As of December 31, 2007, we leased an aggregate of approximately 423,074 square feet of office space for our agencies, insurance companies and retail stores in various locations throughout the United States. The office space includes two leases for approximately 65,527 aggregate square feet of office space in a common building in Burr Ridge, Illinois. One Burr Ridge lease is for approximately 56,875 square feet of office space, and has a term that expires in November 2016. The other Burr Ridge lease is for approximately 8,652 square feet of office space, and has a term that expires in March 2009. We lease approximately 56,888 square feet of office space in Addison, Texas, and our Addison lease term expires in March 2010. We also lease approximately 26,370 aggregate square feet of office space in a common building in Baton Rouge, Louisiana. One Baton Rouge lease is for approximately 20,117 square feet of office space, and has a term that expires in September 2012. The other Baton Rouge lease is for approximately 6,253 square feet of office space, and has a term that expires in March 2010. In addition, we have 221 owned retail stores that presently lease space on an individual basis at various locations in the states in which we do business. None of these individual retail store leases are material to our operations.
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, 2007, 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.
Incurred Loss Development - We use historical case incurred loss and loss adjustment expense (i.e., the sum of cumulative loss and loss adjustment expense payments plus outstanding case loss reserves) over discrete periods of time to estimate future losses. Incurred development methods assume that the case loss and loss adjustment expense reserving practices are consistently applied over time.
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 claims frequency, claim 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.
We determined that our historical loss and LAE reserve development does not provide the most reasonable indication of the potential variability associated with our reserves. Accordingly, we performed a sensitivity analysis of our loss and LAE reserve estimates based on potential variability of our carried loss reserves by accident period.
The variability surrounding the carried loss reserves diminishes for each accident period as the current accident year contains the greatest proportion of losses that have not been reported or settled, and these elements must be estimated as of the current reporting date. The proportion of losses with these characteristics diminishes in subsequent years. Applying a 95% confidence interval based on our paid loss development factors we have determined that the combined effects of adjustments to the initial estimate for loss reserves produce a range of -6.09% to 4.70%.
Historically, one of the factors we have considered in the course of estimating our reserves has included the input of several reinsurance companies, which we have used in determining our initial provisional (expected) loss ratio to book the current treaty year loss ratio. Typically, this ratio has been monitored for adequacy, but not adjusted until 12 months after the beginning of each treaty period. At the time this process was implemented, we had a nominal amount of prior year experience to project ultimate loss reserves, which differed significantly by program. Additionally, we were in the process of developing a consistent set of practices within our claims organization, which reduced our ability to rely on historical patterns. As a result, we placed more weight on initial projected loss ratios than we do presently.
As more information has become available regarding the incurred and paid loss development patterns underlying these periods, the loss development patterns have proven reliable and the reserves have been adjusted to reflect the developed projected results.
The favorable loss development during the past two years has thus been a result of better loss reserve experience than initially expected on these earlier periods.
We conduct regular reviews to assess whether our investments are impaired and if any impairment is other than temporary. Factors considered by us in assessing whether an impairment is other than temporary include the credit quality of the investment, the duration of the impairment, our ability and intent to hold the investment until recovery or maturity and overall economic conditions. If we determine that the value of any investment is other-than-temporarily impaired, we record a charge against earnings in the amount of the impairment.
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 will be effective for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years. We do not expect SFAS No. 157 to have a material impact on our results of operations or financial condition.
The market conditions that existed for the past several years continued in 2007 putting downward pressure on industry rate levels. Our insurance company subsidiaries have continued developing and introducing new and
Premiums. One measurement of our performance is the level of gross premiums written and a second measurement is the relative proportion of premiums written through our three distribution channels. The following table displays our gross premiums written by distribution channel for the years ended December 31, 2007, 2006 and 2005 (in thousands):
Total gross premiums written for 2007 increased $156.5 million, or 54.7%, compared with 2006 due to the acquisition of USAgencies, which had $173.1 million of gross premiums written. Excluding the impact of the USAgencies acquisition, gross premiums from our retail agencies decreased $12.3 million, or 14.2%. This decrease was due to competitive pressures, which shifted sales to third-party products in certain markets. 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 only commission income and fees in our retail distribution channel for sales of third-party insurance policies.
In our independent agency distribution channel, gross premiums written for 2007 decreased $2.7 million, or 1.7%, compared with 2006, principally due to decreased production in our Texas, South Carolina and Indiana underwriting agencies, which was partially offset by increased production in our Michigan and Florida operations. We experienced a full year of production in Michigan as a direct writer and the expansion of our distribution channel in Florida through new agent appointments.
The following table displays our net premiums written by distribution channel for 2007, 2006 and 2005 (in thousands):
Net premiums earned for 2006 decreased $9.7 million, or 3.3%, compared with 2005. Net premiums earned on policies sold through our affiliated distribution channels (retail and independent agencies) increased by $5.9 million, or 2.4%. This increase reflected our increased retention of policies compared to the higher level of reinsurance used in prior periods. Net premiums earned on insurance products sold through the unaffiliated underwriting agencies distribution channel decreased by $15.6 million, or 27.9%, compared with 2005.
In connection with the completion of the acquisition of USAgencies, we reevaluated their reinsurance program in light of the capital structure and risk management programs of the larger combined operations. As a result, terms were renegotiated with the reinsurer and a new quota share reinsurance agreement was made effective April 1, 2007, under which the net retention increased from 30% to 75% in Louisiana and from 25% to 75% in Alabama on policies issued in those two states. This quota share agreement expires on December 31, 2008. Concurrently, we exercised our option to terminate the prior quota share contracts on a cut-off basis. A new catastrophe excess of loss reinsurance contract for risks in Alabama and Louisiana was also negotiated and became effective April 1, 2007.
The Michigan Catastrophic Claims Association (MCCA) is a reinsurance facility that covers no-fault medical losses above a specific retention amount. For policies effective July 1, 2007 to June 30, 2008, the required retention is $420,000. As a writer of personal automobile policies in the state of Michigan, we cede premiums and claims to the MCCA. Funding for the MCCA comes from assessments against automobile insurers based upon their proportionate market share of the state’s automobile liability insurance market. Insurers are allowed to pass along this cost to Michigan automobile policyholders. Our ceded premiums written to the MCCA were $3.6 million in 2007 and $1.8 million in 2006. We did not issue policies in Michigan prior to 2006.
Historically, all of our initial quota share reinsurance agreements contained provisions for sliding scale commissions under which the commission paid to us varies with the loss ratio results under each contract. The effect of this feature in the quota share reinsurance agreements is to limit the reinsurers’ aggregate exposure to loss and thereby reduce the ultimate cost to us as the ceding company. These features also have the effect of reducing the amount of protection relative to the quota share amount of premiums ceded by us. Before entering into these reinsurance agreements, and based on our prior operating history, we concluded that each agreement met the risk transfer test of SFAS No. 113 as the reinsurers assume significant risk and have a reasonable possibility of a significant loss.
Commission income and fees are earned by our underwriting agencies on business that is not written or retained by us. We only earn this income when we reinsure a portion of our insurance business to other parties. With the exception of the USAgencies’ reinsurance program that was in place at the date of acquisition, we have substantially eliminated our reinsurance contracts and, as a result, this income source has been almost eliminated. Instead, we generate additional premium on the retained business, increasing our earned premiums. Had we continued to utilize reinsurance to a greater extent, our earned premiums would have been reduced but we would have earned greater commission income and fees for servicing the policies. As a result of the acquisition of USAgencies, a portion of the business written in Louisiana and Alabama was reinsured. In the future, we may choose to increase the use of reinsurance, which could result in an increase in this type of commission income and fees, and a resulting reduction in earned premiums.
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. We can increase or decrease agency and installment fees at will, 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 subsidiary (acquired as part of our acquisition of USAgencies), 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. We expect premium finance revenue to increase significantly in 2008. Franchise and royalty fees are earned from our franchised stores in Florida, but are not significant to our financial results.
Commission income and fees increased $27.1 million, or 44.4%, in 2007 compared with 2006. The increase is primarily attributable to the addition of income from policyholder and premium finance fees from USAgencies. Commission income and fees on non-retained business has continued to decline as policies that were reinsured in prior periods expire.
Total commission income and fees for 2006 decreased $18.6 million, or 23.4%, compared with 2005. This decrease was primarily related to our increased retention of business written and assumed. In our agencies, we earn commission income and fees that are based on premiums earned in the current period but written in both current and prior periods. In consolidation, we eliminate our agencies’ commission income and fees based on business that our insurance companies retain against our agencies’ expenses. Therefore, when we retain a higher percentage of our written premiums, we eliminate a greater portion of our agencies’ commission income and fees. The reduction in agency fees during 2006 resulted in a reduction of approximately $3.2 million in agency fees in 2006 compared with 2005.
Net investment income for 2007 increased $7.6 million, or 86.2%, compared with 2006. The increase was primarily due to a 45.4% increase in total average invested assets to $332.2 million during 2007 from $228.5 million during 2006, as a result of the acquisition of USAgencies. The average investment yield was 3.59% (5.05% on a taxable equivalent basis) in 2007 as compared to 3.70% (5.33% on taxable equivalent basis) in 2006.
Losses and Loss Adjustment Expenses. Losses and loss adjustment expenses for 2007 increased $97.4 million, or 52.6%, compared with 2006. The increase was primarily due to the acquisition of USAgencies. The percentage of losses and loss adjustment expense to net premiums earned was 71.4% in 2007 compared with 64.3% in 2006. The increase in loss ratio is due to three factors. The 2007 loss ratio reflects an increase compared with 2006 due to a positive, single digit loss trend accompanied by a declining average rate level attributable to selected rate and product changes. Policies written by USAgencies, which were designed with a higher loss ratio than the policies of our other insurance companies, have caused the average loss ratio to increase. Finally, we saw a lower amount of favorable loss development in the current period resulting from the reevaluation of the loss ratio expected on premiums earned prior to 2007 than we experienced in 2006.
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.
Selling, General and Administrative Expenses. Another measurement of our performance that addresses our overall efficiency is the level of selling, general and administrative expenses. We recognize that our customers are primarily motivated by low prices. As a result, we strive to keep our costs as low as possible to be able to keep our prices affordable and thus to maximize our sales while still maintaining profitability. Our selling, general and administrative expenses include not only the cost of acquiring the insurance policies through our insurance company subsidiaries (the amortization of the deferred acquisition costs) and managing our insurance company subsidiaries and the retail stores, but also the costs of the holding company. The largest component of selling, general and administrative expenses is personnel costs, including payroll, benefits and accrued bonus expenses.
The amortization of deferred acquisition costs as a percentage of net premiums earned decreased in 2007 to 17.7% from 25.6% in 2006. The decrease reflected the mix of business produced by our various distribution channels and the relatively lower level of acquisition costs for USAgencies. In addition, the impact of purchase accounting reduced both the earned premiums and amortization of deferred acquisition costs in 2007. This was due to the deferred acquisition costs for policies in force at the date of acquisition being included in unearned premiums. Due to this accounting treatment in 2007, both premiums and amortization of deferred acquisition costs in 2008 should increase compared with 2007 with no net impact on income.
Other selling, general, and administrative expenses increased $22.1 million, or 28.8%, primarily due to the acquisition of USAgencies. In addition, the implementation of our information technology strategy beginning in the fourth quarter of 2006 resulted in significant costs. During 2006, we developed a comprehensive implementation plan and supporting business case to consolidate and transform our primary business applications onto a new strategic platform. This plan encompassed consolidating and migrating our multiple claims, point-of-sale, policy administration and agency management systems onto single strategic platforms, as well as deploying new premium finance, reporting and business analytics capabilities. For all components of this systems transformation plan, we selected software packages that met our unique needs. We believe this systems transformation will position us to realize significant strategic benefits including: systemic pricing advantage in our marketplace via consolidated and streamlined systems and operations; faster product time to market; additional retail revenue via premium financing; improved claims and underwriting performance via increased automated application of best practice processing rules; a platform to simplify and hasten post-merger and acquisition integration - reducing integration costs and accelerating synergies realization; and improved customer focus and retention. Through December 31, 2007, we capitalized $17.6 million of costs related to the transformation and expensed $3.3 million in 2007. The agency management and premium finance systems were initially implemented in the fourth quarter of 2007 and full implementation was completed in the first quarter of 2008. The insurance systems are expected to be fully implemented during the second half of 2008. The implementation of these systems will result in higher depreciation expense and, in the short-term, additional operating expense as the old systems remain in place. Our strategy is to put business on the new systems prospectively and keep the old systems operating until that business runs off.
Net expenses, defined as the sum of selling, general and administrative expenses and depreciation and amortization less commission income and fees, as a percentage of net premiums earned (the net expense ratio) decreased to 23.3% in 2007 compared with 32.6% in 2006. The decrease is primarily due to a 37.5% increase in net premiums earned and a 44.4% increase in commission income and fees (which reduces the net expenses) resulting from the increase in premium finance fees. These increases were partially offset by a 12.3% increase in selling, general and administrative expenses. The following table sets forth the components of the net expenses and the computation of the net expense ratios for the years ended December 31, 2007, 2006 and 2005 (in thousands):
Selling, general and administrative expenses for 2007 increased $18.4 million, or 12.3%, compared with 2006 largely due to the inclusion of USAgencies’ expenses in our operating results. In addition, other items affecting the comparability of the 2007 results to the 2006 results consisted of $1.9 million in IT costs in 2007 related to our strategic systems transformation project, $785,000 in IT expenses related to the migration of our data center and $280,000 for the write-off of software costs deemed to be of no future value. In addition, we expensed $11.5 million in the current period in connection with the IT outsourcing contract. The combined total of the IT outsourcing expense (which excludes the transformation and data center migration costs) and our continuing IT operating expenses in the current period exceeded the cost of our IT operations in the prior year period by approximately $2.0 million. In the fourth quarter of 2007, a commission liability was reduced by $1.7 million to reflect the appropriate amount of the liability.
(4) In 2006: executive severances of $0.7 million and CEO recruiting fees of $0.1 million. In 2005: executive severances of $2.7 million and CEO recruiting fees of $0.2 million.
Other selling, general and administrative expenses for the year ended December 31, 2006 decreased $11.2 million, or 23.1%, compared with 2005. The decrease in other selling, general and administrative expenses was primarily due to decreased salary and related expenses due to a reduction in workforce, as well as a reduction in advertising and repairs and maintenance expenses. As of December 31, 2006, we employed 942 employees compared with 1,182 as of December 31, 2005.
Depreciation and amortization expenses for 2006 increased $191,000, or 4.5% compared with 2005. Depreciation expense decreased by $374,000 in 2006 from 2005. Amortization expense in 2006 increased $565,000, or 63.7%, compared with 2005. Included in the increase of amortization expense was an increase of $569,000 associated with several non-competition agreements. In the fourth quarter of 2005, we completed non-competition agreements with two former executives that resulted in amortization expense of $885,000 in 2006 compared with only $122,000 in 2005. Conversely, the cost of a non-competition agreement negotiated in
Interest Expense. Interest expense for 2007 increased $20.9 million compared with 2006. The increase in interest expense was due to the debt we incurred for the acquisition of USAgencies. In January 2008, we entered into an interest rate swap with a notional amount of $95.0 million that has been designated as a hedge of variable cash flows associated with our senior secured credit facility. Under this swap, we pay a fixed rate of 3.031% and receive a three-month Libor rate. The notional amount of the swap gradually declines to $45.0 million prior to its expiration. In addition, we repaid $20.0 million of the senior secured credit facility during the first quarter of 2008 prior to this filing.
Income tax expense for 2006 was $2.7 million, or an effective rate of 21.3%, compared with $9.8 million, or an effective rate of 34.0% for 2005. The decrease in our effective rate was primarily due to both an increased level of, and a relative proportion of, tax-exempt income.
insurance companies may pay up to $18.6 million in ordinary dividends to us without prior regulatory approval. However, the maximum dividend capacity is not immediately available in 2008 due to dividend payments of $13.1 million by our insurance company subsidiaries in December 2007.
Without supporting bids from the lead broker-dealers, a substantial number of auctions will continue to fail. It is possible that a secondary market for some of these securities may begin to develop in the near future. However, we may find that our ability to sell our auction-rate securities at auction or in a secondary market may be affected by the characteristics of the specific securities. As a result, it is very likely that it will take us longer to sell these securities if we either want or need to sell the securities.
These changes in market conditions have affected some securities in the auction-rate securities market. It is possible that some securities may be priced below par. We are continuing to closely monitor these market conditions. At this point in time, the failed auctions have not had a significant impact on our liquidity nor are they expected to have a significant impact on our liquidity in the near future.
On January 31, 2007, we entered into a $220.0 million senior secured credit facility (the Facility). The Facility provided a $200.0 million senior term loan facility and a revolving facility of $20.0 million, depending on our borrowing capacity. Beginning in 2008, we are 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, will necessitate additional required principal repayments. As of the date of this filing, we have not borrowed any funds under the revolving portion of the Facility. In the first quarter of 2008, we repaid an additional $20.0 million of the senior term loan prior to this filing.
We have audited the accompanying consolidated balance sheets of Affirmative Insurance Holdings, Inc. and subsidiaries (the Company) as of December 31, 2007 and 2006, and the related consolidated statements of income, stockholders’ equity, comprehensive income, and cash flows for each of the years in the two-year period ended December 31, 2007. 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.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Affirmative Insurance Holdings, Inc. and subsidiaries’ internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 14, 2008 expressed an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.
We have audited Affirmative Insurance Holdings, Inc. and its subsidiaries’ (the Company) internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Controls over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.
To the Board of Directors and Shareholders of Affirmative Insurance Holdings, Inc.:
Investments • Investment securities are classified as available-for-sale investment securities and reported at fair value, generally based on quoted market prices, with unrealized gains and losses excluded from earnings and reported as a separate component of stockholders’ equity, net of deferred income taxes.
Investments are considered to be impaired when a decline in fair value is judged to be other-than-temporary. On a quarterly basis, we consider available quantitative and qualitative evidence in evaluating potential impairment of our investments. If the cost of an investment exceeds its fair value, we evaluate, among other factors, general market conditions, the duration and extent to which the fair value is less than cost, and our intent
Premium Finance Receivable • We recognize interest and origination fees from finance receivables. Late fee revenue is recognized when received. Interest is accrued on finance receivables.
Property and Equipment • Property and equipment is stated at cost, less accumulated depreciation. Depreciation is computed for property and equipment, excluding leasehold improvements, using the straight-line method over the estimated useful lives of our assets, typically ranging from three to five years. Leasehold improvements are depreciated using the straight-line method over the shorter of the useful life or the remainder of the lease term.
Commission income - Commission income and related policy fees, written for unaffiliated insurance companies, are recognized, net of an allowance for estimated policy cancellation, at the date the customer is initially billed or as of the effective date of the insurance policy, whichever is later. Commissions on premium endorsements are recognized when premiums are processed. Our allowance for estimated third-party allowance cancellations is periodically evaluated and adjusted as necessary.
Fee Income - Fee income includes policy origination fees, premium finance fees, agency and installment fees to compensate us for the costs of providing installment payment plans, as well as late payment, policy cancellation, policy rewrite and reinstatement fees. We recognize policy origination fees over the premium earning period of the underlying policies and recognize all other fees on a collected basis.
Lease Expense • For long-term real estate leases, we estimate future rate increases to compute a straight-line monthly expense over the term of the lease. Our operating lease rental expenses were $10.2 million, $8.9 million, and $8.3 million for the years ended December 31, 2007, 2006, and 2005, respectively.
Prior to January 1, 2006, we accounted for stock-based payments to employees using Accounting Principles Board Opinion No. 25’s intrinsic value method and, as such, generally recognized no compensation cost on grants of employee stock options.
Income Taxes • Deferred federal income taxes reflect the future tax differences between the tax basis of assets and liabilities and amounts recorded for financial reporting purposes. Recorded amounts will be adjusted to reflect changes in income tax rates for the period in which the change is enacted.
Beginning January 1, 2007, we have accounted for uncertainty in income taxes recognized in the financial statements in accordance with FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes (FIN 48). FIN 48 requires that a more-likely-than-not threshold be met before the benefit of a tax position may be recognized in the financial statements and prescribes how such benefit should be measured. It also provides guidance on derecognition, classification, accrual of interest and penalties, accounting in interim periods, disclosure and transition. It requires that the new standard be applied to the balances of assets and liabilities as of the beginning of the period of adoption and that a corresponding adjustment be made to the opening balance of retained earnings. As a result of the adoption, we recognized no additional liability or reduction in deferred tax asset for unrecognized tax benefits. We are no longer subject to federal, state, local or non-US income tax examinations by tax authorities for years prior to 2004. While we typically do not incur significant interest or penalties on income tax liabilities, our policy is to classify those amounts as administrative expense. We did not change our policy on classification of interest and penalties on income tax liabilities upon adoption of FIN 48.
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 instruments such as premium receivables, commission receivables, and premium payables when carrying values approximate our fair value.
Statutory accounting practices • We are required to report our results of operations and financial position to insurance regulatory authorities based upon statutory accounting practices (SAP). One significant difference between SAP and GAAP is that under SAP, we are required to expense all sales and other policy acquisition costs as they are incurred rather than capitalizing and amortizing them over the expected life of the policy as required by GAAP. The immediate charge off of sales and acquisition expenses and other conservative valuations under SAP generally cause a lag between the sale of a policy and the emergence of reported earnings. Since this lag can reduce our income from operations on a SAP basis, it can have the effect of reducing the amount of funds available for dividends from insurance companies. A second significant difference is that under
SAP, certain assets are designated as “nonadmitted” and are charged directly to unassigned surplus, whereas under GAAP, such assets are included in the balance sheet net of an appropriate valuation reserve. A third significant difference between SAP and GAAP is that SAP requires available-for-sale investments be carried at amortized book value while GAAP requires available-for-sale investments be carried at fair value.
USAgencies • On January 31, 2007, we completed the acquisition of USAgencies through a fully-financed all cash transaction valued at approximately $199.1 million. The goodwill of $97.8 million 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, so the operating results of USAgencies have been included in our consolidated financial statements since that effective date.
The following table summarizes the allocation of the purchase price (in thousands):
Our investment portfolio consists of fixed-income securities, which are classified as available-for-sale investment securities and are carried at fair value with unrealized gains and losses reported in our financial statements as a separate component of stockholders’ equity on an after-tax basis. Our Investment Committee reviewed our investment portfolio in December 2005 and decided to realign a portion of our investment portfolio in order to better align our portfolio with our historical claims life. We determined that the identified securities would not fully recover prior to the expected sale date, therefore the securities were deemed other-than-temporarily impaired in December 2005 when the decision to sell was made. The identified securities were in compliance with our investment guidelines prior to the review by the Investment Committee.
The amortized cost, gross unrealized gains (losses) and estimated fair value of our investments at December 31 are as follows (in thousands):
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, 2007 by contractual maturity are as follows (in thousands):
At December 31, 2007, we owned approximately $17.8 million of pre-refunded municipal bonds. These pre-refunded municipal bonds have contractual maturities in excess of ten years. However, due to pre-refunding, these securities will be called by the issuer generally within three years or less. Pre-refunded municipal bonds are created when municipalities issue new debt to refinance debt issued when interest rates were higher. Once the refinancing is completed, the issuer uses the proceeds to purchase U.S. Treasury securities and places these securities in an escrow account. These proceeds are then used to pay interest and principal on the original debt until the bond is called. Our amortized cost and estimated fair value of pre-refunded municipal bonds at December 31, 2007 by contractual maturity are as follows (in thousands):
Major categories of net investment income for the years ended December 31 are summarized as follows (in thousands):
Proceeds from sales, maturities, and principal receipts of bonds were $178.1 million, $398.1 million, and $7.8 million for the years ended December 31, 2007, 2006, and 2005. Proceeds from investments sold prior to maturity were $116.1 million, $161.8 million, and $4.4 million for the years ended December 31, 2007, 2006, and 2005, respectively. Proceeds from investments sold at maturity were $62.0 million, $236.3 million, and $3.4 million for the years ended December 31, 2007, 2006, and 2005, respectively.
The following table shows our investments with gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position at December 31, 2007 and 2006 (in thousands):
Our portfolio contains only highly-rated, fixed-income securities. For fixed-income securities with unrealized losses due to market conditions, we have the positive intent and ability to hold the investment for a period of time sufficient to allow a market recovery or to maturity. Management did not believe any unrealized losses represent an other-than-temporary impairment based on our evaluation of available evidence at December 31, 2007.
Under certain of our reinsurance transactions, we have received ceding commissions. The ceding commission rate structure varies based on loss experience. The estimates of loss experience are continually reviewed and adjusted, and the resulting adjustments to ceding commissions are reflected in current operations. The ceding commissions recognized are reflected as a reduction of the following expenses for the year ended December 31, 2007 (in thousands):
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 (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, 2007, 2006 and 2005 (in thousands):
At December 31, 2007, our total receivables from reinsurers were $66.8 million, consisting of $36.2 million from a quota share reinsurer (rated A- by A.M. Best) for business reinsured in Louisiana and Alabama, $13.5 million net receivable (net of $3.6 million payable) from subsidiaries of Vesta Insurance Group (VIG), including primarily Vesta Fire Insurance Corporation (VFIC), $12.4 million receivable from the Michigan Catastrophic Claims Association, the mandatory reinsurance association in Michigan and $4.7 million receivables from other reinsurers. Under the reinsurance agreement with VFIC, AIC had the right, under certain circumstances, to require VFIC to provide a letter of credit or establish a trust account to collateralize the gross amount due AIC and Insura Property and Casualty Insurance Company from VFIC under the reinsurance agreement. Accordingly, AIC, Insura and VFIC entered into a Security Fund Agreement effective September 1, 2004. On August 30, 2005, AIC received a letter from VFIC’s President that irrevocably confirmed VFIC’s duty and obligation under the Security Fund Agreement to provide security sufficient to satisfy VFIC’s gross obligations under the reinsurance agreement (the VFIC Trust). At December 31, 2007, the VFIC Trust held $18.4 million (after AIC’s first withdrawal of $5.8 million from the VFIC Trust in the fourth quarter of 2007) to collateralize the $17.1 million gross recoverable from VFIC.
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.
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
The guidance used in determining whether reinsurance contracts contain elements of risk transfer necessary to use reinsurance accounting is stated in paragraph 9 of SFAS No. 113. This paragraph provides that a reinsurer shall not be considered to have assumed significant insurance risk under the reinsurance contract if the probability of a significant variation in either the amount or timing of payments by the reinsurer is remote. SFAS No. 113 specifically provides that whenever a reinsurance contract does not transfer risk, then that reinsurance contract must be accounted for as a deposit-type reinsurance contract.
Effective October 1, 2005, we entered into commutation agreements with several unaffiliated reinsurers who participated in a quota share reinsurance agreement in which we were the direct writer. Pursuant to these agreements, we were substituted in place of these reinsurers assuming all rights, interests, liabilities and obligations related to the original quota share reinsurance agreement. In consideration for our assumption of their liabilities, these reinsurers agreed to pay us an amount equal to their share of the liabilities under the original quota share agreement as of September 30, 2005. We received $9.5 million in relation to the assumption of $9.5 million in policy liabilities. Accordingly, no profit or loss was recognized as a result of these commutation agreements.
Finance receivables, which are secured by unearned premiums from the underlying insurance policies, consisted of the following at December 31, 2007 (in thousands):
Depreciation expense was $5.4 million, $2.9 million, and $3.3 million for the years ended December 31, 2007, 2006 and 2005, respectively.
During the fourth quarter of 2005, we determined that the outside vendor used to develop our new enterprise system had not met the terms of the development and license agreement and had breached the contract. We also determined that we would not be able to obtain any benefit from our investment in this project. We have since initiated litigation and are seeking relief to the full extent possible. As a result, a $2.4 million impairment loss related to this project was recorded in 2005.
Changes in the carrying value of goodwill for the year ended December 31, 2007 and 2006 were as follows (in thousands):
Amortization expense for the intangible assets is as follows (in thousands):
Amortization expense will be recognized over a weighted-average period of approximately 13.1 years for agency relationships, 2 years for trade names, and one year for non-competition agreements. The total weighted average period of amortization is 10.2 years.
We had favorable reserve development relating to prior year losses of $5.0 million, $5.2 million and $8.7 million in 2007, 2006 and 2005, respectively. These reserve redundancies resulted from decreased estimates of the ultimate liability for losses and related loss adjustment expense for claims reported in previous periods.
Our long-term debt instruments and balances outstanding at December 31, 2007 and 2006 were as follows (in thousands):
In 2007, we entered into a $220.0 million senior secured credit facility (the Facility) provided by a syndicate of lenders that provide for a $200.0 million senior term loan facility, which we immediately borrowed under a term loan, and a revolving facility of up to $20.0 million, depending on our borrowing capacity. As of December 31, 2007, we have no borrowings under the revolving portion of the Facility. 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 contains certain financial covenants, which include 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. As time passes, certain of the financial covenants become increasingly more restrictive. At December 31, 2007, we were in compliance with all of our financial and other covenants.
The principal amount of the term loan is payable in quarterly installments of $500,000, with the remaining balance due on the seventh anniversary of the closing of the Facility. Beginning in 2008, we are also required to make additional annual principal 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, 2007 was 8.42%, as determined by using the applicable Libor rates plus a margin of 3.50%.
Effective April 30, 2007, we entered into an interest rate swap with a notional amount of $50.0 million that was designated as a hedge of variable cash flows associated with that portion of the Facility. This derivative instrument requires quarterly settlements whereby we pay a fixed rate of 4.993% and receive a three-month Libor rate. The derivative expires on April 30, 2011. We utilize the hypothetical derivative methodology for the measurement of ineffectiveness. Derivative gains and losses not effective in hedging the expected cash flows are recognized immediately in earnings. There were no components of the derivative instrument that were excluded from the assessment of hedge effectiveness.
Tax effects of temporary differences that give rise to significant portions of our deferred tax assets and deferred tax liabilities at December 31, 2007 and 2006 are as follows (in thousands):
In assessing the realizability of deferred tax assets, we consider whether it is more likely than not that some portion or all of our deferred tax assets will not be realized. Our ultimate realization of deferred tax assets is dependent upon our generation of future taxable income during the periods in which those temporary differences become deductible. We have not established a valuation allowance against deferred tax assets, other than discussed below, as we believe it is more likely than not the net deferred tax asset will be realized.
As of December 31, 2007, we have available for income tax purposes approximately $23.0 million in federal net operating loss carryforwards (NOLs), which may be used to offset future taxable income. Our NOLs expire as follows (in thousands):
At December 31, 2007, we have available approximately $2.6 million of capital loss carryforward resulting primarily from sales of securities executed in 2006 and 2007 to realign a portion of our investment portfolio with our historical claims life. This capital loss carryforward, which may be carried forward for five years, may only
be used to offset future realized capital gains. We recorded a valuation allowance for the full amount of the deferred tax asset resulting from this capital loss carryforward. We believe the available objective evidence, principally the capital loss carryforward being utilizable to offset only future capital gains, our current investment strategy, and a lack of significant historical realized capital gains creates sufficient uncertainty regarding the realizability of our capital loss carryforward.
Affirmative Insurance Holdings, Inc. and Affirmative Insurance Company (referred to herein collectively as Affirmative) brought action against Hopson B. Nance, E. Murray Meadows, Paul H. Saeger, Jr., Fred H. Wright, and Does 1-10 in the United States District Court of the Northern District of Alabama, Southern Division, in December 2006 for negligent misrepresentation, fraud, tortious interference with contractual relations, breach of fiduciary duty, negligence and conversion. The case involves an action by Affirmative to recover $7.2 million of
Affirmative Insurance Holdings, Inc. and Affirmative Property Holdings, Inc. brought action against Business Risk Technology, Inc. and Steven M. Repetti (BRT) in the Circuit Court of the 17th Judicial Circuit, Broward County, Florida in January 2006 for fraudulent inducement, breach of contract, breach of the covenant of good faith and fair dealing, and for declaratory and supplemental relief arising from the defendant’s wrongful conduct and contractual breaches. This action involves our enforcement of certain rights under a software license agreement we entered with BRT wherein BRT agreed to develop and provide us with a complete turnkey software system for use by our various affiliates. BRT has asserted counterclaims for breach of contract, unjust enrichment, and fraud. In July 2007, the court granted summary judgment in favor of BRT on our breach of contract claim. On February 13, 2008, the court dismissed all of BRT’s counterclaims with prejudice. We expect to go to trial on our fraudulent inducement claim against BRT in the second quarter of 2008.
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. An amending petition, filed in October 2003, made class action allegations, and sought class-wide compensatory damages, attorneys’ fees and punitive damages of $5,000 per claimant. After a class certification discovery and a hearing in February 2006, an order was rendered in August 2006 certifying the class. The Louisiana Second Circuit Court of Appeal subsequently affirmed the trial court’s certification of the class in May 2007. In October 2007, the Louisiana Supreme Court denied USAgencies’ writ for certiorari. Pursuant to the terms of the Acquisition Agreement between us and USAgencies, the selling parties (the Seller) 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 (the Marsh Litigation Reserve). The Acquisition Agreement provides that the Marsh Litigation Reserve shall not exceed the amount placed into escrow, and that upon the final resolution of the Marsh litigation by (i) a court order that is final and nonappealable or (ii) a binding settlement agreement, and the determination of all amounts to be paid with respect to Marsh litigation (the Marsh Payments), the amount constituting the Marsh Payments shall be paid out of the Marsh Litigation Reserve to us
In May 2004, our board of directors adopted and our stockholders approved the 2004 Stock Incentive Plan (2004 Plan) to enable us to attract, retain and motivate eligible employees, directors and consultants through equity-based compensatory awards, including stock options, stock bonus awards, restricted and unrestricted stock awards, performance stock awards, stock appreciation rights and dividend equivalent rights. The maximum number of shares of common stock reserved for issuance under the 2004 Plan, as amended, is 3,000,000, subject to adjustment to reflect certain corporate transactions or changes in our capital structure. At December 31, 2007, 993,770 shares were reserved for future grants under the 2004 Plan.
Under the 2004 Plan, the board or committee may fix the term and vesting schedule of each stock option, but no incentive stock option will be exercisable more than ten years after the date of grant. Vested stock options generally remain exercisable for up to three months after a participant’s termination of service or up to 12 months after a participant’s death or disability. Typically, the exercise price of each incentive stock option must not be
less than 100% of the fair market value of our common stock on the grant date, and the exercise price of a nonqualified stock option must not be less than 20% of the fair market value of our common stock on the grant date. In the event that an incentive stock option is granted to a 10% stockholder, the term of such stock option may not be more than five years and the exercise price may not be less than 110% of the fair market value on the grant date. The exercise price of each stock option granted under the 2004 Plan may be paid in cash or in other forms of consideration in certain circumstances, including shares of common stock, deferred payment arrangements or pursuant to cashless exercise programs. A stock option award may provide that if shares of our common stock are used to pay the exercise price, additional stock options will be granted to the participant to purchase that number of shares used to pay the exercise price. Generally, stock options are not transferable except by will or the laws of descent and distribution, unless the board or committee provides that a nonqualified stock option may be transferred.
Stock options outstanding and exercisable at December 31, 2007 are summarized as follows (shares in thousands):
The outstanding restricted stock awards had an aggregate intrinsic value of $1.5 million and the outstanding vested restricted stock awards had an aggregate intrinsic value of $452,000 at December 31, 2007.
discretion, match 100% of each employee’s contribution, up to 3% of the employee’s earnings, plus 50% of each employee’s contribution for the next 2% of the employee’s salary. Our total contributions to the 401(k) plan were $952,000 in 2007 and $1.0 million in both 2006 and 2005.
We lease six of our Insure One retail stores in Chicago, Illinois from ATR Investments, LLC or entities controlled by ATR Investments. The former president of our retail division, Alan T. Rasof, is the sole owner and manager of ATR Investments. These six leases have terms ranging from 3 to 4 years and expiration dates ranging from 2007 to 2011 with total rent due of approximately $860,000. The leases relate to properties with square footage ranging from approximately 1,200 to 1,800 square feet and provide for monthly rental ranging from $2,400 to $4,750. 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 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. For the year ended December 31, 2006, we paid ATR Investments and Captain Management Services an aggregate amount of $135,000 for consulting services.
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 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, 2007, each of our insurance company subsidiaries maintained a risk-based capital level in excess of an amount that would require any corrective actions.
State insurance laws restrict the ability of our insurance company subsidiaries to declare stockholder dividends. These subsidiaries may not make an “extraordinary dividend” until 30 days after the applicable commissioner of insurance has received notice of the intended dividend and has not objected in such time or until the commissioner has approved the payment of the extraordinary dividend within the 30-day period. In most states, an extraordinary dividend is defined as any dividend or distribution of cash or other property whose fair market value, together with that of other dividends and distributions made within the preceding 12 months, exceeds the greater of 10.0% of the insurance company’s surplus as of the preceding year-end or the insurance company’s net income for the preceding year, in each case determined in accordance with statutory accounting practices. In addition, an insurance company’s remaining surplus after payment of a dividend or other distribution to stockholder affiliates must be both reasonable in relation to its outstanding liabilities and adequate to its financial needs. In 2008, our insurance companies may pay up to $18.6 million in ordinary dividends to us without prior regulatory approval. However, the maximum dividend capacity is not immediately available in 2008 due to the dividend payments of $13.1 million by our insurance company subsidiaries in 2007.
The majority of our commission income and fees are directly related to the premiums written from policies sold to individuals located in 13 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.
In 2007, we utilized approximately 7,900 independent agents. At December 31, 2007, we had 221 owned retail stores and 35 franchised retail stores selling the policies that we administer. In 2007, our largest independent agency accounted for less than 4% of total gross written premiums, and only two independent agencies accounted for more than 1% of these gross written premiums.
The methods used in determining the fair value of financial instruments are as follows:
Cash and cash equivalents - The fair value of cash and cash equivalents approximates carrying value due to the highly liquid nature of the instruments.
Interest rate swap - The fair value of the interest rate swap is based on dealer prices.
The following is a summary of our unaudited quarterly consolidated results of operations for the years ended December 31, 2007 and 2006 (in thousands, except per share data):
(1) Includes adjustments increasing net income by $787,000, net of tax, which related to prior periods, including $341,000 for the quarter ended June 30, 2007 and $320,000 for the quarter ended September 30, 2007. These adjustments included a $1.7 million pretax reduction of a commission liability, of which $1.2 million pretax related to prior years, offset by various less significant adjustments to receivables and other liabilities. The after-tax effect of all adjustments related to prior years in 2007 was to increase net income by $94,000, which was immaterial to net income, cash flow and stockholders’ equity as of and for the year ended December 31, 2007.
The condensed financial information of the parent company, Affirmative Insurance Holdings, Inc. as of December 31, 2007 and 2006, and for each of the three years ended December 31, 2007, 2006 and 2005 is presented as follows (in thousands, except share data):