(c) The results of the Assumed Agency Business’s operations and its balance sheet data are included in the Infinity figures as of and for the years ended 2006, 2005, 2004 and 2003.
Infinity experienced another successful year in 2006. Book value per share at December 31, 2006 increased to $33.88, an 11.7% increase from that at December 31, 2005, primarily from the contribution of earnings in excess of shareholder dividends. With a return on equity of 13.5% in 2006, Infinity has exceeded its long-term target of 12% each year since going public in 2003. Net earnings and diluted earnings per share were $87.3 million and $4.26, respectively, in 2006 compared to $106.3 million and $5.09 in 2005. Operating earnings, which exclude realized gains on investments, increased 1.7% from $84.4 million in 2005 to $85.9 million in 2006
A decline in realized gains on investments and a 1.3% decline in earned premiums resulted in a 3.0% decline in revenues for 2006 as compared with 2005. During 2005, Infinity sold from its investment portfolio securities to utilize a portion of available tax loss carryforwards which contributed to $22.3 million of net realized gains. As a result of rising interest rates, during 2006 Infinity generated only $2.0 million of net realized gains. Earned premiums declined compared with 2005 primarily as a result of a decline in written premiums during the first six months of 2006.
during the first half of 2006. The growth during the last six months of the year was aided by a 30.0% growth in California during the fourth quarter of 2006, which is believed to be largely a result of the implementation of electronic enforcement of compulsory insurance laws. Infinity also had strong growth in Arizona, Georgia and Texas during the last six months of 2006.
(See Note 1 of the Consolidated Financial Statements, “Reporting and Accounting Policies”)
Where deviations from historical trends in these key areas exist, when possible, quantitative and qualitative modifications to, or selections of, such factors are made to reflect such deviations. Management analyzes the adequacy of reserves using actuarial data and analytical reserve development techniques, including projections of ultimate paid losses, to determine the ultimate amounts of reserves. The list of “key underlying assumptions” provided above are examples of major factors taken into account in developing these estimates.
Beginning January 1, 2006, Infinity began including corporate litigation losses arising from bad faith claims in loss and loss adjustment expenses. Original estimates have been restated to include corporate litigation loss reserves recorded as of those dates and all periods have been restated for payments. Cumulative deficiency (redundancy) information is presented excluding corporate litigation losses for comparability to the prior year’s filing.
Changes in the fair values of held investment securities are usually recorded as changes in unrealized gains or losses on investments, a component of shareholders’ equity. Net earnings are not affected until the disposition of a given security or, if an unrealized loss is deemed to be other-than-temporary, an impairment charge is recorded as a realized capital loss and the cost basis of the security is reduced.
whether the unrealized loss is credit-driven or a result of changes in market interest rates
The National Association of Insurance Commissioners’ (“NAIC”) model law for risk-based capital (“RBC”) 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, 2006, the capital ratios of all Infinity insurance subsidiaries exceeded the RBC requirements.
In October 2006, the Board of Directors announced a new program to repurchase shares up to $100 million. This program shall end on the earliest of: (a) December 31, 2008 or (b) the completion of all purchases contemplated by the program.
Infinity’s insurance subsidiaries generate liquidity to satisfy their obligations, primarily by collecting and investing premiums in advance of paying claims. Infinity’s insurance subsidiaries had positive cash flow from operations of approximately $28.5 million in 2006, $56.2 million in 2005, and $61.0 million in 2004. In addition, to satisfy their obligations, Infinity’s insurance subsidiaries generate cash from maturing securities from their combined $1.1 billion fixed maturity portfolio. Management believes that cash and investment balances, which are supported by cash flows generated from operations and maturing investments, are adequate to meet the future liquidity needs for Infinity and its insurance subsidiaries.
Additionally, Infinity employs an independent company, American Money Management, to conduct, in accordance with the Company’s investment guidelines, all of the investment purchases and sales for the Company and its insurance subsidiaries. The Company’s Chief Financial Officer and the Audit Committee, at least quarterly, review the performance of the portfolio management and American Money Management’s compliance with the Company’s investment guidelines.
Investments in mortgage-backed securities (“MBS”) represented approximately one-fourth of Infinity’s fixed maturity portfolio at December 31, 2006. MBS are, in periods of rising interest rates, subject to significant extension risk due to the fact that mortgages may be repaid more slowly than expected as borrowers postpone refinancing in anticipation of lower fixed rates in the future. Principal payments, including prepayments, on MBS were approximately $27 million and $39 million for the twelve months ended December 31, 2006, and December 31, 2005, respectively. As of December 31, 2006, approximately 97% of Infinity’s MBS are rated “AAA” by a nationally recognized rating agency. Additionally, all but one MBS, amounting to $1.0 million of the $290 million MBS portfolio, are investment grade according to the NAIC rating guidelines.
The following table shows Infinity’s bonds and redeemable preferred stocks, by NAIC designation and comparable Standard & Poor’s Corporation rating as of December 31, 2006 (in thousands).
Equity price risk is the potential economic loss from adverse changes in equity security prices. Infinity’s exposure to equity price risk is limited as its equity investments comprise only 4.2% of its total investment portfolio. Approximately 60% of the equity holdings are common stocks concentrated in communications, utilities and financial institutions, the largest holding is $7.1 million or 12.8% of the $55.5 million portfolio in an exchange-traded fund consisting of a well diversified portfolio of stocks designed to track closely to the S&P 500 Index. The five largest investments in individual company common stock, out of a total of 33 investments, comprise 34.6% of the total equity portfolio. Holdings include 29 common stocks, with an average beta of 1.20, and four preferred stocks.
Goodwill carried on Infinity’s balance sheet represents the excess of AFG’s carrying value over tangible assets in the NSA Group and the Assumed Agency Business at the date of transfer to Infinity in contemplation of Infinity’s initial public offering in early 2003. In accordance with SFAS No. 142, “Goodwill and Other Intangible Assets,” Infinity performs impairment test procedures on an annual basis. These procedures require Infinity to calculate the fair value of goodwill, compare the result to its carrying value and record the amount of any shortfall as an impairment charge. Infinity performed this test as of September 30, 2006 using a variety of methods, including estimates of future discounted cash flows and comparisons of the market value of Infinity to its major competitors as well as the overall market. The September 30, 2006 test results indicated that there was no impairment at that date. Additionally, there was no indication of impairment at December 31, 2006.
(1) 2006, 2005 and 2004 exclude $5.0 million, $9.8 million and $16.4 million, respectively, of premiums written on behalf of other companies. 2006, 2005 and 2004 also exclude $0.7 million, $4.3 million and $7.2 million, respectively of unearned premium transfers.
In Infinity’s Top Five Focus States, personal auto gross written premiums for the year ended December 31, 2006 grew 0.5% compared with 2005. Gross written premium in California grew 5.2% during 2006 compared to that in 2005. Gross written premium growth of 14.3% during the last six months of 2006 as compared with that in the last six months of 2005 offset a 2.7% decline in premiums during the first six months of 2006 as compared with that in the same period in 2005. During the month of March, several competitors in California implemented new class plan filings that made Infinity’s rates less competitive and as a result, new business applications declined. Although Infinity reacted by filing a class plan to refine the Company’s rate structure, the plan was not approved by the California Department of Insurance until April with an effective date of June 1, 2006. This delayed approval suppressed gross written premium growth resulting in the 2.7% decline in gross written premiums during the first six months. However, during the fourth quarter of 2006, new application counts in California increased 57.1% compared to new application counts during the fourth quarter of 2005, which is believed to be attributable to a result of the California Department of Motor
Vehicle’s implementation of electronic enforcement of compulsory insurance laws. As a result, Infinity’s gross written premiums in California grew 30.0% during the fourth quarter of 2006 compared to that of the same period of 2005. The implementation of electronic enforcement may have favorably impacted Infinity’s retention ratio in California as the policy retention rate at December 31, 2006 increased nearly three points from the retention rate at September 30, 2006. Policies-in-force at December 31, 2006 increased 9.7% compared with the policies-in-force at December 31, 2005.
Gross written premiums in Pennsylvania, Infinity’s second most profitable state, increased during the last half of 2006 after declining during the first six months of 2006. Gross written premiums declined 13.4% during the first six months of 2006 compared to the same period of 2005 due to aggressive marketing and rate actions by competitors that were not matched by Infinity. The Company’s underwriting profit in the state is strong, so in mid-July the Company implemented a Chapter 130 rate decrease, which permits an insurer to decrease rates up to 10% without prior approval from the DOI, with an overall effect of reducing rates by 3.2%. In addition, Infinity enhanced commission rates and agency incentives. These actions contributed to the 8.1% growth during the last six months of 2006 as compared to the last six months of 2005. As a result of growth during the last half of 2006, policies-in-force at December 31, 2006 increased 7.7% over policies-in-force at December 31, 2005.
Gross written premiums in the 14 Remaining Focus States increased 4.9% during 2006 as compared to 2005, with the growth coming in the last six months of the year. Seven of the 14 Remaining Focus States, Alabama, Arizona, Colorado, Indiana, Nevada, Ohio, and Texas, had gross written premium growth during 2006. Gross written premiums in the two largest of these states, Arizona and Texas, grew 45.8% and 18.9%, respectively. In Texas, gross written premiums grew as Infinity took a modest 0.9% rate reduction in June and as Infinity continued to aggressively appoint new agents in key urban areas and to expand marketing programs. Due to the improving profitability in Arizona, Infinity was able to make a rate adjustment in April 2006, which resulted in the Company’s programs becoming more competitive in the marketplace. Policies-in-force in the 14 Remaining Focus States at December 31, 2006, increased 22.6% over those in force at December 31, 2005 as a result of the 30.8% gross written premium growth in the 14 Remaining Focus States during the last half of 2006.
Gross written premiums for the year ended December 31, 2005 grew 5.2% compared to 2004. Infinity achieved gross premium growth of 13.0% during the first six months of the year largely as a result of business from newly appointed agents and brokers, from success in the continued roll-out of its three-tiered product offering in its Focus States (see Item 1 Business - Distribution and Marketing) as well as additional marketing efforts. Gross premiums declined 2.9% during the second half of the year as several competitors decreased rates with Infinity taking selective rate increases to improve profitability in several states. During 2005, Infinity implemented 57 rate revisions in various states with an overall rate impact of a modest 2.2% increase. For the same reasons discussed above, Infinity’s policies-in-force grew 3.8% compared to December 31, 2004.
Gross written premiums ceded under reinsurance coverages fell during the year as a result of the elimination of the physical damage quota share agreement at December 31, 2004.
Earned premiums increased 10.2% during the twelve months ended December 31, 2005 partially due to the elimination of the physical damage quota share agreement at December 31, 2004. Excluding the effect of this agreement, earned premiums grew at a more modest 3.9%.
The combined ratio in the Top Five Focus States increased 2.6 points compared to that in 2005. The loss and LAE Ratio increased 1.7 points primarily from strengthening LAE reserves. The underwriting ratio increase of 0.9 points is primarily a result of an increase in advertising and in part from a larger portion of the shared service costs being attributed to these states.
The combined ratio for the 2006 Classic Collector business increased 11.6 points over 2005 primarily from an 8.8 point increase in the underwriting expense ratio as Infinity attributed more of the shared service costs to Classic Collectors.
Overall, the statutory combined ratio for the year ended December 31, 2005 increased 0.1 points compared to 2004. In 2005, on a statutory basis, Infinity had $17.0 million of favorable development on a prior accident period loss and LAE reserves. In 2004, on a statutory basis, Infinity had $14.5 million of favorable reserve development, excluding $9.3 million of unfavorable development on extra-contractual liabilities arising from bad faith claims, on prior accident period loss and LAE reserves. The favorable development in both years is primarily attributable to California business for 2004 and 2003 as the Company experienced continued improvement in claims frequency trends. Catastrophe related losses were $2.3 million in 2005 compared to $1.6 million in 2004.
The statutory combined ratio in the 14 Remaining Focus States decreased 0.7 points overall in 2005 with a decrease in underwriting ratio of 1.5 points offset by an increase in the loss and LAE ratio of 0.8 points. Infinity took rate actions throughout 2005 to improve the profitability in these states with an overall annual rate increase of 7.0% with double digit increases in some states. In spite of Infinity’s increased marketing costs as new products were introduced, the underwriting expense ratios fell 1.5 points as fixed expenses were spread over a larger premium base.
The combined ratio in the Non-Focus States remained well above 100%. Earned premiums in these states dropped 62% in 2005 and business in these states represented just 1.5% of Infinity’s total personal auto gross written premium. The increase in the loss and LAE ratio in the Non-Focus States is primarily attributable to unfavorable development on prior accident periods in New York and Louisiana, as well as catastrophe losses in Louisiana.
The combined ratio in the commercial vehicle business decreased 0.1 points with a 1.3 point decline in the loss and LAE ratio, offset by a 1.4 point increase in underwriting expenses. In the fourth quarter of 2004, Infinity strengthened reserves on the commercial vehicle business resulting in a higher loss and LAE ratio compared to the fourth quarter of 2005.
Changes in investment income reflect fluctuations in market rates and changes in average invested assets. Investment income increased $2.9 million for the twelve-month period ended December 31, 2006 from 2005. Infinity’s average invested assets increased 0.9%. With rising interest rates in 2006, Infinity used proceeds from sales and maturities of securities to acquire higher yielding securities. As a result, Infinity’s weighted-average gross investment yield increased to 5.0% in 2006 from 4.8% in 2005.
Net investment income decreased $0.2 million for the twelve-month period ended December 31, 2005 from 2004. This slight decrease was due to lower interest expense on the physical damage quota share agreement as a result of the elimination in 2005 of that facility, offset by lower gross investment income despite a 3.9% increase in average invested assets. Infinity’s weighted-average gross investment yield decreased from 5.1% to 4.8% for the twelve-month periods ended December 31, 2004 and 2005, respectively.
The Senior Notes carry a coupon rate of 5.50%, effective yield of 5.55%, and require no principal payment until maturity in February 2014. The term loan accrued interest at a variable rate, which averaged 3.7% from July 16, 2003, the date of issue through February 18, 2004, at which time it was refinanced with the Senior Notes. The risk of variability in future interest expense was partially hedged by the interest rate swap. (See Note 3 of the Consolidated Financial Statements for additional information on the Senior Notes.)
Other expenses increased $4.0 million for the twelve-month period ended December 31, 2006 as compared to 2005. The increase relates primarily to an increase in corporate litigation expense during 2006, partially offset by a smaller loss on sublease. The 2006 corporate litigation expense increase was due to a new reserve for a class action lawsuit compared to a reduction in the litigation reserve in 2005 due to favorable settlements of other class action lawsuits. See Note 12 of the Consolidated Financial Statements “Legal Proceedings”.
Other expenses increased $2.0 million for the twelve-month period ended December 31, 2005 as compared to 2004. The increase relates primarily to the loss recorded on sub-leased space during 2005. The sublease losses in 2005 and 2004 were generated as vacant space following the consolidation of certain redundant administrative functions was sublet. Also, during 2004 was a release of the premium tax accrual which lowered the expense amount in the other category.
The following table reconciles the Company’s GAAP and effective tax rate for the periods ending December 31, 2006, 2005 and 2004.
Consolidated Statements of Changes in Shareholders’ Equity: Years ended December 31, 2006, 2005 and 2004
Consolidated Statements of Cash Flows: Years ended December 31, 2006, 2005 and 2004