The following information should be read in conjunction with Vesta’s Consolidated Financial Statements and related notes reported elsewhere in this Form 10-K:
We report financial information according to five business segments: (1) standard property-casualty insurance; (2) non-standard agency; (3) non-standard underwriting; (4) life insurance; and (5) corporate and other. Since 1999, we have discontinued a number of business lines. We have segregated the reporting for these discontinued operations in our consolidated financial statements.
• The combination of our non-standard auto insurance operations with our non-standard agency operations in an effort to (i) seek separate financial strength ratings for our non-standard auto underwriting operations and our standard property-casualty operations and (ii) facilitate an initial public offering of our combined non-standard auto underwriting and agency operations;
• The anticipated sale of our life insurance operations in March 2004.
Subject to competitive and market trends and regulatory approval, premium rates are generally within our control, and we continuously monitor and seek to adjust rates as appropriate. During 2003, we implemented six rate increases in our standard automobile business line in the states of North Carolina, Ohio, West Virginia and Pennsylvania, which represented a weighted average premium increase of approximately 5.5% on actual gross written premiums during 2003 of $45.4 million. During 2003, we also implemented 17 rate increases in our standard residential property line in the states of West Virginia, Ohio, Pennsylvania,
Tennessee, South Carolina, Arizona, Florida and New York which represented a weighted average premium increase of approximately 18.6% on actual gross written premiums during 2003 of $126.7 million. In regard to our non-standard underwriting segment, our 2003 rate adjustments will result in a weighted-average overall maintenance of rate adequacy, which is reflective of our favorable loss ratio experience.
The financial results of our agency activities primarily depend upon the amount of fees and commissions we can collect from the sale of insurance products and the expenses we incur to conduct our day-to-day operations. Although we expect the minimum commissions and policy fees that we earn under a typical agency contract to be relatively stable, we expect to earn a substantial amount of additional “profit sharing” commissions in excess of the contractual minimums.
Our underwriting agencies appoint our retail agencies and independent agencies to distribute insurance policies to individual customers. In the year ended December 31, 2003, our retail stores were responsible for 42.8% of the gross written premiums produced by our underwriting agencies. In the year ended December 31, 2003, our underwriting agencies utilized approximately 1,900 independent agencies to sell the policies that they administer and these independent agencies were responsible for 57.2% of the gross written premiums produced by our underwriting agencies.
The financial results of our corporate and other segment reflect other revenue and expenses that are not allocated to any particular segment, including (i) investment income related to our property-casualty underwriting operations; (ii) corporate interest expense; (iii) general corporate operating expenses; and (iv) realized gains and losses from the sale of investment securities or the repurchases of our own debt securities at a discount.
We have discussed the application of these critical accounting policies with our Board of Directors and audit committee. In 2003, we initially adopted the following accounting standards:
• FASB Interpretation No. 46, “Consolidation of Variable Interest Entities (VIEs)”;
• SFAS No. 148, “Accounting for Stock-Based Compensation - Transition and Disclosure”; and
When we determine that a claim for loss made under one of our policies is owed, we initially pay the full amount owed to the insured or the claimant. Subsequently, we seek to recover any amounts due from reinsurers in accordance with the terms of the applicable reinsurance contract. We record the amounts we expect to receive from reinsurers pursuant to these contracts as assets in our financial statements.
At December 31, 2003, we have recorded $46.5 million, captioned as “Reinsurance recoverable on paid losses” on our consolidated balance sheet, for our estimate of amounts due Vesta from reinsurers for the payment of valid claims. Additionally, at December 31, 2003, we have recorded $423.7 million, captioned as “Reinsurance balances receivable” on our consolidated balance sheet, for our estimate of amounts due Vesta from reinsurers for unpaid losses, and amounts paid to these reinsurers applicable to terms of policies in force. These amounts reflect the impact of our current reinsurance agreements including the impact from the 2003 50% Quota Share.
The amounts recorded have been estimated based upon management’s interpretation of each reinsurer’s obligations pursuant to individual reinsurance contracts between Vesta and each reinsurer. In establishing the balances for reinsurance recoverables and reinsurance receivables, we have made judgments in assessing the financial viability and credit quality of each reinsurer as well as the ability of each reinsurer to pay amounts owed to us. In evaluating the credit and financial quality of each reinsurer, we rely upon financial statements, credit reports and other publicly available information applicable to each reinsurer as well as management’s experience and industry knowledge.
Deferred policy acquisition costs represent costs we incur in connection with acquiring new business or renewing existing business. Deferred policy acquisition costs are primarily comprised of commissions and other costs related to issuing insurance policies, net of amounts received from reinsurers as reimbursements of such costs. In accordance with GAAP, these costs are not expensed in their entirety upon their incurrence (as is the case for statutory accounting purposes); rather, they are initially recorded as assets in our financial statements and are subsequently amortized over the life of the insurance policies to which they relate or at a constant rate based upon the present
value of the estimated gross profits to be earned from the underlying policies. This treatment is intended to match the expenses associated with issuing an insurance policy with estimated profits to be earned on the policy over the life of the policy. At December 31, 2003, we had established $51.5 million as assets for deferred acquisition costs in our financial statements.
While we anticipate being profitable in future periods, the combination of significant cumulative losses in recent years and uncertainty with respect to our ability to achieve sufficient taxable income to fully realize our year-end deferred tax asset balances within a reasonable time frame, warrants the recording of a valuation allowance under SFAS No. 109. Accordingly, we recorded an additional valuation allowance of $75.4 million for the year ended December 31, 2003, which represents our net deferred tax asset balance for which corresponding deferred tax liabilities did not offset. This increase in our valuation allowance, coupled with the $7.3 million valuation allowance that existed at December 31, 2002 that related to an acquisition made in 2000, resulted in an aggregate deferred tax asset valuation allowance of $82.7 million as of December 31, 2003.
As noted above, our required annual evaluation was performed as of September 30, 2003. Based on this evaluation, we concluded that there is no goodwill impairment. Based on the significance of the events that occurred during and subsequent to the fourth quarter, we updated our goodwill evaluation and again we have concluded that there is no goodwill impairment as of December 31, 2003. With respect to all of our reporting units, our ability to achieve forecasts and projected undiscounted cash flows are based upon various assumptions made by management. There can be no assurance that our actual financial results in the future will not vary materially from the estimates we have used in our assessment of goodwill and intangible assets with indefinite lives. The reader should refer to Exhibit 99.1 of this filing for a summary of the factors we believe present a potential risk to Vesta’s ability to achieve anticipated future performance. Also, because of uncertain market conditions and potential changes in our strategy and business lines, it is possible that forecasts used to support goodwill may change in the future, which could result in additional non-cash charges that would adversely affect our results of operations and financial condition.
The unrealized loss approximates 1.6% of the fair value of the temporarily impaired securities at December 31, 2003. For those securities identified as having temporary impairments for less than twelve months, management noted that the temporary losses are due to recent increases in U.S. Treasury yields and are not due to deterioration in credit quality or impairment issues. During the second half of 2003, 5-10 year U.S. Treasury yields increased .73% to .83% resulting in a lowering of the market values of these securities. Bonds purchased in the lower interest rate environment of early 2003 showed year-end unrealized losses that are attributable to changes in overall yields and, in management’s opinion, do not represent a permanent impairment issues.
Reserves for investment-type contracts are based either on the contract account balance (if future benefit payments in excess of the account balance are not guaranteed) or on the present value of future benefit payments (if such payments are guaranteed). Additions to insurance liabilities are made if it is determined that future cash flows (including investment income) are insufficient to cover future benefits and expenses.
For investment contracts without mortality risk (such as deferred annuities and immediate annuities with benefits paid for a certain period), premium deposits and benefit payments are recorded as increases or decreases in a liability account, rather than as revenue and expense. We record as revenue any amounts charged against the liability account for the cost of insurance, policy administration, and surrender penalties. Any interest credited to the liability account and any benefit payments which exceed the contract liability account balance are recorded as expenses. As of December 31, 2003 and 2002, approximately $135.4 million and $112.5 million, respectively, of Vesta’s annuity reserves are subject to discretionary withdrawal without surrender charges or other adjustments.
Reserves for traditional life contracts are generally calculated using the net level premium method, based on assumptions as to mortality, withdrawals, dividends, and investment yields ranging from 2.5% to 6.5%. These assumptions are generally made at the time the contract is issued or at the purchase date. These assumptions are based on projections from past experience, making allowance for possible unfavorable deviation.
Generally, we consider commission and policy fees earned by our agency activities to be a relatively stable revenue stream. However, a significant portion of our non-standard agency business utilizes profit sharing commissions that enable us to collect, in certain circumstances, commissions and fees in excess of contractual minimums. Profit sharing commissions are recorded when they become probable as determined by our internal actuaries.
We are subject to proceedings, arbitrations, lawsuits and other claims, including proceedings under laws and government regulations related to securities, labor, insurance contracts and other matters. We are required to assess the likelihood of any adverse judgments or outcomes to these matters, as well as potential ranges of probable losses. A determination of the amount of reserves required, if any, for these contingencies is based upon a careful analysis of each individual issue with the assistance of outside legal counsel. Our judgments as to any reserves required in connection with these matters may change in the future because of new developments in each situation or changes in our approach in addressing these matters such as a change in settlement strategy. For more information concerning litigation and arbitration matters to which we are a party, please refer to “Item 3. Legal Proceedings” of this report and Note G to our consolidated financial statements.
For the year ended December 31, 2003, we reported a net loss available to common shareholders of $120.0 million ($3.44 diluted per share), compared with a net loss available to shareholders of $31.7 million ($.94 diluted per share) reported for the previous year.
The primary factors that impacted our financial results in 2003 were as follows:
• A standard property-casualty combined ratio of 101.2%, which included the recognition of $18.3 million of losses and loss adjustment expenses related to series of April, 2003 hail storms in Texas and the Southeastern United States;
• The recognition of a pre-tax charge of $65.9 million related to our 1997 20% whole account quota share and related disputed items.
• Reduction in investment income as a result of an overall decline in interest rates and decline in average invested assets;
• The execution of the 2003 50% Quota Share effective September 30, 2003 covering our residential property book of business in our Continuing States.
• Reduction in operating expenses as a result of declines in total employees and other cost reduction initiatives; and
• Continued growth in our non-standard agency and non-standard underwriting business lines resulting from agency acquisitions in 2001 and 2002.
In our standard property-casualty segment, we underwrite or sell personal automobile and residential property insurance through approximately 2,525 independent insurance sales agencies. In 2003, the standard property-casualty segment generated approximately $313.1 million in revenue, or approximately 50.7% of consolidated revenue. For the year ended December 31, 2003, net premiums written in our standard property-casualty lines decreased by $94.2 million, or 26.6%, to $260.4 million from $354.6 million in the prior year. Net premiums earned for standard property-casualty lines decreased by $19.4 million, or 6.1%, in 2003, to $300.9 million from $320.3 million in 2002. Our standard property-casualty segment pre-tax loss from continuing operations improved from a $7.7 million loss in 2002 to a loss of $2.9 million loss in 2003.
Although we do not expect our net written premium will significantly increase in 2004, we have implemented rate increases to address emerging loss trends and to protect our net written premium relative to expenses, or underwriting margin. During 2003, we implemented six rate increases in our standard automobile business line in the states of North Carolina, Ohio, West Virginia and Pennsylvania, which represented a weighted average premium increase of approximately 5.5% on actual gross written premiums during 2003 of $45.4 million. During 2003, we also implemented 17 rate increases in our standard residential property line in the states of West Virginia, Ohio, Pennsylvania, Tennessee, South Carolina, Arizona, Florida and New York which represented a weighted average premium increase of approximately 18.6% on estimated actual gross written premiums of $126.7 million.
For the year ended December 31, 2003, the loss ratio for standard property-casualty segment was 66.5% compared with 68.1% at December 31, 2002. The decrease in the loss ratio was primarily attributable to improved underwriting performance, including improvements in claim severity for both our homeowners and auto businesses, only partially offset by the aforementioned $18.3 million catastrophe loss.
The combined ratio for the standard property-casualty segment was 101.2% as of December 31, 2003 as compared to 102.5%, resulting in the improvements in the segment’s pre-tax results from continuing operations year over year. The improvement in the combined ratio from 2002 to 3003 is primarily a result of a 5.9% improvement in the loss ratio resulting from improvements in claim severity. Offsetting the improvement in claim severity was an increase in loss and loss adjustment expenses related to the $18.3 million net loss related to a series of hailstorms in Texas and the Southeastern United States.
Total revenues for the year ended December 31, 2003 were $145.9 million, an increase of $14.7 million or 11.2% as compared to total revenues of $131.2 million for the prior year.
Pre-tax income for the year ended December 31, 2003 was $18.6 million, an increase of $6.8 million or 57.6% as compared to pre-tax income of $11.8 million for the prior year. For the year ended December 31, 2003 the pre-tax margin was 12.7% an increase from the 9.0% pre-tax margin recorded in the prior year.
For the year ended December 31, 2003, net premiums earned were $167.4 million an increase of $5.9 million or 3.7% as compared to net premiums earned of $161.5 million in the prior year. Of our total net premiums earned of $167.4 million for the year ended December 31, 2003, the net premiums earned on policies written through our affiliated underwriting agencies were approximately $136.7 million, a decrease of $3.0 million or 2.2% as compared to the prior year. The decrease in net premiums earned during 2003 as compared to 2002 was principally due to reduction in our retention of business written through our affiliated underwriting agencies. For the year ended December 31, 2003 we retained $150.8 million of net premiums written or 54.8% the gross premiums written through our affiliated underwriting agencies, as compared to $173.9 million of net premiums written or 61.5% of the gross premiums written in the prior year.
Net premiums earned on policies written through unaffiliated underwriting agencies were $30.7 million for the year ended December 31, 2003, an increase of $8.9 million or 40.8% as compared to net premiums earned of $21.8 million for the prior year. The increase in net premiums earned during 2003 was principally due to an increase in premium volume from an unaffiliated underwriting agency where we retain 100% of the premium written by the agency.
For the year ended December 31, 2003, loss and loss adjustment expenses were $114.4 million, an increase of $14.1 million or 14.1% as compared to $100.3 million of loss and loss adjustment expenses in the prior year. The loss ratio and loss adjustment expense ratio for year ended December 31, 2003 was 60.4%, compared with 58.1% for the prior year. The increase in loss and loss adjustment expenses was primarily attributable to the increase in premium volume during 2003 as compared to prior year and increases in the loss and loss adjustment expenses of both affiliated and unaffiliated underwriting agencies during 2003 as compared to 2002.
products. Our life insurance products are sold through marketing firms, financial institutions and 400 independent agents located throughout 41 states and the District of Columbia. At December 31, 2003, American Founders had approximately $2.0 billion (face value) of life and annuity products in force, and approximately $725.8 million in invested assets.
In 2003, we incurred $65.9 million of litigation and arbitration settlement expenses related to our 1997 20 percent quota share arbitrations with NRMA, Dorinco and Alfa (as discussed in the “Reinsurance Arbitrations” section on page 6, in Item 3. Legal Proceedings and in Note G. Commitments and Contingencies) and other disputed balances compared to a charge of $9.0 million in 2002. In 2002, we reduced our estimated recoverables from the 20% whole account quota share arbitrations by $23.6 million and received a $16 million gain, before expenses, in a litigation settlement with Cincinnati Insurance Company.
In 2003, operating expenses decreased by $6.5 million from the prior year. The decrease was primarily due to $4.2 million of severance expense incurred by the Company in 2002. The remaining decrease in operating expenses is attributed to lower legal expenses and decreased compensation expense.
Our corporate interest expense includes interest payable on our 8.75% senior debentures due in 2025, interest on certain Federal Home Loan Bank borrowings and our commercial credit borrowings. Interest expense for the twelve months ended December 31, 2003 was $6.4 million compared to $8.6 million in the previous year. The decrease in interest expense is attributable to the repurchase of approximately $24.7 million face amount of our long-term debentures during 2002, which also resulted in a pre-tax gain of $9.5 million during 2002.
The Company’s adoption of the provisions of SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity” (“SFAS 150”) resulted in the Deferrable Capital Security distributions for the six months ended December 31, 2003 being included as a component of segment pre-tax income (loss). Pursuant to the provisions of SFAS No. 150, the classification of Deferrable Capital Security distributions for prior periods was not changed. As a result, $0.9 million increased the pre-tax loss for the corporate and other segment.
During 2003, we redeemed $2.2 million face amount of Deferrable Capital Securities in exchange for approximately 402 thousand shares of common stock resulting in a pre-tax gain of $.6 million. Pursuant to the provisions of SFAS No. 150, the gain is reflected as a component of income from continuing operations.
In 2003, recorded charges for our discontinued operations for the following items (net of tax):
• $4.4 million related to our discontinued health insurance and consulting businesses.
In the fourth quarter of 2002, we made the decision to exit the health insurance and consulting business lines. Accordingly, our health insurance and consulting lines results for all periods presented have been reclassified in our financial statements as part of discontinued operations and are classified as operations held for sale. We consummated the sale of Aegis Financial Corporation (Aegis) and its subsidiary States General Life Insurance Company (States General) effective September 30, 2003 for $4.6 million. The sales price was financed through a $5.0 million note issued by the buyer payable to Vesta Fire. The sale of Aegis resulted in the Company recording an after-tax loss of $2.3 million, which is reflected as a component of discontinued operations. For the year ended December 31, 2003, we recorded a loss of $4.4 million, net of tax, for our health operations and our consulting business, including the aforementioned loss on the sale of Aegis.
For the year ended December 31, 2003, we recorded an after-tax loss of $11.5 million for reinsurance assumed and commercial lines businesses primarily related to the recording of an after-tax charge of $6.8 million on the CIGNA Property and Casualty Insurance Company arbitration reinsurance assumed receivables and the settlement of other litigation, and an after-tax charge of $4.7 million related to reserve adjustments and valuation allowances for receivables related to our commercial and assumed reinsurance books of business. See Item 3. Legal Proceedings, and Note G. Commitments and Contingencies to the consolidated financial statements for a further discussion of the CIGNA arbitration.
• The recognition of charges of $37.2 million related to arbitration matters with USF&G and NRMA Insurance, Ltd.;
• Significant growth in our standard property-casualty business line in Texas;
• Settlement of our claim against Cincinnati Insurance Company, pursuant to which we received $16 million of cash before expenses.
In our standard property-casualty segment, we underwrite or sell personal automobile and residential property insurance through approximately 2,525 independent insurance sales agencies. In 2002, the standard property-casualty segment generated approximately $326.0 million in revenue, or approximately 54.3% of consolidated revenue.
For the year ended December 31, 2002, net premiums written in our standard property-casualty lines increased by $96 million (up 36.3%), to $360 million from $264 million in the prior year. Net premiums earned for standard property-casualty lines increased by $74.2 million in 2002, up 30.2%, to $320.3 million from $246.1 million in 2001. The increase in both net premiums written and net premiums earned was primarily attributable to increased writings in Texas of $130.4 million compared with $16.4 million in the prior year. The growth in premiums was partially offset by decreased writings in the Midwest and Mid-Atlantic regions in connection with our decision to terminate agents and withdraw from certain states. Effective December 1, 2002, we ceded 50% of the premiums and losses on our Texas residential property business to third party reinsurers pursuant to the 2002 50% Quota Share.
Total revenues for the year ended December 31, 2002 were $131.2 million, an increase of $125.0 million as compared to total revenues of $6.2 million for the prior year. The significant increase in total revenue in 2002, as compared to 2001, was principally due to the acquisitions of six retail and/or underwriting agencies in 2001 and 2002. A-Affordable and Space Coast were acquired in October of 2001 and American Agencies, Harbor and InsureOne were acquired in January of 2002. In September of 2002, we acquired Drivers’ Choice. Prior to the six acquisitions, we operated one retail agency that produced non-standard automobile policies for unaffiliated insurance companies.
For the year ended December 31, 2002, pre-tax income was $11.8 million, an increase in pre-tax income of $14.7 million, as compared to a pre-tax loss of $2.9 million in the prior year.
Total revenues for the year ended December 31, 2002 were $177.9 million, an increase of $163.3 million from the prior year total revenues of $14.6 million. The significant increase in total revenue in 2002, as compared to 2001, was principally attributable to new business produced by our affiliated underwriting agency operations, which acquired several agencies in late 2001 and early 2002.
For the year ended December 31, 2002, net premiums earned were $161.5 million an increase of $151.3 million as compared to net premiums earned of $10.2 million in the prior year. Of our total net premiums earned of $161.5 million for the year ended December 31, 2002, the net premiums earned on policies written through our affiliated underwriting agencies were approximately $139.7 million and net premiums earned on policies written through unaffiliated underwriting agencies were $21.8 million. The largest component of our net premiums earned on policies written through our affiliated underwriting agencies was approximately $122.5 million of net premiums earned on policies written through InsureOne, which we acquired January 1, 2002.
For the year ended December 31, 2002, fee income was $16.5 million, an increase of $12.1 million, as compared to $4.4 million of fee income in the prior year. The increase in fee income was due to increases in policy service fees and issuing carrier fees. For the year ended December 31, 2002 policy service fee income was $11.1 million, compared to $0.2 million in policy service fee income in the prior year. The increase in policy service fees principally a result of the non-standard automobile business of InsureOne written by the insurance companies in 2002. We also collected issuing carrier fees of approximately $5.4 million for the year ended December 31, 2002, as compared to $4.2 million in 2001. The increase in issuing carrier fees was primarily attributable to increases in gross premiums written of two unaffiliated underwriting agencies in 2002 as compared to 2001.
For the year ended December 31, 2002, loss and loss adjustment expenses were $100.3 million, an increase of $92.3 million as compared to $8.0 million of loss and loss adjustment expenses in the prior year. The increase in loss and loss adjustment expenses was primarily attributable to the increase in earned premium produced by affiliated underwriting agency operations. The loss ratio and loss adjustment expense ratio for year ended December 31, 2002 was 58.1%, compared with 77.4% for the prior year.
For the year ended December 31, 2002, pre-tax income was $10.6 million, an increase of $6.7 million in 2002, as compared to $3.9 million in the prior year. Our combined ratio for the year ended December 31, 2002 was 97.0% compared to 102.9% for the prior year.
At December 31, 2002, American Founders had approximately $2.5 billion (face value) of life and annuity products in force, and approximately $721.9 million in invested assets.
Life insurance premiums and policy fees increased to $14.0 million from $13.7 million in the prior year as a result of the inclusion of a full year results for acquisitions of Imperial General, Teton National and Washington Life made in 2001 partially offset by normal declines on closed blocks and increased reinsurance. Investment income decreased from the prior year because of an overall decline in market interest rates during 2002. In addition, investment income declined by approximately $1.5 million in 2002 because we did not accrue interest on approximately $27 million of non-performing loans held as investments in our life insurance segment. As described below, these loans were written off in the fourth quarter of 2002.
In an effort to restore American Founders’ surplus to an acceptable level, we increased a third party reinsurer’s coinsurance participation in substantially all of American Founders’ business from 35% to 62.5%, effective October 1, 2002. At December 31, 2002, American Founders had statutory capital of $30.6 million compared with $35 million at December 31, 2001. While this increased reinsurance positively impacted American Founders’ statutory capital at December 31, 2002, it negatively impacted financial results for the fourth quarter, as the decline in policyholders benefits was more than offset by the decline in premium and investment income.
In 2002, operating expenses increased by $7.6 million from the prior year primarily because of a severance payment to our former Chairman of approximately $4.2 million in connection with his resignation in December, 2002. As part of that severance, the former Chairman forfeited 595,000 shares of restricted stock and repaid $2.6 million of loans plus accrued interest.
Vesta’s principal source of liquidity and capital resources to meet its holding company obligations is dividends paid by our subsidiaries. Many of our subsidiaries are insurance companies that are individually supervised by various state insurance regulators, and other unregulated companies that we own, such as Affirmative Insurance Holdings, Inc. (formerly known as Instant Insurance Holdings, Inc.), are owned indirectly through a regulated insurance company. Given our organizational structure, we rely on two subsidiaries to pay dividends to our holding company or otherwise fund the obligations of our holding company on its behalf - Vesta Fire Insurance Corporation, an Illinois domiciled insurer, and J. Gordon Gaines, Inc., a Delaware business corporation.
Transactions between Vesta and its insurance subsidiaries, including the payment of dividends, are subject to certain limitations under the insurance laws of those subsidiaries’ domiciliary states. The insurance laws of the state of Illinois, where Vesta Fire is domiciled, permit the payment of dividends out of unassigned surplus in any year which, together with other dividends or distributions made within the preceding 12 months, do not exceed the greater of 10% of statutory surplus as of the end of the preceding year or the net income for the preceding year, with larger dividends payable only after receipt of prior regulatory approval. The Illinois Insurance Department has indicated that these dividend limitations prohibit the payment of dividends if the insurer has negative or zero “unassigned funds” at the end of the prior year, as reported on its statutorily required annual statement. Our lead insurance subsidiary, Vesta Fire, reported negative “unassigned funds” on its annual statement for 2003, and is expected to continue to report negative unassigned funds for the foreseeable future. Accordingly, we may not be able to declare and pay a dividend from our lead insurance company subsidiary for the foreseeable future without prior approval. There can be no assurance that Vesta Fire will be able to obtain the requisite regulatory approval for the payment of dividends. Vesta Fire did not pay any dividends in 2003.
J. Gordon Gaines, Inc. provides administrative services to all of our property - casualty insurance subsidiaries in exchange for fees pursuant to an administrative services agreement and, with respect to our Texas Select Lloyds Insurance Company, an attorney-in-fact agreement. These management agreements are subject to certain regulatory standards which generally require their terms and fees to be fair and reasonable. The Illinois or Texas Departments of Insurance may review these agreements from time to time to insure the reasonableness of their terms and fees, and it is possible that such terms and fees could be modified to reduce the amounts available to our holding company. Assuming these management agreements are not
Effective February 1, 2003, we entered a $30 million revolving credit arrangement with First Commercial Bank of Birmingham, Alabama (“First Commercial”), secured by a pledge of 358,375 shares of our holding company’s ownership in the common stock of Affirmative Insurance Holdings, Inc. representing approximately 40.6% of Affirmative’s issued and outstanding shares of capital stock as of December 31, 2003. The new facility bears interest at First Commercial’s prime rate and will mature no earlier than June 30, 2005. As of December 31, 2003, we had drawn the entire $30 million available under this Agreement.
In the event we are unsuccessful in having the NRMA arbitration ruling vacated, Vesta Fire will be required to make a $28.1 million payment to NRMA by April 1, 2004. Vesta Fire has sufficient level of liquid assets to meet this obligation in the event payment is required.
(2) Consideration due for acquisitions relates to non-standard agency acquisitions consummated in 2002. Aggregate amount is reflected on our consolidated balance sheet as a component of other liabilities.
Future payments for our interest and operating lease obligations to third parties at December 31, 2003 are as follows (in thousands):
As discussed above, our subsidiary operations are also involved in ongoing reinsurance recoverable disputes that could result in an obligation to repay certain amounts to reinsurers from whom we have collected funds. In connection with these disputes, our principal operating subsidiary, Vesta Fire, has obtained letters of credit for the benefit of reinsurers for which it is contingently liable. At December 31, 2003, Vesta Fire was contingently liable for $38.5 million under the terms of letters of credit obtained in connection with these reinsurance disputes.
In addition to the contractual obligations of our holding company to third parties presented in the tables above, our holding company owes contractual obligations to certain of our subsidiaries that are eliminated in consolidation of our financial
Current dividend levels from Vesta Fire and J. Gordon Gaines are not sufficient to repay the entirety of the inter-company obligations. Failure to repay these amounts could have a material adverse affect on the statutory capital of our subsidiaries. Furthermore, failure to receive regulatory approval to refinance these obligations on favorable terms could negatively impact the financial results of the Company.
On a consolidated basis, net cash (used in) provided by operations for the year ended December 31, 2003 and 2002, was $(16.4) million and $122.6 million, respectively. Cash flow from operations was negative for the current period primarily due to decreases in reinsurance balances payable and unearned premium reserves, reflecting the impact of our increased reinsurance activity at the end of 2002 and throughout 2003. Net cash used in investing activities was $(8.3) million and $(1.1) million for the year ended December 31, 2003 and 2002, respectively, reflecting the impact of acquisitions in the current year offset by lower investment security purchases. Net cash provided by (used in) financing activities was $(23.5) million and $(4.4) million for the year ending December 31, 2003 and 2002, respectively. In 2003, our financing activities were changed in that we reduced our FHLB advances.
In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosure”. This statement is effective for 2003 and amends SFAS No. 123, “Accounting for Stock-Based Compensation” by providing alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, SFAS No. 148 requires additional disclosures related to the effect of stock-based compensation on reported results. Vesta has adopted the disclosure provisions of SFAS No. 148 and has determined the Company will continue to account for stock-based compensation based on Accounting Principles Board Opinion No. 25.
Consolidated Statements of Stockholders’ Equity and Comprehensive Income (Loss) for each of the years in the three-year period ended December 31, 2003
Consolidated Statements of Cash Flows for each of the years in the three-year period ended December 31, 2003
In our opinion, the consolidated financial statements listed in the index appearing under Item 15(a)(1) present fairly, in all material respects, the financial position of Vesta Insurance Group, Inc. and its subsidiaries at December 31, 2003 and 2002, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2003 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedules listed in the index appearing under Item 15(a)(2) present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedules are the responsibility of the Company’s management; our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States of America, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
Nature of Operations: Vesta is a holding company whose principal assets are investments in the capital stock of a group of wholly owned subsidiaries that constitute the Vesta Insurance Group, Inc. (“Vesta Group”). The Vesta Group offers financial services through the production, distribution, and administration of property-casualty and life insurance products. The lead insurers in the Vesta Group are Vesta Fire Insurance Corporation and American Founders Life Insurance Company. In the fourth quarter of 2002, we discontinued our health insurance and consulting lines of business. In 1999 and 2000, we discontinued the commercial line of business and our reinsurance assumed line of business, respectively. Each of these business lines have been segregated from continuing operations herein for all periods presented. See Note R for further discussion of our discontinued operations.
Use of Estimates in the Preparation of the Financial Statements: The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the 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 the premiums in course of collection, reserves for losses and loss adjustment expenses, deferred policy acquisition costs, reinsurance receivables and impairment of assets.
Short-term investments are carried at cost and include investments in certificates of deposit and other interest-bearing time deposits with original maturities of one year or less.
Gains and losses realized on the disposition of investments classified as available for sale are recognized as revenues and are determined on a specific identification basis. Unrealized gains and losses on equity securities and fixed maturities available for sale, net of deferred income taxes, are reflected directly in stockholders’ equity. If an investment becomes other than temporarily impaired, such impairment is treated as a realized loss and the investment is adjusted to net realizable value. An investment in a debt or equity security is impaired if its fair value falls below its book value and the decline is considered other than temporary. A debt security is deemed to have an other than temporary impairment if it is probable that the Company will not be able to collect all amounts due under the security’s contractual terms. Equity investments are deemed to have an other than temporary impairment when it becomes apparent that the Company will not recover its cost over the expected holding period.
Derivatives: The Company holds certain bonds and preferred stocks within the Company’s fixed maturities and equity securities portfolios which contain the option to convert into the common stock of the issuers and are considered embedded derivatives. These options are carried at current market values, as provided by a third-party
Determination of Fair Values of Financial Instruments: Fair values for cash, short-term investments, short-term debt, receivables and payables approximate their carrying value. Fair values for investment securities and long-term debt are based on quoted market prices, if available. If quoted prices are not available, fair value is primarily determined based upon management’s assessment of the market value of comparable investments. Our determination of fair value also considers various factors including time value and volatility issues, credit quality of the counterparty and existing conditions in the overall financial markets.
• Earned premiums on property-casualty business are recognized as revenue on a pro-rata basis over the respective period of each property-casualty insurance policy. Reinsurance premiums ceded are similarly pro-rated with the prepaid portion recorded as a component of reinsurance balances receivable in the consolidated balance sheet.
Losses and Loss Adjustment Expenses: The liability for losses and loss adjustment expenses (“LAE”) includes an amount determined from loss reports and individual cases. It also includes an amount for losses incurred but not reported (“IBNR”) which is based on historical experience. Such liabilities are necessarily based on estimates and, while management believes that the amount is adequate, the ultimate liability may be in excess of or less than the amounts provided. The methods for making such estimates and for establishing the resulting liabilities are continually reviewed, and any adjustments are reflected in earnings currently. These reserves are established on an undiscounted basis and are reduced for estimates of salvage and subrogation.
Property and Equipment: Property and equipment is reported at cost less allowances for depreciation. Depreciation is recorded primarily on the straight-line method over the estimated useful lives of these assets that range from 1 to 15 years. Ordinary maintenance and repairs are charged to expense as incurred.
Depreciation expense on property and equipment used in the business was $5.6 million, $5.5 million and $3.9 million for the years ended December 31, 2003, 2002, and 2001, respectively.
Goodwill and other intangible assets: Goodwill and other intangible assets at December 31, 2003 and 2002 are as follows (in thousands):
Income Per Share: Basic earnings per share (“EPS”) is computed by dividing net income available to common stockholders by the weighted average common shares outstanding for the period. Diluted EPS is calculated by adding to shares outstanding the additional net effect of potentially dilutive securities or contracts that could be exercised or converted into common shares. Reconciliations of net loss available to common shareholders and average shares outstanding as follows:
* In 2003, 2002 and 2001, 53 thousand 184 thousand and 1.2 million shares, respectively, had an anti-dilutive effect and were excluded in accordance with SFAS No. 128.
In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation - Transition and Disclosure”. This statement is effective for 2003 and amends SFAS No. 123, “Accounting for Stock-Based Compensation” by providing alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, SFAS No. 148 requires additional disclosures related to the effect of stock-based compensation on reported results. Vesta has adopted the disclosure provisions of SFAS No. 148 and has determined the Company will continue to account for stock-based compensation based on Accounting Principles Board Opinion No. 25.
In November 2002, the FASB issued FASB Interpretation No. (“FIN”) 45, “Guarantor’s Accounting and Disclosures Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others.” FIN 45 clarifies the requirements of SFAS No. 5, “Accounting for Contingencies,” related to a guarantor’s accounting for, and disclosures of, the issuance of certain types of guarantees. The disclosure requirements are effective for financial statements of interim and annual periods ending after December 15, 2002 and have been included in the Notes to the consolidated financial statements included herein. The impact on the Company’s financial statements from the application of the recognition and measurement provisions of FIN No. 45 is dependent on the level of guarantees issued or modified in 2003 and thereafter. No guarantees were issued or modified during the year ended December 31, 2003, which were impacted by the provisions of FIN No. 45.
On October 1, 2003, the Company adopted Derivatives Implementation Group Issue No. B-36, “Embedded Derivatives: Modified Coinsurance Arrangements and Debt Instruments That Incorporate Credit Risk Exposures That Are Unrelated or Only partially Related to the Creditworthiness of the Obligor under Those Instruments”(DIG B-36). DIG B-36 requires the bifurcation of embedded derivatives within certain modified coinsurance and funds withheld coinsurance arrangements that expose the creditor to credit risk of a company other than the debtor, even if the debtor owns as invested assets the third-party securities to which the creditor is exposed. In connection with the adoption of DIG B-36, the Company elected to reclassify to trading securities the investments, which are held in a separate trust, supporting a funds withheld treaty. In addition, the Company recognized a loss from the cumulative effect from the adoption of DIG B-36 of $1,167, net of tax, in connection with recording the derivatives embedded in its modified coinsurance and funds withheld coinsurance arrangements.
In July 2003, the AICPA issued Statement of Position 03-1, Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts (SOP 03-1). SOP 03-1 provides guidance on the reporting method and presentation of separate accounts, recognition of gains and losses on the transfer of assets from the general account to a separate account, as well as several liability valuation issues related to nontraditional long-duration contracts such as universal life and annuity contracts. SOP 03-1 is effective for financial statements for fiscal years beginning after December 15, 2003. Management is currently analyzing the effects that the implementation of SOP 03-1 will have on our consolidated financial statements.
During the second quarter of 2003, the Company acquired the 20% minority interest in InsureOne Independent Insurance Agency, LLC for $11.2 million. The transaction has been accounted for as a purchase and resulted in an increase to goodwill of $9.1 million.
In the second quarter of 2003, the Company settled certain contingent consideration provisions related to prior period standard property-casualty acquisitions. The result of the settlement of the contingent consideration provisions was an increase of goodwill of $3.2 million.
In January of 2002, the Company completed three acquisitions: (1) the acquisition of certain assets of InsureOne Agency and the renewal rights to a book of non-standard automobile business; (2) acquisition of the non-standard automobile related assets of Harbor Insurance Group; and (3) purchase of the common stock of Old American Investments. The combined purchase price for these transactions was $36.8 million, with $16.6 million due at closing and $20.2 million due upon the occurrence of certain future events. In 2003, the Company paid $2.0 million in contingent consideration and settled the remaining $16.5 million through an agreement by which the Company is required to make scheduled payments through August 2005. The balance of the contingent consideration liability at December 31, 2003 is $10.0 million and is reflected as a component of other liabilities on the accompanying consolidated balance sheet.
The Company executed a definitive agreement on March 12, 2004 to sell American Founders Financial Corporation (“AFFC”), our life insurance subsidiary, for a total purchase price of approximately $63.5 million, consisting of $25 million in cash at closing and a promissory note in the amount of approximately $38.5 million. The note will bear a floating interest rate of LIBOR plus 200 basis points and will be repaid over a six-year term, with the interest payments only in the first year and the principal repayments in five equal annual payments thereafter. The note will be secured by a pledge of the stock of both AFFC and all capital stock and surplus debentures issued by AFFC’s immediate subsidiary, Laurel Life Insurance Company, which owns 100% of the capital stock of American Founders Life Insurance Company. The divestiture of AFFC will not result in a significant impact to our GAAP equity, but will have a significant positive impact on our statutory surplus. We anticipate an increase in statutory surplus of approximately $19.5 million upon the closing of this transaction. Although we have executed a definitive agreement, the consummation of this transaction is subject to regulatory approval from various state departments of insurance. Such approval is beyond our control and no assurance can be given that this transaction will receive the required regulatory approval.
Upon our initial adoption of SFAS No. 142, we identified three reporting units that would be tested for goodwill impairment: homeowners’ insurance operations; life insurance operations; and non-standard automobile insurance operations. Pursuant to the provisions of SFAS No. 142, we conduct an evaluation, on at least an annual basis, to assess whether the fair value of our reporting units exceeds each reporting unit’s carrying value. Our annual evaluation is performed on September 30th and is based on (a) the historical financial performance of each reporting unit; (b) the most recent financial performance of each unit; (c) management’s financial forecast for each reporting unit; (d) information regarding publicly available financial terms of recent transactions in the insurance industry; and (e) other publicly available information. Based on the charges recorded by the Company in the fourth quarter of 2003, we updated our goodwill analysis. Based on this updated analysis, the Company concluded there was no indication of impairment as of December 31, 2003.
For the year ended December 31, 2001, we recorded $2.2 million in amortization of goodwill. The impact of amortization of goodwill on net income was as follows (in thousands, except per share data):
The estimated amortization expense for each of the five succeeding fiscal years is as follows (in thousands):
The Company filed its statutory financial information for Vesta Fire Insurance Corporation and American Founders Life prior to February 28, 2004. The reported statutory capital and surplus and statutory net (loss) of Vesta Fire as of and for the year ended December 31, 2003 was $203.8 million and $(20.0) million, respectively, compared to $200.1 million and $(74.3) million in 2002. Additionally, the statutory capital and surplus and statutory income (loss) of American Founders as of and for the year ended December 31, 2003 was $35.7 million and $4.7 million, respectively, compared to $30.7 million and $(15.3) million in 2002.
A summary of fixed maturities and equity securities available-for-sale by amortized cost and estimated fair value at December 31, 2003 and 2002 is as follows (in thousands):
Gross gains (losses) realized on the sale of equity securities were $6.1 million, $(.6) million and $0.7 million in 2003, 2002 and 2001, respectively. Gross gains realized on the sale of fixed maturities were $6.5 million, $10.5 million and $3.0 million in 2003, 2002 and 2001, respectively. Gross losses on the sale of fixed maturities were $6.0 million, $10.2 million and $0.5 million in 2003, 2002 and 2001, respectively.
We maintain a mortgage loan portfolio consisting of first-lien residential and commercial mortgages. At December 31, 2003, our residential mortgages had carrying values of approximately $1.6 million and commercial mortgages had carrying values of approximately $7.5 million.
Management evaluates securities for other-than-temporary impairment on at least a quarterly basis, and more frequently when economic concerns warrant such an evaluation. Factors considered by management in determining whether an impairment of an investment security is other than temporary includes the credit quality of the security, the severity of the decrease between the security’s cost and market value, the length of time of the security’s impairment and the likelihood that the impairment will reverse in the future.
Vesta and two former officers of Vesta are defendants in a lawsuit styled James H. Cashion, Jr. d/b/a American Health Underwriters v. Vesta Insurance Group, Inc., et al., Plaintiff, a former general agent of our subsidiary States General Life Insurance Company, which we purchased in 2001 and disposed of in 2003, alleges that the defendants engaged in an actionable civil conspiracy to tortiously interfere with his agency contracts. The civil conspiracy claim is premised, in part, on certain payments made to these two former officers of Vesta by another agent who replaced Mr. Cashion. The plaintiff is seeking actual and punitive damages. Vesta denies tortiously interfering with plaintiff’s agency contract, believes the claims asserted against it have no merit, and is vigorously defending this lawsuit. The trial court recently denied defendant’s motion to compel arbitration, which decision is currently on appeal to the Texas Supreme Court. Discovery has been stayed pending resolution of this appeal. In the opinion of management, resolution of this lawsuit is not expected to have a material adverse effect on our financial position.
As discussed in previous SEC filings, in 1998 we corrected our accounting for assumed reinsurance business through restatement of our previously issued financial statements. Similar corrections were made on a statutory accounting basis through recording cumulative adjustments in Vesta Fire’s 1997 statutory financial statements. The impact of this correction has been reflected in amounts ceded under our 20 percent whole account quota share treaty, which was terminated on June 30, 1998 on a run-off basis. We believed such treatment was appropriate under the terms of this treaty and calculated the quarterly reinsurance billings presented to the three treaty participants accordingly. The aggregate amount included as recoverable from such reinsurers totaled $33.4 million at September 30, 2003. Additionally, we previously collected approximately $48.5 million from the drawdown of collateral on hand. Such amount net of related expenses had been reflected in the Company’s consolidated financial statements.
NRMA Insurance Limited (“NRMA”), one of the participants in the 20 percent whole account quota share treaty, filed a lawsuit in the United States District Court for the Northern District of Alabama contesting our billings.
NRMA sought rescission of the treaty and a temporary restraining order preventing us from drawing down approximately $34.5 million of collateral. We filed a demand for arbitration as provided for in the treaty and also filed a motion to compel arbitration which was granted in the United States District Court action. Vesta reached an agreement with NRMA to collect the $34.5 million of collateral in exchange for posting a $25 million letter of credit in favor of NRMA to provide collateral for any amounts NRMA may recover as a result of the arbitration. Pursuant to an order of the NRMA arbitration panel Vesta posted an additional $4.8 million letter of credit in October, 2003 in favor of NRMA. We also filed for arbitration against Alfa Mutual Insurance Company (“Alfa”) and Dorinco Reinsurance Company (“Dorinco”), the other two participants on the treaty.
On March 14, 2002, Alfa filed a motion for declaratory judgment asking the arbitration panel to order that there is no enforceable agreement between Alfa and Vesta or alternatively that there is no coverage for developmental losses under the treaty. After a hearing in June, 2002, the arbitration panel denied Alfa’s motion. The hearing on the merits of the arbitration with Alfa was scheduled for May, 2003, however on April 21, 2003, Alfa filed a lawsuit against Vesta Fire in the state court in Montgomery, Alabama seeking a declaration from the court on certain procedural and organizational matters and requesting that the court stay the arbitration proceedings during the pendency of the litigation in state court in Alabama. On April 24, 2003, the court issued a temporary restraining order staying the proceedings in the on-going arbitration in order to maintain the status quo until the merits of Alfa’s petition could be heard and determined. After the hearing in the Circuit Court of Montgomery County on December 8 and 9, 2003, the court decided the procedural and organizational matters partially in favor of the Company and partially for Alfa. While the arbitration hearing has not yet been rescheduled it is likely to be scheduled for early 2005.
Third party auditors hired by Vesta have identified coverage issues that cast doubt on the validity of a number of claims. In addition, there is no actual retrocessional agreement that evidences the terms and conditions of Pool III which involves 60% or more of the incurred losses at issue. Although there are other tangential documents that the Liquidator may attempt to rely on to prove liability under Pool III, we believe that the Liquidator will not be able to establish liability for any portion of the Pool III claims. We also believe that a number of the losses allegedly incurred in connection with Pool I may be avoided on specific coverage grounds. We are defending this matter vigorously and are reasonably optimistic regarding the ultimate outcome, although an adverse ruling in this case could have a material effect on our financial condition. The first mediation session in this case was held on January 8, 2004 and a continued mediation is scheduled for March 31, 2004.
On September 5, 2002, New Cap Re served us with an Application pursuant to Section 588FF of the Australian Corporations Act seeking an order directing us to pay New Cap Re and its liquidator $1.0 million that Vesta allegedly received as an “unfair preference” and/or arising out of an “uncommercial transaction,” as those terms are defined by the Corporations Act. We filed a Notice of Appearance on October 31, 2002. The liquidator filed a Statement of Claim on August 13, 2003, and the Company filed its defense on December 18, 2003. Discovery has not commenced. While management intends to vigorously defend this matter, given the preliminary nature of these proceedings, it is too early to evaluate the likelihood of success.
As part of its ongoing reinsurance recoverable arbitrations, we have obtained letters of credit for the benefit of certain parties. Our principal operating subsidiary, Vesta Fire is contingently liable under the terms of these letters of credit. For our reinsurance arbitrations, we have obtained letters of credit totaling $38.5 million for which we are contingently liable. Additionally, as part of our specialty lines underwriting retained, we have pledges of securities totaling $13.4 million securing our obligations under various reinsurance agreements. As part of our Federal Home Loan Bank Program, as more fully described in Note N, we have pledged securities with a market value of $178.8 million securing our obligation thereunder.
Future payments for operating lease obligations at December 31, 2003 are as follows (in thousands):
We evaluate the recoverability of our deferred tax assets on an ongoing basis. In making this evaluation during 2003, we considered all available positive and negative evidence, including our past results, the existence of significant cumulative losses in recent years, and our estimate of future taxable income.
We will continue to review our estimated taxable income in relation to our actual results on an ongoing basis. In the event that certain planned transactions are consummated or management believes that existing uncertainties regarding our forecasted taxable income are minimized, the existing valuation allowance may be reversed.
During 2003, we redeemed $2.2 million face amount of Deferrable Capital Securities in exchange for approximately 402 thousand share of common stock resulting in a gain of $.6 million. Pursuant to the provisions of SFAS No. 150, the gain is reflected as a component of income from continuing operations.
In 2001, we sold 5.5 million shares of common stock to third parties for approximately $32.3 million. In June 2001, we completed a follow on offering of 8.625 million shares of common stock for approximately, $64.0 million, net of offering expenses. Additionally, in 2001, we purchased 1.4 million shares on the open market for approximately $9.7 million. These shares were used for various restricted stock awards, debt for equity exchanges or are held in treasury.
Unearned stock consists of shares of common stock issued by Vesta that remain subject to certain future restrictions, and therefore are shown as a reduction to stockholders’ equity. Unearned stock compensation is composed of the following at December 31, 2003 and 2002 (in thousands):
Our non-standard agency segment does not engage in underwriting activities. The primary focus of our agency segment is the distribution of non-standard auto insurance products for various retail and wholesale insurance carriers in exchange for commissions and fees. Our non-standard insurance policies, which generally are issued for the minimum limits of liability coverage mandated by state laws, provide coverage to drivers who find it difficult to obtain insurance from standard insurance companies due to a number of factors, including lack of prior coverage, failure to maintain continuous coverage, age, prior accidents, driving violations, type of vehicle or limited financial resources. Typically, non-standard auto insurance customers are considered higher-risk than standard customers, and premiums for non-standard insurance are generally more expensive.
Long-term debt and Deferrable Capital Securities at December 31, 2003 and 2002 consists of the following (in thousands):
This credit agreement contains covenants which require us to maintain (i) consolidated GAAP net income (excluding realized gains and losses) of at least $15 million for any calendar year, (ii) consolidated debt to capital ratio of no more than 39%, measured on a quarterly basis, (iii) an A.M. Best rating of “B” or better, measured continuously, (iv) consolidated GAAP net worth of at least $208 million, measured quarterly, (v) an interest coverage ratio of not less than 1.5 to 1 for any calendar year and (vi) risk-based capital of not less than 150% of the NAIC’s authorized control level, measured continuously. As of December 31, 2003, the Company was in
Although management does not anticipate an event of default with respect to these covenants in 2004, there can be no assurance that we will remain in compliance with these covenants in the future. Furthermore, current dividend levels from Vesta Fire and J. Gordon Gaines would not be sufficient to repay the anticipated outstanding balance of this credit facility were we to violate a covenant without seeking prior approval. Although management believes the Company would be able to secure waivers on any future covenant violations, the failure to obtain such waivers of the potential covenant violations or refinance the credit facility on similar terms could have a material adverse impact on our financial condition. The failure of the Company to secure refinancing of the credit facility would force the Company to secure other forms of financing as current operating cash flows would not be sufficient to cover the contractually required debt service requirements. The Company’s inability to secure other financing to refinance the credit facility would have a material adverse impact on the Company. Additionally, refinancing the Credit Facility with other financing at higher interest rates could negatively impact the Company’s financial performance.
In 1997, our single purpose finance subsidiary, Vesta Capital Trust I, issued $100 million principal amount of its 8.525% Deferrable Capital Securities. We have unconditionally guaranteed Vesta Capital Trust’s obligation to make semi-annual distributions on these capital securities, and we have issued a debenture in a like amount to Vesta Capital Trust which requires us to make interest payments in the same amounts and at the same times as the distributions which are payable on these capital securities. These securities and the related distributions are treated in a manner similar to minority interest in the financial statements.
During the year ended December 31, 2001, we exchanged 966 thousand shares of common stock for $10 million face amount of Deferrable Capital Securities. The resulting after tax gain of $1.9 million was recorded directly to retained earning in accordance with EITF 86-32. During the year ended December 31, 2002, we exchanged 69 thousand shares of common stock for $805 thousand face amount of Deferrable Capital Securities. The resulting after-tax gain of $209 thousand was recorded directly to retained earnings in accordance with EITF 86-32. The after-tax gains from these transactions have been included in the respective computations of income available to common shareholders and related earnings per share computations in accordance with EITF Topic No. D-42, “The Effect on the Calculation of Earnings per Share for the Redemption or Induced Conversion of Preferred Stock.”
As of December 31, 2003, our long term debt carried a semi-annual distribution obligation of approximately $3.3 million.
Advances from the Federal Home Loan Bank (“FHLB”) as of December 31, 2003 and 2002 are as follows (in thousands):
We are required to maintain a collateral deposit with FHLB. At December 31, 2003 and 2002 respectively, investments having a market value of approximately $178.8 million and $183.6 million were pledged to the FHLB. For the years ended December 31, 2003 and 2002, interest expense was approximately $6.2 million and $7.4 million, respectively.
The carrying amounts and estimated fair values of Vesta’s financial instruments, none of which were held for trading purposes, at December 31, 2003 and 2002 are as follows (in thousands):
The fair values presented represent management’s best estimates and may not be substantiated by comparisons to independent markets and, in many cases, could not be realized in immediate settlement of the instruments. Certain financial instruments and all nonfinancial instruments are not required to be disclosed; therefore, the aggregate fair value amounts presented do not purport to represent the underlying fair value of Vesta. Except as noted below, fair values were estimated using quoted market prices.
• Equity Securities - The carrying value of unaffiliated common stock, except for stock of FHLB, approximates fair value. Because FHLB shares are not publicly traded, the market value of the stock was considered to be equivalent to its cost due to the fact that FHLB has historically redeemed the shares at the original cost.
• Mortgage Loans - The fair value of mortgage loans is calculated by discounting scheduled cash flows through the estimated maturity using the current rates at which similar loans would be made to borrowers with similar credit and interest rate risks. Approximately $1.8 million of the loans were in the process of foreclosure.
• Other Invested Assets - The carrying value of certain other invested assets approximates fair value because existing rates of return approximates the current rates of return required on similar investments.
• Annuity Account Balances - Annuity account balances include single premium and flexible premium deferred and immediate annuity contracts, supplementary contracts not having significant mortality risk, policyholder dividend accumulations, and separate account liabilities. Cash surrender value is used in determining the fair value of single premium and flexible premium deferred annuity contracts. Carrying amounts approximated fair value for immediate annuities, supplementary contracts, policyholder dividend accumulations, and separate account liabilities.
In 1999, we elected to exit all commercial lines programs by not accepting new commercial policy applications and non renewing existing in-force policies at their renewal dates. In November of 1999, we received final regulatory approval to non renew our commercial lines policies from all of the states in which we wrote commercial lines. Such approval represented the measurement date for treatment of the commercial segment as a discontinued operation under APB Opinion No. 30. Therefore, the commercial operations have been segregated from continuing operations herein for all periods presented. Vesta will continue to pay losses on policies with coverage periods prior to the measurement date as those losses become due.
As a result of an unexpected increase in the severity and volume of reported claims associated with both our discontinued commercial and assumed reinsurance lines and an increase in payments on claim reserves during 2001, we increased our expected losses from discontinued operations in the third quarter of 2001 by approximately $19.5 million, net of tax. The increase in our expected losses with respect to our commercial business related to a variety of underlying coverages including general liability. These types of claims may take many years to fully develop and we must continue to monitor trends in their ultimate development. Similarly, we experienced negative development in some of our assumed reinsurance contracts, principally related to certain homeowners coverages. These types of claims should fully develop over a comparatively shorter period of time. During 2002, we incurred an after-tax charge of $9.5 million due to the completion of arbitration with F&G Re related to ceded commercial and assumed reinsurance business.
For the year ended December 31, 2003, we recorded a loss of $11.5 million, net of tax, for reinsurance assumed and commercial lines businesses primarily related to the recording of an after-tax charge of $6.8 million on the CIGNA Property and Casualty Insurance Company arbitration reinsurance assumed receivables, the recording of an after-tax charge of $0.7 million related to the settlement of the Nichols lawsuit, and an after-tax charge of $4.7 million related to reserve adjustments and valuation allowances for receivables related to our commercial and assumed reinsurance books of business.
In June of 2001, the Company settled a contingent liability with three of its executives under the Executive Officer Incentive Compensation Plan by issuing 1.25 million shares of restricted stock and giving the executives total loans of $5.0 million. The restricted stock, which is recorded as Unearned Stock at December 31, 2003, vests over a 10-year period under certain circumstances. The loans, which are recorded as Other Assets at December 31, 2003 may be forgiven over a 10-year period. The Company will record the vesting of the restricted stock and any forgiveness of the loans as compensation expense in the appropriate periods.