The following table presents selected financial information in thousands of dollars:
In the first quarter of 2006, the Company issued $25 million of 30 year subordinated debentures, which enabled the Company to redeem its outstanding Series A Preferred Stock due in January 2011, and provided additional capital of $5 million. In the fourth quarter of 2006, the Company issued $18 million of 30 year subordinated debentures, which the Company used for general corporate purposes. See “Capital Transaction - Subordinated Debentures.”
The Company continues to settle and reduce its inventory of commercial lines claims. At December 31, 2007, there were 47 claims associated with the Company’s runoff book outstanding, compared to 73 as of December 31, 2006. As of December 31, 2007, in respect of its runoff lines, the Company had $10.3 million in net unpaid claims and claim adjustment expenses (“C & CAE”) compared to $15.9 million as of December 31, 2006. For the periods presented, the Company has recorded favorable development in unpaid C & CAE from the runoff lines with the settlement and reduction in the inventory of commercial lines claims. See “Results of Operations - Claims and claim adjustment expenses.” Due to the long tail and litigious nature of these claims, the Company anticipates it will take a substantial number of years to complete the adjustment and settlement process with regard to existing claims and the additional claims it expects to receive in the future from its past business writings. Most of the remaining claims are in suit and the Company’s future results may or may not be impacted either negatively or positively based on its ability to settle the remaining claims and new anticipated claims within its established reserve level.
$9,500,000 of these increases is attributable to bodily injury liability coverage. Approximately $12,070,000 relates to the 2006 accident year.
New business and the entry into new territories and product lines, associated with the Company’s growth beginning in 2005, has generally produced higher claims and greater uncertainty in determining reserves than more seasoned in-force business; see ITEM 1A. Risk Factors. The unfavorable development for prior accident years for nonstandard personal auto in 2007 is primarily the result of actual and projected increases in severity associated with bodily injury liability. The Company’s growth and the associated risks and uncertainties (see Item 1A. Risk Factors ) made it difficult to estimate ultimate claims liabilities, and the unfavorable development occurred as the Company revised previous estimates to reflect current claims data. The unfavorable development for prior accident years includes approximately $2,051,000 for 2007 relating to obligations and potential claims exposure relating to “extra-contractual” claims, in which claimants seek to recover amounts significantly in excess of applicable policy limits. In 2007, the Company had incurred several “extra-contractual” claims primarily related to claims occurring in prior accident years. (see Item 1A, Risk Factors-”Litigation may affect our financial condition, results of operations and cash flows”).
During 2006, the Company began implementing improved claim practices in each of the major regions’ claims departments in order to seek to ultimately decrease the average time from when a claim occurs to when it is settled. The Company believes that, over the long term, timeliness in the settlement of claims is likely to produce the most favorable claim results for the Company. However, when this practice is initially implemented, it can cause an increase in the C & CAE and introduce greater uncertainty into the process of setting reserves. These operational changes may result in an increase in the amount of aggregate claim settlements and cause our ultimate claim and claim adjustment expense to increase in comparison to prior accident years.
With regard to environmental and product liability claims, the Company has an immaterial amount of exposure. The Company did not provide environmental impairment coverage and excluded pollution and asbestos related coverages in its policies. A portion of the Company’s remaining claims is related to construction defects.
Underwriting and operating expenses increased $4,543,000 (18%) in 2007 from 2006 primarily due to an increase in advertising, underwriting reports, employment fees and actuarial and information technology consulting fees as a result of enhancing marketing, underwriting and pricing functions. Underwriting and operating expenses as a percent of Net premiums earned and Agency revenues were 15% for 2007 and 13% for 2006.
In January 2006, a wholly-owned subsidiary, GAINSCO Capital Trust I, issued $25 million of 30-year capital securities. The capital securities require quarterly payments of interest at a floating interest rate equal to the 3-month LIBOR (London interbank offered rate for U.S. dollar deposits) plus a margin of 3.85%. The capital securities will mature on March 31, 2036 and are redeemable at the Company’s option beginning after March 31, 2011, in whole or in part, at the liquidation amount of $1,000 per capital security. Taken together, the Company’s obligations provide a full, irrevocable and unconditional guarantee of payments of distributions and other amounts due on the capital securities, subject to the subordination provisions of the agreements.
As of December 31, 2007 and 2006, the net deferred tax asset before valuation allowance was $28,951,000 and $25,862,000 and the valuation allowance was $28,699,000 and $15,516,000, respectively.
Investments and Cash decreased in 2007 primarily as a result of cash used for operations for the payment of claims. At December 31, 2007, 84% of the Company’s investments were rated investment grade with an average duration of approximately 1.6 years, including approximately 25% that were held in short-term investments. The Company classifies its bond securities as available for sale. The net unrealized loss associated with the investment portfolio was $488,000 (net of tax effects) at December 31, 2007 (see Note 2 of Notes to Consolidated Financial Statements which appears in Item 8 of this Report).
Ceded unpaid C & CAE decreased as a result of the settlement of commercial claims subject to the commercial excess casualty and quota share reinsurance agreements. This balance represents unpaid C & CAE which have been ceded to reinsurers under the Company’s various reinsurance agreements, other than the reserve reinsurance cover agreement. These amounts are not currently due from the reinsurers but could become due in the future when the Company pays the claim and requests reimbursement from the reinsurers.
Deferred Federal income taxes is comprised of temporary differences and the tax asset from net operating loss carryforwards less a valuation allowance that reduces the net operating loss carryforwards deferred tax asset. The Company considered it appropriate to fully reserve the valuation allowance, see “Liquidity and Capital Resources - Net Operating Loss Carryforwards.”
Unpaid C & CAE decreased primarily as a result of the settlement of claims in the normal course and favorable development in 2007 from the runoff lines, which were offset with unfavorable development recorded for the nonstandard personal automobile lines. As of December 31, 2007, the Company had $66,000,000 in net unpaid C & CAE (Unpaid C & CAE of $74,694,000 less Ceded unpaid C & CAE of $8,694,000). This amount represents management’s best estimate of the ultimate liabilities. The significant operational changes we have recently made in the nonstandard personal auto claims adjustment process and changing claims trends increase the uncertainties which exist in the estimation process and could lead to inaccurate estimates of claim and claim adjustment expense.
The reserve estimates were made each quarter by our in-house actuarial staff and reviewed by an independent actuarial firm. We do not rely upon the review by the independent actuarial firm to determine the amount of our GAAP reserves. However, the analysis provided by the independent actuarial firm was used to corroborate the reserve selections made by the in-house actuarial staff. Our independent actuarial firm also provides annual opinions related to adequacy of the statutory reserves for the insurance company subsidiary.
Premiums payable, Commissions payable and Reinsurance balances payable all decreased primarily due to a reinsurance fronting arrangement that was reducing throughout 2007.
Critical accounting policies are defined as those that are reflective of significant judgments and uncertainties, and potentially result in materially different results under different assumptions and conditions. The Company’s critical accounting policies are described below. For a detailed discussion on the application of these and other accounting policies. See Note 1 of Notes to Consolidated Financial Statements which appears in Item 8 of this Report.
Deferred policy acquisition costs are principally commissions, premium taxes, marketing expenses and some underwriting expenses which are deferred. Policy acquisition costs are principally commissions, premium taxes, marketing expenses, some underwriting expenses and the change in deferred policy acquisition costs that are charged to operations over the period in which the related premiums are earned. The Company utilizes investment income when assessing recoverability of deferred policy acquisition costs. A premium deficiency and a corresponding charge to income is recognized if the sum of the expected claims and claim adjustment expenses, unamortized acquisition costs and maintenance costs exceeds related unearned premiums and anticipated investment income. At December 31, 2007, a premium deficiency, net of anticipated investment income, was recognized of approximately $623,000 against deferred policy acquisition costs for expected underwriting losses on the South Central business. At December 31, 2006, there was no premium deficiency.
Goodwill represents the excess of purchase price over fair value of net assets acquired. The goodwill recorded is related to the 1998 acquisition of the Lalande Group. In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets,” goodwill is not amortized but rather is subject to an annual impairment test, or earlier if certain factors are present, based on its estimated fair value. Therefore, impairment losses could be recorded in future periods. These procedures require GAN to estimate the fair value of the reporting unit, compare the results to its carrying value and record the amount of any shortfall as an impairment charge. GAN performed this test as of December 31, 2007 and 2006, using a variety of methods, including estimates of future discounted cash flows. The test results indicated that there was no impairment loss at December 31, 2007 or 2006.
We maintain reserves for the payment of claims and claim adjustment expenses for both case and IBNR under policies written by the insurance company subsidiary. These claims reserves are estimates, at a given point in time, of amounts that we expect to pay on incurred claims based on facts and circumstances then known. The amount of case claims reserves is primarily based upon a case-by-case evaluation of the type of claim involved, the circumstances surrounding the claim, and the policy provisions relating to the type of claim. The amount of IBNR claims reserves is estimated on the basis of historical information and anticipated future conditions by lines of insurance and actuarial review. Reserves for claim adjustment expenses are intended to cover the ultimate costs of settling claims, including investigation and defense of lawsuits resulting from such claims. Inflation is implicitly reflected in the reserving process through analysis of cost trends and review of historical reserve results.
In addition to the factors described above that are generally applicable to property and casualty insurers, our ability to estimate claims reserves accurately is subject to risks and uncertainties arising out of the recent history and growth of the Company. These factors are discussed in more detail in Item 1A of this Report, “Risk Factors.” The following are particularly significant factors that limit our ability, as compared with a more mature insurer with a larger and more stable book of business, to estimate claims reserves accurately:
The actuarial staff monitors accident quarter data, seeking to identify whether these assumptions have remained consistent and, if deviations are identified, to adjust reserves to take them into account by making qualitative and quantitative modifications to reflect such deviations. This process necessarily involves the exercise of judgment in assessing the impact of changes from the patterns indicated by the assumptions noted above.
During the fourth quarter of 2006, we analyzed the time from report date to close date for all of our closed claims. We noticed a significant reduction in the number of days our claims department was taking to close claims, starting during the third quarter of 2006, which we believe is the result of changes we have made in our claim practices. This speed-up in claim closure rate implies future development patterns will be different from historical patterns which are used to estimate ultimate liabilities. We attempted to take this into consideration in our estimate of reserves by utilizing a Berquist-Sherman adjustment, adjusting selected loss development factors, and utilizing actuarial judgment.
• Historical information used to prepare a priori expected loss ratios; historical information regarding claims frequency; the level of case reserve adequacy
Since we experienced rapid growth during 2006, the credibility associated with each accident quarter gradually increased over time. Changes in credibility over time affect development patterns in that past development patterns are less stable than future patterns based on more credible data. However, the fact that the Company has continued to enter new markets results in limits on credibility for the foreseeable future. No adjustments were recorded in the fourth quarter of 2006 as a result of these changes, but they are closely monitored as we seek to identify any deviations from existing patterns.
When we reviewed claims data to make estimates for the fourth quarter of 2007, some of the same variances were found. Based on the analysis of these variances, we made the following adjustments:
During 2007, we continued to expand our writings and to diversify further. We also expanded into various other driver classes, namely into the internationally licensed segment. Expanding into different geographical segments meant writing more business in jurisdictions with different judicial systems and negligence laws, including areas that may be more susceptible to insurance fraud. These changes can affect development patterns, so that historical patterns may not be reflective of future patterns. We attempted to take these changes into consideration in our estimate of reserves by the selection of loss development factors and use of actuarial judgment.
During our review of data for the fourth quarter of 2007, we noticed that the average case reserve per claimant in bodily injury coverages had increased for our Texas loss experience. We attempted to take the increase in case reserves into consideration by utilizing a Berquist-Sherman adjustment, selection of loss development factors and use of actuarial judgment.
As the trend first observed in 2006 continued, the credibility associated with each accident quarter gradually increased over time. Changes in credibility over time affect development patterns in that past development patterns are less stable than future patterns based on more credible data. However, the fact that the Company has continued to enter new markets results in limits on credibility for the foreseeable future. We attempted to take this into consideration in our estimates by selection of loss development factors and use of actuarial judgment.
For our runoff lines, however, the remaining number of claims has declined to the point that these conventional actuarial methods are of less utility than during the period in which the number of active claims provided more complete statistical data. Accordingly, in recent reporting periods the aggregate case and IBNR reserve estimates for runoff claims have been based primarily on evaluations of individual claim files. This methodology is not used for our personal lines business.
In both personal lines and commercial runoff business, we utilize the same procedures for estimating reserves on a quarterly basis as we do annually. Historically, the independent actuarial consulting firm that we retain had the responsibility for making the reserve estimate used in our financial statements. However, we changed our procedures beginning with the financial statements for the third quarter of 2007 and subsequent quarterly and annual periods. In our revised procedures, the reserve estimates are made for each period by our in-house actuarial staff, and we do not rely upon the review by the independent actuarial firm to estimate the amount of our GAAP reserves. However, the analysis provided by the independent actuarial firm is used to corroborate the reserve selections made by the in-house actuarial staff, and that firm also provides additional analysis as requested. Our independent actuarial consulting firm has also provided annual opinions related to adequacy of the statutory reserves for the insurance company subsidiary.
Personal umbrella - because coverage is related to the resolution of claims in underlying insurance policies, development tends to occur over a relatively long time period. We do not expect additional claims.
For private passenger auto business, Incurred but Not Reported Reserves include provisions in the aggregate for the following:
Claims that have been reported to us, but have not been recorded on our system, and a case reserve has not been established yet.
Claims that are closed, but may be re-opened for payment/additional payments at a future date.
Claims that are known and recorded in our system, but may have development beyond the case reserve established when the claim was first reported.
In determining our reserve estimates for nonstandard personal automobile insurance, for each financial reporting date we record our best estimate, which is a point estimate, of our overall unpaid claims and CAE for both current and prior accident years. Because the underlying processes require the use of estimates and professional actuarial judgment, establishing claims reserves is an inherently uncertain process. As our experience develops and we learn new information, our quarterly reserving process may produce revisions to our previously reported claims reserves, which we refer to as “development,” and such changes may be material. We recognize favorable development when we decrease our previous estimate of ultimate losses, which results in an increase in net income in the period recognized. We recognize unfavorable development when we increase our previous estimate of ultimate losses, which results in a decrease in net income in the period recognized. Accordingly, while we record our best estimate, our claims reserves are subject to potential variability.
The Company and its subsidiaries file a consolidated Federal income tax return. Deferred income tax items are accounted for under the “asset and liability” method which provides for temporary differences between the reporting of earnings for financial statement purposes and for tax purposes, primarily deferred policy acquisition costs, the discount on unpaid claims and claim adjustment expenses, net operating loss carry forwards and the nondeductible portion of the change in unearned premiums.
In the fourth quarter of 2007, the Company increased the amount of the valuation allowance by $9,678,000, resulting in an allowance on the gross deferred tax asset of $28,699,000. In making this determination, the Company considered all available evidence, including the fact that the Company incurred a taxable loss in 2007 and had incurred, as of December 31, 2007, a cumulative taxable loss for the three years then ended, which was not the case as of September 30, 2007. The Company increased the amount of the valuation allowance by $3,505,000 in previous quarters of 2007.
In September 2006, the Securities Exchange Commission (“SEC”) issued Staff Accounting Bulletin (“SAB”) No. 108, “Considering the Effect of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements,” which provides interpretive guidance on the consideration of the effects of prior year misstatements in quantifying current year misstatements for the purpose of a materiality assessment. SAB No. 108 is effective for fiscal years ending after November 15, 2006. The implementation of the guidance in the SAB did not have a significant effect on the Company’s consolidated financial position or results of operations and financial condition.
Forward-looking statements are relevant only as of the dates made, and we undertake no obligation to update any forward-looking statement to reflect new information, events or circumstances after the date on which the statement is made. All written or oral forward-looking statements that are made by or are attributable to us are expressly qualified in their entirety by this cautionary notice. Our actual results may differ significantly from the results we discuss in these forward-looking statements.
The following Consolidated Financial Statements are on pages 62 through 102:
Consolidated Statements of Shareholders’ Equity and Comprehensive (Loss) Income for the Years Ended December 31, 2007 and 2006
Consolidated Statements of Cash Flows for the Years Ended December 31, 2007 and 2006
The following Consolidated Financial Statements Schedules are on pages 103 through 113: