory income tax rate of 34% against the net operating loss carryforwards of $68,750,000.
In certain circumstances, Section 382 of the Internal Revenue Code may apply to materially limit the amount of the Company’s taxable income that may be offset in a tax year by the Company’s net operating losses carried forward from prior years (the “§ 382 Limitation”). The annual § 382 Limitation generally is an amount equal to the value of the Company (immediately before an “ownership change”) multiplied by the long-term tax-exempt rate for the month in which the change occurs (e.g., 4.36% if the ownership change occurred in March 2006). This annual limitation would apply to all years to which the net operating losses can be carried forward.
The primary sources of the insurance subsidiaries’ liquidity are funds generated from insurance premiums, net investment income and maturing investments. The short-term investments and cash are intended to provide adequate funds to pay claims without selling fixed maturity investments. At December 31, 2005, the insurance subsidiaries held short-term investments and cash that the insurance subsidiaries believe are at adequate liquidity for the payment of claims and other short-term commitments.
Ceded unpaid C & CAE decreased as a result of the decrease in Unpaid C & CAE with regard to commercial claims subject to the commercial excess casualty and quota share reinsurance agreements. This balance represents unpaid C & CAE which have been ceded to reinsurers under the Company’s various reinsurance agreements, other than the reserve reinsurance cover agreement. These amounts are not currently due from the reinsurers but could become due in the future when the Company pays the claim and requests reimbursement from the reinsurers.
Deferred Federal income taxes increased as a result of a reduction in the valuation allowance for Deferred Federal income taxes. This was the result of continued increasing levels of taxable operating income and continued positive expectations for the future. The Company considered it proper to reduce the valuation allowance.
Unpaid C & CAE decreased primarily as a result of the settlement of claims in the normal course and favorable development in 2005 from the runoff lines. As of December 31, 2005, the Company had $55,831,000 in net unpaid C & CAE (Unpaid C & CAE of $78,503,000 less Ceded unpaid C & CAE of $22,672,000). This amount represents management’s best estimate, as derived from the actuarial analysis and was set equal to the selected reserve estimate as established by an independent actuary. The independent actuary identified the recent adverse development in the Company’s unpaid C & CAE and the Company’s decision in 2002 to discontinue writing commercial lines as risk factors. In consideration of these risk factors the independent actuary believes that there are significant risks and uncertainties that could result in material adverse deviation of the unpaid C & CAE. Management has reviewed and discussed the results of the actuarial analysis with the actuary and believes the reserve estimate selected by the independent actuary to be the best estimate of reserves at this time.
As of December 31, 2005, in respect of its runoff lines, the Company had $28,653,000 in net unpaid C & CAE. Historically, the Company has experienced significant volatility in its reserve projections for its commercial lines. This volatility has been primarily attributable to its commercial automobile and general liability product lines. On February 7, 2002, the Company announced it had decided to discontinue writing commercial lines insurance due to continued adverse claims development and unprofitable results. The Company has been settling and reducing its remaining inventory of commercial claims. See “Business Operations - “Discontinuance of Commercial Lines”. As of December 31, 2005, 149 runoff claims remained versus 264 at December 31, 2004. The average commercial lines claim reserve was approximately $192,000 per claim and $169,000 per claim at December 31, 2005 and December 31, 2004, respectively.
Deferred Federal income taxes are comprised of the taxes on the unrealized gains of the bonds available for sale. The unrealized gains have been recorded net of taxes in “Accumulated other comprehensive income.”
Retained deficit decreased as a result of net income offset by dividends and accretion of discount on the Preferred stock.
The Company is not aware of any current recommendations by regulatory authorities, which, if implemented, would have a material effect on the Company’s liquidity, capital resources or results of operations. The Company’s statutory capital exceeds the benchmark capital level under the Risk Based Capital formula for its insurance companies. Risk Based Capital is a method for establishing the minimum amount of capital appropriate for an insurance company to support its overall business operations in consideration of its size and risk profile.
The following table summarizes the Company’s contractual obligations as of December 31, 2005:
See Item 1, “Business - Unpaid Claims and Claim Adjustment Expenses” and Note 1(k) of Notes to Consolidated Financial Statements with respect to liabilities to policyholders in respect of insurance policies written by the Company.
In May, 2005, the Company entered into an Office Lease (the “Lease”) with Crescent Real Estate Funding VIII, L.P., a Delaware limited partnership (“Crescent Funding”). The Lease (recorded in “Operating leases” in the table above) is for a term of ten years, and the Company has the option of terminating the Lease at the end of the fifth year of the term subject to payment of a penalty. Pursuant to the Lease, the Company is renting space in the office building located at 3333 Lee Parkway in Dallas, where the Company has moved its executive offices and relocated all of its operations previously located in Fort Worth, Texas and certain operations previously conducted in Miami, Florida. This step toward consolidation of operations is a component part of the Company’s long-term plan that was initiated in conjunction with the recapitalization of the Company. The lease commenced in September, 2005 upon completion of tenant improvements required by the Company for its reconfigured operations.
Blackhawk is owned and controlled by Robert W. Stallings, the Executive Chairman of the Company. The Company’s Board of Directors authorized the agreement at a meeting in February, 2006. In authorizing the agreement, the Board of Directors considered Mr. Stallings’ role and concluded that, under the circumstances, the Sponsorship Agreement is fair to, and in the best interests of, the Company. The Sponsorship Agreement contains provisions protecting the Company’s interests, including a termination provision that permits the Company unilaterally to terminate the agreement at any time and thereby cease making installment payments of the sponsorship fee.
requires that intangible assets with definite useful lives be amortized over their respective estimated useful lives to their estimated residual values, and reviewed for impairment in accordance with Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” The Company adopted the provisions of Statement 142 effective January 1, 2002, which resulted in the Company no longer amortizing goodwill.
The process of establishing claims reserves is imprecise and reflects significant judgmental factors. In many liability cases, significant periods of time, ranging up to several years or more, may elapse between the occurrence of an insured claim and the settlement of the claim. The actual emergence of claims and claim adjustment expenses may vary, perhaps materially, from the Company’s estimates thereof, because (a) estimates of claims and claim adjustment expense liabilities are subject to large potential errors of estimation as the ultimate disposition of claims incurred prior to the financial statement date, whether reported or not, is subject to the outcome of events that have not yet occurred (e.g., jury decisions, court interpretations, legislative changes (even after coverage is written and reserves are initially set) that broaden liability and policy definitions and increase the severity of claims obligations, subsequent damage to property, changes in the medical condition of claimants, public attitudes and social/economic conditions such as inflation), (b) estimates of losses do not make provision for extraordinary future emergence of new classes of losses or types of losses not sufficiently represented in the Company’s historical data base or which are not yet quantifiable, and (c) estimates of future costs are subject to the inherent limitation on the ability to predict the aggregate course of future events.
In May 2005, the Financial Accounting Standards Board (“FASB”) issued Statement 154, “Accounting Changes and Error Corrections” which changes the requirements for the accounting and reporting of a change in accounting principle. Statement 154 applies to all voluntary changes in accounting principle as well as to changes required by an accounting pronouncement that does not include specific transition provisions. Statement 154 requires that changes in accounting principle be retrospectively applied. Under retrospective application, the new accounting principle is applied as of the beginning of the first period presented as if that principle had always been used. The cumulative effect of the change is reflected in the carrying value of assets and liabilities as of the first period presented and the offsetting adjustments would be recorded to opening retained earnings. Statement 154 replaces APB Opinion No. 20 and FASB Statement 3. Statement 154 is effective for the Company beginning in fiscal year 2006.
Notes to Consolidated Financial Statements December 31, 2005, 2004 and 2003
The following Consolidated Financial Statements Schedules are on pages 96 through 106: