Statutory data has been derived from the separate financial statements of the Company’s insurance companies prepared in accordance with SAP. The statutory deficit at December 31, 2002 relates only to AIC, the Company’s only consolidated insurance company. The statutory deficit at December 31, 2002 was significantly impacted by the non-admission of pledged investments totaling approximately $89.9 million, under statutory accounting principles.
The principal lines of the Company’s Agricultural Segment were MPCI, supplemental
coverages, and named peril insurance. MPCI is a federally subsidized risk management program designed to encourage agricultural producers to manage their risk through the purchase of insurance policies. MPCI provides the agricultural producers with yield coverage for crop damage from substantially all natural perils. CRC is an extension of the MPCI program that provides a producer of crops with varying levels of insurance protection against loss of revenues caused by changes in crop prices, low yields, or a combination of the two. As used herein, the term MPCI includes CRC, unless the context indicates otherwise.
Certain characteristics of the Company’s crop business may affect comparisons, including: (i) the seasonal nature of the business whereby profits or losses are generally recognized predominately in the third or fourth quarter of the year; (ii) the nature of crop business whereby losses are known within a one year period; and (iii) the limited amount of investment income associated with crop business. In addition, cash flows from such business differ from cash flows from certain more traditional lines. The Company’s Agricultural Segment produced more volatility in the operating results on a quarter-to-quarter or year-to-year basis than has historically been the case due to the seasonal and short-term nature of the Company’s crop business, as well as the impact on the crop business of weather and other natural perils.
Many parts of the country experienced drought and abnormal growing conditions that significantly impacted the amount of losses under 2002 MPCI policies issued by the Company. These MPCI losses impact the Company’s share of profit it receives from or loss it pays to the Federal Crop Insurance Corporation (“FCIC”) under the profit sharing formula established by law and administered by the Risk Management Agency. Because of the extraordinary reported and expected volume and severity of crop insurance claims in 2002, the Company recorded a negative 1.5% profit share on a retained pool of approximately $418.2 million and recognized MPCI reinsurance costs and underwriting expenses through December 31, 2002 of approximately $79.6 million. Therefore the Company recorded a loss from crop insurance underwriting and operation for the year ended December 31, 2002 of approximately $87.3 million. The negative 1.5% profit share in 2002 compares to an adjusted 2001 crop year profit share of 16.2% on a retained pool of approximately $498.4 million, or approximately $80.9 million. See “Results of Operations.”
As of December 31, 2002 the only remaining consolidated insurance company of AICI is AIC. The Director entered an administrative Order of Supervision with respect to AIC on December 20, 2002 and AIC currently is operating pursuant to that Order. Under the Order of Supervision, AIC is required to pay all costs incurred by the Supervisor, AIC may not accept or renew any insurance business and may not perform any activities beyond those that are routine in the day-to-day conduct of its runoff business without prior approval of the Director or Supervisor. The Director currently has the authority to increase regulatory control of AIC by requesting an appropriate court to enter an Order of Rehabilitation or an Order of Liquidation, with or without a change in the financial condition of AIC. The Company believes increased regulatory control of AIC would have a significant negative impact on the Company.
The Company continues to manage the run-off of discontinued and sold businesses. Based upon the above, the Company expects the Property and Casualty Segment net premiums earned in 2003 to be significantly lower than 2002 and be primarily comprised of adjustments related to audits and endorsements for policies expiring in 2002 and prior years.
A critical accounting policy of the Company relates to the accounting treatment for MPCI business which is different than more traditional property and casualty insurance lines. The Company issued and administered MPCI policies, for which it received administrative fees, and the Company participated in a profit sharing arrangement in which it received from the government a portion of the aggregate profit, or paid a portion of the aggregate loss, with respect to the business it wrote. The Company’s share of profit or loss from its MPCI business is determined after the crop season ends on the basis of a profit sharing formula established by law and the Risk Management Agency (“RMA”). Due to the nature of several of the CRC
products whereby results are based on the market prices of various commodities in the fourth quarter, as well as yields, and the significance of CRC as a percentage of MPCI, the Company historically has recorded its initial estimate of profit or loss for MPCI and related products in the fourth quarter. Due to the significance of known and estimatible losses for the 2002 crop year, the Company recorded its initial estimate of loss for MPCI and related products in the third quarter of 2002. Any changes in estimates typically occur during the following two to three quarters, after the claim adjustment process is substantially complete. The Company receives its profit share in cash, with 60% of the amount in excess of 17.5% of its MPCI Retention (as defined in the profit sharing agreement) in any year carried forward to future years, or it must pay its share of losses. For statement of operations purposes, gross premiums written consist of the aggregate amount of MPCI premiums paid by agricultural producers, and do not include any related federal premium subsidies. Additionally, any profit share earned by the Company, net of the cost of third party excess of loss reinsurance, is shown as net premiums written, which equals net premiums earned for MPCI business; whereas, any share of losses payable by the Company is charged to losses and loss adjustment expenses. MPCI premiums received during the year which correspond to next year’s crop season are deferred until the next year. Insurance underwriting expenses are presented net of administrative fees received from the RMA for reimbursement of costs incurred by the Company.
The Company accrues liabilities for unpaid losses and loss adjustment expenses. This liability for policy claims is established based on its review of individual claim cases and the estimated ultimate settlement amounts. This liability also includes estimates of claims incurred but not reported based on Company and industry paid and reported claim and settlement expense experience. Due to the inherent uncertainties in estimating this liability, the actual amounts may differ materially from the recorded amounts. These differences that arise between the ultimate liability for claims incurred and the liability established are reflected in the statement of operations in the period such information becomes known.
Reinsurance recoverables on unpaid losses and loss adjustment expenses are similarly subject to change of estimations. In addition to factors noted above, estimates of reinsurance recoveries may prove uncollectible if the reinsurer is unable or unwilling to meet its responsibilities under the reinsurance contracts. Reinsurance contracts do not relieve the ceding company of its obligations to indemnify its own policyholders.
Under reinsurance agreements with previously owned insurance subsidiaries, the Company assumes business, after cessions to outside reinsurers. While the amounts recoverable from these outside reinsurers are not assets of the Company, the Company is contingently liable for any uncollectible amounts due from outside reinsurers related to this business. The Company analyzes this contingent liability as part of its review of reinsurance recoverable exposures. Any differences that arise between previously accrued amounts and actual unrecoverable amounts are reflected in the statement of operations in the period such information becomes known.
The Company has recorded a net deferred income tax asset to reflect the Company’s net operating loss carryforwards and the tax impact of temporary differences between the carrying amounts for financial and tax purposes. For tax purposes, the Company’s net operating loss carryforwards expire, if unused, beginning in 2019. The realization of the net deferred tax asset is dependent upon the Company’s ability to generate sufficient taxable income in future periods. In determining whether the net deferred tax asset will be realized, management is required to estimate future earnings and project reversal of temporary differences. Future effects from any changes in these estimates, which may be material, are recorded in the period of the change.
Except for the historical information contained in this Annual Report on Form 10-K, matters discussed herein may constitute forward-looking information within the meaning of the Private Securities Litigation Reform Act of 1995. Such forward-looking information reflects the Company’s current best estimates regarding future operations, but, as these are only estimates, actual results may differ materially from such estimates.
A variety of events, most of which are outside the control of the Company, cannot be accurately predicted and may materially impact estimates of future operations. Important among such factors are changes in state and federal regulations, changes in the reinsurance market, including the ability and willingness of reinsurers to pay claims, changes in tax laws, financial market performance, changes in federal policies or court decisions affecting coverages, changes in the rate of inflation, interest rates and general economic conditions.
While based upon current expectations AICI would likely have the ability to meet its cash flow needs through December 31, 2003, there can be no assurances considering the significant uncertainties that exist.
Forward-looking information set forth herein does not take into account any impact from the various factors noted above which may affect future results. See “Business-Uncertainties” and “General” for additional information regarding these events and factors.
The increase in the net loss from continuing operations was primarily related to a decrease in net investment income and net realized gains and change in valuation allowance for deferred taxes. Net investment income was impacted by a declining portfolio and a lower interest rate environment. During the year ended December 31, 2002, the Company’s ability to generate sufficient taxable income in future periods was significantly impacted by results in its Agricultural Segment. Management concluded it is unlikely that the deferred tax asset will be realized and recorded a valuation allowance related to continuing operations of $9.3 million as of December 31, 2002.
The increase in the net loss from discontinued operations, net of tax, during the year ended December 31, 2002 was primarily attributable to an increase in the underwriting loss in the Agricultural Segment, the expensing of $27.5 million in current and future obligations under a multi-year reinsurance agreement, the impairment of $5.7 million of intangibles, the write-off of the excess of cost over acquired net assets of $30.0 million, the impairment of property and equipment of $3.7 million, the establishment of a deferred income tax valuation allowance of $73.1 million and a decrease in net investment income and realized capital gains (losses). Partially offsetting these increases was a decrease in the Property and Casualty Segment underwriting loss and the $4.0 million adjustment to equity and investment interest in AGIC and subsidiaries related to adjusting the negative equity to fair market value of zero as the Company is no longer responsible for AGIC’s net liabilities.
approximately $5.7 million, and the goodwill carried on the books of the Company at approximately $30.0 million were impaired and were written down to zero.
During the year ended December 31, 2002, the Company’s ability to generate sufficient taxable income in future periods was significantly impacted by results in its Agricultural Segment. Management concluded it is unlikely that the deferred tax asset would be realized and recorded a valuation allowance of $73.1 million related to discontinued operations as of December 31, 2002.
On November 18, 2002 the Company announced that it signed a Non-Binding Letter of Intent setting forth the preliminary terms for the Company’s potential sale of certain crop insurance assets to Rain and Hail L.L.C. and ACE American Insurance Company (collectively “Rain and Hail”). On November 25, 2002 Rain and Hail announced “termination of further negotiations under the previously announced Non-Binding Letter of Intent because RMA (USDA Risk Management Agency) would not allow the transaction as set forth in the terms of the Non-Binding Letter of Intent.”
Subsequent to the RMA and Rain and Hail actions, the operations of the Agricultural Segment were discontinued and AGIC was placed in rehabilitation by the District Court of Lancaster County, Nebraska. In rehabilitation, AGIC and its subsidiaries ceased to be under the control of the Company and are not included as consolidated subsidiaries of the Company at December 31, 2002. As the Company’s equity interest in AGIC and its subsidiaries are negative, the Company has reflected its investment in AGIC and its subsidiaries at fair market value of zero as the Company is no longer responsible for AGIC’s net liabilities. The adjustment to equity and investment interest in subsidiaries is comprised of the negative equity investment in AGIC and subsidiaries which was adjusted to a fair market value of zero as the Company is no longer responsible for AGIC’s net liabilities net of the establishment of a one hundred percent allowance for the $20 million surplus note receivable AIC has from AGIC. AIC does have exposure under reinsurance agreements with AGIC (See “Business-Reinsurance” and “Business-Uncertainties”). The Company does not expect to be impacted by the discontinued operations of the Agricultural Segment in the future.
The Company’s Property and Casualty Segment had an underwriting loss of approximately $26.1 million for the year ended December 31, 2002 compared to an underwriting loss of approximately $34.0 million for 2001. The results for the year ended December 31, 2002 included a reserve strengthening of approximately $21.1 million. The reserve development for the year ended December 31, 2002 was comprised of approximately $20.3 million of adverse reserve development attributable to the general liability and commercial multi-peril lines of business.
While the Company has discontinued its Property and Casualty Segment business, its operating results may continue to be significantly impacted by the Property and Casualty Segment. Significant factors that may impact future results include the adequacy of the Company’s estimate of loss and loss
profit share of $40.0 million on its MPCI retained pool of approximately $232.0 million, or 17.2%. During 2001, the profit share relating to the 2000 crop year was reestimated at $35.2 million, or 15.2% of the MPCI retained pool.
Gross and net earned premiums for the Company’s crop hail, other named peril and supplemental coverages (“non-MPCI”) increased from $59.1 million and $14.9 million, respectively, during the year ended December 31, 2000 to $82.6 million and $21.6 million, respectively, during the year ended December 31, 2001. Approximately $36.9 million and $3.8 million of the gross and net earned premiums, respectively, for 2001 relate to the crop business acquired in the IGF transaction. The crop hail quota share cessions for 2001 included a 100% quota share with an affiliate of IGF for the crop hail business acquired from IGF, specifically for all policies effective prior to June 6, 2001. The 2001 crop year results on the Company’s non-MPCI business improved from 2000 primarily as a result of the improved loss ratio. For the years ended December 31, 2001 and 2000 the Company’s crop year net loss ratios for non-MPCI were approximately 79.7% and 111.5%, respectively.
The Company’s net investment income included in discontinued operations declined from approximately $22.3 million for the year ended December 31, 2000 to approximately $14.7 million for the year ended December 31, 2001. This decrease in investment income was primarily a result of a significantly lower interest rate environment during 2001 coupled with a decline in the size of the investment portfolio.
The Company has included a discussion of the liquidity and capital resources requirement of the Company and the Company’s insurance subsidiaries.
At December 31, 2002 the Company has $3.1 million in cash and short-term investments. The Company also holds a surplus note for $20 million issued by AIC, bearing interest at the rate of 9% per annum payable quarterly. The Company does not expect to have access to any surplus note interest payments or dividend payments from AIC, as these payments would require Nebraska Department of Insurance (“NEDOI”) approval as AIC is currently under the supervision of the NEDOI.
During the first quarter of 2003, the Company sold its office building in Council Bluffs, Iowa. The net proceeds included $100,000 cash and a note receivable totaling approximately $1.4 million.
Cash payments for interest related to the Junior Subordinated Debentures were approximately $6.4 million, $8.5 million and $8.5 million during the years ended December 31, 2002, 2001 and 2000. Effective November 18, 2002, the Company elected to defer payment of interest on its Junior Subordinated Debentures, as permitted by the trust agreement and indenture, beginning with the interest payment date on December 31, 2002 until not later than September 30, 2007. The interest payments on the Preferred Securities will be deferred for a corresponding period.
The Company’s only consolidated insurance subsidiary at December 31, 2002 is AIC. The principal liquidity needs of AIC are to fund losses and loss adjustment expense payments and operating expenses related to the run-off of its operations. The available sources to fund these requirements are cash flows from the Company’s investment activities, of which at December 31, 2002 approximately 83% and 33% of AIC’s fixed maturity securities and short-term investments, respectively, are pledged to states and to acquirers of former Company affiliates.
Additionally, as required by insurance regulatory laws, certain fixed maturity securities with an estimated fair value of approximately $7.6 million at December 31, 2002 were deposited in trust with regulatory agencies.
Cash used by operating activities was $32.3 million during the year ended December 31, 2002 compared to positive cash flows from operating activities of $13.9 million for the year ended December 31, 2001. The Company expects negative cash flows from operating activities as the Company runs off its operations. See “The Parent-Company Only” and “Acceptance Insurance Company” regarding uncertainties of the Company to meet its ongoing cash flow needs.
The Company’s balance sheet includes a significant amount of assets and liabilities whose fair value are subject to market risk. Market risk is the risk of loss arising from adverse changes in market interest rates or prices. The Company currently has interest rate risk as it relates to its fixed maturity securities and equity price risk as it relates to its marketable equity securities. The Company’s market risk sensitive instruments are entered into for purposes other than trading.
The Company uses two models to analyze the sensitivity of its market risk assets. For its fixed maturity securities, the Company uses duration modeling to calculate changes in fair value. For its marketable equity securities, the Company uses a hypothetical 20% decrease in the fair value of these securities. Actual results may differ from the hypothetical results assumed in this disclosure due to possible actions taken by management to mitigate adverse changes in fair value and because fair values of securities may be affected by credit concerns of the issuer, prepayment speeds, liquidity of the security and other general market conditions. The sensitivity analysis duration model used by the Company produces a loss in fair value of $1.6 million and $1.0 million on its fixed maturity securities as of December 31, 2002 and 2001, respectively, based on a 100 basis point increase in interest rates. The hypothetical 20% decrease in fair value of the Company’s marketable equity securities produces a loss in fair value of $1.5 million and $1.0 million as of December 31, 2002 and 2001, respectively.
The acquisition was accounted for by the purchase method of accounting and, accordingly, the statements of operations include the acquired crop results beginning June 6, 2001. The assets acquired and recognition of liabilities directly related to the acquisition of $34.2 million and $6.8 million, respectively, were recorded at estimated fair values as determined by the Company’s management. The Company’s purchase price allocation included $18.3 million of goodwill and $10.1 million of intangible assets. The assets acquired and recognition of liabilities directly related to the acquisition and the allocation of the purchase price was revised in the second quarter of 2002 based upon final determination of fair values. During 2002, it was determined that the intangible asset related to non-competition agreements and the goodwill carried on the books of the Company are impaired. Accordingly, the Company wrote down these assets to zero.
In general, the minimum amount to be included in the trust account is based upon the greater of 1) certain percentages of loss and loss adjustment expense reserves assumed by the Company from Clarendon and Redland and reinsurance recoverables from Clarendon Reinsurers for which the Company is contingently liable or 2) 70% of the Bond Requirements.
In March 2001, the Company sold a significant portion of its Property and Casualty Segment business to Insurance Corporation of Hannover (“ICH”). The terms of the agreement included the sale of selected lines of business, a reinsurance treaty whereby the unearned premium and any additional premiums for these selected lines would be reinsured by ICH, and the transfer of certain employees to ICH. Additionally, the Company’s right to repurchase Redland under the agreement between the Company and Clarendon, an affiliate of ICH, was waived.
As of July 1, 2001, the Company sold two wholly owned insurance companies to McM Corporation, a Raleigh, North Carolina based insurance holding company (“McM”). The two companies, Acceptance Indemnity Insurance Company (“AIIC”) and Acceptance Casualty Insurance Company (“ACIC”), underwrote primarily Property and Casualty Segment insurance. The sale was a cash transaction of approximately $20.6 million that resulted in a realized gain in the third quarter of 2001 of approximately $375,000. The Company also reinsures certain portions of the business written by AIIC and ACIC. As of
December 31, 2002 approximately $11.5 million of fixed maturities available-for-sale and $130,000 of short-term investments were placed in a trust and pledged to McM to secure the Company’s net obligations under the reinsurance agreements. Under these reinsurance agreements, the Company assumes business from AIIC and ACIC after cessions to outside reinsurers (“AIIC Reinsurers”). The Company is contingently liable for any uncollectible amounts due from AIIC Reinsurers related to this business. At December 31, 2002, AIIC and ACIC reinsurance recoverables from AIIC Reinsurers, which are not included on the balance sheet of the Company, totaled approximately $40 million (See “Business-Reinsurance”).
In July 2001, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 141 (“SFAS No. 141”), Business Combinations, and Statement No. 142 (“SFAS No. 142”), Goodwill and Other Intangible Assets. SFAS No. 141 requires business combinations initiated after June 30, 2001 to be accounted for using the purchase method of accounting and specifies the criteria for recognition of intangible assets separately from goodwill.
SFAS No. 142 requires that goodwill and intangible assets with indefinite useful lives no longer be amortized, but instead tested for impairment at least annually. Intangible assets with a determinable useful life will continue to be amortized over that period. The adoption of SFAS No. 142 had no impact on the Company’s financial statements at January 1, 2002. With the adoption of SFAS No. 142 on January 1, 2002 goodwill is no longer amortized and in accordance with SFAS No. 142 the goodwill is tested for impairment annually and between annual tests if an event occurs that would more likely than not reduce the fair value of the reporting unit. During the second quarter, the Company completed the transitional goodwill impairment test required by SFAS No. 142 and determined that there was no goodwill impairment. As a result
of the significant operating losses and the discontinuance of the Agricultural Segment, the Company reevaluated the recoverability of the goodwill and intangible assets during the third and fourth quarters of 2002. Based upon the results of such reviews, it was determined that the intangible asset related to non-competition agreements, approximately $5.7 million, and the goodwill carried on the books of the Company at approximately $30.0 million were impaired and were written down to zero.
In June 2002, the FASB issued Statement of Financial Accounting Standards No. 146 (“SFAS No. 146”), Accounting for Costs Associated with Exit or Disposal Activities, which addresses financial accounting and reporting for costs associated with exit or disposal activities. This pronouncement is effective for exit or disposal activities that are initiated after December 31, 2002, with early application encouraged. The Company has elected to adopt SFAS No. 146 during 2002. As noted above, the Company has exited its Agricultural Segment and Property and Casualty Segment operations during 2002. In the Property and Casualty Segment, the Company expects to incur approximately $1.1 million of termination benefits, of which approximately $131,000 have been expensed in discontinued operations-underwriting expenses during 2002.
In January 2003, the FASB issued FIN No. 46, Consolidation of Variable Interest Entities, which addresses the consolidation of certain entities (“variable interest entity”) when control exists through other than voting interests. FIN 46 requires that a variable interest entity be consolidated by the holder of the majority of the risks and rewards associated with the activities of the variable interest entity. FIN 46 is effective immediately for variable interest entities created after January 31, 2003. For variable interest entities created prior to February 1, 2003, FIN 46 is effective for the first interim period beginning after June 15, 2003, and may be applied retroactively or prospectively. The Company does not anticipate any impact from the adoption of FIN 46.