Prior to acquiring our insurance companies effective December 31, 2003, our operations were comprised of our non-standard personal automobile insurance underwriting and retail agency operations. The business written by the insurance companies we acquired from Vesta was 100% reinsured by Vesta Fire in accordance with a quota share reinsurance agreement. As a result of this internal reinsurance, the historical financial statements of Affirmative Insurance Company and Insura included only certain revenues, primarily policy fees that were not ceded to Vesta Fire and excludes the underwriting results of the business ceded.
The following table presents the effect of the restatement on our previously reported consolidated statement of operations for the year ended December 31, 2004. See Management’s Discussion and Analysis of Financial Condition and Results of Operations - Restatement of Previously Issued Financial Statements for a description of the adjustments included in the restatement. See also Notes 2 and 26 to the consolidated financial statements contained elsewhere herein.
We are an insurance holding company engaged in underwriting, servicing and distributing non-standard personal automobile insurance policies and related products and services to individual consumers in highly targeted geographic areas. Our subsidiaries include two insurance companies, four underwriting agencies, five retail agencies with 179 owned and 45 franchise retail store locations as of December 31, 2005. As of the date of this filing, we offer our products and services in 13 states, including Texas, Illinois, California and Florida. We were formerly known as Instant Insurance Holdings, Inc., and we incorporated in Delaware on June 25, 1998.
Historically, we have measured the total premiums written from which we derive commissions by our underwriting agencies or premiums by our insurance companies as our “total controlled premium”. Total controlled premium differs from gross written premiums in that total controlled premium includes all business produced by our agencies, both affiliated and unaffiliated, whereas gross written premium includes only business that is written or assumed by our insurance companies. Total controlled premium has been an important measure of our performance in the past because we were not retaining 100% of the business produced by our agencies, but our agencies earned commissions and fee-based revenues on the business that we did not retain. Since we currently retain most of the business written by our agencies, gross written premium has become a more meaningful measure of our performance.
When cancellations occur, total controlled premium is reduced by 100% of the cancellation since it reflects 100% of the business. However, gross written premiums are reduced only by the portion of the cancellations that pertain to the retained business. Therefore, current year cancellations of premiums produced in the prior year on those programs that are currently less than 100% retained by our insurance companies will reduce total controlled premium by the total cancellation whereas gross written premium will only be reduced by the retained portion. When we retain 100% of premiums written for consecutive years, total controlled premium and gross written premium are the same.
Of the $321.2 million that was written or assumed by our insurance companies, $101.1 million was written by Old American County Mutual Fire Insurance Company, an unaffiliated Texas county mutual insurer, but 100% assumed by our insurance companies.
Total controlled premium for the year ended December 31, 2005 was $337.9 million, a decrease of $69.4 million, or 17.1%, as compared to $407.3 million for the same period in 2004. In our retail distribution channel, total controlled premium decreased $6.9 million, or 5.6%, to $114.7 million, as compared to $121.5 million for the same period in 2004, primarily due to decreases in our Texas and Midwest markets due to increased advertising competition, partially offset by acquisitions of retail stores in Florida and Texas markets. In our independent agency distribution channel, total controlled premium decreased $18.3 million, or 10.3%, to $159.3 million compared to $177.6 million for the same period in 2004, due to decreases in our Florida underwriting agency as a result of continued competition and planned reductions in the amount of business that we write in Miami - Dade County, as well as reduced production in our Texas and Midwest underwriting agencies. These decreases are partially offset by production in our Michigan operation, which was acquired July 2005, in our New Mexico underwriting agencies due to an acquisition in July 2004, and in our South Carolina underwriting agencies. Total controlled premium from unaffiliated underwriting agencies decreased by $44.3 million, or 40.9%, to $63.9 million compared to $108.2 million for the same period last year, primarily due to run-off of two of our programs in California, and programs in Alabama, Georgia and Utah. The unaffiliated underwriting agencies we contract with in Alabama, Georgia and Utah received regulatory approval for licensing of their insurance companies from these states and are transitioning policies to their own insurance companies.
Gross written premium for the year ended December 31, 2005 was $321.2 million, an increase of $39.4 million, or 14.0% as compared to $281.8 million for the same period in 2004. In our retail distribution channel, gross written premium of $116.4 million increased $14.0 million, or 13.7%, as compared to $102.4 million in the prior year, primarily due to increased retention in our insurance companies and new retail stores. In our independent agency distribution channel, gross written premium was $159.8 million, an increase of $63.4 million, or 65.8%, as compared to $96.4 million for the same period in 2004, principally due to increased retention in our insurance companies. Gross written premium for our unaffiliated agencies was $44.7 million, a decrease of $38.3 million, or 46.2%, as compared to $83.0 million in the prior year. The decrease was primarily due to run-off of two of our programs in California, and programs in Alabama, Georgia and Utah, as described above.
combined basis. Prior to December 31, 2003, our insurance companies ceded 100% of their premiums, losses and loss adjustment expenses to Vesta Fire. Accordingly, our insurance companies’ historical statements of operations prior to January 1, 2004 do not include any of the premiums, losses or loss adjustment expenses on policies written by our insurance companies.
Change in Management. In the fourth quarter of 2005, we completed separation and non-competition agreements with three former executives that resulted in materially increased costs relative to previous periods. The expenses incurred in connection with this change in management in the fourth quarter of 2005 were $3.0 million, including $2.7 million in severance, $122,000 in amortization related to non-competition agreements, and $200,000 incurred for a retained search for a replacement executive.
Space Coast. On October 1, 2001 we purchased a 74.5% ownership interest in Space Coast Holdings, Inc., the parent company of Space Coast Underwriters Insurance Agency, Inc., a Florida-based underwriting agency. At the time of our acquisition, the remaining 25.5% ownership of Space Coast was held by the management of Space Coast. Following the transaction, the management of Space Coast exercised options and increased its ownership percentage to 27.0%, with our ownership percentage decreasing to 73.0%. However, in March 2006, we completed the acquisition of the minority ownership interest (27%) of Space Coast. Consequently, our current ownership interest in Space Coast is 100%.
A-Affordable. On October 31, 2001, we acquired substantially all of the assets of A-Affordable Insurance Agency, Inc. A-Affordable is a Dallas-based underwriting agency and retail agency operation.
Driver’s Choice. On August 1, 2002, we purchased Driver’s Choice Insurance Services, LLC, a South Carolina-based underwriting agency and retail agency operation.
On May 7, 2003, we acquired from an unrelated third party the 20.0% minority interest in InsureOne’s retail agency that we did not already own. We accounted for this acquisition as a purchase and accordingly, the purchase price was allocated to the assets purchased based upon their fair values at the time of acquisition.
Reinsurance transaction with Vesta. Effective December 31, 2003, Vesta restructured its internal reinsurance arrangements relating to non-standard personal automobile insurance policies to transfer to our insurance companies all of the future economic interest in Vesta’s non-standard personal automobile insurance business. Under this transaction, which was effected through a quota share reinsurance agreement, Vesta Fire retained all loss and loss adjustment expense reserves as of December 31, 2003 related to these policies and remains liable to indemnify us for any losses and allocated loss adjustment expenses associated with these policies that occurred on or prior to December 31, 2003. Vesta’s non-standard personal automobile insurance business had net premiums earned of $167.4 million for the year ended December 31, 2003. We determined that this restructuring of Vesta’s internal reinsurance did not constitute a business combination within the meaning of SFAS No. 141 and, accordingly, our historical consolidated statements of operations included in this report do not reflect any underwriting results on these policies during the periods presented.
The commission rate paid to our underwriting agencies is established annually in contractual agreements between our underwriting agencies and our insurance companies and the unaffiliated insurance company our underwriting agencies represent. Provisional commissions are paid to our underwriting agencies based upon a contractually established provisional commission rate multiplied by the premiums that they produce. Our underwriting agencies also can earn profit-sharing commissions from our insurance companies and the unaffiliated insurance company they represent if the loss ratio on the business they produce is lower than a contractually established provisional loss ratio. Profit-sharing is recorded when we conclude it is probable that estimates of losses will result in loss ratios that are lower than the provisional loss ratios. These loss ratio estimates are based on various actuarial assumptions and determinations by our internal actuaries regarding potential future losses. If the actual loss experience is less favorable than the estimates used, income may be reduced in subsequent periods.
Our losses, loss adjustment expense reserves and deposit liabilities were $126.9 million on a gross basis and $106.5 million on a net basis, which were our best estimates as of December 31, 2005. The analysis provided by our independent opining actuaries, as of December 31, 2005, indicated that the expected range for the ultimate liability for our loss and loss adjustment expense reserves was between $111.5 million and $130.7 million on a gross basis and between $92.8 million and $108.1 million on a net basis.
reduce the Company’s gain from operations on a SAP basis, it can have the effect of reducing the amount of funds available for dividend from insurance companies.
Accounting for business combinations, goodwill and other intangible assets. We adopted SFAS No. 141 and SFAS No. 142, Goodwill and Other Intangible Assets, effective January 1, 2002. With the exception of our acquisitions of our insurance companies and InsureOne from Vesta, both of which were accounted for as a pooling of interests, we have accounted for all of our acquisitions using the purchase method of accounting. In acquisitions using the purchase method of accounting, the purchase price for the acquisition is allocated to the assets acquired, including identified intangible assets and liabilities assumed based on their estimated values. The excess of cost of an acquired entity over the net of the amounts assigned to assets acquired and liabilities assumed is an asset referred to as goodwill. Indirect and general expenses related to business combinations are expensed as incurred.
Principally, all of our goodwill and intangible assets relate to our agency acquisitions. Our insurance company segment has no material associated goodwill or intangible assets. We test our goodwill and intangible assets for impairment annually, or more frequently if impairment indicators arise. We test for impairment based upon the following: (1) the historical financial performance of the unit; (2) the most recent financial performance of the unit; (3) management’s financial forecast for the unit; (4) information regarding publicly available financial terms of recent transactions in the insurance industry; and (5) other publicly available information. We perform impairment tests annually on September 30. The test performed as of September 30, 2005 indicated there was no goodwill or indefinite life intangible asset impairment.
For presentation in the consolidated financial statements, we combine several of the line items disclosed in more detail in the segment information in Note 24 to the consolidated financial statements. The revenue line item “Commission income and fees” on the consolidated statements of operations consists of the combination of the following segment line items: (a) commission income, (b) fee income and (c) claims processing fees. The expense line item “Selling, general and administrative expense” on the consolidated statements of operations consists of the combination of the following three segment line items: (a) policy acquisition expenses, (b) employee compensation and benefits and (c) operating expenses.
Agency segment. Our agency segment is comprised of our underwriting agencies and our retail agencies. Our underwriting agencies primarily design, distribute and service policies that are issued or reinsured by our insurance companies. Our retail agencies primarily sell non-standard personal automobile insurance policies that are issued or reinsured by our insurance companies and administered by our underwriting agencies. However, both our underwriting agencies and retail agencies do business with unaffiliated third parties. During 2005, our underwriting agencies also administered the nonstandard personal automobile insurance policies of one unaffiliated insurance company.
Our underwriting agencies appoint both unaffiliated independent agencies and our retail agencies to distribute insurance policies to individual customers. In the year ended December 31, 2005, our underwriting agencies were responsible for a total of $276.2 million of gross premiums written, $159.8 million, or 57.9%, of which were distributed through independent agencies, and $116.4 million, or 42.1%, of which were distributed through our retail agencies.
commissions generated by our retail agencies from selling insurance policies issued by unaffiliated insurance companies;
policy acquisition fees, installment and late payment fees, and fees from the sale of ancillary products; and
Insurance company segment. The historical financial results of our insurance companies prior to 2004 only included certain revenues, primarily policy fees, that were not ceded to Vesta Fire. Beginning January 1, 2004, our revenues also include premiums and investment income and our expenses also include losses and loss adjustment expenses. Therefore, beginning January 1, 2004, the financial results of our insurance companies are primarily dependent on: (1) the amount of premiums we collect, which is dependent on rate, volume and retention levels; (2) the investment income we earn by collecting and investing premiums in advance of paying claims, as well as the investment income we earn on investments related to the statutory surplus that we maintain in our insurance companies to support the premiums that we underwrite; (3) the losses and other costs we incur to adjust and pay claims submitted by individuals we have insured; (4) the cost of reinsurance programs; and (5) the expenses we incur for policy acquisition and to operate our insurance companies.
Subject to regulatory approval, premium rates are generally within our control and we continuously monitor and seek to adjust rates as appropriate. With respect to volume, our ability to increase the amount of written premium retained by our insurance companies is largely dependent on the statutory leverage of our insurance companies, generally expressed as the amount of net written premiums relative to statutory surplus. Statutory surplus is defined as total assets less total liabilities of our insurance companies in accordance with statutory accounting principles. We operate with a limited amount of statutory surplus and as a result may utilize reinsurance to maintain our statutory leverage at a level we believe is acceptable.
net investment income we earn on our invested assets, together with realized gains and losses on our investments; and
operating and general expenses, which include general and administrative expenses and other expenses.
Corporate and other. 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 and investment gains and losses on investments held at the holding company level; (2) corporate interest expense; and (3) general corporate overhead expenses.
The following table summarizes our historical results of operations by reporting segment. For more detailed information concerning the components of revenues and expenses by segment, please refer to Note 24 to our consolidated financial statements contained elsewhere in this report.
Consolidated net investment income increased to $5.7 million in 2005 from $2.3 million in 2004 primarily as a result of a 32.0% increase in invested assets to $210.8 million at December 31, 2005 from $159.7 million at December 31, 2004. The increase in invested assets is primarily the result of cash flows from operations. The average investment yield increased to 3.3% (4.5% on a taxable equivalent basis) in 2005 from 3.1% (3.8% on a taxable equivalent basis) in 2004 primarily as the result of the higher interest rates available for new investments in 2005.
Total expenses for the year ended December 31, 2005 were $352.7 million, an increase of $70.9 million, or 25.1%, as compared to total expenses of $281.9 million for the prior year. The increase in total expenses was principally due to increases in expenses related to our retention of premiums that were previously ceded to Vesta. As discussed above, as retention increases, a greater percentage of the agency segment expenses are eliminated in consolidation.
Pre-tax income for the year ended December 31, 2005 was $28.7 million, a decrease of $12.7 million, or 30.7%, as compared to $41.5 million for the prior year. The decreases in pre-tax income were due to lower pre-tax margins in both the agency and insurance segments. Additional discussion regarding each segment is included below.
For the year ended December 31, 2005, minority interest net of income taxes was $672,000 as compared to $804,000 in the prior year. The decrease in minority interest was a result of lower earnings of our Space Coast underwriting agency, where our ownership interest was 73.0% for the periods presented.
For the year ended December 31, 2005, the loss in our equity interest in unconsolidated subsidiaries net of income taxes was zero as compared to $913,000 in the prior year. The remainder of this investment was written off in the fourth quarter of 2004.
Consolidated trade ratios. In past filings with the Securities and Exchange Commission, we have employed trade ratio calculations (loss ratio, expense ratio, and combined ratio) that are different from those used by other companies engaged in the private passenger automobile insurance business. We have historically calculated our ratios based on our insurance segment results with commission income and fees included in the divisor. The more widely used industry calculation is based on consolidated results and includes all commission income and fees as a reduction in the dividend, with the divisor consisting of earned premium only. Our methodology has caused our loss ratio to appear lower and expense ratio to appear higher than would have been the case had we employed the more widely used method of calculation. In this report on Form 10-K, our trade ratios are presented using the more widely used methodology on our consolidated results. We believe that conforming our calculation to the more widely used methodology will make it easier for investors to compare our performance with other industry participants.
For the year ended December 31, 2005, our loss and loss adjustment expense ratio was 64.2% as compared to 66.4% in the prior year. This improvement reflects decreases in our overall loss and loss adjustment expense ratio for both our owned and non-owned programs due to favorable loss ratio development in the current period. The impact from the favorable loss ratio development on our loss and loss adjustment expense ratio was 4.6% for the year ended December 31, 2005 as compared to 1.3% in the prior year.
Our combined ratio (sum of the loss ratio and the expense ratio) on a consolidated basis for the year ended December 31, 2005 was 90.5% as compared to 79.6% in the prior year.
Agency segment. Total revenues for the year ended December 31, 2005 were $169.8 million, an increase of $4.1 million, or 2.4%, as compared to total revenues of $165.8 million in the prior year. Revenues for the years ended December 31, 2005 and 2004 were generated primarily through commissions, policy fees and claims processing fees, as follows:
Commission income for the year ended December 31, 2005 was $95.6 million, an increase of $449,000, or 0.5%, as compared to commissions of $95.2 million in the prior year. We earned commissions in both our underwriting agencies and retail agencies. Commissions in our underwriting agencies, which include both provisional and profit sharing commissions, for the year ended December 31, 2005 were $85.7 million, a decrease of $2.8 million, or 3.2%, as compared to $88.5 million in the prior year.
Profit sharing commission income for the year ended December 31, 2005 was $13.1 million, an increase of $757,000, or 6.1%, as compared to profit sharing commissions of $12.4 million for the prior year. Profit sharing commissions are a result of favorable loss ratio development for business produced by our underwriting agencies as compared to loss ratios recorded as of the beginning of the period. The increase in profit sharing commissions was the result of overall favorable loss ratio development in prior treaty years. We have not recognized any profit sharing commission on treaties that incepted during 2005.
Policy and other fees for the year ended December 31, 2005 were $42.8 million, an increase of $85,000, or 0.2%, as compared to policy and other fees of $42.7 million for the prior year. The slight increase in policy and other fees was primarily due to $2.6 million associated with the acquisitions of IPA in July 2005 and Fed USA in December 2004, offset by decreased policy fees associated with lower premium volume in our Texas and Midwest underwriting agencies.
Claims processing fees for the year ended December 31, 2005 were $31.2 million, an increase of $3.4 million, or 12.2%, as compared to claims processing fees of $27.8 million in the prior year. Claims processing fees are paid to us based on a contractual rate relative to the amount of gross premiums earned on business that our underwriting agencies produce and recognized as income over the expected claims service period. The increase in claims processing fees is primarily attributable to the addition of allocated loss adjustment expenses in our remaining contracts starting in 2004. The increase in fees paid on these contracts will increase revenue over the service period.
Total expenses for the year ended December 31, 2005 were $153.3 million, an increase of $13.7 million, or 9.8%, as compared to total expenses of $139.6 million in the prior year.
Policy acquisition expenses for the year ended December 31, 2005 were $26.9 million, a decrease of $960,000, or 3.4%, as compared to $27.9 million for the prior year. Policy acquisition expenses’ sole component is commission expense in our agency segment. Commission expense is derived from the production of total controlled premium. The decrease in policy acquisition expenses is principally due to our 8.4% decrease in total controlled premium as compared to prior year. Excluding the acquisitions of Fed USA and IPA discussed earlier, total controlled premium decreased 13.4% from prior year. This decrease was partially offset by an increase in the average commission rate to 16.9% from 15.6% in the prior year. This increase results from changes in the geographic distribution of our policies produced as well as increases in commission rates in certain geographic areas in response to existing market conditions. The commission rates we pay independent agents are established based on prevailing market conditions.
Employee compensation and benefit expenses for the year ended December 31, 2005 were $67.3 million, an increase of $9.1 million, or 15.7%, as compared to $58.2 million in the prior year. The increase in employee compensation and benefit expenses was primarily due to an increase in compensation during 2005 from the Fed USA and IPA acquisitions, which
Pretax income for the year ended December 31, 2005 was $16.5 million, a decrease of $9.7 million, or 37.0%, as compared to pretax income of $26.1 million in the prior year. For the year ended December 31, 2005 the pretax margin was 9.7%, a decrease from the 15.8% pretax margin recorded in the prior year.
Corporate and other segment. The pre-tax loss for the year ended December 31, 2005 was $5.0 million as compared to $1.1 million for the prior year.
Operating expenses for the year ended December 31, 2005 were $1.5 million compared to $492,000 for the prior year. The increase is attributable to public company expenses such as directors and officers insurance, investor relations expenses and directors fees.
Consolidated. Total revenues for the year ended December 31, 2004 were $323.3 million, an increase of $219.3 million, or 210.9%, as compared to total revenues of $104.0 million for the prior year. The increase in total revenues was principally due our retention of gross premiums written in our insurance companies following the termination of the reinsurance agreements with Vesta that allowed us to start retaining premiums beginning January 1, 2004 that were previously ceded to Vesta.
Pre-tax income for the year ended December 31, 2004 was $41.5 million, an increase of $10.6 million, or 34.5%, as compared to $30.8 million for the prior year.
Income tax expense for the year ended December 31, 2004 was $15.3 million, or an effective rate of 36.9%, as compared to income tax expense for the year ended December 31, 2003 of $11.0 million, or an effective rate of 35.8%. The increase in the effective tax rate in year ended December 31, 2004 as compared to prior year was principally due to higher state income taxes partially offset by the favorable impact of tax exempt income from our investment portfolio.
Commission income for the year ended December 31, 2004 was $95.2 million, an increase of $14.1 million, or 17.4%, as compared to commissions of $81.1 million in the prior year. We earned commissions in both our underwriting agencies and retail agencies.
Commissions in our underwriting agencies, which include both provisional and profit sharing commissions, for the year ended December 31, 2004 were $88.5 million, an increase of $14.3 million, or 19.3%, as compared to $74.2 million in the prior year.
Provisional commission income for our underwriting agencies for the year ended December 31, 2004 was $76.1 million, an increase of $8.7 million, or 12.9%, as compared to provisional commissions of $67.4 million in the prior year. The $67.4 million in provisional commissions recorded in the prior year were favorably impacted by a $2.4 million reduction in a deferred revenue accrual. Excluding the impact of this adjustment, provisional commission for the year ended December 31, 2004 would have increased $11.1 million or 17.2%, as compared to the prior year. The increase in provisional commission was attributable to increases in total controlled premium produced by our underwriting agencies, which increased 8.7% over prior year, as well as increases in provisional commission rates which increased to 25.5% for the year ended December 31, 2004 from 23.6% in the prior year.
Profit sharing commission income for the year ended December 31, 2004 was $12.4 million, and increase of $5.6 million, or 82.9%, as compared to profit sharing commissions of $6.8 million for the prior year. Profit sharing commissions are a result of favorable loss ratio development for business produced by our underwriting agencies as compared to loss ratios recorded as of the beginning of the period. The increase in profit sharing commissions was the result of favorable loss ratio development in prior treaty years. We have not recognized any profit sharing commission on treaties that incepted during 2004.
Claims processing fees for the year ended December 31, 2004 were $27.8 million, an increase of $922,000, or 3.4%, as compared to claims processing fees of $26.9 million in the prior year. The increase in claims processing fees is primarily due to the increases in earned premiums. Claims processing fees are paid to us based on a contractual rate relative to the amount of gross premiums earned on business that underwriting agencies produce and recognized as income over the expected claims service period.
Policy acquisition expenses for the year ended December 31, 2004 were $27.9 million, an increase of $4.1 million, or 17.2%, as compared to $23.8 million for the prior year. Policy acquisition expenses’ sole component is commission expense in our agency segment. Commission expense is derived from the production of gross written premium. The increase in policy acquisition expenses is principally due to increases in written premium volume produced by certain underwriting agencies as well as an increase caused by the acquisition of a book of business in 2004. In addition to increases in premiums produced, the average commission rate increased from 15.1% to 15.6% during the year. This increase results from changes in the geographic distribution of our policies produced as well as increases in commission rates in certain geographic areas in response to existing market conditions. The commission rates we pay independent agents are established based on prevailing market conditions.
Employee compensation and benefit expenses for the year ended December 31, 2004 were $58.2 million, an increase of $1.1 million, or 1.8%, as compared to $57.1 million in the prior year. The increase in employee compensation and benefit expenses was primarily due to an increase in overall headcount during 2004 that contributed to an increase of $2.0 million, offset by decreases from prior years in performance-based compensation and severance related expenses of $968,000.
Operating expenses for the year ended December 31, 2004 were $49.3 million, an increase of $8.3 million, or 20.1%, as compared to $41.1 million in the prior year. The increase in operating expenses was primarily a result of increases in operational expenses such as fronting fees, premium taxes and claims processing expenses of $2.9 million due to the increased premiums produced by our underwriting agencies, increased advertising expenditures of $1.4 million, increases in legal and professional fees of $2.7 million associated with various legal projects as well as expenses related to our ongoing litigation with a former employee.
Insurance company segment. Total revenues for the year ended December 31, 2004 were $225.1 million, an increase of $214.9 million as compared to total revenues of $10.2 million for the prior year. The increase in total revenues was principally due our retention of gross premiums written in our insurance companies following the termination of the reinsurance agreements with Vesta that allowed us to start retaining premiums beginning January 1, 2004 that were previously ceded to Vesta.
Net investment income for the year ended December 31, 2004 was $2.3 million, an increase of $2.1 million from net investment income of $159,000 in the prior year. The increase in investment income is attributable the increase in the size of our investment portfolio as a result of capital contributions to the insurance companies from the proceeds of our initial public offering and our issuance of trust preferred securities, as well as operating cash flow as our insurance companies began retaining premiums that were previously ceded to Vesta. As of December 31, 2004 we had invested assets of $159.7 million as compared to invested assets of $7.5 million as of December 31, 2003.
Pre-tax income for the year ended December 31, 2004 was $16.4 million, an increase of $5.7 million, or 52.5%, as compared to pre-tax income of $10.8 million in the prior year. The increase in pre-tax income was principally a result of the profitability of the business being retained starting January 1, 2004 as compared to policy fees retained in our insurance companies in the prior year. Our insurance segment combined ratio for the year ended December 31, 2004 was 93.6%.
State insurance laws restrict the ability of our insurance company subsidiaries to declare stockholder dividends. These subsidiaries may not make an “extraordinary dividend” until 30 days after the applicable commissioner of insurance has received notice of the intended dividend and has not objected in such time or until the commissioner has approved the payment of the extraordinary dividend within the 30-day period. An extraordinary dividend is defined as any dividend or distribution of cash or other property whose fair market value, together with that of other dividends and distributions made within the preceding 12 months, exceeds the greater of 10.0% of the insurance company’s surplus as of the preceding December 31 or the insurance company’s net income for the 12-month period ending the preceding December 31, in each case determined in accordance with statutory accounting practices. In addition, an insurance company’s remaining surplus after payment of a dividend or other distribution to stockholder affiliates must be both reasonable in relation to its outstanding liabilities and adequate to its financial needs. In 2006, our insurance companies may pay up to $7.2 million in ordinary dividends without prior regulatory approval.
The National Association of Insurance Commissioners’ model law for risk-based capital provides formulas to determine the amount of capital that an insurance company needs to ensure that it has an acceptable expectation of not becoming financially impaired. At December 31, 2005, the capital ratios of both of our insurance companies substantially exceeded the risk-based capital requirements. As of December 31, 2005, the capital ratios of both of our insurance companies exceeded the highest level for regulatory action under the risk-based capital guidelines.
Net cash used in investment activities was $66.6 million for the year ended December 31, 2005, as compared to $129.2 million for the year ended December 31, 2004 and $22.2 million for the year ended December 31, 2003. The decrease in cash used in investment activities for the year ended December 31, 2005 compared to the prior year is primarily due to decreased bond purchases in the investment portfolios of our insurance companies. The increase in cash used in investment activities for the year ended December 31, 2004 as compared to the prior year reflects increases in bond purchases in the investment portfolios of our insurance companies due to their increased capitalization following our initial public offering.
We believe that existing cash and investment balances, as well as new cash flows generated from operations and our available credit facility will be adequate to meet our capital and liquidity needs during the 12-month period following the date of this report at both the holding company and insurance company levels. We do not currently know of any events that could cause a material increase or decrease in our long-term liquidity needs.
Credit facility. On August 6, 2004, we entered into a senior secured credit facility with The Frost National Bank. Under this credit facility, the maximum amount available to us from time to time is $15.0 million, which may include up to $15.0 million under a two-year revolving line of credit, up to $10.0 million in five-year term loans and up to $10.0 million in five-year stand-by letters of credit. The borrowings under our credit facility will initially accrue interest at an annual rate of LIBOR plus 1.50% and we will pay letter of credit fees based on an initial annual rate of 0.75%. Our obligations under the facility are guaranteed by our material operating subsidiaries (other than our insurance companies) and are secured by a first lien security interest on all of our assets and the assets of our material operating subsidiaries (other than our insurance companies), including a pledge of 100% of the stock of Affirmative Insurance Company. The facility contains certain financial covenants, which include combined ratio, risk-based capital requirement, fixed charge coverage ratio, consolidated net worth and consolidated net income requirements, and other restrictive covenants governing distributions and management changes. The proceeds are available to issue letters of credit securing our obligations under reinsurance agreements, to fund general working capital for our agency operations, capital surplus for our insurance companies and to finance acquisitions activities.
From time to time, we and our subsidiaries are subject to random compliance audits from federal and state authorities regarding various operations within our business that involve collecting and remitting taxes in one form or another. Recently, two of our owned underwriting agencies were subject to a sales and use tax audit conducted by the State of Texas.
We have completed an integrated audit of Affirmative Insurance Holdings, Inc.’s 2005 consolidated financial statements and of its internal control over financial reporting as of December 31, 2005 and audits of its 2004 and 2003 consolidated financial statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Our opinions, based on our audits, are presented below.
Also, we have audited management’s assessment, included in Management’s Report on Internal Control Over Financial Reporting appearing under Item 9A, that Affirmative Insurance Holdings, Inc. did not maintain effective internal control over financial reporting as of December 31, 2005, because of the effect of the material weaknesses relating to the (1) access to, and changes in, their information technology systems, financial applications and underlying financial data (2) the elimination of intercompany transactions and (3) accuracy and completeness of the reconciliation of certain balance sheet accounts based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express opinions on management’s assessment and on the effectiveness of the Company’s internal control over financial reporting based on our audit.
A material weakness is a control deficiency, or combination of control deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. The following material weaknesses have been identified and included in management’s assessment as of December 31, 2005:
In our opinion, management’s assessment that Affirmative Insurance Holdings, Inc. did not maintain effective internal control over financial reporting as of December 31, 2005, is fairly stated, in all material respects, based on criteria established in Internal Control - Integrated Framework issued by the COSO. Also, in our opinion, because of the effects of the material weaknesses described above on the achievement of the objectives of the control criteria, Affirmative Insurance Holdings, Inc. has not maintained effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control - Integrated Framework issued by the COSO.
Affirmative Insurance Holdings, Inc. is an insurance holding company engaged in underwriting, servicing and distributing non-standard automobile insurance policies and related products and services to individual consumers in highly targeted geographic areas. As of December 31, 2005, our subsidiaries included two insurance companies licensed to write insurance policies in 34 states, four underwriting agencies and five retail agencies with 179 owned retail store locations and 45 franchised retail store locations serving seven states. We offer our products and services in 13 states, including Texas, Illinois, California and Florida. Our growth has been achieved principally as a result of the acquisition and integration of six retail and/or underwriting agencies in 2001 and 2002. We were formerly known as Instant Insurance Holdings, Inc., and we incorporated in Delaware on June 25, 1998.
All financial information herein gives effect to the restatement described in Note 2 “Restatement”.
We have restated herein the previously issued audited consolidated financial statements as of December 31, 2004 and for the year then ended and the previously issued unaudited interim consolidated financial statements as of and for the quarters and year to date periods ended March 31, 2005, June 30, 2005, September 30, 2005, March 31, 2004, June 30, 2004 and September 30, 2004. This restatement corrects errors related to the consolidating elimination entries used to prepare the previously filed financial reports. The erroneous consolidating elimination entries had no effect on reported net income, earnings per share, invested assets or stockholders’ equity, but did have the effect of materially understating gross revenues and expenses and misstating assets and liabilities.
We incorrectly recorded a reduction in losses and loss adjustment expenses of $1.0 million in the third quarter of 2005 that were related to the August 1, 2005 novation agreements with several unaffiliated reinsurers described in more detail in Note 8 “Reinsurance”. In the third quarter of 2005, we recorded a reduction in losses and loss adjustment expenses as permitted under our revenue recognition policy related to profit-sharing commissions as described in Note 3, “Summary of Significant Accounting Policies”. This is the amount that would have increased net income before taxes in the third quarter of 2005 if we had not completed the novation agreements. However, subsequent to the reporting of our third quarter financial results, we determined that the novation agreements did not meet the appropriate risk transfer requirements of reinsurance accounting, which necessitated the application of deposit accounting, also described in Note 3, to those agreements. The required accounting treatment for the novation agreements provides that the deposit liability should be adjusted based on the adjusted amount and timing of the cash flows. Changes in the carrying amount of the deposit liability should be reported as income or expense as appropriate. Based on the actual losses settled under these agreements in the third quarter of 2005 subsequent to the date of the novation, the adjustment to the deposit liability (representing an increase in net income before tax) was $143,000 in the quarter, with the remaining $859,000 previously booked remaining as a component of the deposit liability included in reserves for losses on the September 30, 2005 consolidated balance sheet until future periods as losses are settled.
The effect of the restatement on line items in our previously reported audited consolidated statement of operations for the year ended December 31, 2004 is detailed below (dollars in thousands). We have also reflected the effect of the restatement in notes 24 and 26.
The effect of the restatement on line items presented in our previously reported audited consolidated balance sheet as of December 31, 2004 is as follows (dollars in thousands):
Our consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) and include our accounts and the accounts of our operating subsidiaries. All intercompany accounts and transactions have been eliminated in consolidation.
As discussed in Note 7, we purchased certain operations from Vesta in 2002 and 2003 that are accounted for herein in a manner similar to a pooling of interests. Therefore, the results of these operations are included in the historical results for all periods presented.
Our preparation of financial statements in conformity with GAAP requires us to make estimates and assumptions that affect our reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of our financial statements and our reported amounts of revenues and expenses during the reporting period. Actual results could differ materially from those estimates. These estimates and assumptions are particularly important in determining revenue recognition, reserves for losses and loss adjustment expenses, deferred policy acquisition costs, reinsurance receivables and impairment of assets.
Gains and losses realized on the disposition of bonds are determined on the specific identification basis and credited or charged to income. Amortization of premium and accretion of discount on bonds are determined on the interest method and credited or charged to income.
We record treasury stock purchases under the cost method, whereby the entire cost of the acquired stock is recorded as treasury stock. Treasury stock will be reissued at the average purchase price per share of the aggregate treasury shares held.
We account for our equity interest in unconsolidated subsidiaries under the equity method of accounting. Under the equity method of accounting, we record our proportionate share of the income (losses), net of income taxes in our consolidated statements of operations. As of December 31, 2005, our equity investment and related income in unconsolidated subsidiaries was zero.
The Company is required to report its results of operations and financial position to Departments of Insurance based upon statutory accounting practices (“SAP”). The significant differences between SAP and GAAP are as follows: (1) under SAP the Company is required to expense all sales and other policy acquisition costs as they are incurred rather than capitalizing and amortizing them over the expected life of the policy as required by GAAP. The immediate charge off of sales and acquisition expenses and other conservative valuations under SAP generally cause a lag between the sale of a policy and the emergence of reported earnings. Because this lag can reduce the Company’s gain from operations on a SAP basis, it can have the effect of reducing the amount of funds available for dividends from insurance companies. (2) under SAP, certain assets are designated as “nonadmitted” and are charged directly to unassigned surplus, whereas under GAAP, such assets are included in the balance sheet net of an appropriate valuation reserve.
Property and equipment is stated at cost, less accumulated depreciation, and consists primarily of telephone equipment and furniture and fixtures. Depreciation is computed using the straight-line method over the estimated useful lives of our assets, typically ranging from three to five years.
Intangible assets consist of brand names, agency relationships, and non-competition agreements; and goodwill represents the excess cost over the fair value of identifiable net assets acquired. Goodwill and indefinite life intangible assets are not amortized but are subject to periodic impairment testing. Finite life intangible assets are amortized over their expected useful lives, ranging from two to twenty years (Note 11).
We maintain reserves in the amount of the estimated ultimate liability for unpaid losses and loss adjustment expenses related to incurred claims and our estimate of unreported claims. Our estimation of the ultimate liability for unpaid losses and loss adjustment expenses is based on projections developed by our actuaries using analytical methodology commonly used in the property-casualty insurance industry. Our liabilities stated for unpaid claims and for expenses of investigation and adjustment of unpaid claims are based on: (1) the accumulation of estimates of individual claims for losses reported prior to the close of the accounting period; (2) estimates received from ceding companies, reinsurers and insurance pools and associations; (3) estimates of unreported losses based on past experience; (4) estimates based on past experience of expenses for investigating and adjusting claims; and (5) estimates of subrogation and salvage collections. We periodically adjust our loss and loss adjustment expense reserves for changes in product mix, underwriting
Effective July 9, 2004, the date of our initial public offering, we terminated our tax allocation agreement with Vesta and have filed separate federal income tax returns from that date forward. Prior to July 9, 2004, we were included in the consolidated income tax return with Vesta with our provision for income taxes having been recorded as if we filed a separate federal income tax return. Deferred federal income taxes reflect the future tax differences between the tax basis of assets and liabilities and amounts recorded for financial reporting purposes. Recorded amounts will be adjusted to reflect changes in income tax rates for the period in which the change is enacted.
Claims processing fees - Claims processing fees are received from insurance companies over the premium earning period of the underlying policies. The fees are recognized as revenue over the expected period during which processing services are performed and in amounts appropriate to the processing effort and related costs. The service period and related revenues are based upon historical and expected claims settlement data. All claims processing fees from our insurance companies are eliminated in consolidation.
Accounting and Reporting for Reinsurance. Pursuant to SFAS No. 113, “Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts,” we are required to review the contractual terms of all our reinsurance purchases to ensure compliance with that statement. The statement establishes the conditions required for a contract with a reinsurer to be accounted for as reinsurance and prescribes accounting and reporting standards for those contracts. For all reinsurance transactions, immediate recognition of gains is precluded unless our liability to our policyholders is extinguished. SFAS No. 113 also requires us to disclose the nature, purpose and effect of reinsurance transactions, including the premium amounts associated with reinsurance assumed and ceded. It also requires disclosure of concentrations of credit risk associated with reinsurance receivables and prepaid reinsurance premiums. Contracts that do not result in the reasonable possibility that the reinsurer may realize a significant loss from the insurance risk assumed generally do not meet the conditions for reinsurance accounting and must be accounted for as deposits according to the guidelines of SOP 98-7, “Deposit Accounting for Insurance and Reinsurance Contracts that do not Transfer Insurance Risk”. Under Deposit Accounting, excess deposit liabilities are recorded as income based on a percentage of actual paid losses, if the estimated deposit liabilities are less than the recorded deposit liabilities. We believe we have properly accounted for all of our reinsurance contracts. (Note 8)
Effective December 31, 2003, we acquired Affirmative Insurance Company and Insura Property & Casualty Insurance Company (“Insura”) from a subsidiary of Vesta in exchange for 3,408,382 shares of our common stock (Note 7).
Effective December 31, 2003, we paid a ceding commission to Vesta of 1,471,984 shares of our common stock in a reinsurance transaction where we assumed the unearned premium of the in-force non-standard personal automobile business of Vesta (Note 8).
In January 2005, we issued 6,734 shares of restricted common stock to certain members of our Board of Directors, in lieu of cash as their annual retainer. In both February and May 2005, we issued 7,500 shares of restricted common stock to certain members of our Board of Directors for compensation related to services performed. In November 2005, 7,000 shares of restricted common stock that had been issued were cancelled due to the resignation of certain board members.
Expected maturities may differ from contractual maturities because certain borrowers may have the right to call or prepay obligations with or without penalties. Our amortized cost and estimated fair value of fixed income securities at December 31, 2005 by contractual maturity are as follows (dollars in thousands):
At December 31, 2005 and 2004, investments in fixed maturity securities with an approximate carrying value of $54.3 million and $15.1 million were on
Effective July 9, 2004, the date of our initial public offering, we terminated our tax allocation agreement with Vesta and began filing separate federal income tax returns on a go forward basis. Prior to July 9, 2004, we were included in a consolidated income tax return filed by Vesta. Under the tax allocation agreement with Vesta, a company with taxable income pays tax equal to an amount that would have been paid had the company filed a separate return. A company with a taxable loss is paid a tax benefit currently to the extent that affiliated companies within the consolidated group utilizes that loss.
Tax effects of temporary differences that give rise to significant portions of our deferred tax assets and deferred tax liabilities at December 31, 2005 and 2004 are as follows (dollars in thousands):
determined that we will generate taxable income in future years to utilize our NOLs and reversed our valuation allowance and reduced our goodwill balance related to the Vesta acquisition in the amount of $10.2 million, the total value of our NOLs as determined by our analysis.
Effective December 31, 2003, we acquired Affirmative Insurance Company and Insura from a subsidiary of Vesta for 3,408,382 shares of our common stock. Affirmative Insurance Company and Insura are Illinois domiciled insurance companies and are licensed to write business in 34 states. We accounted for the acquisition of our insurance companies at Vesta’s historical carrying value amounts as transfers of net assets between entities under common control in accordance with SFAS 141. Pursuant to pooling of interest accounting treatment, our historical consolidated financial statements have been presented to reflect our combined results of operations.
Vesta transferred our insurance company subsidiaries to us on December 31, 2003. Before this time, these insurance companies had ceded 100% of the business that they wrote to Vesta Fire as part of an intercompany reinsurance agreement. In connection with a reinsurance restructuring agreement, Vesta Fire retained all liability with respect to any losses and allocated loss adjustment expenses occurring on or prior to December 31, 2003 on policies issued by our insurance companies, and retained all corresponding loss and loss adjustment expense reserves as of December 31, 2003. As a result, as of December 31, 2003, our insurance companies had no net loss or loss adjustment expense reserves. In connection with the acquisition of our insurance companies from Vesta, this reinsurance agreement was terminated as of December 31, 2003, and our insurance companies began accruing losses and loss adjustment expenses, subject only to third-party reinsurance arrangements, for reported and incurred but not reported losses for insurance policies issued or assumed by our insurance companies after December 31, 2003. Therefore, due to the termination of this 100% reinsurance agreement as of December 31, 2003, our insurance companies have recorded losses and loss adjustment expenses in their respective statements of operations beginning January 1, 2004. Although Vesta Fire remains liable as a reinsurer for all of our insurance companies’ losses and loss adjustment expenses associated with these policies occurring on or prior to December 31, 2003, we are subject to primary liability with respect to these policies. Consequently, we face exposure to credit risk with respect to Vesta Fire’s ability to satisfy its obligations to us. Vesta Fire is currently rated “C++” (Marginal) by A.M. Best. According to our reinsurance agreement, if Vesta Fire’s A.M. Best financial strength rating remains below “B+” we have the right to require Vesta Fire to provide a letter of credit or establish a trust account to collateralize the gross amounts due to us from Vesta Fire under these reinsurance agreements. On July 27, 2004, we notified Vesta to establish a trust account collateralizing the net amount due to us, due to the fact that Vesta Fire’s A.M. Best rating was below a “B+”. At December 31, 2005, we recorded $18.5 million in receivable from reinsurers due from Vesta related to this agreement. This receivable is collateralized by $22.0 million that is held in a trust account. We also included $7.2 million in Other Assets that represents a receivable from Vesta as part of the original transfer to us of our insurance companies at December 31, 2003. Vesta’s management has indicated that they believe that this amount has been settled, although they are unable to demonstrate any such payment, and that they will need additional supporting documentation from us to verify that they have not previously paid this amount in connection with settlements for other subsequent treaty periods. We have consulted with Vesta’s management and agreed to provide them with the supporting reconciliations for all inception-to-date payments from December 31, 2003 through December 31, 2005 in order to help satisfy Vesta that this amount has not been settled and is still outstanding. We believe that our documentation will definitively support our position and that, as a result, Vesta will ultimately pay this liability. Should payment not be forthcoming, we are confident that we will prevail upon pursuing our other available options.
We are continuing to transition the non-standard personal automobile business written on all Vesta insurance company subsidiaries to Affirmative Insurance Company and Insura. During this transitional period Affirmative Insurance Company or Insura will reinsure the new and renewal policies
written by the Vesta insurance company subsidiaries through a 100% quota share reinsurance agreement, whereby Affirmative Insurance Company will assume 100% of the underwriting results of the Vesta insurance subsidiaries related to non-standard personal automobile polices produced by our underwriting agencies.
For the year ended December 31, 2005, we have ceded $29.2 million of paid losses and $6.1 million of incurred losses and loss adjustment expense to various reinsurers. For the year ended December 31, 2004, we ceded $47.5 million of paid losses and $49.1 million of incurred losses and loss adjustment expense to various reinsurers.
Effective May 1, 2005, we amended our quota share reinsurance agreement entered into on May 1, 2004 to continue ceding 25% of the business written through our Florida underwriting agency to the unaffiliated reinsurer at substantially the same terms and conditions. This contract continues in force until terminated by us or our reinsurer at any April 30 with not less than 90 days prior notice. The reinsurance under this agreement is provided by Folksamerica, which is rated “A” by A.M. Best.
All of our quota share reinsurance agreements contain provisions for sliding scale commissions, under which the commission paid to us varies with the loss ratio results under each contract. The effect of this feature in the quota share reinsurance agreements is to limit the reinsurer’s aggregate exposure to loss and thereby reduce the ultimate cost to us as the ceding company. These features also have the effect of reducing the amount of protection relative to the quota share amount of premiums ceded by us. Before entering into these reinsurance agreements, and based on our prior operating history, we concluded that each agreement met the risk transfer test of SFAS No. 113 (“SFAS 113”) Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts as the reinsurers assume significant risk and have a reasonable possibility of significant loss.
On January 31, 2006, the Court absolved Hawaiian and SCJ Insurance Services of all counts filed against them in this litigation on the trial court level by virtue of court order on motions for summary judgment that were submitted by both Hawaiian and SCJ Insurance Services. The trial judge has denied a request by plaintiff for an interlocutory appeal of the judge’s ruling on the motions for summary judgment for both Hawaiian and SCJ Insurance Services. Defendants Prompt Insurance Services, Paul Ruelas and David Medina remain in the litigation, and the outcome as to such defendants is uncertain. Should plaintiff seek to appeal, Hawaiian and the other defendants thereto will vigorously contest and exercise all available rights and remedies against any such appeal.
As of August 1, 2005, we recorded the following amounts related to this novation (dollars in thousands):
Effective October 1, 2005, we entered into commutation agreements with several unaffiliated reinsurers who participated in a quota share reinsurance agreement in which we were the direct writer. Pursuant to these agreements, we were substituted in place of these reinsurers assuming all rights, interests, liabilities and obligations related to the original quota share reinsurance agreement. In consideration for our assumption of their liabilities, these reinsurers agreed to pay us an amount equal to their share of the liabilities under the original quota share agreement as of September 30, 2005. As of December 31, 2005, we have received $4.5 million in relation to this commutation.
As of October 1, 2005, we recorded the following amounts related to this commutation (dollars in thousands):
Our components of deferred policy acquisition costs and the related policy acquisition expenses amortized to expense for our insurance companies at December 31, 2005 and December 31, 2004 are as follows (dollars in thousands):
We evaluate impairment of goodwill and indefinite life intangibles in our agency reporting unit, as the insurance company reporting unit has no associated goodwill or indefinite life intangibles. Goodwill impairment is based upon (1) the historical financial performance of the unit; (2) the most recent financial performance of the unit; (3) our financial forecast for the unit; (4) information regarding publicly available financial terms of recent transactions in the industry; and (5) other publicly available information. We will perform an impairment test annually on September 30. The test performed as of September 30, 2005 indicated there was no goodwill impairment.
We recorded in our financial statements $61.0 million of goodwill, $14.7 million of indefinite life intangible assets and $4.9 million of intangible assets having estimated lives of between two and 20 years. We expect $50.2 million of our goodwill and other intangible assets to be fully deductible for tax purposes.
Other intangible assets at December 31, 2005, 2004 and 2003 are as follows (dollars in thousands):
Amortization expense was $887,000, $738,000, and $1.0 million for the years ended December 31, 2005, 2004 and 2003.
Property and equipment is stated at cost, less accumulated depreciation, and consists primarily of telephone equipment and furniture and fixtures. Depreciation is computed using the straight-line method over the estimated useful lives of the assets, typically ranging from three to five years.
A summary of property and equipment at December 31, 2005 and 2004 is as follows (dollars in thousands):
In addition, we have presented, in the accompanying consolidated balance sheets, the following amounts related to contracts with Vesta and its subsidiaries (dollars in thousands):
As part of the terms of the acquisition of Affirmative Insurance Company and Insura, Vesta has indemnified us for any losses due to uncollectible reinsurance related to reinsurance agreements entered into with unaffiliated reinsurers prior to December 31, 2003. As of December 31, 2005, all such unaffiliated reinsurers had A.M. Best ratings of “A-” or better.
Any failure by one of our insurance company subsidiaries to meet the applicable risk-based capital or minimum statutory capital requirements imposed by the laws of Illinois or other states where we do business could subject it to further examination or corrective action imposed by state regulators, including limitations on our writing of additional business, state supervision or liquidation. Any changes in existing risk-based capital requirements or minimum statutory capital requirements may require us to increase our statutory capital levels, which we may be unable to do. As of December 31, 2005, each of our insurance company subsidiaries maintained a risk-based capital level in excess of an amount that would require any corrective actions on our part.
On June 1, 2005, our newly formed trust subsidiary, Affirmative Insurance Holdings Statutory Trust II (“Trust Subsidiary II”), completed a private placement of $25.0 million of 30 year floating rate trust preferred securities. Simultaneously, we borrowed $25.0 million from Trust Subsidiary II and the net proceeds from this borrowing, along with cash from operations, were used to purchase the 2.0 million shares of our common stock as discussed in Note 18. The trust preferred securities, which can be redeemed in whole or in part by the issuer after five years, bear an initial interest rate of 7.792% until June 15, 2010, at which time they will adjust quarterly to the 90-day LIBOR rate plus 355 basis points. As of December 31, 2005, the note balance was $25.8 million.
We currently lease approximately 444,000 square feet of retail location and underwriting agency locations under differing operating lease obligations. Total rent expense for the years ended December 31, 2005, 2004 and 2003 was $8.1 million, $7.3 million and $5.5 million, respectively.
Our Credit Agreement requires us to provide the bank with written notification and documents related to certain events. On August 12, 2005 we entered into a First Amendment to Credit Agreement and Waiver of Defaults to the credit facility which amended and waived certain notice requirements of the Credit Agreement and waived all existing defaults and all events of default related to written notice requirements related to certain acquisitions of business in December 2004 and January, February, and July 2005, the repurchase of shares in June of 2005, and the issuance of trust preferred securities in December of 2004 and June of 2005. As of December 31, 2005, there were no outstanding loan amounts due under our credit facility, and we are in compliance with all of our financial and other restrictive covenants.
On July 9, 2004, we completed our initial public offering of our common stock. We issued 4,420,000 additional shares of our common stock and Vesta sold 3,750,000 shares of our common stock that they owned, at an initial public offering price of $14 per share. On July 26, 2004, our underwriters exercised their option to purchase an additional 663,000 shares from us, and an additional 562,500 shares from Vesta. Our net proceeds from the offering were $65.3 million, after deducting our estimated offering expenses. We contributed $64.3 million of the net proceeds to our insurance companies in
On June 1, 2005, we purchased 2,000,000 shares of treasury stock from Vesta for $14.00 per share. We recorded the purchase at cost. The purchase was funded with the proceeds from our new trust preferred securities, as discussed in Note 15, and with cash from operations.
In December 2004, the FASB issued SFAS No. 123R (“SFAS 123R”), Share-Based Compensation, which is a revision of FASB Statement No. 123, Accounting for Stock-Based Compensation, and supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees, and its related implementation guidance. SFAS 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. This standard is effective for public companies at the beginning of the first annual period beginning after June 15, 2005. In March 2005, the SEC issued Staff Accounting Bulletin 107 (“SAB 107”) to assist preparers by simplifying some of the implementation challenges of SFAS 123R. In particular, SAB 107 provides supplemental implementation guidance on SFAS 123R, including guidance on valuation methods, classification of compensation expense, inventory capitalization of share-based compensation cost, income tax effects, disclosures in Management’s Discussion and Analysis and several other issues. We will apply the principles of SAB 107 in conjunction with our adoption of SFAS 123R.
A “modified retrospective” method which includes the requirements of the modified prospective method described above, but also permits entities to restate based on the amounts previously recognized under SFAS 123 for purposes of pro forma disclosures either (a) all periods presented or (b) prior interim periods of the year of adoption.
We established our 1998 Omnibus Incentive Plan, or 1998 Plan, to enable us to attract, retain and motivate eligible officers, employees, directors, advisors and consultants through equity-based compensatory awards, including stock options, restricted and unrestricted stock, deferred stock awards, performance stock awards and dividend equivalent rights. We do not expect to grant any further equity awards under the 1998 Plan, but intend to make all future awards under the 2004 Stock Incentive Plan. While all awards previously granted under the 1998 Plan will remain outstanding, 1998 Plan shares will not be available for re-grant if these outstanding awards are forfeited or cancelled.
In connection with our initial public offering, on May 25, 2004, our board of directors adopted and our stockholders approved the 2004 Stock Incentive Plan, or 2004 Plan, to enable us to attract, retain and motivate eligible employees, directors and consultants through equity-based compensatory awards, including stock options, stock bonus awards, restricted and unrestricted stock awards, performance stock awards, stock appreciation rights and dividend equivalent rights. The maximum number of shares of common stock reserved for issuance under the 2004 Plan is 1,500,000, subject to adjustment to reflect certain corporate transactions or changes in our capital structure.
A summary of expiration dates and weighted average exercise price for all outstanding options and options currently exercisable at December 31, 2005 is as follows:
To eliminate the ability of directors to receive restricted stock in lieu of an annual retainer.
In 2005, our affiliated and unaffiliated underwriting agencies utilized approximately 6,500 independent agencies and 179 owned retail stores and 45 franchised retail stores to sell the policies that we administer. In 2005, no one independent agency accounted for more than 2.6% of the gross written premiums produced by our affiliated and unaffiliated underwriting agencies, and only two independent agencies accounted for more than 1% of these gross written premiums.
Fixed maturities and short-term investments - The fair values of fixed maturities and short term investments are calculated using quoted market prices by third party organizations.
Notes payable - The fair value of the notes payable approximates carrying value as the explicit interest rate of notes payable approximates current interest rates.
In June 1997, the FASB issued Statement of SFAS No. 131 (“SFAS 131”), Disclosures about Segments of an Enterprise and Related Information. SFAS 131 defines an operating segment as a component of an enterprise if it meets the following criteria: (1) it engages in business activities from which it may earn revenue and incur expenses; (2) whose operating results are regularly reviewed by the enterprise’s chief operating decision maker; and (3) for which discrete financial information is available.
As discussed in Note 7, we acquired two insurance companies effective December 31, 2003 which are accounted for as a pooling of interest. Pursuant to pooling of interest accounting treatment, our historical financial statements have been presented to reflect the results of operations for these two insurance companies on a combined basis for all years presented.
Our agency segment is comprised of our underwriting agencies and our retail agencies. Our underwriting agencies primarily design, distribute and service policies issued or reinsured by our insurance companies or another unaffiliated insurance company. In our insurance segment, we issue non-standard personal automobile insurance policies through our two Illinois-domiciled insurance company subsidiaries. Our insurance companies possess the certificates of authority and capital necessary to transact insurance business and issue policies, but they rely on both affiliated and unaffiliated underwriting agencies to design, distribute and service those policies.
For presentation in the consolidated financial statements, we combine several of the line items disclosed in more detail in the segment information below. The revenue line item “Commission income and fees” on the consolidated statements of operations consists of the combination of the following segment line items: (a) commission income, (b) fee income and (c) claims processing fees. The expense line item “Selling, general and administrative expenses” on the consolidated statements of operations consists of the combination of the following three segment line items: (a) policy acquisition expenses, (b) employee compensation and benefits and (c) operating expenses.
Our insurance subsidiaries are required to file statutory-basis financial statements with state insurance departments in all states where they are licensed. These statements are prepared in accordance with accounting practices prescribed or permitted by the State of Illinois Department of Insurance. Each state of domicile requires that insurance companies domiciled in those states prepare their statutory-basis financial statements in accordance with the National Association of Insurance Commissioners Accounting Principles and Procedures Manual subject to any deviations prescribed or permitted by the insurance commissioner in each state of domicile.
The following is a summary of selected statutory information of our insurance subsidiaries at and for the years ended December 31 (dollars in thousands):
As discussed in Note 2, we have restated our previously issued consolidated financial statements to reflect the correction of certain errors. The quarterly financial data in the table below has been restated for the correction.
Business Risk Technology, Inc. and Steven M. Repetti (“BRT) are defendants in an action Affirmative Insurance Holdings, Inc. (“Affirmative”) brought in the United States District Court for the Southern District of Florida, Fort Lauderdale Division in January, 2006 for fraudulent inducement, breach of contract, breach of the covenant of good faith and fair dealing, and for declaratory and supplemental relief arising from Defendants’ wrongful conduct and contractual breaches, and the details of such allegations are set forth in Affirmative’s petition. This action involves Affirmative’s enforcement of certain rights under a software license agreement it entered with BRT wherein BRT promised to provide Affirmative with a complete, turnkey software system for use by its various affiliates. Among the requested relief, Affirmative is seeking declaratory relief, a return of confidential and proprietary information, monetary damages, punitive damages, attorneys’ fees, and reasonable pre-judgment and post-judgment interest, and any other relief the Court deems just. No substantive proceedings have occurred in the case. We are vigorously prosecuting the claims against the defendants and are exercising all available rights and remedies against them.
Affirmative Insurance Company, a wholly-owned subsidiary is a party to a 100% quota share reinsurance agreement with The Hawaiian Insurance & Guaranty Company, Ltd. (“Hawaiian”), which is ultimately a wholly-owned subsidiary of Vesta. Affirmative Insurance Company is sharing the defense in a litigation matter concerning Hawaiian in the Superior Court of the State of California. On January 31, 2006, the Court absolved Hawaiian and SCJ Insurance Services, another named defendant, of all counts that the plaintiff had filed against them in litigation on the trial court level by virtue of court order on motions for summary judgment that were submitted by both Hawaiian and SCJ Insurance Services, another named defendant. The trial judge denied a request by plaintiff for an interlocutory appeal of the judge’s ruling on the motions for summary judgment for both Hawaiian and SCJ Insurance Services. Should plaintiff seek to appeal, Hawaiian and the other defendants thereto will vigorously contest and exercise all available rights and remedies against any such appeal.
The State of Illinois Department of Financial and Professional Regulation, Division of Insurance, has recently completed field work on a financial examination of Affirmative Insurance Company and Insura P&C Insurance Company and has delivered a draft report to us. We expect that a final report will be issued early in the second calendar quarter of 2006. Generally the findings were anticipated by management and we concur with the field examiners’ preliminary comments. The insurance companies have already implemented most of those changes necessary to satisfy the examiners’ recommendations and plan to implement the remaining changes in the near future. There is no effect on the GAAP consolidated financial statements.