We lease approximately 115,000 square feet for our home office at 3760 River Run Drive, Birmingham, Alabama under a long-term operating lease. For our life insurance businesses, we leased approximately 25,000 square feet in Phoenix, Arizona until the sale of our life insurance operations on September 20, 2005 as discussed in Note D to the Consolidated Financial Statements. We believe our office facilities are suitable and adequate for our current and anticipated level of operations.
We have restated our Consolidated Financial Statements for each of the years ended December 31, 2003, 2002, 2001 and 2000. The restated Consolidated Financial Statements reflect the correction of accounting errors which occurred during these periods as discussed in Item 7, “Managements Discussion and Analysis of Operations and Financial Condition” and Note B to the Consolidated Financial Statements. The Selected Financial Data presented below should be read in conjunction with “Management’s Discussion and Analysis of Results of Operations and Financial Condition- Restatement of Previously Issued Financial Statements” and Vesta’s Consolidated Financial Statements and accompanying notes included elsewhere herein. A reconciliation of previously reported Consolidated Financial Statements to the restated Consolidated Financial Statements also follows the tables below.
See Management's Discussion and Analysis of Results of Operation and Financial Condition-Restatement of Previously Issued Financial Statements for a description of each accounting error resulting in the adjustments. See also Note B of Notes to Financial Statements.
See Management’s Discussion and Analysis of Results of Operation and Financial Condition-Restatement of Previously Issued Financial Statements for a description of each accounting error resulting in the adjustments.
As part of its internal review, the Company thoroughly evaluated its financial reporting consolidation and elimination process and the resulting financial statements. The financial consolidation process was a focus of the internal review due to a number of acquisitions during the years 2000 through 2004 and the complexities of the integration of accounting processes of the newly acquired entities into Vesta’s financial statement consolidation process. The Company also reviewed its ceded reinsurance process.
In regards to the consolidation process component of the internal review, the Company determined that it was necessary to essentially reperform the consolidation of the financial statements in prior periods beginning with the consolidated balance sheet as of December 31, 2000. The reperformance of the consolidation of the financial statements was a time consuming process due to the multiple general ledger systems in place during this period, the number of acquisitions and dispositions during that time, turnover of key accounting personnel and the volume and complexities of intercompany transactions. Furthermore, the ceded reinsurance process component of the internal review required extensive time and effort due to system conversions during the period and the fact that many of the reinsurance treaties involved in the process were put into place several years ago.
Ceded Reinsurance Adjustments-As part of our review of our ceded reinsurance process, the Company identified certain ceded reinsurance assets that, with the exception of $73 thousand incorrectly reported in 2002, should have been charged to expense in the Consolidated Statements of Operations in periods prior to December 31, 2000 (as further described below under the heading of “Ceded Reinsurance Balances”). If these assets had been appropriately charged to expense during these periods, a deferred tax asset would have been provided. As a consequence, the income tax expense recorded in the 4th quarter of 2003 related to the recording of a full valuation allowance on our deferred tax asset would have increased. The impact of the 2003 adjustment to income tax expense, and the erroneous reinsurance expense in 2002 on the Consolidated Statements of Operations and total comprehensive loss is as follows (in thousands):
Net premiums earned-In conducting our internal review, the Company noted certain intercompany reinsurance transactions that were not properly eliminated during the consolidation process. Properly eliminating these balances resulted in an increase to the reported net earned premiums by $783 thousand and $50 thousand for the years ended December 31, 2003 and 2002, respectively.
Realized Gains-In the acquisition of Florida Select Insurance Holdings, the Company appropriately assigned new costs basis to the acquired investment portfolio in accordance with APB No. 16, “Business Combinations.” However, the Company’s underlying investment accounting system reflected investment values in accordance with statutory accounting guidelines which do not require the investment portfolio to be reported at its new cost basis. As these investment securities were subsequently sold and the realized gains and losses were calculated by the investment accounting system, the Company failed to include the adjusted cost basis in the calculation of reported gains and losses. As such, the Company overstated its realized capital gains by $58 thousand and $263 thousand for the years ended December 31, 2003 and 2002, respectively.
In the aggregate, the correction of these errors impacted our Consolidated Statements of Operations and consolidated total comprehensive loss as follows (in thousands):
Additionally, during our internal review, the Company identified two errors which resulted in changes to the previously issued consolidated balance sheet as of December 31, 2003. The first error relates to aggregate cash overdraft balances. In 2003, the aggregate cash overdraft balances were not properly reflected as liabilities in the consolidated balance sheet. In the restated consolidated balance sheet, the Company properly reflected these aggregate cash overdraft balances as a component of other liabilities resulting in an increase in cash and other liabilities of $9.5 million. This error did not have an impact on Consolidated Stockholders’ Equity in 2003.
The second error relates to the establishment of certain deferred tax liability balances in conjunction with the application of purchase accounting related to our acquisition of American Founders Financial Corporation in 2000. In connection with our evaluation of the carrying value of the goodwill associated with our life insurance operations reporting unit, we identified this error. Consequently, we have reflected the correction of the purchase accounting error in the December 31, 2003 consolidated balance sheet, resulting in a reduction of goodwill and deferred income taxes of $3.3 million. This error did not have an impact on Consolidated Stockholders’ Equity.
contract, it was determined that certain realized investment gains and losses had been recorded as income in full by AFLIC instead of reflecting a portion of these gains as being due to the third party reinsurer, as required by the reinsurance contract. As such, the Company overstated its Consolidated Stockholders Equity by $480 thousand and $201 thousand as of December 31, 2003 and 2002, respectively. The impact to Consolidated Stockholders’ Equity is net of a deferred tax benefit of $259 thousand and $107 thousand as of December 31, 2003 and 2002, respectively. This error did not have an impact on Consolidated Stockholders’ Equity as of December 31, 2001.
Ceded Reinsurance Adjustment-As part of our review of our ceded reinsurance process, the Company identified approximately $3.8 million of ceded reinsurance assets that should have been charged to expense in the Consolidated Statements of Operations in periods prior to December 31, 2000. The identified errors consisted of the following: (1) $1.5 million of reinsurance recoverables related to the failure to properly record ceded premiums related to various reinsurance agreements in the late 1990’s, (2) $1.3 million of reinsurance recoverables related to the failure to properly expense certain unearned premiums related to the cancellation of a reinsurance contract prior to 2000, and (3) $1.0 million related to several smaller reinsurance balances that were generated prior to 2001 and which appear to not have been recoverable at that date. The amount reflected in the 2002 restated consolidated balance sheet is net of a tax benefit of $1.3 million. In 2003, the $1.3 million deferred tax asset was offset by an adjustment to the Company’s deferred tax asset valuation allowance that was originally recorded in 2003. Due to these errors, the Company overstated its Consolidated Stockholders’ Equity by $3.8 million, $2.5 million and $2.5 million as of December 31, 2003, 2002 and 2001, respectively.
Life Insurance Reinsurance Adjustments-For the year ended December 31, 2003 the Company identified errors in the recording of ceded losses to certain external reinsurers of AFLIC. Specifically, we identified that the Company had erroneously ceded too many losses to these reinsurers. As a result, the Company’s reinsurance balances receivable was overstated by $213 thousand as of December 31, 2003. In recording the correction of these errors, the Company also recorded a $74 thousand reduction of deferred income taxes to reflect the tax impact of the errors. The net impact of these errors reduced Consolidated Stockholders’ Equity by $139 thousand as of December 31, 2003.
The following table presents the impact of the aforementioned adjustments on our Consolidated Statement of Operations for the period ended December 31, 2003.
During 2004, Vesta conducted business in three areas of the personal insurance industry: standard property and casualty, non-standard automobile, and life. We report the financial information of these three areas of personal insurance according to three business segments: (1) standard property-casualty insurance; (2) life insurance; and (3) corporate and other. Our consolidated revenue is derived principally from risk-bearing premiums, policy fees, investment income and investment gains and losses. Our consolidated expenses consist primarily of payments for claims and expenses associated with underwriting activities and operational support for such functions.
The degree to which the Company is able to realize the positive impact from these rate increases is contingent upon the degree to which we can sustain current net written premium levels. Decreased written premium levels due to competition, adverse developments from our financial strength ratings or changes in the degree to which we utilize reinsurance would reduce the impact of these rate increases. Furthermore, the impact of these rate increases may be reduced through future rate reductions enacted by state regulatory agencies.
The financial results of our life insurance operations primarily depend upon (1) the amount we collect as premium; (2) the amount of investment income earned on invested premium; and (3) the benefits we pay to beneficiaries of insureds upon their death. Unlike the standard property-casualty segment, we typically hold the premium collected on our life products for many years and invest such premium over a long period of time, making investment income a significant component of revenue that we report in the life segment. The greatest variable in our revenue in the life segment is the amount of income we can earn on invested assets, which is dependent upon interest rates and market conditions. The greatest variable in our expense from period to period is the mortality rate of our insureds, as mortality rates in excess of our actuarially predicted levels will adversely impact financial results in any given period.
The financial results of our corporate and other segment reflect other revenue and expenses that are not allocated to any particular segment, including (1) investment income related to our property-casualty underwriting operations; (2) corporate and property-casualty interest expense; (3) general corporate operating
expenses; and (4) realized gains and losses from the sale of investment securities or the repurchases of our own debt securities at a discount.
Our Consolidated Financial Statements are based upon the selection and application of accounting policies that require management to make significant estimates and assumptions. Our consolidated financial results would be directly impacted by changes in assumptions and judgments used to apply our accounting policies, particularly in certain critical areas. We believe the following are some of the more critical judgment areas in the application of our accounting policies that affect our consolidated financial condition and results of operations:
Recoverability of assets, including reinsurance receivables, deferred policy acquisition costs, deferred tax assets and other intangible assets;
We have discussed the application of these critical accounting policies with our Board of Directors and Audit Committee. In 2004, we initially adopted the following accounting standards:
For a discussion of the accounting pronouncements that we have recently adopted, please refer to Note A to our Consolidated Financial Statements.
The amounts recorded have been estimated based upon management’s interpretation of each reinsurer’s obligations pursuant to individual reinsurance contracts between Vesta and each reinsurer. In establishing the balances for reinsurance recoverables and reinsurance receivables, we have made judgments in assessing the financial viability and credit quality of each reinsurer. In evaluating the credit and financial quality of each reinsurer, we rely upon financial statements, credit reports and other publicly available information applicable for each reinsurer as well as management’s experience and industry knowledge.
The following is a summary of ceded balances to unaffiliated reinsurers in excess of $5.0 million as of December 31, 2004 (in thousands):
As noted above, the Company has ceded reserves of $37.6 million to Lumbermens Mutual Casualty Company (“Lumbermens”), a member of the Kemper Insurance Companies, primarily related to long-term care
For more discussion of reinsurance recoverables and other amounts subject to estimation due to arbitrations with our reinsurers, please refer to Notes I and K to our Consolidated Financial Statements.
Deferred income taxes are provided for temporary differences between amounts of assets and liabilities for financial reporting purposes and the basis of such assets and liabilities as measured by tax laws and regulations, as well as net operating losses, tax credits and other carryforwards. Statement of Financial Accounting Standards (“SFAS”) No. 109, “Accounting for Income Taxes”, requires that deferred tax assets be reduced by a valuation allowance if, based on available evidence, it is more likely than not that all of the recorded deferred tax assets will not be realized in future periods. This assessment requires significant judgment, and an evaluation of both objective and subjective, positive and negative factors.
We again performed an evaluation of the recoverability of our deferred tax assets as of December 31, 2004. Based on our operating results during 2004, we determined that maintaining a full valuation allowance was appropriate for those companies included in the Vesta Insurance Group, Inc. consolidated tax group. As of December 31, 2004, our recorded valuation allowance was $84.1 million for the Vesta Insurance Group, Inc. consolidated tax group. In addition, we concluded the combination of significant cumulative losses in recent years and the uncertainty with respect to our ability to achieve sufficient taxable income to fully realize our year-end deferred tax asset balances related to our life insurance companies warranted a full valuation. As a result, we recorded an additional valuation allowance of $5.7 million in 2004. In the aggregate, the recorded deferred tax asset valuation allowance was $89.8 million as of December 31, 2004.
In our financial statements, we record goodwill, which represents the amount by which the price we paid to acquire net assets of businesses we acquired exceeds the fair value of tangible assets and identified intangible assets with definite lives acquired less the fair value of the liabilities assumed. The determination of whether these assets are impaired involves significant judgments based upon management’s short and long-term projections of future performance for each of our identified reporting units. Certain of these forecasts reflect assumptions regarding our ability to sustain or increase activities in these reporting units as well as assumptions regarding catastrophic loss activity. Changes in our overall strategy may result in changes to recorded asset balances. Furthermore, changes in market conditions, including but not limited to changes to our financial strength ratings, increased competition or accessibility to reinsurance, may also result in changes to recorded asset balances.
Pursuant to the provisions of SFAS No. 142, “Goodwill and Other Intangibles”, we no longer amortize goodwill. Additionally, on at least an annual basis, we conduct an evaluation to assess whether the fair value of our reporting units exceeds each reporting units’ carrying value. Our annual evaluation is performed as of September 30th. Upon the occurrence of significant events, which could impact the assumptions we use to project future profitability, we update our evaluation of our reporting units. We evaluate impairment of two reporting units: homeowners’ insurance operations and life insurance operations. For purposes of applying the provisions of SFAS No. 142, we compare the aggregate fair value and carrying value of each reporting unit to determine if there is any indication of impairment.
At December 31, 2004, included in securities available-for-sale are the following investments with unrealized losses classified according to the term of the unrealized loss of less than twelve months or twelve months or longer (in thousands):
Unrealized losses greater than twelve months represent 0.8% of the fair value of the temporarily impaired securities. For those securities identified as having temporary impairments of twelve months or more, approximately 73.8% of these unrealized losses occurred in federal agency mortgage-backed securities and U.S. Treasury obligations. Management does not view these losses as being related to credit quality as these bonds are guaranteed by the issuing agency and/or the U.S. Treasury. It is not expected that the securities would be settled at a price less than the amortized cost of the investment.
We maintain property-casualty loss reserves to cover the estimated ultimate unpaid liability for losses and loss adjustment expenses with respect to reported and unreported claims incurred. Reserves do not represent an exact calculation of the ultimate liability, but rather utilize actuarial projection techniques commonly used in the insurance industry. Reserve estimates represent managements’ expectations of what the ultimate settlement and administration of claims will cost based upon, among other factors, (1) an assessment of facts and circumstances then known; (2) a review of historical settlement patterns; (3) estimates of trends in claims severity and frequency; and (4) estimates of salvage and subrogation. Reserves are carried in our financial statements at an estimate of the ultimate expected loss for each claim without any discount to reflect the time value of money.
At December 31, 2004, we had recorded liabilities for loss and loss adjustment expenses of $318.9 million which represents the point estimate as calculated by the Company. Our loss and loss adjustment expense reserves comprise the largest property and casualty liability and most significant estimate or compilation of estimates in our Consolidated Financial Statements. Furthermore, our loss and loss adjustment expense reserves are subject to significant inherent uncertainties and therefore, there can be no assurance as to whether the actual results will be higher or lower than these estimates. Any adjustments or changes for such differences may be material, especially to our operating results for a period. As our loss and loss adjustment expense reserves are re-evaluated, changes to those estimates, if any, are recognized through a charge to income in the period in which the change is determined. See item I “Reserves” for a discussion of the development of our standard property and casualty reserves.
The Company is exposed to adverse development stemming from third-party reporting and third-party contract negotiations. In relation to third-party reporting, the Company does rely, in certain instances, upon claims information from third-parties to determine loss reserve amounts. The aforementioned instances include losses assumed from our discontinued assumed reinsurance program as well as loss on our previously owned non-standard auto program in which we are reliant upon the timeliness and accuracy of claims activity reporting from third parties. However, we believe this risk is mitigated based on the decreased number of assumed reinsurance treaties that remain outstanding as well as the reinsurance agreement that exists that serves to cede all losses incurred after December 31, 2003. The aggregate amount of these reserves is $97.6 million as of December 31, 2004.
In relation to third party contract negations and their potential impact on current reserves, the Company has experienced instances in which certain assumed reinsurance treaties have been commuted by the lead reinsurer. The Company was not a party to these negotiations and was unaware that they were occurring until notification from the cedant that the commutation was final. Although the Company’s exposure to this risk is limited to the total number of treaties outstanding and is further limited by the Company’s ability to cede such losses to other reinsurers, the Company is unable to quantify any potential adverse development that could occur from these situations.
For investment contracts without mortality risk (such as deferred annuities and immediate annuities with benefits paid for a certain period), premium deposits and benefit payments are recorded as increases or decreases in a liability account, rather than as revenue and expense. We record as revenue any amounts charged against the liability account for the cost of insurance, policy administration, and surrender penalties. Any interest credited to the liability account and any benefit payments which exceed the contract liability account balance are recorded as expenses. As of December 31, 2004 and 2003, approximately $97.1 million and $122.2 million, respectively, of Vesta’s annuity reserves, included in policy liabilities on the Consolidated Balance Sheets, are subject to discretionary withdrawal without surrender charges or other adjustments. The liability for future policy benefits includes estimated unpaid claims that have been reported and claims incurred but not reported.
Our consolidated revenue is derived principally from premiums, commissions, fees, investment income and investment gains and losses. Premium income, the largest component of our consolidated revenue and policy fees are generally recognized on a pro-rata basis over the respective period of each property-casualty insurance policy. Reinsurance premiums ceded are similarly pro-rated with the prepaid portion recorded as a component of reinsurance balances receivables in the Consolidated Balance Sheet. Premium receivables are recorded net of an estimated allowance for uncollectible amounts. Premiums on life insurance contracts are recognized as income as they become due. Profit sharing income under our quota share reinsurance contracts are recorded each period based on the actual results through the end of the applicable period.
The primary factors that impacted our financial results in 2004 were as follows:
The initial public offering of Affirmative in the third quarter of 2004, resulting in the recognition of a gain of $11.2 million and the subsequent application of the equity method of accounting for our remaining 42.9% ownership of Affirmative;
The renewal of our residential property 50% quota share in July of 2004, with a new term of one year;
The addition of a 25% quota share on our residential property book of business in December of 2004;
Impairment charge of $66.7 million related to our homeowners and life insurance operations reporting unit goodwill balances; and
For a depiction of the various components of revenue, expense and financial results for each of our business segments for the years ending December 31, 2004 please refer to Note N of our Consolidated Financial Statements.
As noted previously, during 2004 we experienced significant losses from hurricane activity in Florida and the Southeastern United States. Although our reinsurance program, including the Florida Hurricane Catastrophe Fund (“FHCF”), operated as intended and served to reduce our net losses, the volume and severity of the hurricane activity during the year had a significant negative impact on our 2004 operating results. The following is a summary of the estimated gross, ceded and net losses from the third quarter hurricanes (amounts in thousands):
As shown in the preceding table, we ceded a significant portion of our gross losses to the FHCF. Additionally, we ceded losses to other reinsurers, which includes cessions under our 2004 50% Quota Share Agreement and our excess of loss reinsurance program. Based on the estimates used to calculate the gross losses noted above and the terms of the FHCF and our excess of loss reinsurance, our exposure to higher actual losses for Hurricanes Charley, Frances, Ivan and Jeanne is minimal based on the FHCF retention level of $23.2 million and our remaining capacity under the FHCF of approximately $38.5 million with a 10% co-insurance requirement. Additionally, our excess of loss reinsurance program remains in place as described on page 22 of this report. In addition to our net losses of $66.5 million, we incurred approximately $5.5 million in reinstatement premiums that were recorded as a reduction to earned premium in 2004.
casualty lines decreased by $86.4 million, or 33.1%, to $174.3 million from $260.7 million in the prior year. Net premiums earned for standard property-casualty lines decreased by $76.5 million, or 25.3%, in 2004, to $225.6 million from $302.1 million in 2003. Our standard property-casualty segment pre-tax loss from continuing operations increased from a $2.4 million loss in 2003 to a loss of $131.8 million loss in 2004.
We maintained the 50% residential property throughout 2004 by renewing the 2003 50% Quota Share Agreement in July of 2004 (“2004 50% Quota Share Agreement”). In addition, we entered into an additional 25% residential property quota share agreement effective December 1, 2004 covering the same policies and on similar terms as the 2004 50% Quota Share Agreement.
Although net written premiums and earned premiums significantly decreased in 2004 as compared to 2003, gross written premiums decreased only 4.5% from $464.4 million in 2003 to $443.5 in 2004, with a majority of these decreases resulting from decreases in the states of Texas and California, stemming from our decision to curtail writing new business in certain areas of Texas and from increased competition in California.
We have implemented rate increases to address emerging loss trends and to protect our net written premium relative to expenses and underwriting margins. During 2004, we received approval for a weighted average premium increase of approximately 6.8% for our standard auto business in Alabama, Arizona, Connecticut, Hawaii, Rhode Island, Pennsylvania and West Virginia, on estimated annual gross written premiums of approximately $26.7 million. In regard to our residential property business, we received approval for 14 rate changes with a weighted average premium increase of approximately 20.5% on estimated annual premiums of $74.4 million. Less significant rate increases were approved for business in Alaska, Alabama, Arizona, Massachusetts, New Jersey, New York, Pennsylvania, Rhode Island, South Carolina and West Virginia.
Loss and loss adjustment expenses (LAE) for standard property casualty lines for the year ended December 31, 2004 increased by $10.2 million, or 4.9%, to $217.9 million from $207.7 million in the prior year. The increase in loss and loss adjustment expenses incurred was primarily attributable to catastrophe losses of $83.1 million incurred during 2004, $66.5 of which resulted from four hurricanes that hit Florida and the Southeastern United States. This compares to catastrophe losses of $32.4 million in the prior year. Offsetting the impact of catastrophe losses in the current year is the increased cession of non-catastrophe losses under our various residential property quota share agreements, including a full year’s impact from our 50% quota share agreements in 2004 versus a partial year’s impact in 2003 and, to a lesser degree, the impact of the 2004 25% Quota Share Agreement during the fourth quarter of 2004.
Operating expenses increased by $21.3 million, or 47.9%, to $65.8 million from $44.5 million. The increase in operating expenses is primarily attributed to the recognition of $15.7 million in allowances relating to recoverables from Lumbermens, NewCap Re and Transatlantic Re as well as $2.1 million in valuation allowances related to various other reinsurance receivables and recoverables. In addition, the 2004 operating expenses increased due to increased information technology costs in the latter half of 2004 as the Company prepares to consolidate its policy issuance and administrative functions into the home office.
The combined ratio for the standard property-casualty segment was 155.1% as of December 31, 2004 as compared to 101.0% in 2003. The higher combined ratio in 2004 as compared to 2003 is primarily a result of the increased level of catastrophic losses in the current year as compared to the prior year and higher costs associated with our increased level of quota share reinsurance in 2004.
We provided a variety of life insurance products through our holdings in American Founders Financial Corporation, a holding company for two life insurance companies domiciled in Texas. American Founders’ business is currently driven by the acquisitions of closed blocks of life insurance policies and by marketing and distributing its single premium annuity products. Our life insurance products are sold through marketing firms, financial institutions and 400 independent agents located throughout 41 states and the District of Columbia. At December 31, 2004, American Founders had approximately $1.9 billion (face value) of life and annuity products in force, and approximately $876.4 million in invested assets.
In 2004, our life insurance segment generated approximately $39.9 million in revenue, or 8.6% of consolidated revenue, excluding realized gains and losses and gain on sale of subsidiary. Segment pre-tax income from continuing operations for our life insurance segment decreased from income of $6.8 million in 2003 to a loss of $1.0 million in 2004. The most significant factor impacting the reduction in income in 2004 related to a $7.5 million charge related to the impairment of the life insurance reporting unit goodwill. See Note E to the Consolidated Financial Statements for additional information regarding the 2004 life insurance reporting unit goodwill impairment charge.
In 2003, we incurred $66.7 million of litigation and arbitration settlement expenses related to our 1997 20 percent Whole Account Quota Share arbitrations with NRMA, Dorinco and Alfa. During 2004, we settled our disputes with NRMA, Dorinco and Alfa resulting in the recognition of $12.5 million of favorable changes to accrued litigation charges.
In 2004, operating expenses decreased by $5.7 million from the prior year. The decrease was primarily due to lower expenses associated with the amortization of restricted stock issuances in prior years and lower legal expenses as a significant portion of Vesta’s reinsurance arbitrations were settled throughout 2004, partially offset by increased expenses associated with complying with Sarbanes Oxley Section 404.
Our corporate interest expense includes interest payable on our 8.75% senior debentures due in 2025, interest on Federal Home Loan Bank borrowings and our commercial credit borrowings. Interest expense for the twelve months ended December 31, 2004 was $5.7 million compared to $6.4 million in the previous year. The decrease in interest expense is primarily attributable to lower average balances outstanding on our commercial line of credit in 2004 as compared to 2003 and a slight reduction in the average interest rate on these borrowings.
The Company’s adoption of the provisions of SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity” (“SFAS 150”) resulted in the Deferrable Capital Security distributions for the six months ended December 31, 2003 being included as a component of segment pre-tax income (loss). Pursuant to the provisions of SFAS No. 150, the classification of Deferrable Capital Security distributions for prior periods was not changed. As a result of the application of the provisions of SFAS No. 150, our Deferrable Capital Security distributions included in continuing operations increased from $0.9 million in 2003 to $1.7 million in 2004.
Previously, in 2000 and 1999, we exited the reinsurance assumed and commercial lines of businesses, respectively. As a result, the reporting for these business lines is included in discontinued operations in our financial statements. At the time we made the decision to exit each of these business lines, we estimated the reserves required to fulfill our expected future obligations with respect to these discontinued operations. However, we continue to monitor our recorded estimates with respect to ultimate settlement on an ongoing basis.
Based upon available information, we believe the recorded reserves for discontinued operations at December 31, 2004 of $65.8 million are adequate. Furthermore, we believe that established accruals for current disputes and/or pending arbitrations related to any reinsurance assumed and commercial treaties are adequate based on the facts and circumstances as they are known. However, we will continue to monitor these reserves and their related claims activity and experience as well as the status of any disputes or arbitrations. Further adjustments to our estimates could be necessary as we continue to run off remaining outstanding claims, pursue commutations of treaties or resolve pending disputes and arbitrations.
For the year ended December 31, 2004, we recorded an income tax benefit of $6.5 million, compared with an income tax expense of $51.9 million recorded in the prior year. During the fourth quarter of 2003, we recorded a deferred tax expense of $76.6 million primarily related to determining a full valuation allowance was
The recognition of a pre-tax charge of $65.9 million related to our 1997 20% whole account quota share and related disputed items.
In 2003, the standard property-casualty segment generated approximately $314.3 million in revenue, or approximately 51.0% of consolidated revenue. For the year ended December 31, 2003, net premiums written in our standard property-casualty lines decreased by $94.2 million, or 26.6%, to $260.4 million from $354.6 million in the prior year. Net premiums earned for standard property-casualty lines decreased by $17.7 million, or 5.5%, in 2003, to $302.1 million from $319.8 million in 2002. Our standard property-casualty segment pre-tax loss from continuing operations improved from a $7.7 million loss in 2002 to a loss of $2.4 million loss in 2003.
Loss and loss adjustment expenses for standard property-casualty lines for the year ended December 31, 2003 decreased by $13.8 million, or 6.2%, to $207.7 million from $221.5 million in the prior year. The decrease in loss and loss adjustment expenses incurred was primarily attributable to a $9.0 million impact resulting from the effects of the 2003 50% Quota Share and improved underwriting results, offset by increases in catastrophe losses, including $18.3 million in loss and loss adjustment expenses resulting from a series of hail storms in Texas and the Southeastern United States.
For the year ended December 31, 2003, the loss ratio for standard property-casualty segment was 66.3% compared with 68.2% at December 31, 2002. The decrease in the loss ratio was primarily attributable to improved underwriting performance, including improvements in claim severity for both our homeowners and auto businesses, only partially offset by the aforementioned $18.3 million catastrophe loss.
For the year ended December 31, 2003, policy acquisition expenses decreased by $7.2 million, or 10.0%, to $64.5 million from $71.7 million for the same period of the prior year. Policy acquisition expenses as a percentage of net premiums earned decreased to 21.4% in 2003 from 22.4% in 2002, reflecting the effects of the 2003 Quota Share and a shifting of business concentration to states with lower agent commissions and other policy acquisition expenses. The 2003 Quota Share Agreement includes a provisional ceding commission that is 11% higher than that of the 2002 50% Quota Share agreement.
Operating expenses increased by $4.6 million, or 11.5%, to $44.5 million from $39.9 million. The increase in operating expenses is primarily attributed to a $2.6 million increase in expenses related to Texas and a $2.0 million increase in expenses related to California. The increase in Texas is a direct result of the significant increase in that book of business throughout 2002 and the maintaining of this premium level throughout 2003. The increase in California relates to start-up costs as we began to write standard homeowner’s business in California in 2003.
Claim processing fee income for the year ended December 31, 2003 was $26.5 million, equal to the amount of claims processing fee income of $26.5 million for the prior year.
Total revenues for the year ended December 31, 2003 were $192.3 million, an increase of $14.4 million or 8.1% as compared to total revenues of $177.9 million in the prior year. The increase in total revenue during 2003, as compared to prior year was principally due to increases in net premiums earned and policy service fee income.
For the year ended December 31, 2003, policy fee and other income was $24.9 million, an increase of $8.4 million or 50.9%, as compared to $16.5 million of fee income in the prior year. The increase in fee income was due to increases in policy service fees, partially offset by a decline in issuing carrier fees. For the year ended December 31, 2003 policy service fee income was $22.0 million, an increase of $10.9 million, compared to $11.1 million in policy service fee income in the prior year. The increase in policy service fees is principally a result of increases in fee income of the non-standard automobile business produced by our underwriting agencies in Texas and Florida and written by the insurance companies. We also collected issuing carrier fees of approximately $2.9 million for the year ended December 31, 2003, as compared to $5.4 million in 2002. The decrease in issuing carrier fees was primarily attributable to the decrease in gross premiums written through an unaffiliated underwriting agency in California that we terminated in the fourth quarter of 2002.
For the year ended December 31, 2003, pre-tax income was $9.2 million, a decrease of $1.4 million, compared to $10.6 million of pre-tax income in the prior year. Our combined ratio for the year ended December 31, 2003 was 96.6% compared to 97.0% for the prior year.
In 2003, our life insurance segment generated approximately $40.4 million in revenue, or 6.6% of consolidated revenue, excluding realized gains and losses. Segment pre-tax income from continuing operations for our life insurance segment improved from a loss of $18.9 million in 2002 to income of $6.8 million in 2003.
Our life insurance segment reflects realized gains of $2.0 million in 2003 compared to realized losses of $28.5 million in the prior year. The realized losses in 2002 were primarily related to the write-off of
For the year ended December 31, 2003, net investment income related to our property-casualty underwriting operations decreased by $5.8 million to $12.0 million from $17.8 million in 2002. The decrease in interest income is attributed to several factors. First, average invested assets decreased from $409.7 million in 2002 to $407.4 million in 2003. Compounding the impact on investment income from the decrease in the overall size of the investment portfolio was higher levels of mortgage-backed security paydowns and decreases in overall interest rates in 2003. The weighted average annual yield (excluding realized and unrealized gains and losses) on invested assets for the year ended December 31, 2003 was 3.1% compared to 4.0% in the prior year.
In 2003, operating expenses decreased by $6.3 million from the prior year. The decrease was primarily due to $4.2 million of severance expense incurred by the Company in 2002. The remaining decrease in operating expenses is attributed to lower legal expenses and decreased compensation expense.
$6.7 million related to our discontinued health insurance and consulting businesses;
$5.5 million in development of our commercial and assumed reinsurance loss reserves.
For the year ended December 31, 2003, we recorded an income tax expense of $62.1 million, compared with an income tax benefit of $6.0 million recorded in the prior year. During the fourth quarter of 2003, we recorded a deferred tax asset valuation expense of $75.4 million, which is reflected as a component of income tax expense.
Vesta’s principal source of liquidity and capital resources to meet its holding company obligations is dividends paid by our subsidiaries. Given our organizational structure, we rely on two subsidiaries to pay dividends to our holding company or otherwise fund the obligations of our holding company on its behalf - Vesta Fire Insurance Corporation, an Illinois domiciled insurer, and J. Gordon Gaines, Inc., a Delaware business corporation.
Effective September 30, 2004, we amended our existing $30 million revolving credit arrangement with First Commercial Bank of Birmingham, Alabama (“First Commercial”). The amended revolving credit agreement is collateralized by a pledge of 2.5 million shares of our holding company’s ownership in the common stock of Affirmative Insurance Holdings, Inc. In addition, Vesta is required to maintain a loan to collateral ratio of 80% throughout the term of the agreement. The facility bears interest at First Commercial’s prime rate and will mature no earlier than June 30, 2006. As of December 31, 2004, we had drawn the entire $30 million available under the credit facility.
The principal sources of funds for our insurance subsidiaries are premiums, investment income and proceeds from the sale or maturity of invested assets. The principal uses of funds in our subsidiary operations are the payment of claims, operating expenses, commissions and the purchase of investments. Our subsidiaries also borrow funds from the Federal Home Loan Bank (“FHLB”) from time to time and invest the proceeds at prevailing interest rates, and we have a need to repay these funds to the FHLB as indicated in the table illustrating our overall contractual obligations presented below.
Our subsidiary operations also involve ongoing reinsurance recoverable disputes that could result in an obligation to repay certain amounts to reinsurers from whom we have collected funds. In connection with these disputes, our principal operating subsidiary, Vesta Fire, has obtained letters of credit for the benefit of reinsurers for which it is contingently liable. At December 31, 2004, Vesta Fire was contingently liable for $38.5 million under the terms of letters of credit obtained in connection with these reinsurance disputes.
The following table sets forth the principal maturities and future payments for interest of our material contractual obligations owing to third parties at December 31, 2004 (in thousands):
(2) As of September 30, 2005, the Company had fully repaid and terminated the line of credit. Proceeds to repay the line of credit were generated from the sale of the Company’s Affirmative common stock in 2005.
(4) As part of our investment in a limited partnership, whose purpose is to invest funds in the private equity markets, our remaining contractual requirement is $5.7 million. As of December 31, 2004, we had contributed $4.3 million to the partnership. The Company contributed approximately $2.7 million in 2005. Although we do not expect the entirety of the remaining funding requirement to occur in 2006, there are no contractual annual limitations to the funding requirement. As such, the remaining funding balance as of December 31, 2004 is reflected as the actual payments made in 2005 with the remaining balance being reflected in 2006.
We are a party to an indenture related to our 8.75% Senior Debentures due 2025 (the Debentures) which requires us to file with the Indenture Trustee our periodic reports required by the Securities Exchange Act of 1934 within 15 days after they are required to be filed with the Securities and Exchange Commission. Since the Company did not file its September 30, 2004 Form 10-Q and its 2004 Form 10-K with the required time, we were in violation of the covenant under this indenture. In addition, we have not filed our periodic reports for 2005 with the Securities and Exchange Commission in the time required by the Commission’s rules, and, therefore, are in technical default under the terms of this Indenture. Such default will not constitute an Event of Default, as defined in the indenture, unless and until the Indenture Trustee delivers notice of default to the Company, and the Company fails to cure or otherwise remedy this default within sixty days of receipt of the notice. If such a notice were to be delivered, we believe the Event of Default could be remedied by the filing of the delinquent reports. We intend to file such reports with the SEC as soon as practicable. However, we can give no assurance that the reports could be filed within the sixty day cure period. As of the date of the filing of this report on Form 10-K, neither we nor, to the best of our knowledge, the Indenture Trustee had received any notice of default arising from the delinquency of these reports.
If notice of default were delivered to the Company on the Debentures or the Capital Securities, or both, the Company would not have the funds necessary to repay these obligations. The Company would have to pursue alternative financing, asset sales or capital raising activities. There can be no assurances that the Company could raise the necessary cash to pay the Debentures and/or Capital Securities or that it could on terms acceptable to the Company.
Additionally, we regularly obtain letters of credit or otherwise pledge securities for the benefit of ceding insurers in our nonstandard underwriting segment pursuant to reinsurance contracts. As of December 31, 2004, we had pledged approximately $16.8 million in securities pursuant to these reinsurance contracts.
As is typical in the insurance industry, we collect cash in the form of premiums and invest that cash until claims are paid. Cash collected from premiums and cash paid for claims are included in cash flow from operations, while the cash impact from our investing activities is included in cash flow from investing activities. In periods such as 2001 and 2000, when we were exiting certain lines of business such as commercial lines and reinsurance assumed lines, we funded the payout of commercial and reinsurance assumed claims through the liquidation of invested assets.
adopted as of March 31, 2004 and did not impact the Company’s consolidated financial position or results of operations.
In April 2003, the Derivatives Implementation Group of the FASB issued DIG B36. DIG B36 requires the bifurcation of potential embedded derivatives within modified coinsurance and funds withheld coinsurance agreements in which the terms require the future payment of a principal amount plus a return based on a specified proportion of the ceding company’s return on either its general account assets or a specified block of those assets. The effective date of the implementation guidance in DIG B36 was for the first fiscal quarter beginning after September 15, 2003 and was to be applied on a prospective basis. On October 1, 2003, the Company adopted DIG B36. In connection with the adoption of DIG B36, the Company elected to reclassify to trading securities the investments, which are held in a separate trust, supporting a funds withheld treaty. In addition, the Company recognized a cumulative effect from the adoption of DIG B36 in 2003 of $(1,167) (net of $628 in taxes) in connection with recording the derivates embedded in its modified coinsurance and funds withheld coinsurance arrangements. The recording of this loss increased both basic and diluted net loss available to common shareholders per share by $0.03 for the year ended December 31, 2003.
In December 2004, the FASB issued Statement of Financial Accounting Standards (SFAS) No. 123R, “Accounting for Share Based Payment, an amendment to SFAS No. 148, Stock-Based Compensation -
Consolidated Statements of Operations for each of the years in the three-year period ended December 31, 2004, 2003 (Restated) and 2002 (Restated)
Consolidated Statements of Stockholders’ (Deficit) Equity and Comprehensive Loss for each of the years in the three-year period ended December 31, 2004, 2003 (Restated) and 2002 (Restated)
As discussed in Note C to the financial statements, the Company has suffered recurring losses from operations, has a net capital deficiency and is in default of certain covenants on its 8.75% Senior Debentures and 8.525% Deferred Capital Securities.
(a) The Company did not effectively communicate the importance of controls throughout the Company or set an adequate tone around control consciousness.
The control environment sets the tone of an organization, influences the control consciousness of its people, and is the foundation of all other components of internal control over financial reporting. The Company’s failure to maintain an effective control environment contributed to each of the material weaknesses discussed in 2 through 10 below.
2. The Company did not maintain an effective risk assessment function. Specifically, management failed to establish a formal risk assessment process designed to identify, assess and respond to control and fraud risks relevant to financial reporting. The failure to maintain an effective risk assessment function limited management’s ability to appropriately and timely respond to matters that impact the entity’s risk profile, such as entity size, complexity of operations, and degree of regulation over its activities.
3. The Company did not maintain effective controls over the completeness and accuracy of the period end financial reporting and close processes related to financial statement consolidations, intercompany eliminations and reconciliations of sub-ledger to general ledger balances. In addition, management did not have effective review and monitoring over such processes and the documentation supporting these activities was not adequate. Further, the Company lacked standard procedures for the authorization and review of consolidation and post-closing journal entries. This control deficiency resulted in the restatement of the Company’s consolidated financial statements for the years ended December 31, 2003 and 2002, for each of the quarters in the year ended December 31, 2003 and for the first and second quarter of the year ended December 31, 2004 as well as audit adjustments to the third and fourth quarter financial statements for the year ended December 31, 2004 to correct significant accounts and disclosures.
4. The Company did not maintain effective controls over vendor setup for the corporate accounts payable system. Specifically, the Company did not maintain a process to independently confirm the validity of vendors prior to such vendors being placed in our accounts payable system to receive payment. This control deficiency resulted in an audit adjustment due to the misappropriation of company funds by the Chief Information Officer. In addition, an individual within the claims department was able to exploit this control and misappropriate company funds.
5. The Company did not maintain effective controls over the review and evaluation of the recoverability of goodwill. Specifically, management did not maintain effective controls over the review of the periodic evaluation of the carrying amount of goodwill attributable to the Homeowners reporting unit. This control deficiency resulted in errors in the underlying analyses supporting the goodwill impairment evaluation related to (i) the calculation of the discounted cash flow projections and (ii) the calculation of the actuarially determined catastrophe losses.
Each of the control deficiencies described in items 1 through 10 above could result in a misstatement in the aforementioned accounts or disclosures that would result in a material misstatement to the consolidated financial statements that would not be prevented or detected.
Nature of Operations: Vesta, or the Company, is a holding company whose principal assets are investments in the capital stock of a group of wholly owned subsidiaries that constitute the Vesta Insurance Group, Inc. (“Vesta Group”). The Vesta Group offers financial services through the production, distribution, and administration of property-casualty and life insurance products. The lead insurers in the Vesta Group are Vesta Fire Insurance Corporation (“Vesta Fire”) and American Founders Life Insurance Company (see Note D for discussion of the sale of our life insurance operations on September 30, 2005). In the fourth quarter of 2002, we discontinued our health insurance and consulting lines of business. In 1999 and 2000, we discontinued the commercial line of business and our reinsurance assumed line of business, respectively. Each of these business lines has been segregated from continuing operations herein for all periods presented. See Note T for further discussion of our discontinued operations.
Investments: Investment securities are classified as either available for sale or trading. Investment securities classified as available for sale are reported at fair value, with unrealized gains and losses excluded from earnings and reported in a separate component of stockholders’ equity. Investment securities classified as trading are reported at fair value, with unrealized gains and losses reflected in earnings. Mortgage loans and policy loans are stated at the aggregate unpaid principal balances, net of any unamortized premium or discount and less any allowance for losses.
Short-term investments include investments in certificates of deposit and other interest-bearing time deposits with original maturities of one year or less.
Gains and losses realized on the disposition of investments classified as available for sale are recognized as revenues and are determined on a specific identification basis. Unrealized gains and losses on equity securities and fixed maturities available for sale, net of deferred income taxes, are reflected directly in stockholders’ equity.
If an investment becomes other than temporarily impaired, such impairment is treated as a realized loss and the investment is adjusted to fair value. An investment in a debt or equity security is impaired if its fair value falls below its book value and the decline is considered other than temporary. A debt security is deemed to have an other than temporary impairment if it is probable that the Company will not be able to collect all amounts due under the security’s contractual terms. Equity investments are deemed to have an other than temporary impairment when it becomes apparent that the Company will not recover its cost over the expected holding period.
Cash: Cash consists of balances on hand and on deposit in banks and financial institutions. Any consolidated overdraft balances are included in other liabilities on the Consolidated Balance Sheets. Consolidated overdraft balances are $25.2 million and $9.5 million as of December 31, 2004 and 2003, respectively.
Earned premiums on property-casualty business are recognized as revenue on a pro-rata basis over the respective period of each property-casualty insurance policy. Reinsurance premiums ceded are similarly pro-rated with the prepaid portion recorded as a component of reinsurance balances receivable in the Consolidated Balance Sheet;
Policy fees are recorded as revenue on a pro-rata basis over the policy term; and
Profit sharing income related to quota share reinsurance contracts is recorded on the actual results determined on an accrual method through the end of the applicable period.
For investment contracts without mortality risk (such as deferred annuities and immediate annuities with benefits paid for a certain period), premium deposits and benefit payments are recorded as increases or decreases in a liability account, rather than as revenue and expense. We record as revenue any amounts charged against the liability account for the cost of insurance, policy administration, and surrender penalties. Any interest credited to the liability account and any benefit payments which exceed the contract liability account balance are recorded as expenses. As of December 31, 2004 and 2003, approximately $97.1 million and $122.2 million, respectively, of Vesta’s annuity reserves are subject to discretionary withdrawal without surrender charges or other adjustments.
The costs to acquire blocks of life insurance representing the present value of future profits from such blocks of insurance is also included in deferred policy acquisition costs. We amortize the present value of future profits over the premium payment period. The unamortized present value of future profits was approximately $21.0 million and $13.0 million at December 31, 2004 and 2003, respectively. For the years ended December 31, 2004, 2003 and 2002, amortization expense of future profits were $0.3 million, $1.8 million and $2.4 million, respectively.
Based on current conditions and assumptions as to future events on policies in force, the deferred policy acquisition costs and value of business acquired as of December 31, 2004, excluding the effect of the fair value adjustment of investment securities available-for-sale, is expected to amortize as follows (in thousands):
Reinsurance: We report assets and liabilities related to insurance contracts before the effects of reinsurance. Reinsurance receivables and prepaid reinsurance premiums (including amounts related to insurance liabilities) are reported as assets. Estimated reinsurance receivables are recognized in a manner consistent with the liabilities related to the underlying insurance contracts. The Company records reinsurance receivables and recoverables net of any valuation allowances.
Income Taxes: Vesta accounts for income taxes using the asset and liability method under which deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. A valuation allowance is required when it is more likely than not that some portion of the deferred tax assets will not be realized. Realization is dependent on generating sufficient future taxable income.
Property and Equipment: Property and equipment is reported at cost less allowances for depreciation. Depreciation is recorded primarily on the straight-line method over the estimated useful lives of these assets that range from 1 to 9 years. Ordinary maintenance and repairs are charged to expense as incurred.
A summary of property and equipment used in the business at December 31, 2004 and 2003 is as follows (in thousands):
Depreciation expense on property and equipment was $4.8 million, $5.6 million and $5.5 million for the years ended December 31, 2004, 2003, and 2002, respectively.
Goodwill and Other Intangible Assets: The aggregate of goodwill and other intangible assets at December 31, 2004 and 2003 are as follows (in thousands):
The insurance industry has developed a variety of methods for determining reserves associated with losses that have been incurred but not yet reported (“IBNR”). One common method of actuarial evaluation is the loss development method. This method utilizes the pattern by which losses have been reported over time and assumes that each accident year’s experience will develop in the same pattern as the historical loss development. We also rely upon industry data to provide the basis for reserve analysis on newer lines of business.
(Loss) Income Per Share: Basic earnings per share (“EPS”) is computed by dividing net income available to common stockholders by the weighted average common shares outstanding for the period. Diluted EPS is calculated by adding to shares outstanding the additional net effect of potentially dilutive securities or contracts that could be exercised or converted into common shares. Net loss available to common shareholders and average shares outstanding as follows (in thousands):
the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated support from other parties. The effective date of FIN 46R is March 31, 2004. However, FIN 46R was applicable to entities that are considered special-purpose entities as of December 31, 2003. The application of FIN 46R had no effect on our Consolidated Financial Statements as of December 31, 2003.
As previously permitted by SFAS No. 123, the Company has elected to continue to apply the intrinsic-value-based method of accounting described above, and has adopted only the disclosure requirements of these statements. The Company plans to expense stock options using the modified prospective transition method prescribed in SFAS 123R. The modified prospective transition method requires expense to be recognized for new grants or modifications issued in the period of adoption, plus the current period expense for non-vested awards issued prior to the adoption of this standard. No expense is recognized for awards vested in prior periods. The Company is currently evaluating the use of various models, as well as the necessary assumptions for calculating the impact from adoption of this standard. Based on current guidance, the Company intends to adopt SFAS 123R and begin expensing share based compensation on January 1, 2006.
The internal review has since been completed. As a result of the findings of the internal review, the Company has concluded that its prior financial statements should be restated. The restatement resulted in a cumulative reduction to stockholders’ equity of approximately $11.6 million, $9.5 million, and $9.5 million as of December 31, 2003, 2002 and 2001, respectively, and a (decrease) increase to the previously reported net losses available to common shareholders of approximately $(191) thousand and $247 thousand for the years ended December 31, 2003 and 2002, respectively. In addition, the restatement resulted in an increase (decrease) to total comprehensive loss of approximately $2.3 million and $(234) thousand for the years ended December 31, 2003 and 2002, respectively.
In addition, the Company noted errors in our account reconciliation processes which resulted in adjustments of $494 thousand to earned premiums $(123) thousand to loss and loss adjustment expenses and $604 thousand to policy acquisition costs for the year ended December 31, 2003 and $(494) thousand to earned premiums, $459 thousand to policy acquisition costs and $(50) thousand to operating expenses for the year ended December 31, 2002. The amounts in 2003 reflect the reversal of the 2002 identified errors.
Finally, the Company noted that previously reported net investment income did not reflect all investment income related expenses. Rather, these expenses were previously reported as a component of operating expenses. As such, the Company reduced net investment income and operating expenses by $1.9 million and $2.2 million in 2003 and 2002, respectively, to correct this error.
Reflecting these adjustments in the restated financial statements impacted our Consolidated Statements of Operations and total comprehensive loss as follows (in thousands):
Consolidation Differences-As part of our internal review, the Company identified various errors in the Company’s previously reported Consolidated Statement of Operations. These errors predominately stem from the Company’s failure (1) to properly eliminate reinsurance transactions between its subsidiaries, (2) to properly eliminate other operating expenses allocated to its subsidiaries and (3) to properly reconcile the consolidated reported results of operations to the Company’s underlying accounting records. The following is a more detailed discussion of these aforementioned errors.
Investment Income-During our internal review, the Company noted that interest income related to a particular intercompany debt instrument was not being properly eliminated. To correct this error, the previously reported interest income was reduced by $320 thousand and $600 thousand for the years ended December 31, 2003 and 2002, respectively.
Net change in unrealized gain-The Company determined that errors occurred relating to the calculation of accumulated other comprehensive income as of December 31, 2003, 2002 and 2001. These errors predominately related to the calculation of tax expense associated with accumulated comprehensive income and the inappropriate application of new cost basis to the acquired investment portfolio at Florida Select Insurance Holdings, as described above. The correction of these errors decreased total comprehensive loss by $525 thousand and $234 thousand for the years ended December 31, 2003 and 2002, respectively.
In the aggregate, the correction of these errors impacted our Consolidated Statements of Operations and total comprehensive loss as follows (in thousands):
The items mentioned above, affected specific line items in the Statements of Operations as follows (in thousands):
Correction of Misclassifications-As part of our internal review, the Company identified certain prior period balance sheet items that were improperly classified and therefore are not comparable to the current year balance sheet presentation. These items, which predominately relate to the reclassification of the consolidated income tax receivable of $2.3 million from other liabilities to other assets, were reclassified in the restated December 31, 2003 Consolidated Balance Sheet.
In addition, the Company determined that errors occurred in the application of the intra-period tax allocation provisions of SFAS No. 109 as it relates to accumulated other comprehensive income as of December 31, 2003. Furthermore, errors were identified relating to the calculation of accumulated other comprehensive income as of December 31, 2003, 2002, and 2001 predominately associated with the appropriate application of new cost basis to the acquired investment portfolio at Florida Select Insurance Holdings. The correction of these errors decreased accumulated other comprehensive income by $1.9 million as of December 31, 2003 and increased accumulated comprehensive income by $412 thousand and $178 thousand as of December 31, 2002 and 2001, respectively.
Other Differences-As part of our internal review, the Company identified certain adjustments to reinsurance balances receivable and loss and loss adjustment expenses and unearned premiums as of December 31, 2003. These adjustments increased Consolidated Stockholder’s equity by $258 thousand, $195 thousand and $280 thousand as of December 31, 2003, 2002 and 2001, respectively.
Reinsurance Contract Realized Gains-One of the Company’s insurance subsidiaries, American Founders Life Insurance Company (“AFLIC”), entered into a reinsurance contract with a third party effective October 1, 2002. Under the terms of that agreement, AFLIC ceded the investment results, including realized gains and losses, on part of its investment portfolio to the third party reinsurer. Upon the termination of this contract, it was determined that certain realized investment gains and losses had been recorded as income in full by AFLIC instead of reflecting a portion of these gains as being due to the third party reinsurer, as required by the reinsurance contract. As such, the Company overstated its Consolidated Stockholders’ Equity by $480 thousand and $201 thousand as of December 31, 2003 and 2002, respectively. The impact to Consolidated Stockholders’ Equity is net of a deferred tax benefit of $259 thousand and $107 thousand as of December 31, 2003 and 2002, respectively. This error did not have an impact on Consolidated Stockholders’ Equity as of December 31, 2001.
Ceded Reinsurance Adjustment-As part of our review of our ceded reinsurance process, the Company identified approximately $3.8 million of ceded reinsurance assets that should have been charged to expense in the Consolidated Statements of Operations in periods prior to December 31, 2000. The identified errors consisted of the following: (1) $1.5 million of reinsurance recoverables related to the failure to properly record ceded premiums related to various reinsurance agreements in the late 1990’s, (2) $1.3 million of reinsurance recoverables related to the failure to properly expense certain unearned premiums related to the cancellation of a reinsurance contract prior to 2000, and (3) $1.0 million related to several smaller reinsurance balances that were generated prior to 2001 and which appear to not have been recoverable at that date . The amount reflected in the 2002 restated consolidated balance sheet is net of a tax benefit of $1.3 million. In 2003, the $1.3 million deferred tax asset was offset by an adjustment to the Company’s deferred tax asset valuation allowance that was originally recorded in 2003. Due to these errors, the Company overstated its Consolidated Stockholders’ Equity by $3.8 million, $2.5 million and $2.5 million as of December 31, 2003, 2002 and 2001, respectively.
The items mentioned above impacted specific line items in the December 31, 2003 Consolidated Balance Sheet as follows (in thousands):
The following schedule provides details of the adjustments included in the restatement of consolidated stockholders’ equity at December 31, 2002 and 2001 (in thousands):
Furthermore, as described in more detail in Note O, the Company is currently in default on certain covenants related to the timely filing of financial statements on its publicly traded 8.75% Senior Debentures (the Debentures) and 8.525% Deferred Capital Securities (the Capital Securities). The total amount of this debt outstanding as of December 31, 2004 was $75.9 million. While the Company has not received notice of an event of default from its bondholders or trustee, this default could lead to the acceleration of future debt payments.
If notice of default were delivered to the Company on the Debentures or the Capital Securities, or both, the Company does not have the funds necessary to repay these obligations. The Company would have to pursue
Accordingly, the Company, in consultation with its financial advisors, is pursuing several possible transactions to address the Company’s current financial condition. Possible transactions being considered by the Company include the following:
- Asset dispositions-The Company is also evaluating possible asset dispositions, including the possible sale of certain subsidiary insurance companies. As with the possible capital raising initiatives, the Company is in the preliminary phase of analyzing which asset groups or subsidiary companies would allow the Company to maximize the increase in statutory surplus and/or reduction of written premium levels.
improving our financial condition and our financial strength rating. In the event we are unable to improve our financial condition and our financial strength rating, we anticipate significant deterioration in our premium volume at a rate which is expected to exceed our ability to reduce expenses. Accordingly, we may not be able to achieve future profitability.
Furthermore, in regards to the aforementioned increased regulatory scrutiny, various state regulators have informed the Company that the failure of the Company to secure an improved financial condition could likely result in adverse regulatory action, including but not limited to regulatory supervision of the applicable insurance subsidiaries. Regulatory supervision of the insurance subsidiaries would likely have a material adverse impact on the Company’s premium volumes as well as its ability to secure reinsurance. Such an occurrence would result in a significant decrease in the Company’s cash flows and would negatively impact the Company’s ability to meet its contractual obligation, including the repayment of the inter-company bonds held by Vesta Fire, the Debentures and the Capital Securities.
Finally, the sources of cash available to our holding company to pay holding company expenses, including principal and interest on outstanding indebtedness, are dividends paid by our management company subsidiary, J. Gordon Gaines, Inc., and its subsidiaries. These management companies earn management fees and attorney in fact fees paid by our insurance company subsidiaries, which are largely dependent on the amount of premium written by those companies. A significant deterioration in premium volumes could lead to inadequate cash available to our holding company to fund all of its obligations. For further information concerning our holding company obligations and sources of funds available, please refer to “MD&A-Liquidity and Capital Resources” included in this report.
Effective July 9, 2004, the initial public offering of 8.2 million shares of Affirmative Insurance Holdings, Inc. (“Affirmative”) was consummated at a price of $14 per share. Of the shares sold, 4.4 million shares were newly issued shares offered by Affirmative while 3.8 million shares were offered by the Company. Additionally, on July 26, 2004 the underwriters of Affirmative’s initial public offering exercised in full the over-allotment option to purchase an additional 1.2 million shares of Affirmative common stock at a price of $14 per share. Of the shares sold in connection with the over-allotment, 663 thousand shares were newly issued shares offered by Affirmative while the Company offered 562 thousand shares.
The Company received total net proceeds from these transactions of approximately $55.4 million and retained 7.2 million shares, or approximately 42.9% of the outstanding shares of Affirmative. The Company recorded a third quarter gain in 2004 from these transactions of $11.2 million.
On August 30, 2005, we sold our remaining 5.2 million shares of Affirmative common stock to an unaffiliated third party. In this transaction, Vesta Insurance Group, Inc. sold approximately 1.3 million shares and Vesta Fire sold approximately 3.9 million shares. We received $77.5 million in proceeds, net of closing costs. Vesta will report a gain of approximately $9.4 million in the third quarter of 2005 related to this transaction.
Effective September 30, 2003, we consummated a stock purchase agreement for the sale of all common stock of our health insurance operations, which included Aegis Financial Corporation (Aegis) and its subsidiary States General Life Insurance Company (States General) for $4.6 million. The sales price was financed through a $5.0 million note issued by the buyer payable to Vesta Fire. The note bears interest at a fixed rate of 6%, with interest payments due semi-annually and principal due in September 2006. The note is collateralized by the common stock of Aegis. The results of Aegis have been reclassified to discontinued operations for all periods presented. Vesta did not receive the scheduled interest only payment due on September 30, 2004 related to the $5.0 million note. In the third quarter of 2004, the Company recorded a realized loss of $5.3 million on the entirety of the recorded note and accrued interest balances based on our assessment of the collectibility of the note and the underlying collateral. Since that time, Aegis entered receivership. Management believes the likelihood of recovering any amounts due is remote.
In June, 2001, the FASB issued SFAS No. 141, “Business Combinations” and SFAS No. 142, “Goodwill and Other Intangible Assets,” having a required effective date for fiscal years beginning after December 15, 2001. Under these pronouncements, goodwill and other intangible assets deemed to have indefinite lives will no longer be amortized but will be subject to at least annual impairment testing as prescribed by SFAS No. 142. Other intangible assets will continue to be amortized over their useful lives. We adopted SFAS No. 142 effective January 1, 2002.
Upon our initial adoption of SFAS No. 142, we identified three reporting units that would be tested for goodwill impairment: homeowners’ insurance operations; life insurance operations; and non-standard automobile agency operations. With the consummation of the initial public offering of Affirmative in the third quarter of 2004, the Company’s reporting units were reduced to homeowners’ insurance operations and life insurance operations. Pursuant to the provisions of SFAS No. 142, we conduct an evaluation, on at least an annual basis, to assess whether the fair value of our reporting units exceeds each reporting unit’s carrying value. Upon the occurrence of significant events, which could impact the assumptions we use to project future profitability, we update our evaluation of our reporting units. Our annual evaluation is performed on September 30th. In connection with our evaluation of the recorded goodwill in 2004, we engaged a third party to assist management in its assessment of the valuation of goodwill.
As noted above, we update our evaluation in situations where significant events occur which could impact the assumptions utilized in our September 30th evaluation. Such a situation occurred in 2004 related to our evaluation of the recoverability of goodwill associated with our life insurance operations. Due to the failure to close the sale of AFFC, which was a critical component of our September 30, 2004 evaluation of our life insurance operations goodwill, management performed another assessment as of December 31, 2004. Based on similar factors noted above, management concluded that as of December 31, 2004, there was an indication of impairment for the life insurance operations goodwill. After applying step II of the goodwill valuation model as required by SFAS No. 142, management concluded that the entire $7.5 million of goodwill attributed to the life insurance operations reporting unit was impaired. As such, management recorded a full impairment loss of $7.5 million in the fourth quarter of 2004.
In the fourth quarter of 2002, we wrote off $9.1 million of goodwill associated with our discontinued health insurance ($7.9 million) and consulting ($1.2 million) business lines. (See Note T for further discussion of discontinued operations).
The audited statutory capital and surplus and statutory net loss of Vesta Fire as of and for the year ended December 31, 2004 was $50.0 million and $138.5 million, respectively, compared to $189.4 million and $20.0 million in 2003. Additionally, the statutory capital and surplus and statutory loss of Laurel Life Insurance Company as of and for the year ended December 31, 2004 was $26.3 million and $1.7 million, respectively, compared to $32.8 million and $1.0 million in 2003. As discussed further in Note I, the admitted value of Vesta Fire’s ownership of $57.3 million (par value) of bonds issued by Vesta Insurance Group, Inc. was $40.0 million as of December 31, 2004. The admitted value of the intercompany bonds comprises 80.1% of Vesta Fire’s statutory surplus at December 31, 2004.
Vesta Fire and three other insurance subsidiaries redomisticated to the State of Texas in May of 2006. The Company believes that the limitation of dividend payments in the State of Texas are similar to those in Illinois. Accordingly, we will not be able to declare and pay a dividend from our lead insurance company subsidiary for the foreseeable future without prior approval.
Insurance Corporation and 553% for Laurel Life Insurance Company. Vesta Fire’s statutory surplus was $76.2 million as of December 31, 2005, or approximately $700 thousand below company action level. As of March 31, 2006, the Vesta Fire’s statutory surplus was $82.8 million. Although Vesta Fire’s risk-based capital was below company action level as of December 31, 2004 and 2005 which would have required the Company to submit a plan to address this deficiency, the Company’s current statutory surplus is above company action level. As the Company is currently above company action level, no plan has been submitted.
During the course of a routine triennial regulatory exam, one of our state regulators identified certain transactions that had occurred in the past which had not received the prior approval required by the Holding Company Acts applicable to the Company and its insurance subsidiaries. Management is currently discussing these prior transactions with various state regulators and, at this time, is unable to predict what, if any, consequences or remedies that may be imposed as a result.
Various state insurance regulators have indicated concerns regarding our subsidiary insurance companies’ financial condition and operating performance. These state regulators have informed the Company that the failure of the Company to secure an improved financial condition could likely result in adverse regulatory action, including but not limited to regulatory supervision of the applicable insurance subsidiaries. Regulatory supervision of the insurance subsidiaries would likely have a material adverse impact on the Company’s premium volumes as well as its ability to secure reinsurance. Such an occurrence would result in a significant decrease in the Company’s cash flows and would negatively impact the Company’s ability to meet its contractual obligation, including the Debentures and the Capital Securities.
A summary of fixed maturities-trading (at fair value) as of December 31, 2003 are as follows (in thousands):
During the fourth quarter of 2004, the Company’s modification of the Scottish Re Life Corporation reinsurance contract resulted in the transferring of the assets held in trust, which were classified as trading securities prior to the change, to the reinsurers. As a result of this contract modification, no securities were classified as trading as of December 31, 2004.
A schedule of fixed maturities available for sale by contractual maturity at December 31, 2004 is shown in the table below (in thousands). Actual maturities could differ from contractual maturities due to call or prepayment provisions.
The Company has pledged investments having a market value of $172.2 million to the Federal Home Loan Bank, pledged investments having a market value of $31.3 million pursuant to certain reinsurance contracts, and has deposited investments having a market value of $31.9 million to certain state insurance agencies.
We maintain a mortgage loan portfolio consisting of first-lien residential and commercial mortgages. At December 31, 2004 and 2003, our residential mortgages had carrying values of approximately $2.8 million and $1.6 million, respectively, and commercial mortgages had carrying values of approximately $5.7 million and $7.5 million, respectively.
The aggregate unrealized losses approximate 1.4% of the fair value of the temporarily impaired securities at December 31, 2004. For those securities identified as having temporary impairments for less than twelve months, the temporary losses are primarily due to recent increases in U.S. Treasury yields and are not due to deterioration in credit quality issues. While the 10-year U.S. Treasury yield ended 2004 nearly unchanged at 4.22%, the rate did fluctuate from 3.68% to 4.87% during the year. The fair value of bonds purchased at the lower end of the 10-year Treasury yield range were adversely impacted by the increase in the rate at the end of the year.
The most significant adverse event in 2004 that effected prior year development related to our settlement of the Muhl lawsuit for $14.5 million, net of reinsurance. The net amount of the Muhl settlement is reflected in the above table as being adverse development due to the fact that no reserves existed for losses under the related reinsurance treaty at the time of the settlement. In addition, Vesta commuted various assumed reinsurance treaties in 2004 at amounts that, in the aggregate, were in excess of the recorded reserves. The combination of the Muhl settlement and treaty commutations, coupled with adverse development on the discontinued lines, resulted in approximately $16.5 million in 2004 of adverse development in 2004. The entirety of this amount related to prior accident years. Offsetting this amount was the favorable development prior to 2004 related to our retained non-standard automobile reserves of approximately $5.3 million and favorable development related to settlements with NRMA, Dorinco and Alfa of approximately $12.5 million.
Two significant factors occurred in 2003 that impacted the cumulative deficiency related to 2002. The first such factor involved an increase of paid losses and the liability for unpaid losses and loss adjustment expenses of $60.2 million related to reinsurance arbitrations with NRMA, Dorinco and Alfa. The $60.2 million noted previously represents the $65.9 million aggregate charge for the 1997 20 percent whole account quota share, net of interest charges. Similar to 2004, Vesta commuted various reinsurance assumed treaties in 2003 at amounts in excess of the booked reserves. The commutations along with additional adverse development on the discontinued lines was approximately $5.0 million in 2003, all related to prior accident years. In addition, in 2003 Vesta had adverse development on the homeowners line of business for accident year 2002.
As discussed in previous SEC filings, in 1998 we corrected our accounting for assumed reinsurance business through restatement of our previously issued financial statements. Similar corrections were made on a statutory accounting basis through recording cumulative adjustments in Vesta Fire’s 1997 statutory financial statements. The impact of this correction has been reflected in amounts ceded under our 20 percent whole account quota share treaty, which was terminated on June 30, 1998 on a run-off basis. We believed such treatment was appropriate under the terms of this treaty and calculated the quarterly reinsurance billings presented to the three treaty participants accordingly.
During the third quarter of 2004, Dorinco’s portion of this billing dispute was settled by the parties for an agreed payment of $12 million by Dorinco to Vesta. As a result of the settlement, the Company recorded a reduction to litigation and billing dispute settlements, the line item in which the original charge was classified, to reflect a decrease of $3.1 million in the necessary valuation allowance as of September 30, 2004. Vesta received such payment in October of 2004.
Muhl vs. Vesta is a case in the Supreme Court of the State of New York, County of New York, brought by the Liquidator of Midland Insurance Company (“Midland”), claiming recoveries under two alleged retrocession agreements (Pool I and Pool III) between Midland and Interstate Fire Insurance Company, Vesta’s predecessor in interest. The plaintiff is seeking approximately $22.0 million in damages comprised of approximately $16.0 million of claims and approximately $6.0 million of interest on paid claims. During the third quarter of 2004, the court ruled that the case would be bifurcated with separate trials on Pool I and Pool III. The trial on the issue of the existence, terms and conditions of Pool III commenced on November 1, 2004. On November 8, 2004 a verdict was reached in favor of the plaintiff that Pool III does exist. At the request of the plaintiff, we agreed to enter mediation to attempt to resolve the issues of breach of contract and damages.
Vesta vs. New Cap Re is an arbitration against an Australian reinsurer, to collect reinsurance recoverables pursuant to two accident year excess of loss ratio reinsurance agreements. In the arbitration, New Cap Re
challenged Vesta’s earlier draw on a Letter of Credit for $7.5 million, which was held in connection with one of the two contracts. Shortly after the arbitration commenced, New Cap Re became the subject of insolvency proceedings in Australia and an ancillary proceeding in the U.S. Bankruptcy Court in New York. The Bankruptcy Court stayed all pending litigation and arbitration against New Cap Re, and we appealed that ruling to the Southern District of New York, and ultimately to the U.S. Court of Appeals for the Second Circuit, which affirmed the Bankruptcy Court’s stay of the arbitration against New Cap Re. Hence, our efforts to recover losses of approximately $12.5 million as well as New Cap Re’s efforts to challenge the earlier draw on the $7.5 million Letter of Credit by us are stayed and the Company’s options may be limited to seeking adjudication of the dispute in Australia.
In August 2005, ERC notified Vesta Fire that it was demanding arbitration pursuant to the Loss Portfolio Transfer (“LPT”) agreement. ERC seeks a declaration that it is owed approximately $2.5 million. ERC is also seeking to consolidate its arbitration with the arbitration demanded by Vesta Fire under the Reinsurance Agreements. The Company is opposing consolidation of the two arbitrations and has filed a declaratory judgment action in Federal Court in Dallas, Texas, seeking an adjudication that the statute of limitations has expired on any claim ERC may have under the Acquisition Agreement or the LPT. At the organizational meeting of the arbitration panel on February 28, 2006, the panel ruled that it would bifurcate the arbitration, with phase one to
Shelby Casualty Insurance Co., f/k/a/ Federal Kemper Insurance Company (“Shelby”) vs. Lumbermens is an arbitration against Lumbermens Mutual Insurance Company (“Lumbermens”), an affiliate of Kemper Insurance Co. (“Kemper”), to collect a reinsurance recoverable pursuant to Kemper Inter-Company Reinsurance Agreement No. 204 (“Agreement No. 204”). In July 2005, Shelby, a wholly owned subsidiary of Vesta, notified Lumbermens that it was demanding arbitration because of Lumbermens’ failure to pay balances of approximately $4.0 million owed under Agreement No. 204. In the arbitration, Shelby is seeking to recover 100% of all outstanding losses and loss adjustment expenses related to certain asbestos claims and losses, plus interest, costs and attorney fees. Lumbermens contends that the asbestos related claims are not covered under Agreement No. 204.
Management believes that all losses and expenses relating to these asbestos claims are properly ceded to Lumbermens pursuant to Agreement No. 204. Both parties have named their respective arbitrators who have recently selected an umpire and the organizational meeting is scheduled for June 1, 2006. Management established a $12.2 million valuation allowance related to balances due the Company from Lumbermens. Of the $12.2 million valuation allowance, approximately $2.0 million of this balance relates to the aforementioned arbitration. The remaining $10.2 million valuation allowance was recorded related to the deterioration of the financial condition of Lumbermens as more fully discussed in Note K to the Consolidated Financial Statements. The entirety of the $12.2 million valuation allowance was recorded in the third quarter of 2004 as a component of operating expenses in our standard property and casualty segment.
and also breached its contract with Vesta in a number of respects. The remaining issues and damages are expected to be adjudicated at the trial of this case, which is scheduled to commence September 26, 2006.
Also, in March 2005, Vesta Fire filed a separate action against other involved parties in the IV related transactions seeking additional damages. On October 5, 2005, the Company reached a settlement with these parties collectively for a $2.0 million payment to the Company. The impact of this settlement will be recorded in the fourth quarter of 2005.
Our subsidiary, American Founders Financial Corporation (“American Founders”), is a defendant in a lawsuit in the United States Bankruptcy Court for the Southern District of Texas brought by the trustee of the bankruptcy estate of IFS Holdings, Inc.-the former holder of American Founders’ series A and C preferred stock-alleging that American Founders purchased its Series A and Series C preferred stock from IFS Holdings, Inc. for less than “reasonably equivalent value,” and, therefore, engaged in a voidable fraudulent transfer. The trustee’s lawsuit alleges damages equal to the difference between the “face value” of the preferred stock and the cash amounts paid therefore in certain redemption transactions, as well as other exemplary damages. American Founders believes that (i) the “face value” of the preferred stock in question bears little or no resemblance to its reasonable fair value, (ii) that the redemption transaction was for reasonably equivalent value; and (iii) that the allegations brought against it in this lawsuit are without merit. American Founders’ sale of its operating subsidiaries in September of 2005 did not relieve its potential exposure in this lawsuit.
Discovery is complete, and motions for summary judgment have been filed but not yet ruled upon. Trial may be set in June or July, 2006, depending on the court’s trial calendar. Based on its most recent amended complaint, plaintiff appears to be claiming damages in excess of $64 million, although plaintiff’s calculations appear to contain errors and duplication. AFFC is vigorously contesting the claims made by the plaintiff and does not believe plaintiff suffered any damages as a result of the transactions about which plaintiffs complain. To the contrary, AFFC contends that plaintiff received more than reasonably equivalent value for the preferred stock which was the subject of those transactions. In the opinion of management, the resolution of the lawsuit should not result in any award of damages to plaintiff. However, given the amount of damages claimed by plaintiff, an
As discussed further in Note K, the Company transferred Affirmative Insurance Company and Insura Insurance Company to Affirmative effective December 31, 2003. In addition, the Company entered into a reinsurance agreement with these insurance companies’s to cede all of the non-standard automobile underwriting results effective December 31, 2003. However, the Company retained all losses and loss adjustment expenses incurred prior to December 31, 2003.
During 2006, the management of Affirmative notified the Company that they believed that a balance of $7.2 million was owed to Affirmative by the Company. Affirmative noted that they believed that this balance stemmed from amounts owed by the Company from the original transfer of Affirmative Insurance Company and Insura Insurance Company to Affirmative at December 31, 2003. The Company has a liability of $14.5 million recorded as of December 31, 2004 and believes that this amount is accurate based on premiums, losses and commissions ceded to and from Affirmative and cash payments to and from Affirmative. The Company believes that the information provided from both Affirmative and third-party managing general agents, as well as the payments made to and received from Affirmative, provides the Company with adequate documentation as to the validity of our recorded balances with Affirmative as of December 31, 2004.
Vesta Fire Insurance Corporation contends that Robert Moreno, an individual doing business as Robert Moreno Insurance Services (“RMIS”), a general agency in California producing nonstandard automobile business, owes Vesta Fire approximately $1.7 million under the terms of the general agency agreement between Vesta Fire and RMIS. RMIS claims that a contingent commission payment is due them in the amount of $486,606 pursuant the terms of the general agency agreement. On February 17, 2006 RMIS filed a lawsuit against Vesta Fire and California Select Insurance Agency, Inc. wherein RMIS alleges several causes of action including, breach of the oral contract, fraud and/or negligent misrepresentation, breach of contract, misappropriation of trade secrets, and for a declaratory judgment that RMIS’s claims are not subject to an arbitration agreement with Vesta Fire and that RMIS should be compensated according to the terms of the general agency agreement. RMIS claims damages in excess of $30 million.
Since this lawsuit has just recently been filed, there has been no discovery taken and no final evaluation can be made as to the merits of the plaintiff’s claims. However, based on its knowledge of the facts, Management does not believe there is any merit to the plaintiff’s contentions and that RMIS filed this lawsuit in response to Vesta Fire’s demand for reimbursement for the $1.7 million due it from RMIS. Vesta Fire intends to vigorously contest the claims by RMIS and does not believe RMIS suffered any damages as a result of the actions about which RMIS claims.
Vesta, through its subsidiaries, is routinely a party to other pending or threatened legal proceedings and arbitration relating to the regular conduct of its insurance business. These proceedings involve alleged breaches of contract, torts, including bad faith and fraud claims and miscellaneous other specified relief. Based upon information presently available, and in light of legal and other defenses available to Vesta and its subsidiaries, management does not consider liability from any threatened or pending litigation regarding routine matters to be material.
During 2004, we sold all of the outstanding common stock of Aegis for $4.6 million. The sales price was financed through a $5.0 million note issued by the buyer and payable to Vesta Fire.
The Company’s insurance subsidiaries entered into a 50% quota share agreement (“2003 50% Quota Share Agreement”), effective September 30, 2003, on our residential property book of business in the states of Alabama, Alaska, Arizona, California, Connecticut, Florida, Hawaii, Massachusetts, New Jersey, New York, Pennsylvania, Rhode Island, South Carolina, Tennessee, and West Virginia (“Continuing States”), representing the states in which the Company intends to continue to write new property and casualty business. Effective
December 1, 2003, the residential property book of business in Texas was added to this 2003 50% Quota Share Agreement, which had been previously reinsured under a separate treaty covering only residential property business in Texas (“2002 50% Quota Share Agreements”) from December 1, 2002 to November 30, 2003.
Simultaneous with the commutation of the 2003 50% Quota Share Agreement, the Company’s insurance subsidiaries entered into a new 50% quota share agreement (“2004 50% Quota Share Agreement”). The 2004 50% Quota Share Agreement is effective for residential property business in our Continuing States, and retains similar economic terms including ceding commissions and profit sharing commissions. The initial term of the contract is one year. As of December 31, 2004, we ceded approximately $16.3 million of catastrophe losses to the 2004 50% Quota Share Agreement, which represents the maximum amount of catastrophe losses that can be ceded under the terms of the contract.
Effective December 1, 2004, the Company’s insurance subsidiaries entered into an additional 25% quota share agreement (“2004 25% Quota Share Agreement”). The 2004 25% Quota Share Agreement is on similar terms as the existing 2004 50% Quota Share Agreement, including the policies subject to the agreement, ceding commission and profit sharing commissions and expiration date of June 30, 2005.
In connection with certain catastrophe losses resulting from hurricanes occurring in the third quarter of 2004, the Company ceded losses of approximately $46.2 million to the FHCF and approximately $37.3 million to other reinsurers under our 2004 50% Quota Share Agreement and traditional excess of loss reinsurance program. As of December 31, 2004, the Company had $38.5 million of coverage left from the FHCF with a 10% co-insurance requirement. The amount of coverage from the FHCF will reset for 2005.
During February and March 2005, we purchased $35.0 million of additional catastrophe reinsurance in excess of our retention of $10 million reinsurance for our Texas business to cover losses from all perils, particularly hail.
Our reinsurance agreements, including our standard property and casualty quota share agreements, contain various provisions such as profit sharing arrangements, loss ratio limitations, and occurrence limitations that 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 potentially reducing the amount of reinsurance recoveries available to us under the various contracts. Furthermore, these reinsurance agreements do not relieve the Company’s insurance subsidiaries from their primary obligation to policyholders, as they remain liable to its policyholders to the extent that any reinsurer does not meet its obligations for reinsurance ceded to it under reinsurance contracts.
The effect on premiums earned and losses and loss adjustment expenses incurred of all ceded and assumed reinsurance transactions are as follows (in thousands):
under personal injury protection auto policies of the Shelby insurance companies originating prior to their acquisition in 1997. Lumbermens and other members of the Kemper Insurance Companies, which operate under a business pooling arrangement, were assigned an A. M. Best’s rating of “D” (Poor) on June 30, 2003. The Company is closely monitoring the financial condition of Lumbermens, which has entered into a voluntary run-off plan with the Illinois Department of Insurance. Based on Lumbermens financial condition, management concluded that the recording of a valuation allowance was appropriate. As such, management recorded a valuation loss of approximately $10.2 million in the third quarter of 2004. Additionally management recorded a valuation allowance of $2.0 million in the third quarter of 2004 related to an outstanding arbitration as discussed in Note I. In the aggregate, the Company has recorded a valuation allowance of $12.2 million as of December 31, 2004.
The amount of reserves for unpaid losses and loss adjustment expenses, policy benefits and unearned premiums that we would remain liable for should reinsuring companies be unable to meet their obligations are as follows (in thousands):
The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 2004 and 2003 are presented below (in thousands):
Gross operating loss carryforwards expire in periods through 2024 with approximately $178.0 million of the total expiring after 2017.
We evaluate the recoverability of our deferred tax assets on an ongoing basis considering all available positive and negative evidence, including our past results, the existence of significant cumulative losses in recent years, and our estimate of future taxable income.
In connection with our evaluation as of December 31, 2003, we considered the combination of significant cumulative losses in recent years and the uncertainty with respect to our ability to achieve sufficient taxable income to fully realize our year-end deferred tax asset balances within a reasonable time frame. Based on these factors, we determined that the recording of a valuation allowance of $76.6 million related to those companies included in the Vesta Insurance Group, Inc. consolidated tax group was warranted, resulting in an aggregate valuation allowance of $83.9 million as of December 31, 2003.
We again performed an evaluation of the recoverability of our deferred tax assets as of December 31, 2004. Based on our operating results during 2004, we determined that maintaining a full valuation allowance was appropriate for those companies included in the Vesta Insurance Group, Inc. consolidated tax group. As of December 31, 2004, our recorded valuation allowance was $84.1 million for the Vesta Insurance Group, Inc.
consolidated tax group. In addition, we concluded the combination of significant cumulative losses in recent years and the uncertainty with respect to our ability to achieve sufficient taxable income to fully realize our year-end deferred tax asset balances related to our life insurance companies, a separate tax paying entity, warranted a full valuation allowance. As a result, we recorded an additional valuation allowance of $5.7 million in 2004. In the aggregate, our recorded deferred tax asset valuation allowance was $89.8 million as of December 31, 2004.
We will continue to review our estimated taxable income in relation to our actual results on an ongoing basis. In the event management believes that existing uncertainties regarding our forecasted taxable income are minimized, the existing valuation allowance may be reversed.
In 2002, we purchased 218 thousand shares of treasury stock on the open market for approximately $1.4 million. In the first quarter of 2002, we issued 57 thousand shares of treasury stock in exchange for 328 thousand shares of Instant Insurance Holdings, Inc. held by four minority shareholders. As of December 31, 2003, the Board of Directors has authorized the Company to acquire up to 5.0 million shares of treasury stock.
Unearned stock consists of shares of common stock issued by Vesta that remain subject to certain future restrictions, and therefore are shown as a reduction to stockholders’ equity. Unearned stock compensation is composed of the following at December 31, 2004 and 2003 (in thousands):
The Senior Debentures are unsecured and rank on parity with all other unsecured and unsubordinated indebtedness. The debentures contain certain restrictions on the ability of Vesta to issue, sell, or otherwise dispose of any restricted subsidiary or to pledge the capital stock of any restricted subsidiary.
We are a party to an indenture related to our 8.75% Senior Debentures due 2025 (the Debentures) which requires us to file with the Indenture Trustee our periodic reports required by the Securities Exchange Act of 1934 within 15 days after they are required to be filed with the Securities and Exchange Commission. Since the
Effective September 30, 2004, we amended our existing $30 million revolving credit arrangement with First Commercial Bank of Birmingham, Alabama (“First Commercial”). The amended revolving credit agreement is collateralized by a pledge of 2.5 million shares of our holding company’s ownership in the common stock of Affirmative. In addition, Vesta is required to maintain a loan to collateral ratio of 80% throughout the term of the agreement. The facility bears interest at First Commercial’s prime rate. As of December 31, 2004, we had drawn the entire $30 million available under the credit facility. The Company was in violation of certain covenants associated with the revolving credit facility as of December 31, 2004.
As of December 31, 2004, our long-term debt carried a semi-annual distribution obligation to unaffiliated third parties of approximately $3.3 million.
As of December 31, 2003, the Company has recorded, as a component of other liabilities, $14.3 million related to consideration for nonstandard agency acquisitions made by the Company in 2002. Such obligations are not obligations of the Company as of December 31, 2004 as a result of the divestiture of Affirmative.
Advances from the Federal Home Loan Bank (“FHLB”) as of December 31, 2004 and 2003 are as follows (in thousands):
The following summary sets forth activity under the aforementioned Plans for the years ended December 31:
The following table shows expiration dates and weighted average exercise price for all outstanding options and options currently exercisable at December 31, 2004:
The following table presents the impact of the financial statement adjustments on our Consolidated Statements of Operations for our four quarters in 2004.
The carrying amounts and estimated fair values of Vesta’s financial instruments at December 31, 2004 and 2003 are as follows (in thousands):
Mortgage Loans-The fair value of mortgage loans is calculated by discounting scheduled cash flows through the estimated maturity using the current rates at which similar loans would be made to borrowers with similar credit and interest rate risks. No loans were in the process of foreclosure at December 31, 2004.
securities. Fair value of cash overdrafts approximates carrying value based on the short term nature of the balances.
For the year ended December 31, 2003, we recorded a loss of $17.1 million, for assumed reinsurance and commercial lines businesses primarily related to the recording of an after-tax charge of $10.5 million on the CIGNA Property and Casualty Insurance Company arbitration, the recording of an after-tax charge of $1.1 million related to the settlement of the Nichols lawsuit, and an after-tax charge of $5.5 million related to reserve adjustments and valuation allowances for receivables related to our commercial and assumed reinsurance books of business.
Operating results of discontinued reinsurance assumed, commercial, health and consulting lines were as follows (in thousands):
Assets and liabilities of the commercial and reinsurance assumed businesses are primarily comprised of the following at December 31, 2004 and 2003 (in thousands):
During 2004 and 2003 the law firm of Balch & Bingham LLP, of which Walter M. Beale, Jr., one of our directors, is a partner, rendered various legal services to Vesta and certain of its subsidiaries. The fees paid by us to Balch & Bingham were $194 thousand, $360 thousand and $310 thousand in 2004, 2003 and 2002, respectively.
In December 2002, James E. Tait, the former Chairman, voluntarily resigned. Mr. Tait received a severance payment of $4.2 million. In addition, Mr. Tait returned to Vesta 450 thousand shares of unvested restricted stock and also repaid an outstanding loan in the amount of $1.8 million plus accrued interest under the Executive Officer Incentive Compensation. Also, Mr. Tait returned 145 thousand shares of restricted stock, repaid a $250 thousand relocation loan for a relocation advance, and repaid a Promissory Note of $550 thousand plus accrued interest.