We are a distributor and producer of non-standard personal automobile insurance policies for individual consumers in targeted geographic markets. Non-standard personal automobile insurance policies provide coverage to drivers who find it difficult to obtain insurance from standard automobile insurance companies due to their lack of prior insurance, age, driving record, limited financial resources or other factors. Non-standard personal automobile insurance policies generally require higher premiums than standard automobile insurance policies for comparable coverage.
In 2007, we completed the acquisition of USAgencies L.L.C. (USAgencies), a non-standard automobile insurance distributor and provider headquartered in Baton Rouge, Louisiana, in a fully-financed all cash transaction valued at approximately $199.1 million. At the time of acquisition, USAgencies had 91 operating retail sales locations in Louisiana, Illinois and Alabama selling its products directly to consumers through its owned retail stores, virtual call centers and internet site. The acquisition gave us a leading market position in Louisiana, the twelfth largest non-standard automobile insurance market. The transaction was effective as of January 1, 2007. The purchase of USAgencies was financed through $200.0 million in borrowings under a $220.0 million senior secured credit facility that was entered into concurrently with the completion of the acquisition.
Our three operating components often function as a vertically integrated unit, capturing the premium and associated risk and commission income and fees generated from the sale of an insurance policy. There are other instances, however, when each of our operations functions with unaffiliated entities on an unbundled basis, either independently or with one or both of the other two operations. For example, as of December 31, 2008, our insurance companies had relationships with two unaffiliated underwriting agencies that design, distribute and service our policies through their approximately 4,100 independent agencies, and our underwriting agencies distributed insurance policies through approximately 3,900 independent agencies in addition to our owned and franchised retail stores. In addition, our retail stores earn commission income and fees from sales of third-party policies.
The preparation of our consolidated financial statements in conformity with U. S. generally accepted accounting principles (generally accepted accounting principles) requires us to make estimates and assumptions when applying our accounting policies. The following sections provide information about our estimation process related to certain of our critical accounting policies:
As of December 31, 2008 and 2007, we had no reserve for uncollectible reinsurance recoverables. We assessed the collectibility of our year-end receivables and believe all amounts are collectible based on currently available information.
Deferred policy acquisition costs. Deferred policy acquisition costs represent the deferral of expenses that we incur acquiring new business or renewing existing business. Policy acquisition costs (primarily commissions, advertising, premium taxes and underwriting and agency expenses related to issuing a policy) are deferred and charged against income ratably over the terms of the related policies. Management regularly reviews the categories of acquisition costs that are deferred and assesses the recoverability of this asset. A premium deficiency and a corresponding charge to income is recognized if the sum of the expected losses and loss adjustment expenses, unamortized acquisition costs and maintenance costs exceeds related unearned premiums and anticipated investment income. At December 31, 2008, we determined that there was no premium deficiency. Judgments as to the ultimate recoverability of such deferred costs are highly dependent upon estimated future loss costs associated with the premiums written.
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. 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 their 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.
We currently have one relationship with an unaffiliated reinsurer from which we obtain data that we use in the course of estimating our loss and loss adjustment expense reserves. Our relationship with this reinsurer consisted of a fronting relationship in which we ceded 100% of the policies written to the reinsurer, who was also responsible for managing the book of business. This book of business went into run-off in 2000. The reinsurer is currently responsible for the handling of claims. We receive estimates of direct loss and loss adjustment expense reserves on a monthly basis from the reinsurer, which we use in the course of estimating our own loss and loss adjustment expense reserves. We usually receive the monthly report within 10 business days from the close of the month. To our knowledge, there has been very little variation in the reinsurer’s reserve practices and methods. We review the data and evaluate using generally accepted actuarial loss and LAE reserving methodologies. The data is reconciled to the reinsurer’s Schedule F. There have been very few, if any, adjustments made to the data. At this time, we do not have (nor have there ever been) any disputes with this reinsurer, and we do not anticipate that our relationship with this unaffiliated reinsurer will have an impact on our financial position, due to our belief that this reinsurer’s financial strength is adequate (such belief is in part based upon and supported by the fact that the reinsurer is rated A- by A.M. Best).
Paid Bornhuetter/Ferguson - We use a combination of paid 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.
There are numerous factors, both internal and external, that we consider when evaluating the reasonableness of the various methods used to determine the actuarial best estimate of loss and loss adjustment expense reserves. Many of the factors vary for different states, programs, coverage groups, and accident periods. Some examples of internal factors considered are changes in product mix, changes in claims-handling practices, loss cost trends and underwriting standards and rules. External factors considered include frequency, severity, the effect of inflation on medical hospitalization, material repair and replacement costs, as well as general economic and legal trends. The majority of our customer base includes individuals with low disposable incomes, who have less money to spend as gas prices rise. As gas prices increase for a sustained period of time, consumers in general (and our customers in particular) change their driving habits to reduce gas consumption by car-pooling, using mass transit or simply by consolidating trips and driving less, which results in a decline in auto claims. Consequently, our frequency rates tend to improve as gas prices increase.
There can be no assurance that actual future loss and LAE development variability will be consistent with any potential variation indicated by our historical loss and LAE development experience.
Valuation of trading investments. Our trading investment portfolio consists of fixed-income securities, which are carried at fair value with realized gains and losses reported in the current period’s earnings.
Valuation of goodwill and other intangible assets. We account for business combinations using the purchase method of accounting and accordingly, the assets and liabilities of the acquired entities are recorded at their estimated fair values at the date of acquisition. Goodwill represents the excess of the purchase price over the fair value of net assets, including the amount assigned to identifiable intangible assets. Identifiable intangible assets consist of brand names, agency relationships and non-competition agreements. Identifiable intangible assets that are determined to have a finite life are amortized over their useful lives, which range from two to twenty years. The results of operations of acquired businesses are included in our Consolidated Financial Statements from the respective dates of acquisition.
the financial markets in general and the specific performance of the Company as indicated by written premium volumes as compared to plan during the recent months of economic decline. Management also evaluated whether any other events occurred or circumstances changed that would trigger the requirement of an interim impairment test of goodwill, and determined that there were none. Therefore no update of the goodwill impairment test was necessary at December 31, 2008.
Deferred income taxes. We account for taxes under the asset and liability method. Under this method, deferred income taxes are recognized for temporary differences between the financial statement and tax return bases of assets and liabilities. Any resulting future tax benefits are recognized to the extent that realization of such benefits is more likely than not, and a valuation allowance is established for any portion of a deferred tax asset that management believes will not be realized. The assessment of the need for a valuation allowance requires management to make estimates and assumptions about future earnings, reversal of existing temporary differences and available tax planning strategies. If actual experience differs from these estimates and assumptions, the recorded deferred tax asset may not be fully realized resulting in an increase to income tax expense in our results of operations. In addition, the ability to record deferred tax assets in the future could be limited resulting in a higher effective tax rate in that future period.
On January 1, 2008, we adopted the provisions of Statement of Financial Accounting Standards (SFAS) No. 157, Fair Value Measurements. SFAS No. 157 defines fair value to be the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date and emphasizes that fair value is a market-based measurement, not an entity-specific measurement. SFAS No. 157 establishes a fair value hierarchy and expands disclosures about fair value measurements in both interim and annual periods. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years. In February 2008, the Financial Accounting Standards Board (FASB) issued FASB Staff Position No. FAS 157-1 Applications of FASB Statement No. 157 to FASB Statement No. 13 and Other Accounting Pronouncements That Address Fair Value Measurements for Purpose of Lease Classification or Measurement under Statement 13 (FSP 157-1) which removes leasing transactions from the scope of SFAS No. 157. FSP 157-1 is effective upon adoption of SFAS No. 157. In October 2008, the FASB issued FASB Staff Position 157-3, Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active (FSP 157-3). FSP 157-3 clarifies the application of SFAS No. 157 in an inactive market and illustrates how an entity would determine fair value when the market for a financial asset is not active. FSP 157-3 is effective upon issuance and any revisions resulting from a change in valuation technique or its application will be accounted for as a change in accounting estimate. The adoption of SFAS No. 157, FSP 157-1 and FSP 157-3 did not have a material impact on our consolidated results of operations or financial condition.
In March 2008, the FASB issued SFAS No. 161, Disclosures about Derivative Instruments and Hedging Activities, an amendment to FASB Statement No. 133. SFAS No. 161 amends and expands the disclosure
The market conditions that existed for the past several years continued in 2008 putting downward pressure on industry rate levels. Our insurance company subsidiaries have continued developing and introducing new and better segmented products to serve our target markets during the past twelve months. In the aggregate, our rate level during 2008 modestly increased, as we continued to focus on seeking an appropriate balance between competitive positioning and profitability.
In the independent agency distribution channel and the unaffiliated underwriting agency distribution channel, the effect of competitive conditions is the same as in our owned retail store distribution channel. As in our retail stores, independent agents (either working directly with us or through unaffiliated underwriting agencies) not only offer our products but also offer their customers a selection of products by third-party carriers. Therefore, our insurance products must be competitive in pricing, features, commission rates and ease of sale or the independent agents will sell the products of those third-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.
Total gross premiums written for 2008 decreased $57.6 million, or 13.0%, compared with 2007. The decrease was primarily due to macroeconomic effects and the insurance industry continued to experience a soft market. 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 and franchised stores. We earn commission income and fees in our retail distribution channel for sales of third-party insurance policies. Gross premiums written in our retail distribution channel decreased $13.6 million, or 5.5%, from 2007. In our independent agency distribution channel, gross premiums written for 2008 decreased $35.4 million, or 22.7%, compared with 2007. Gross premiums written by our unaffiliated agencies in 2008 decreased $8.6 million, or 22.1%, compared with 2007. For strategic reasons, we have chosen to reduce our emphasis on growth in the unaffiliated underwriting agencies distribution channel.
The following table displays our net premiums written by distribution channel for 2008, 2007 and 2006 (in thousands):
The following table sets forth net premiums earned by distribution channel for 2008, 2007 and 2006 (in thousands):
The largest component of revenues is net premiums earned on our insurance policies. Net premiums earned for 2008 decreased $38.7 million, or 9.8%, compared with 2007. Since insurance premiums are earned over the life of the policies, the revenue in the current period includes premiums earned on insurance products written through our three distribution channels in both current and previous periods. This decline was due to the decline in gross written premiums. Net premiums earned during 2008 on policies sold through our affiliated underwriting agencies (including retail and independent agencies) decreased by $30.5 million, or 8.6%. Net premiums earned on insurance products sold through the unaffiliated underwriting agencies distribution channel decreased by $8.3 million, or 20.7%, compared with 2007.
The amount of recoveries pertaining to quota-share reinsurance contracts that were deducted from losses and loss adjustment expenses incurred during 2008 was approximately $31.3 million. The amount of loss reserves and unearned premium we would remain liable for in the event our reinsurers are unable to meet their obligations is as follows for the years ended December 31, 2008, 2007 and 2006 (in thousands):
The following table summarizes the ceded incurred losses and loss adjustment expenses (consisting of ceded paid losses and loss adjustment expenses and change in reserves for loss and loss adjustment expenses ceded) to various reinsurers for the years ended December 31, 2008, 2007 and 2006 (in thousands):
Commission income and fees consists of (a) policy, installment, premium finance, franchise, royalty and agency fees earned for business written or assumed by our insurance companies both through independent agents and our retail agencies and (b) the commission income earned on sales of unaffiliated, third-party companies’ insurance polices or other products sold by our retail agencies. These various types of commission income and fees are impacted in different ways by the decisions we make in pursuing our corporate strategy.
Policy, installment, premium finance, franchise, royalty and agency fees are earned for business written or assumed by our insurance companies both through independent agents and our retail agencies. Policy, installment and agency fees are fees charged to the customers in connection with their purchase of coverage from our insurance company subsidiaries. Generally, we can increase or decrease agency and installment fees subject to limited regulatory restrictions, but policy fees and interest rates must be approved by the applicable state’s department of insurance. Premium finance fees are financing fees, which were primarily earned by our premium finance subsidiaries, and consist of interest and origination fees on our carriers’ policies that customers choose to finance. In December 2007, we began issuing premium finance contracts to our customers that obtain coverage from third-party carriers. Franchise and royalty fees are earned from our franchised stores in Florida, but are not significant to our financial results.
our insurance products that could result in an increase in our commission income and fees from non-affiliated third-party insurers. We negotiate commission rates with the various third-party carriers whose products we agree to sell in our retail stores. As a result, the level of third-party commission income will also vary depending upon the mix by carrier of third-party products that are sold. In addition, we earn fees from the sales of other products and services such as tax preparation services, auto club memberships and bond cards offered by unaffiliated companies.
Commission income and fees decreased $9.2 million, or 10.5%, in 2008 compared with 2007. The decrease was primarily due to a decline in policyholder fees due to the decline in premium production. Commission income and fees related to sales of third-party insurance policies and products decreased $0.6 million, or 4.7%, in 2008 compared to 2007. This decrease was primarily due to the macroeconomic and soft market conditions that affected the Company’s own premium production.
Commission income and fees increased $27.2 million, or 44.5%, in 2007 compared with 2006. The increase was primarily attributable to the addition of income from policyholder and premium finance fees from USAgencies. Commission income and fees related to sales of third-party insurance policies and products for 2007 decreased 1.0% compared with 2006. In the second quarter of 2006, we reduced or eliminated our agency fees in our retail stores to reduce the cost to the customer of purchasing coverage from us. This increased the overall level of sales and thereby increased our commission income (when the product sold is a third-party carrier’s coverage) and earned premiums (when the product sold is our insurance company subsidiaries’ coverage). In the fourth quarter of 2006, we reinstituted certain agency fees but at a moderate level compared with the first half of 2006.
Net Investment Income and Other Income. At December 31, 2008, our fixed-income investments were invested in the following: U.S. Government and agencies securities 11.1%, corporate securities 0.4%, mortgage-backed securities 2.4%, and tax-exempt securities 86.1%. As of December 31, 2008, all of our fixed-income securities were rated “A” or better by nationally recognized statistical rating organizations. We attempt to mitigate interest rate risk by managing the duration of our fixed-income portfolio to a target range of three years or less. As of December 31, 2008, the effective duration of our fixed-income investment portfolio was 1.58 years.
Net investment income for 2008 decreased $2.7 million, or 16.4%, compared with 2007. The decrease was primarily due to a 8.1% decrease in total average invested assets to $305.2 million during 2008 from $332.2 million during 2007. The average investment yield was 3.44% (4.75% on a taxable equivalent basis) in 2008 as compared to 3.59% (5.05% on taxable equivalent basis) in 2007.
As of December 31, 2008, we held $51.3 million par value and $40.2 million fair value of auction-rate tax-exempt securities. Generally, the interest rates for these securities are determined by bidding every 7, 28 or 35 days. When there are more sellers than buyers, an auction fails and bondholders that want to sell are left holding the securities. Auctions for these securities began to fail in late January 2008. Issuers remain obligated to
pay interest and principal when due when an auction fails. Rates at failed auctions are set at a level established in the terms of the debt. In mid-February 2008, investment banks stopped committing capital to the auctions and there have been widespread auctions failures since that time.
In August 2008, our broker announced settlements in principle with each of the Division Enforcement of the U.S. Securities and Exchange Commission (SEC), the New York Attorney General and other state agencies to purchase all of its clients’ auction-rate securities at par and several other items including fines. In October 2008, our broker filed a prospectus with the SEC, which published a legally-binding offer to all authorized holders of auction-rate securities in our broker’s accounts (“the settlement”). The majority of our auction-rate securities qualify under the terms of our broker’s prospectus. The time frames that our broker has set for buybacks have different start dates based upon the individual client’s size, which is determined by each client’s balance of investments held at our broker. For the majority of our auction-rate holdings, the buybacks are expected to occur between July 2010 and two years thereafter. In November 2008, the Company elected to participate in our broker’s offer to purchase our auction-rate securities at par. In November 2008, we classified our portfolio of auction-rate securities as trading and recorded a realized loss of $11.1 million for the difference in fair value and carrying amount. The fair value of the settlement was $9.6 million which we elected to report in other assets with changes in fair value reported in other income.
The loss ratio for the year (losses and loss adjustment expenses divided by net premiums earned) increased to 76.8% in 2008, compared with 73.2% in 2007, primarily due to increased losses from Florida policies. The Florida losses were the result of our decision to push the full coverage product in Florida in 2007 in response to the Personal Injury Protection (PIP) sunset in that state on October 1, 2007. Inadequate pricing and product management produced significantly higher losses than anticipated. We have drastically reduced the production of this product by restricting writings by agent, territory and coverage based on where significant loss ratio swings occurred. In addition, the Company had $2.5 million in losses in 2008 related to Hurricanes Gustav and Ike.
The following table presents the development of reserves for unpaid losses and loss adjustment expenses from 1998 through 2008 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
As a result of the 100% quota-share reinsurance contract with VFIC, all losses and loss adjustment expense reserves of our insurance companies as of December 31, 2003 were reinsured by VFIC. In addition, VFIC remains liable for all losses and loss adjustment expenses for losses occurring on or prior to December 31, 2003.
The following table sets forth the impact that amortization of deferred acquisition costs had on selling, general and administrative expenses and the change in deferred acquisition costs for the years ended December 31, 2008, 2007 and 2006 (in thousands):
Selling, general and administrative expenses for 2007 increased $11.7 million, or 7.8%, compared with 2006 largely due to the inclusion of USAgencies’ expenses in our operating results. In addition, other items affecting
Depreciation and Amortization. Depreciation and amortization expenses for 2008 decreased $2.1 million, or 18.4%, compared with 2007. Depreciation expense increased by $2.0 million or 36.9%. The increase was primarily due to the implementation of the agency management, premium finance and insurance systems. Amortization expense decreased $4.1 million or 69.8% for the current period. The decrease is primarily a result of agreements that were fully amortized in 2007.
Interest expense for 2007 increased $20.7 million compared with 2006. The increase in interest expense was due to the debt we incurred for the acquisition of USAgencies.
Income Taxes. Income tax benefit for 2008 was $3.4 million, or an effective rate of 174.3%, compared with income tax expense of $2.1 million, or an effective rate of 17.9%, for 2007. The increase in the effective tax rate was due to the pretax loss in 2008 and the relatively high proportion of the investment income generated by the tax-exempt securities in our investment portfolio.
Minority Interest. Minority interest, net of income tax expense, was $81.0 million for 2006. We purchased the remaining 27.0% interest in our Florida underwriting agency from the minority holders in March 2006.
The National Association of Insurance Commissioners’ model law for risk-based capital provides formulas to determine the amount of capital that an insurance company needs to ensure that it has an acceptable expectation of not becoming financially impaired. At December 31, 2008, each of our insurance subsidiaries maintained a risk-based capital level that was in excess of an amount that would require any corrective actions on our part.
Our obligations under the facility are guaranteed by our material operating subsidiaries (other than our insurance companies) and are secured by a first lien security interest on all of our assets and the assets of our material operating subsidiaries (other than our insurance companies), including a pledge of 100% of the stock of AIC. The facility contained certain financial covenants, which included capital expenditure limitations, minimum interest coverage requirements, maximum leverage ratio requirements, minimum risk-based capital requirements, maximum combined ratio limitations, minimum fixed charge coverage ratios and a minimum consolidated net worth requirement, as well as other restrictive covenants. At December 31, 2008, we were in compliance with all of our financial and other covenants.
(2) All of the outstanding notes payable at December 31, 2008 are redeemable in whole or in part after five years of issuance. For this disclosure, it is assumed that none of these notes will be redeemed before their contractual maturities and interest rates on these notes will remain at their current levels. Difference between future cash payments and the carrying value of the notes represents fair value adjustment at the date of acquisition of USAgencies that is being amortized into interest expense over the notes outstanding period.
We have audited the accompanying consolidated balance sheets of Affirmative Insurance Holdings, Inc. and subsidiaries (the Company) as of December 31, 2008 and 2007, and the related consolidated statements of income, stockholders’ equity, comprehensive income (loss), and cash flows for each of the years in the three-year period ended December 31, 2008. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
Certain prior year amounts have been reclassified to conform to the current presentation. The reclassifications primarily affected the presentation of certain ceding commissions as reductions of policy acquisition expenses rather than reductions of loss adjustment expenses.
On January 1, 2008, we adopted the provisions of Statement of Financial Accounting Standards (SFAS) No. 157, Fair Value Measurements. SFAS No. 157 defines fair value to be the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date and emphasizes that fair value is a market-based measurement, not an entity-specific measurement. SFAS No. 157 establishes a fair value hierarchy and expands disclosures about fair value measurements in both interim and annual periods. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years. In February 2008, the Financial Accounting Standards Board (FASB) issued FASB Staff Position No. FAS 157-1 Applications of FASB Statement No. 157 to FASB Statement No. 13 and Other Accounting Pronouncements That Address Fair Value Measurements for Purpose of Lease Classification or Measurement under Statement 13 (FSP 157-1) which removes leasing transactions from the scope of SFAS No. 157. FSP 157-1 is effective upon adoption of SFAS No. 157. In October 2008, the FASB issued FASB Staff Position 157-3, Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active (FSP 157-3). FSP 157-3 clarifies the application of SFAS 157 in an inactive market and illustrates how an entity would determine fair value when the market for a financial asset is not active. FSP 157-3 is effective upon issuance and any revisions resulting from a change in valuation technique or its application will be accounted for as a change in accounting estimate. The adoption of SFAS No. 157, FSP 157-1 and FSP 157-3 did not have a material impact on our consolidated results of operations or financial condition.
On January 1, 2008, we also adopted the provisions of SFAS No. 159, Establishing the Fair Value Option for Financial Assets and Liabilities. SFAS No. 159 permits entities to choose to measure many financial instruments and certain other items at fair value. The objective is to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. This statement is expected to expand the use of fair value measurement, which is consistent with the FASB’s long term measurement objectives for accounting for financial instruments. SFAS No. 159 applies to all entities and most of the provisions apply only to entities that elect the fair value option. SFAS No. 159 is effective for fiscal years beginning after November 15, 2007. The initial adoption of SFAS No. 159 did not have a material impact on our consolidated results of operations or financial condition.
Amounts Due from/to Reinsurers • We collect premiums from insureds and after deducting our authorized commissions, we remit these premiums to the appropriate insurance and reinsurance companies. Our obligation to remit these premiums is recorded as amounts due reinsurers in our consolidated balance sheet. We record the amounts we expect to receive from reinsurers as an asset on our balance sheet. Our insurance companies report as assets the estimated reinsurance recoverable on paid losses and unpaid losses, including an estimate for losses incurred but not reported.
Deferred Policy Acquisition Costs • Deferred policy acquisition costs represent the deferral of expenses that we incur acquiring new business or renewing existing business. Policy acquisition costs, consisting of primarily commission, advertising, premium taxes, underwriting and agency expenses, are deferred and charged against income ratably over the terms of the related policies. We regularly review the categories of acquisition costs that are deferred and assess the recoverability of this asset. A premium deficiency, and a corresponding charge to income is recognized, if the sum of the expected losses and loss adjustment expenses, unamortized acquisition costs, and maintenance costs exceeds related unearned premiums and anticipated investment income. Amounts received as expense allowances on reinsurance contracts that represent reimbursement of acquisition costs are recorded as reductions of deferred acquisition costs.
Goodwill and Other Intangible Assets • We account for business combinations using the purchase method of accounting and accordingly, the assets and liabilities of the acquired entities are recorded at their estimated fair values at the date of acquisition. Goodwill represents the excess of the purchase price over the fair value of net assets, including the amount assigned to identifiable intangible assets. Identifiable intangible assets consist of brand names, agency relationships and non-competition agreements. Identifiable intangible assets that are determined to have a finite life are amortized over their useful lives, which range from two to twenty years. The results of operations of acquired businesses are included in our Consolidated Financial Statements from the respective dates of acquisition.
At least annually, we evaluate goodwill and indefinite life intangibles for impairment. Goodwill impairment is based upon: (1) historical financial performance; (2) the most recent financial performance; (3) our financial forecast; (4) information regarding publicly available financial terms of recent transactions in the industry; and (5) other publicly available information.
We reviewed the USAgencies tradename and determined that it had an indefinite useful life. As a result, we no longer amortize the USAgencies tradename. We will test for impairment annually or more frequently if events or changes in circumstances indicate that the asset might be impaired.
Revenue Recognition • Premium income - Premium, net of premiums ceded, is earned over the life of a policy on a pro rata basis. Unearned premiums represent that portion of premiums written that is applicable to the unexpired terms of policies in force. Premiums receivable are recorded net of an estimated allowance for uncollectible amounts.
Profit sharing commissions, which enable us to collect commission income and fees in excess of provisional commissions, are recorded when we conclude it is probable that estimates of loss ratios will be below the levels stated in our agency contracts. Provisional commissions may be reduced when we conclude it is probable that estimates of loss ratios will be above the levels stated in our agency contract.
Fee Income - Policy origination fees, agency and installment fees compensate us for the costs of providing installment payment plans, as well as late payment, policy cancellation, policy rewrite and reinstatement fees. We recognize policy origination fees over the underlying policy terms and recognize other fees on a collected basis when services are provided. Premium finance and origination fees are recognized over the term of the finance contracts.
Losses and Loss Adjustment Expenses • We maintain reserves in the amount of the estimated ultimate liability for unpaid losses and loss adjustment expenses related to incurred claims and our estimate of unreported claims. Our estimation of the ultimate liability for unpaid losses and loss adjustment expenses is based on projections developed by our actuaries using analytical methodology commonly used in the property-casualty insurance industry. Our liabilities stated for unpaid claims and for expenses of investigation and adjustment of unpaid claims are based on: (1) the accumulation of estimates of individual claims for losses reported prior to the close of the accounting period; (2) estimates received from ceding companies, reinsurers and insurance pools and associations; (3) estimates of unreported losses based on past experience; (4) estimates based on past experience of expenses for investigating and adjusting claims; and (5) estimates of subrogation and salvage collections. We periodically adjust our losses and loss adjustment expense reserves for changes in product mix, underwriting standards, loss cost trends and other factors. Our losses and loss adjustment expense reserves may also be impacted by factors such as the rate of inflation, claims settlement patterns, litigation and legislative activities. Unpaid losses and loss adjustment expenses have not been reduced for reinsurance recoverable. Changes in estimates of our liabilities for unpaid losses and loss adjustment expenses are reflected in our consolidated statement of income in the period in which determined. Ultimately, our actual losses and loss adjustment expenses may differ materially from the estimates we have recorded.
Fair Value of Financial Instruments • We disclose the fair values of financial instruments for which it is practicable to estimate the value. Fair value disclosures exclude certain financial assets such as premium receivables, commission receivables, and premium payables as carrying values approximate fair value.
Recently Issued Accounting Standards • In March 2008, the FASB issued SFAS No. 161, Disclosures about Derivative Instruments and Hedging Activities, an amendment to FASB Statement No. 133. SFAS No. 161 amends and expands the disclosure requirements of Statement 133 in order to provide users of financial statements with enhanced disclosures about an entity’s derivative and hedging activities and thereby improving the transparency of financial reporting. To meet these objectives, SFAS No. 161 requires qualitative disclosure about objectives and strategies for using derivatives, quantitative disclosures about fair value amounts of and gains and losses on derivative instruments, and disclosures about credit-risk-related contingent features in derivative agreements. SFAS No. 161 is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008, with early application encouraged. We do not expect SFAS No. 161 to have a material impact on our consolidated results of operations or financial condition.
USAgencies • On January 31, 2007, we completed the acquisition of USAgencies through a fully-financed all cash transaction valued at approximately $199.1 million. Goodwill of $97.8 million was recognized and represents future significant cash flows. The purchase of USAgencies was financed through $200.0 million in borrowings under a $220.0 million senior secured credit facility that was entered into concurrently with the completion of the acquisition. For accounting purposes, the transaction was effective as of January 1, 2007. The operating results of USAgencies have been included in our consolidated financial statements since that effective date.
The estimated fair values and useful lives of assets acquired and liabilities assumed are based on management’s valuation. We completed a valuation study to determine the allocation of the total purchase price to the various assets acquired and liabilities assumed. The final purchase price allocations did not result in material differences in allocations for tangible and intangible assets.
Included in the purchase price allocation are intangible assets subject to amortization totaling $9.8 million, consisting of $1.0 million for a non-competition agreement, $4.7 million of customer relationships, $3.9 million of trade name and $200,000 of lease interest. As of December 31, 2008, these intangible assets had a carrying value of $3.1 million. Goodwill recorded in connection with the acquisition is not deductible for tax purposes. Other intangible assets related to state licenses of $1.7 million are not subject to amortization.
The following table presents unaudited pro forma financial information incorporating the historical (pre-acquisition) financial results of USAgencies (in thousands, except per share amounts). This information has been prepared as if the acquisition of USAgencies had been completed on January 1, 2006 as opposed to the actual date that the acquisition occurred. The unaudited pro forma information is based upon data currently available and certain estimates and assumptions made by management. As a result, this information is not necessarily indicative of the financial results had the transactions actually occurred on this date. Likewise, the unaudited pro forma information is not necessarily indicative of future results.
During 2007 and 2006, we paid $366,000 and $1.1 million, respectively, in contingent purchase price adjustments related to prior acquisitions. In 2006, we also paid $225,000 for the acquisition of two retail stores and $64,000 for the purchase of a franchise.
The amortized cost, realized losses and estimated fair value of our trading securities at December 31, 2008, are as follows (in thousands):
Our investment portfolio consists of fixed-income securities, which are classified as available-for-sale investment securities. Our available-for-sale investment securities are carried at fair value with unrealized gains and losses reported in our financial statements as a separate component of stockholders’ equity on an after-tax basis. The Investment Committee periodically reviews investment portfolio results and evaluates strategies to maximize yields, to match maturity durations with anticipated needs, and to maintain compliance with investment guidelines.
Expected maturities may differ from contractual maturities because certain borrowers may have the right to call or prepay obligations with or without penalties. Our amortized cost and estimated fair value of fixed-income securities at December 31, 2008 by contractual maturity are as follows (in thousands):
Our amortized cost and estimated fair value of pre-refunded municipal bonds at December 31, 2008 by contractual maturity are as follows (in thousands):
Proceeds from sales, maturities, and principal receipts of investment securities were $224.2 million, $178.1 million, and $398.1 million for the years ended December 31, 2008, 2007, and 2006, respectively. Proceeds from investments sold prior to maturity were $150.5 million, $116.1 million, and $161.8 million for the years ended December 31, 2008, 2007, and 2006, respectively. Proceeds from investments sold at maturity were $73.7 million, $62.0 million, and $236.3 million for the years ended December 31, 2008, 2007, and 2006, respectively.
In June 2006, the Texas Department of Insurance (TDI) placed VFIC, along with several of its affiliates, into rehabilitation and subsequently into liquidation (except for VIG which remains in rehabilitation). In accordance with the TDI liquidation orders, all VIG subsidiary reinsurance agreements were terminated. Prior to the termination, we assumed various quota-share percentages according to which managing general agents (MGAs) produced the business. With respect to business produced by certain MGAs, we assumed 100% of the contracts. For business produced by other MGAs, our assumption was net after VIG cession to other reinsurers. For this latter assumed business, the other reinsurers and their participation varied by MGA. Prior to the termination of the VIG subsidiary reinsurance agreements, the agreements contained no maximum loss limit other than the underlying policy limits. The ceding company’s retention was zero and these agreements could be terminated at the end of any calendar quarter by either party with prior written notice of not less than 90 days.
Our other significant assumed reinsurance agreement is with 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 MGAs. The county mutual does not retain any of this business and there are no loss limits other than the underlying policy limits. The county mutual reinsurance agreement may be terminated by either party upon prior written notice of not less than 90 days. In the event of such termination, the MGA agrees that for ten years the MGA shall produce automobile insurance business in the State of Texas solely for the benefit of the county mutual. The county mutual reinsurance agreement automatically terminates on January 1, 2014. AIC has established a trust to secure our obligation under this reinsurance contract with a balance of $24.8 million as of December 31, 2008.
At December 31, 2008, $12.4 million was included in reserves for losses and loss adjustment expenses that represented the amounts owed from AIC and Insura under reinsurance agreements with the VIG affiliated companies, including Hawaiian Insurance and Guaranty Company, Ltd (Hawaiian). Affirmative established a trust account to collateralize this payable, which currently holds $22.9 million (including accrued interest) in securities (the AIC Trust). The AIC Trust has not been drawn upon by the SDR in Texas or the SDR in Hawaii. It is the expectation that the terms for withdrawal of funds from the AIC trust will be similar to those we expect to be agreed to in regards to the VFIC Trust.
Effective August 1, 2005, we entered into novation agreements with several unaffiliated reinsurers who participated in a quota-share reinsurance agreement in which we also participated. Pursuant to these agreements, we were substituted in place of these reinsurers assuming all rights, interests, liabilities and obligations related to the original quota-share reinsurance agreement. As a result of these novation agreements, our participation in the original reinsurance agreement increased from 5% to 100% effective August 1, 2005. In consideration for our assumption of their liabilities, these reinsurers agreed to pay us an amount equal to their share of the liabilities under the original quota-share agreement as of July 31, 2005. The terms of this reinsurance agreement did not meet the risk transfer requirements according to SFAS No. 113; therefore, this contract was accounted for as deposits according to the guidelines of SOP 98-7, Deposit Accounting for Insurance and Reinsurance Contracts that do not Transfer Insurance Risk. If the estimated deposit liabilities are less than the recorded liabilities, we record excess deposit liabilities as income based on a percentage of actual paid losses. We believe that this methodology approximates the effective interest method prescribed in SOP 98-7. Changes in the carrying amount of the deposit liability should be reported as income or expense as appropriate. We received cash in the amount of $14.2 million in relation to this novation. The deferred gain initially totaled $1.8 million, of which we recognized $0.1 million, $0.4 million, and, $0.7 million in income for the years ended December 31, 2008, 2007, and 2006, respectively.
Policy acquisition costs, consisting of primarily commission, advertising, premium taxes, underwriting and agency expenses, are deferred and charged against income ratably over the terms of the related policies. The components of deferred policy acquisition costs and the related policy acquisition expenses amortized to expense were as follows (in thousands):
Other intangible assets at December 31, 2008 and 2007 were as follows (in thousands):
The $30.9 million notes payable due 2035 are redeemable in whole or in part by the issuer after five years. The notes were issued in December 2004 and bear an initial interest rate of 7.545 percent until December 15, 2009, at which time the securities will adjust quarterly to the three-month LIBOR rate plus 3.6 percent.
The principal amount of the term loan is payable in quarterly installments of $348,665, with the remaining balance due on the seventh anniversary of the closing of the facility. Beginning in 2008, we were also required to make additional annual principal payments that are to be calculated based upon our financial performance during the preceding fiscal year. In addition, certain events, such as the sale of material assets or the issuance of significant new equity, necessitate additional required principal repayments.
The interest rate is determined at the beginning of each interest period based on the Alternative Base Rate (ABR) or the Adjusted Libor Rate as defined in the credit agreement. The ABR is the greater of (a) the prime rate plus 2.50% or (b) the federal funds rate plus 3.00%. The Adjusted Libor Rate is the one, two, three or six month Libor rate plus a margin of 3.50%. The interest rate on the borrowings under the facility at December 31, 2008 was 6.12%, as determined by using the applicable Libor rates plus a margin of 3.50%.
On March 27, 2009, we entered into an amendment to the facility. The amendment included the following changes:
Tax effects of temporary differences that give rise to significant portions of our deferred tax assets and deferred tax liabilities at December 31, 2008 and 2007 were as follows (in thousands):
The following table summarizes our minimum future IT outsourcing and operating lease commitments at December 31, 2008 (in thousands):
We and our subsidiaries are named from time to time as parties in various legal actions arising in the ordinary course of our business and arising out of or related to claims made in connection with our insurance policies and claims handling. We believe that the resolution of these legal actions will not have a material adverse effect on our financial position or results of operations. However, the ultimate outcome of these matters is uncertain.
In December 2003, InsureOne Independent Agency, LLC (InsureOne), American Agencies General Agency, Inc. and Affirmative Insurance Holdings, Inc. brought action in the Circuit Court of Cook County, Illinois to enforce non-compete and non-solicitation agreements entered into with James Hallberg, the former president of InsureOne, a wholly-owned subsidiary, and eight former employees of InsureOne and two of Hallberg’s family trusts. On November 21, 2008, the Court entered a Memorandum Order and Judgment, which was amended on January 20, 2009, entering judgment in favor of InsureOne Independent Agency, LLC, American Agencies General Agency, Inc. and Affirmative Insurance Holdings, Inc., awarding us $7.7 million, plus reasonable attorneys’ fees and costs. The Court also entered judgment in favor of James Hallberg on a counterclaim, awarding him $130,168, plus attorneys’ fees and costs.
In October 2002, the named plaintiff Nickey Marsh filed suit in the Fourth Judicial District Court of Louisiana against USAgencies alleging that certain adjustments to the actual cash value of his total loss automobile claim were improper. In October 2003, the action was amended to a class action and the court certified the class in August 2006. On March 3, 2009, we executed a settlement agreement with the plaintiff which, subject to class notice and final court approval, will resolve this proceeding. Pursuant to the terms of the Acquisition Agreement between us and USAgencies, the selling parties are bound to indemnify us from any and all losses attendant to claims arising out of the Marsh litigation out of a sum placed into escrow specifically for such purpose.
Affirmative Insurance Company is a party to a 100% quota-share reinsurance agreement with Hawaiian Insurance and Guaranty Company, Ltd (Hawaiian), which is ultimately a wholly-owned subsidiary of VIG. In November 2004, Hawaiian was named among a group of four other named defendants and twenty unnamed defendants in a complaint filed in the Superior Court of the State of California for the County of Los Angeles alleging causes of action as follows: enforcement of coverage under Hawaiian’s policy of an underlying default judgment plaintiff obtained against Hawaiian’s former insured, who was denied a defense in the underlying lawsuit due to his failure to timely pay the Hawaiian policy premium; ratification and waiver of policy lapse and declaratory relief against Hawaiian; breach of implied covenant of good faith and fair dealing against Hawaiian with the plaintiff as the assignee of the insured; intentional misconduct as to the defendant SCJ Insurance
Services (SCJ); and professional negligence as to the defendants Prompt Insurance Services, Paul Ruelas, and Anthony David Medina. SCJ, Prompt Insurance Services, Paul Ruelas, and Anthony David Medina are not affiliated with AIC. The plaintiff sought to enforce an underlying default judgment obtained against Hawaiian’s insured in September 2004 in the amount of $35.0 million and additional bad faith damages including punitive damages in the amount of $35.0 million. In August 2005, plaintiff served a copy of its Second Amended Complaint, which added a cause of action for fraud and deceit against all defendants, and a cause of action for negligent misrepresentation against Hawaiian and SCJ.
In October 2006, The Court of Appeal of the State of California, Second Appellate District, Division Five, granted the stay order requested by Hawaiian. In December 2006, the court modified its October 2006 stay order by lifting it as to SCJ, causing the suit to proceed with SCJ as the sole defendant. Hawaiian filed a status update with the court in March 2007, indicating that the liquidation proceeding for Hawaiian remained pending and in full force and effect. On March 15, 2007, plaintiff moved the Court of Appeal to lift the stay and that motion was denied. On March 27, 2007, plaintiff filed a petition with the Supreme Court of California for review of the Court of Appeal’s order denying plaintiff’s motion to lift the stay, and in July 2007, the Supreme Court of California denied that petition. At this time, we are uncertain of the probability of the outcome of plaintiff’s appeal and therefore cannot reasonably estimate the ultimate liability.
Stock options outstanding and exercisable at December 31, 2008 were as follows (shares in thousands):
The stock options outstanding and exercisable at December 31, 2008 had aggregate intrinsic values of zero as the aggregate exercise price was greater than the aggregate market value. No stock options were exercised during 2008. Stock options exercised during 2007 and 2006 had an aggregate intrinsic value of $110,000 and $456,000, respectively.
The outstanding vested restricted stock awards had an aggregate intrinsic value of $213,000 at December 31, 2008.
We recognized total compensation expense related to the restricted stock awards of $377,000, $375,000 and $46,000 during 2008, 2007 and 2006, respectively. Compensation expense is included in selling, general and administrative expenses in the consolidated statement of income. As of December 31, 2008, there was approximately $908,000 of total unrecognized compensation cost related to unvested restricted stock awards which will be recognized over a weighted average period of approximately 2.8 years.
As part of the terms of the acquisition of AIC and Insura, VIG has indemnified us for any losses due to uncollectible reinsurance related to reinsurance agreements entered into with unaffiliated reinsurers prior to December 31, 2003. As of December 31, 2008, all such unaffiliated reinsurers had A.M. Best ratings of “A-” or better with a reinsurance recoverable of $3.4 million.
We lease nine of our Insure One retail stores in Illinois from ATR Investments, LLC or entities controlled by ATR Investments. The former president of our retail division, Alan T. Rasof, is the sole owner and manager of ATR Investments. These nine leases have terms ranging from 2 months to 3 years and expiration dates ranging from 2009 to 2011 with total rent due of approximately $678,000. The leases provide for monthly rental ranging from $2,700 to $6,300. During 2007, we made total related party rental payments to ATR Investments of an insignificant amount due to Mr. Rasof’s resignation on March 6, 2007 from Affirmative Insurance, at which time Mr. Rasof was no longer a related party. During 2006, we made total rent payments to ATR Investments of approximately $137,000. In some instances, we also engaged Captain Management Services, Ltd. to remodel our retail store locations. Captain Management is wholly-owned by Mr. Rasof. For the years ended December 31, 2007 and 2006, we paid Captain Management an insignificant amount and approximately $352,000, respectively, relating to remodeling and build out services performed for 15 of our retail locations in Illinois and Indiana. We were a party to a consulting agreement with ATR Investments from June 1, 2006 through October 8, 2006 pursuant to which ATR Investments provided us with certain consulting services, including, without limitation, marketing, management and operational services relating to new and existing and competitor retail store locations and developing retail location site selection criteria. We did not pay ATR Investments and Captain Management Services any consulting fees in 2008 and an insignificant amount in 2007. In 2006, we paid ATR Investments and Captain Management Services an aggregate amount of $135,000 for consulting services.
In connection with the Lease, KRCC had procured a Letter of Credit in favor of the Landlord in the amount of $293,257 as a security deposit against KRCC’s obligations under the Lease. In connection with the Assignment, Affirmative Property agreed to replace KRCC’s Letter of Credit at a future date with a Letter of Credit of like amount issued in favor of the Landlord on Affirmative Property’s behalf. In May 2007, Affirmative Insurance Holdings, Inc. entered into an irrevocable Letter of Credit in favor of the Landlord in the amount of $293,257 as a replacement for the KRCC Letter of Credit.
Any failure by one of our insurance company subsidiaries to meet the applicable risk-based capital or minimum statutory capital requirements imposed by the laws of Illinois, Louisiana, Michigan, and New York or other states where we do business could subject it to further examination or corrective action imposed by state regulators, including limitations on our writing of additional business, state supervision or liquidation. Any changes in existing risk-based capital requirements or minimum statutory capital requirements may require us to increase our statutory capital levels, which we may be unable to do. As of December 31, 2008, each of our insurance company subsidiaries maintained a risk-based capital level in excess of an amount that would require any corrective actions.
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, 2008, our insurance companies could not pay ordinary dividends to us without prior regulatory approval due to a negative unassigned surplus position. However, as mentioned previously, our nonregulated entities provide adequate cash flow to fund their own operations. Dividend payments of $7.3 million were received from our insurance company subsidiaries in 2008. In February 2009, we obtained approval from the New York Department of Insurance for one of our insurance subsidiaries to retire one million shares of its stock for $2.9 million and approved payment of an extraordinary dividend for $100,000.
The majority of our commission income and fees are directly related to the premiums written through our insurance subsidiaries from policies sold to individuals located in certain states. Accordingly, we could be adversely affected by economic downturns, natural disasters, and other conditions that may occur from time-to-time in these states.
The Company evaluates the various types of financial assets and liabilities to determine the appropriate fair value hierarchy based upon trading activity and the observability of market inputs. The Company employs control processes to validate the reasonableness of the fair value estimates of its assets and liabilities, including those estimates based on prices and quotes obtained from independent third-party sources. The Company’s procedures generally include, but are not limited to, initial and on going evaluation of methodologies used by independent third-parties and monthly analytical reviews of the prices against current pricing trends and statistics.
global credit and capital market are not readily available. The fair value of these securities is estimated using third-party valuation sources.
The Company’s Level 3 financial liabilities are interest rate swaps. The fair value of these swaps are determined by quotes from brokers that are not considered binding.
Fair value measurements for assets in category Level 3 as of December 31, 2008 were as follows (in thousands):
Fair values represent our best estimates and may not be substantiated by comparisons to independent markets and, in many cases, could not be realized in immediate settlement of the instruments. Certain financial instruments and all non-financial instruments are not required to be disclosed. Therefore, the aggregate fair value amounts presented do not purport to represent our underlying value. Certain nonfinancial assets and nonfinancial liabilities have not been disclosed at their fair values. The following financial liabilities are not required to be recorded at fair value but their fair value is being disclosed.
Notes payable - The fair value of the notes payable based on third-party valuation sources is estimated to be $26.3 million.
Our insurance subsidiaries are required to file statutory-basis financial statements with state insurance departments in all states where they are licensed. These statements are prepared in accordance with accounting practices prescribed or permitted by the applicable state of domicile. Each state of domicile requires that insurance companies domiciled in those states prepare their statutory-basis financial statements in accordance with the National Association of Insurance Commissioners Accounting Principles and Procedures Manual subject to any deviations prescribed or permitted by the insurance commissioner in each state of domicile.
The following is a summary of our unaudited quarterly consolidated results of operations for the years ended December 31, 2008 and 2007 (in thousands, except per share data):
At December 31, 2008, we served as the franchisor for thirty-three operating franchise stores located in Florida under the Fed USA brand name. Our franchising operations generate minimal revenues and therefore do not have a significant impact on our consolidated operating results. We are engaged in our franchise business primarily for the purpose of creating additional sales locations for the generation of insurance and ancillary product revenues, as opposed to seeking revenues from franchise or royalty fees. We include initial franchise fees and royalty payments that we collect and receive from our franchisees as part of our reported revenues relating to commission income and fees in our financial statements.