Leased Properties. The Company leases space for its principal offices and for some of its insurance operations in an office building located in Atlanta, Georgia, from Delta Life Insurance Company under a lease which continues until either party provides written notice of cancellation at least twelve months in advance of the actual termination date. The lease, which commenced on November 1, 2007, provides for rent adjustments on every fifth anniversary of the commencement date. Under the current terms of the lease, the Company occupies approximately 49,586 square feet of office space. Delta Life Insurance Company, the owner of the building, is controlled by J. Mack Robinson, the majority shareholder of the Company, and his wife Harriett Robinson, a member of our board of directors. The terms of the lease are believed by Company management to be comparable to terms which could be obtained by the Company from unrelated parties for comparable rental property.
Deferred acquisition costs comprised 8% of the Company’s total assets at December 31, 2012. Deferred acquisition costs are commissions, premium taxes, and other costs that vary with and are primarily related to the acquisition of new and renewal business and are generally deferred and amortized. The deferred amounts are recorded as an asset on the balance sheet and amortized to expense in a systematic manner. Traditional life insurance and long-duration health insurance deferred policy acquisition costs are amortized over the estimated premium-paying period of the related policies using assumptions consistent with those used in computing the related liability for policy benefit reserves. The deferred acquisition costs for property and casualty insurance and short-duration health insurance are amortized over the effective period of the related insurance policies. Deferred policy acquisition costs are expensed when such costs are deemed not to be recoverable from future premiums (for traditional life and long-duration health insurance) and from the related unearned premiums and investment income (for property and casualty and short-duration health insurance). Assessments of recoverability for property and casualty and short-duration health insurance are extremely sensitive to the estimates of a subsequent year’s projected losses related to the unearned premiums. Projected loss estimates for a current block of business for which unearned premiums remain to be earned may vary significantly from the indicated losses incurred in any previous calendar year.
Receivables are amounts due from reinsurers, insureds and agents, and any sales of investment securities not yet settled, and comprised 8% of the Company’s total assets at December 31, 2012. Insured and agent balances are evaluated periodically for collectibility. Annually, the Company performs an analysis of the creditworthiness of the reinsurers with whom the Company contracts using various data sources. Failure of reinsurers to meet their obligations due to insolvencies, disputes or otherwise could result in uncollectible amounts and losses to the Company. Allowances for uncollectible amounts are established, as and when a loss has been determined probable, against the related receivable. Losses are recognized by the Company when determined on a specific account basis and a general provision for loss is made based on the Company’s historical experience.
Cash and investments comprised 83% of the Company’s total assets at December 31, 2012. Substantially all of the Company’s investments are in bonds and common and preferred stocks, the values of which are subject to significant market fluctuations. The Company carries all investments as available for sale and, accordingly, at their estimated fair values. The Company owns certain fixed maturities that do not have publicly quoted values, but had an estimated fair value as determined by management of $2.1 million at December 31, 2012. Such values inherently involve a greater degree of judgment and uncertainty and therefore ultimately greater price volatility than the value of securities with publicly quoted market values. On occasion, the value of an investment may decline to a value below its amortized purchase price and remain at such value for an extended period of time. When an investment’s indicated fair value has declined below its cost basis for a period of time, the Company evaluates such investment for an other than temporary impairment. The evaluation for an other than temporary impairment is a quantitative and qualitative process, which is subject to risks and uncertainties in the determination of whether declines in the fair value of investments are other than temporary. Potential risks and uncertainties include, among other things, changes in general economic conditions, an issuer’s financial condition or near term recovery prospects and the effects of changes in interest rates. In evaluating a potential impairment, the Company considers, among other factors, management’s intent and ability to hold these securities until price recovery, the nature of the investment and the expectation of prospects for the issuer and its industry, the status of an issuer’s continued satisfaction of its obligations in accordance with their contractual terms, and management’s expectation as to the issuer’s ability and intent to continue to do so, as well as ratings actions that may affect the issuer’s credit status. If an other than temporary impairment is deemed to exist, then the Company will write down the amortized cost basis of the investment to its estimated fair value. While any such write down does not impact the reported value of the investment in the Company’s balance sheet, it is reflected as a realized investment loss in the Company’s consolidated statements of operations in the period incurred.
The Company determines the fair values of certain financial instruments based on the fair value hierarchy established in Accounting Standards Codification (“ASC”) 820-10-20, Fair Value Measurements and Disclosures (“ASC 820-10-20”). The fair values of fixed maturity and equity securities are largely determined by either independent methods prescribed by the National Association of Insurance Commissioners, which do not differ materially from nationally quoted market prices, when available, or independent broker quotations. See Note 2 and Note 15 of the accompanying notes to consolidated financial statements with respect to assets and liabilities carried at fair value and information about the inputs used to value those financial instruments, by hierarchy level, in accordance with ASC 820-10-20.
Deferred income taxes comprised 3% of the Company’s total liabilities at December 31, 2012. Deferred income taxes reflect the effect of temporary differences between assets and liabilities that are recognized for financial reporting purposes and the amounts that are recognized for tax purposes. These deferred income taxes are measured by applying currently enacted tax laws and rates. Valuation allowances are recognized to reduce the deferred tax asset to the amount that is deemed more likely than not to be realized. In assessing the likelihood of realization, management considers estimates of future taxable income and tax planning strategies.
On a consolidated basis, the Company had net income of $4.4 million, or $0.18 per diluted share, in 2012, compared to net income of $3.3 million, or $0.12 per diluted share, in 2011. Included in net income in 2011 were realized investment losses of $1.2 million related to the write-down in the cost basis of certain bonds and equity securities due to other than temporary impairments. There were no similar impairment charges in 2012. Operating income was $3.6 million in 2012 compared to $3.3 million in 2011. The increase in operating income during 2012 was primarily due to an increase in premium revenue and investment income with a relatively consistent level of fixed general and administrative expenses. Operating income is calculated as net income before income tax expense (benefit) and any net realized investment gains or losses. Management believes operating income is a useful metric for investors, potential investors, securities analysts and others in that it isolates the “core” results of the Company before considering certain items that are either beyond the control of management (such as taxes, which are subject to timing and rate changes depending on the timing and location of the associated revenues) or not expected to regularly impact the Company’s operational results (such as any realized investment gains, which are not a part of the Company’s primary operations and are, to an extent, subject to discretion in terms of timing of realization).
Total revenue was $139.8 million in 2012 as compared to $118.3 million in 2011. Premium revenue increased to $126.7 million in 2012 from $107.5 million in 2011. The increase in premiums was primarily due to increases in Medicare supplement business. The increase in investment income was primarily attributable to a higher average balance of fixed maturities held by the Company in 2012 as compared to 2011. Also, included in total revenue were net realized investment gains of $1.4 million in 2012 compared to net realized investment gains of $27,000 in 2011. The magnitude of realized investment gains and losses in any year is a function of the timing of trades of investments relative to the markets themselves as well as the recognition of any other than temporary impairments on investments.
Total expenses were $134.7 million in 2012 as compared to $115.0 million in 2011. As a percentage of premiums, insurance benefits and losses incurred and commissions and underwriting expenses were 96.5% and 96.0% in 2012 and 2011, respectively. The increase in the ratio was primarily due to higher loss ratios in the property and casualty operations partially offset by the increase in premium revenue and more favorable loss experience in the life and health operations.
Gross written premiums at American Southern decreased $1.7 million, or 3.8%, during 2012 as compared to 2011. The decrease in gross written premiums was primarily attributable to a decrease of $5.9 million in commercial automobile written premiums primarily resulting from the cancellation of two agencies in 2012 due to unfavorable loss experience; as well as the cancellation of certain general liability programs with gross written premiums of $0.8 million. Also contributing to the decrease in gross written premiums was a decline in surety business in the amount of $0.4 million due to the strengthening of the company’s underwriting guidelines with respect to such business. Partially offsetting the decrease in gross written premiums in 2012 were increases of $3.3 million in commercial automobile business written by a newly appointed agency and $2.0 million in commercial automobile business written by an existing agency. In an effort to increase gross written premiums and diversify its business, American Southern continually evaluates new underwriting programs and expects to be able to offset the decrease in business writings from cancelled agencies and/or programs.
Ceded premiums increased $1.1 million, or 17.1%, during 2012 as compared to 2011. The increase in ceded premiums was primarily due to increased cession rates as well as an increase in commercial automobile earned premiums which have higher contractual cession rates than other lines of business.
Net earned premiums decreased slightly during 2012 as compared to 2011. The decrease in net earned premiums during 2012 was primarily attributable to the increase in reinsurance rates as well as the decrease in general liability business as discussed previously. Partially offsetting the decrease were increases in commercial automobile and surety earned premiums resulting from a higher volume of business written in the current year and during 2011. Premiums are earned ratably over their respective policy terms, and therefore premiums earned in the current year are related to policies written during both the current year and immediately preceding year. In 2012, American Southern’s five principal states in terms of premium revenue were Alabama, Florida, Georgia, Indiana, and Texas and accounted for approximately 63% of total earned premiums for 2012.
In establishing reserves, American Southern initially reserves for losses at the higher end of the reasonable range if no other value within the range is determined to be more probable. Selection of such an initial loss estimate is an attempt by management to give recognition that initial claims information received generally is not conclusive with respect to legal liability, is generally not comprehensive with respect to magnitude of loss and generally, based on historical experience, will develop more adversely as time and information develops. However, as a result, American Southern generally experiences reserve redundancies when analyzing the development of prior year losses in a current period. At December 31, 2012, the range of estimates developed in connection with the loss reserves for American Southern indicated that reserves could be as much as 14.6% lower or as much as 15.5% higher. Development from prior years’ reserves has historically reduced the current year loss ratio; however, such reduction in the current year loss ratio is generally offset by the reserves established in the current year for current period losses. American Southern’s estimated net reserve redundancies for the years ended December 31, 2012 and 2011 were $1.7 million and $3.1 million, respectively. To the extent reserve redundancies vary between years, there is an incremental impact on the results of operations of American Southern and the Company. The indicated redundancy in 2012 was $1.4 million less than that in 2011. After considering the impact on contingent commissions and other related accruals, the $1.4 million decline in the redundancy resulted in a decline in income from operations before tax of approximately $0.8 million in 2012 as compared to 2011. Management believes that such differences will continue in future periods but is unable to determine if or when incremental redundancies will increase or decrease, until the underlying losses are ultimately settled.
Benefits and losses increased $13.1 million, or 26.5%, during 2012 as compared to 2011. As a percentage of premiums, benefits and losses were 70.0% in 2012 compared to 70.6% in 2011. The decrease in the loss ratio was primarily attributable to more favorable loss experience in the Medicare supplement line of business in 2012 as compared to 2011. The company continues to implement rate increases on its Medicare supplement line of business which has helped to mitigate the impact of higher medical costs and contributed to the more favorable loss experience.
Other expenses (commissions, underwriting expenses, and other expenses) increased $3.5 million, or 9.0%, in 2012 as compared to 2011. The increase in other expenses during 2012 was primarily attributable to increased commission and underwriting costs in the life and health operations associated with the higher volume of business as well as increases in advertising and agency related expenses. Partially offsetting the increase in other expenses in 2012 was the $1.9 million decrease in commission accruals at American Southern due to recent loss experience. The majority of American Southern’s business is structured in a way that agents are compensated based upon the loss ratios of the business they place with the company. During periods in which the loss ratio increases, commissions and underwriting expenses will generally decrease, and conversely, during periods in which the loss ratio decreases, commissions and underwriting expenses will generally increase. As a percentage of earned premiums, other expenses were 33.4% in 2012 as compared with 36.1% in 2011. The decrease in the expense ratio was primarily due to the increase in earned premiums coupled with a relatively consistent level of fixed general and administrative expenses and a reduction in American Southern’s commission expense as discussed previously.
The primary differences between the effective tax rate and the federal statutory income tax rate resulted from the dividends-received deduction (“DRD”), the small life insurance company deduction (“SLD”) and the change in deferred tax asset valuation allowance. The current estimated DRD is adjusted as underlying factors change and can vary from the estimates based on, but not limited to, actual distributions from these investments as well as the amount of the Company’s taxable income. The SLD varies in amount and is determined at a rate of 60 percent of the tentative life insurance company taxable income (“LICTI”). The SLD for any taxable year is reduced (but not below zero) by 15 percent of the tentative LICTI for such taxable year as it exceeds $3.0 million and is ultimately phased out at $15.0 million. The change in deferred tax asset valuation allowance was primarily due to the unanticipated utilization of certain capital loss carryforward benefits that had been previously reduced to zero through an existing valuation allowance reserve.
Cash flows at the Parent are derived from dividends, management fees, and tax-sharing payments, as described below, from the subsidiaries. The cash needs of the Parent are for the payment of operating expenses, the acquisition of capital assets and debt service requirements. At December 31, 2012, the Parent had approximately $27.4 million of unrestricted cash and investments.
During 2006, the Company entered into a zero cost interest rate collar with Wells Fargo to hedge future interest payments on a portion of the Junior Subordinated Debentures. The notional amount of the collar was $18.0 million with an effective date of March 6, 2006. The collar has a LIBOR floor of 4.77% and a LIBOR cap of 5.85% and adjusted quarterly on the 4th of each March, June, September and December through its termination date of March 4, 2013. The Company began making payments to Wells Fargo under the zero cost interest rate collar on June 4, 2008. As a result of interest rates remaining below the LIBOR floor of 4.77% through 2012, these payments to Wells Fargo continued through the maturity date.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements and schedules. We believe that our audits provide a reasonable basis for our opinion.
At December 31, 2012, the Parent owned three insurance subsidiaries, Bankers Fidelity Life Insurance Company (“Bankers Fidelity”), American Southern Insurance Company and its wholly-owned subsidiary, American Safety Insurance Company (together known as “American Southern”), in addition to one non-insurance subsidiary, xCalibre Risk Services, Inc. The Parent has issued a guarantee of all liabilities of Bankers Fidelity.
Goodwill represents the excess of cost over the fair value of net assets acquired and is not amortized. The Company periodically reviews its goodwill to determine if any adverse conditions exist that could indicate impairment. Conditions that could trigger impairment include, but are not limited to, a significant change in business climate that could affect the value of the related asset, an adverse action, or an assessment by a regulator. No impairment of the Company’s recorded goodwill was identified during the periods presented.
Deferred income taxes represent the expected future tax consequences when the reported amounts of assets and liabilities are recovered or paid. They arise from differences between the financial reporting and tax basis of assets and liabilities and are adjusted for changes in tax laws and tax rates as those changes are enacted. The provision for income taxes represents the total amount of income taxes due related to the current year, plus the change in deferred income taxes during the year. A valuation allowance is recognized if, based on management’s assessment of the relevant facts, it is more likely than not that some portion of the deferred tax asset will not be realized.
In May 2011, the FASB issued ASU No. 2011-04, Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs (“ASU 2011-04”). This guidance resulted in a consistent definition of fair value and common requirements for measurement of and disclosure about fair value between GAAP and International Financial Reporting Standards. While many of the amendments to GAAP are not expected to have a significant effect on practice, this guidance changes some fair value measurement principles and disclosure requirements. ASU 2011-04 was required to be applied prospectively. For public entities, this guidance is effective for interim and annual periods beginning after December 15, 2011. The Company adopted ASU 2011-04 on January 1, 2012. Adoption of ASU 2011-04 did not have a material impact on the Company’s financial condition or results of operations. See Note 15 for expanded disclosures.
The preparation of financial statements and related disclosures in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and revenues and expenses during the reporting period. Significant estimates and assumptions are used in developing and evaluating deferred income taxes, deferred acquisition costs, insurance reserves, investments (Note 15), and commitments and contingencies, among others, and actual results could differ materially from management’s estimates.
The following tables present the Company’s unrealized loss aging for securities by type and length of time the security was in a continuous unrealized loss position as of December 31, 2012 and 2011.
The fair value hierarchy prioritizes the inputs in the valuation techniques used to measure fair value into three broad levels. The following describes the fair value hierarchy and provides information as to the extent to which the Company uses fair value to measure the value of its financial instruments and information about the inputs used to value those financial instruments.
As of December 31, 2012, financial instruments carried at fair value were measured on a recurring basis as summarized below:
The Company’s bond portfolio included 98% investment grade securities, as defined by the NAIC, at December 31, 2012.
A reconciliation of the differences between income taxes computed at the federal statutory income tax rate and the income tax expense is as follows:
Deferred tax liabilities and assets at December 31, 2012 and 2011 were comprised of the following:
At December 31, 2012, the Company had regular federal net operating loss carryforwards (“NOLs”) of approximately $4,500 expiring generally between 2025 and 2032. Currently, the Company believes that deferred income tax benefits relating to the NOLs will be realized. However, expected realization of the NOLs is assessed periodically based on the Company’s then current and anticipated results of operations, and amounts could increase or decrease if estimates of future taxable income change.
As of December 31, 2012 and 2011, a valuation allowance of $5,268 and $5,708, respectively, was established against deferred income tax benefits relating primarily to capital loss carryforwards that may not be realized. The Company does not currently anticipate having sufficient future capital gains to offset certain of these capital losses during the applicable carryforward period. However, the Company continues to periodically assess the potential realization of these and all other deferred tax benefits. During 2012, the Company’s valuation allowance decreased by $440. The decrease was primarily due to the unanticipated utilization of certain capital loss carryforward benefits that had been previously reduced to zero through an existing valuation allowance reserve.
The estimated fair value and related carrying value of the Company’s interest rate collar at December 31, 2012 was a liability of approximately $141 with a corresponding decrease in AOCI in shareholders’ equity, net of deferred tax.
A summary of the status of the Company’s stock options at December 31, 2012 and 2011 is as follows:
The Company initiated a nonqualified stock purchase plan (the “Agent Stock Purchase Plan”) in May 2012. The purpose of the Agent Stock Purchase Plan is to promote and advance the interests of the Company and its stockholders by providing independent agents who qualify as participants with an opportunity to purchase the common stock of the Company. Under the Agent Stock Purchase Plan, payment for shares of common stock of the Company is made by either deduction from an agent’s commission payment or a direct cash payment. Stock purchases are made at the end of each calendar quarter at the then current market value. The Company pays the sales commissions, if any, associated with such purchases.
The Company had 70,000 shares of Series D Preferred Stock (“Series D Preferred Stock”) outstanding at December 31, 2012 and 2011. All of the shares of Series D Preferred Stock are held by an affiliate of the Company’s controlling shareholder. The outstanding shares of Series D Preferred Stock have a stated value of $100 per share; accrue annual dividends at a rate of $7.25 per share (payable in cash or shares of the Company’s common stock at the option of the board of directors of the Company) and are cumulative. In certain circumstances, the shares of the Series D Preferred Stock may be convertible into an aggregate of approximately 1,754,000 shares of the Company’s common stock, subject to certain adjustments and provided that such adjustments do not result in the Company issuing more than approximately 2,703,000 shares of common stock without obtaining prior shareholder approval; and are redeemable solely at the Company’s option. The Series D Preferred Stock is not currently convertible. As of December 31, 2012 and 2011, the Company had accrued, but unpaid, dividends, on the Series D Preferred Stock of $23 and $530, respectively. During 2012, the Company paid $1,015 in Series D Preferred Stock dividends. The 2011 Series D Preferred Stock dividend of $508 was paid in January 2012.
The amount of reported statutory net income and surplus (shareholders’ equity) for the Parent’s insurance subsidiaries for the years ended December 31 was as follows:
Under the insurance code of the state of jurisdiction in which each insurance subsidiary is domiciled, dividend payments to the Parent by its insurance subsidiaries are subject to certain limitations without the prior approval of the applicable state’s Insurance Commissioner. The Parent received dividends of $7,350 and $6,535 in 2012 and 2011, respectively, from its subsidiaries. In 2013, dividend payments to the Parent by the insurance subsidiaries in excess of $9,586 would require prior approval.
The Company leases approximately 49,586 square feet of office and covered garage space from one such controlled entity. During the years ended December 31, 2012 and 2011, the Company paid $853 and $865, respectively, under this lease.
Certain members of the Company’s management are shareholders and on the Board of Directors of Gray Television, Inc. (“Gray”). At December 31, 2012 and 2011, the Company owned 388,060 shares of Gray Class A common stock and 106,000 shares of Gray common stock. The aggregate carrying value of these investments in Gray at December 31, 2012 and 2011 was $908 and $696, respectively.