The Company owns its corporate offices in Fort Worth, Texas that provide approximately 35,000 square feet of office space and additional parking. The Company has entered into a contract to sell this office building. See "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations."
(1) Excludes premiums of $16,627,000 in 2001, $26,973,000 in 2000, $58,137,000 in 1999, $47,588,000 in 1998 and $40,136,000 in 1997 from the Company's fronting arrangements, the commercial automobile plans of Arkansas, California, Louisiana, Mississippi, and Pennsylvania under which the Company was a servicing carrier and the reinsurance arrangement in Florida whereby MGAI premiums are ceded to a non-affiliated reinsurer and assumed by General Agents.
(2) Includes after tax net realized gains (losses) from securities transactions of $2,822,000, $(1,258,000), $400,000, $457,000 and $212,000 for 2001, 2000, 1999, 1998 and 1997, respectively.
(3) Based on shares of Common Stock outstanding of 27,369,736, 27,369,736, 27,119,833, 20,896,563, and 20,874,224 at the end of 2001, 2000, 1999, 1998, and 1997, respectively. Common Stock outstanding at December 31, 2001, 2000 and 1999 assumes conversion of the Series A Convertible Preferred stock that was issued in the 1999 GMSP transaction.
Critical accounting policies are defined as those that are reflective of significant judgements and uncertainties, and potentially result in materially different results under different assumptions and conditions. The Company's critical accounting policies are described below. For a detailed discussion on the application of these and other accounting policies, see Note (1) of the Notes to Consolidated Financial Statements.
Bonds available for sale, common stock and other investments are stated at fair value with changes in fair value recorded as a component of comprehensive income. Short-term investments are stated at cost. The "specific identification" method is used to determine costs of investments sold. Provisions for possible losses are recorded only when the values have experienced impairment considered "other than temporary" by a charge to realized losses resulting in a new cost basis of the investment. The Company's policy is to review investments on a regular basis to evaluate whether or not each investment has experienced an "other than temporary" impairment.
Goodwill, which represents the excess of purchase price over fair value of net assets acquired, is amortized on a straight-line basis over 25 years, which is the expected period to be benefited. The Company periodically reviews the recoverability of goodwill based on an assessment of undiscounted cash flows of future operations to ensure it is appropriately valued. The recoverability of goodwill is evaluated on a separate basis for each acquisition.
The remaining $3,468,507 of goodwill is associated with the 1998 acquisition of the Lalande Group and reflects the estimated fair valuation levels of agencies in the personal automobile marketplace.
The Company and its subsidiaries file a consolidated Federal income tax return. Deferred income tax items are accounted for under the "asset and liability" method which provides for temporary differences between the reporting of earnings for financial statement purposes and for tax purposes, primarily deferred policy acquisition costs, the discount on unpaid claims and claim adjustment expenses, net operating loss carry forwards and the nondeductible portion of the change in unearned premiums.
In 2001 the Company recorded a net loss of $75,607,047, or $3.68 per share (basic), primarily as a result of unfavorable claims experience, goodwill impairment and a valuation allowance for deferred Federal income taxes. On February 7, 2002, the Company announced its plans to discontinue writing commercial lines insurance due to continued adverse claims development and unprofitable results. In 2000 the Company recorded a net loss of $19,551,365, or $.97 per share (basic), primarily as a result of significant unfavorable claims experience in the commercial auto liability line of business. The Company materially increased the ultimate estimated liabilities for the line and entered into a reinsurance agreement, effective December 31, 2000, that provides significant additional protection in the event of further adverse reserve development. Additionally, the Company has reinsured the run-off of this business in 2001. In 1999, net income was $7,127,137, or $.32 per share (diluted). The Company recorded GAAP combined ratios of 172.6% in 2001, 126.3% in 2000, and 99.4% in 1999.
On January 7, 2000, the Company expanded its personal lines business conducted through the Lalande Group through the acquisition of Tri-State, an insurance operation specializing in underwriting, servicing and claims handling of nonstandard personal auto insurance in Minnesota, North Dakota and South Dakota. Tri-State owned and operated a managing general agency, a motor vehicle driving records service company and an insurance subsidiary, MCIC that had policyholders' surplus of approximately $3,034,000. The purchase price consideration consisted of $6,000,000 in cash at closing plus additional cash payments of $1,200,000 and $1,600,000 paid in July 2000 and January 2001, respectively. On August 31, 2001, the Company sold all of the stock of Tri-State to Herbert A. Hill for a cash price of $935,000. Mr. Hill is the President and a former owner of Tri-State. The Company retained MCIC which had policyholders' surplus of approximately $3,078,000 at December 31, 2001.
2001 GMSP Transaction. On March 23, 2001, the Company consummated a transaction with GMSP (the "2001 GMSP Transaction") pursuant to which, among other things, the Company issued shares of its newly created Series C Preferred Stock to GMSP in exchange for an aggregate purchase price of $3.0 million in cash.
The annual dividend rate on the Series C Preferred Stock is 10% during the first three years and 20% thereafter. Unpaid dividends are cumulative and compounded. The Series C Preferred Stock is redeemable at the Company's option after five years and at the option of the majority holders after six years at a price of $1,000 per share plus accrued and unpaid dividends. The Series C Preferred Stock is not convertible into Common Stock.
On March 23, 2001, the Company consummated a transaction with Robert W. Stallings (the "Stallings Transaction") pursuant to which, among other things, the Company issued shares of its newly created Series B Preferred Stock and a warrant to purchase an aggregate of 1,050,000 shares of Common Stock at $2.25 per share in exchange for an aggregate purchase price of $3.0 million in cash. The annual dividend provisions and the redemption provisions of the Series B Preferred Stock are the same as those for the Series C Preferred Stock. The Series B Preferred Stock is convertible into Common Stock at $2.25 per share. Subject to adjustment for certain events, the Series B Preferred Stock is convertible into a maximum of 1,333,333 shares of Common Stock. The term of the warrant is five years. Mr. Stallings was elected non-executive Vice Chairman of the Board and a director of the Company. On September 6, 2001, Mr. Stallings was elected non-executive Chairman of the Board of Directors of the Company.
The discussion below primarily relates to the Company's insurance operations, although the selected consolidated financial data appearing elsewhere is on a consolidated basis. The expense item "Underwriting and operating expenses" includes the operating expenses of the computer software, plan servicing and premium finance operations.
COMMERCIAL LINES decreased 40% in 2001 and increased 17% in 2000. Commercial auto contributed 30 points to the decrease in 2001 for the reason mentioned previously and 2 points to the increase in 2000. The general liability line contributed 6 points to the decrease in 2001 and 14 points to the increase in 2000. The large increase in 2000 is primarily attributable to specialty lines of business in professional liability and directors and officers liability. Commercial lines writings should decline very rapidly in 2002 since the Company announced its decision to discontinue writing commercial lines insurance business due to continued adverse claims development and unprofitable results.
PERSONAL LINES decreased 11% in 2001 primarily as a result of the Florida nonstandard auto business. Personal lines increased 49% in 2000 primarily as a result of nonstandard auto and umbrella business. The Company began a transition during 2001 to write a majority of the nonstandard auto business on six month policies instead of twelve month policies as had been done in the past. This accounts for a significant portion of the decrease in writings in 2001. This decision gives the Company greater flexibility in managing the business.
For 2001 gross premiums written percentages by significant product line are as follows: personal auto (37%), general liability (22%), commercial auto (20%) and garage (14%), with no other product line comprising 5% or more. Net premiums earned decreased 55% in 2001 primarily as a result of the commercial quota share reinsurance agreements and exiting certain commercial trucking business. They increased 34% in 2000 primarily as a result of the level of premiums written.
The Company recorded net realized capital gains of $4,275,192 and $605,606 in 2001 and 1999, respectively, versus net realized capital losses of $1,906,911 in 2000. The losses recorded in 2000 were the result of restructuring the portfolio into higher taxable equivalent yields.
Interest expense from the note payable decreased in 2001 as a result of principal payments on the note and lower interest rates. The increase in 2000 was a result of higher interest rates.
Underwriting and operating expenses were up 12% in 2001 from 2000 and 14% in 2000 from 1999. The increase for 2001 was the result of the Company recording a provision for potentially uncollectible reinsurance balances receivable of $2,653,597. Without this provision underwriting and operating expenses were down 4% primarily as a result of a decrease in personnel costs. The increase for 2000 was primarily due to salary increases, personnel additions and bad debt reserve increases on premiums receivable.
Goodwill impairment is a result of the Company's decision to no longer pursue a long-term geographic expansion strategy in personal automobile beyond that of its core operation in Florida and to sell its Tri-State agency subsidiary (See "Business Operations - Tri-State Acquisition and Sale"). As a result the remaining goodwill associated with the Tri-State acquisition was written off in the second quarter of 2001. In December 2001 the Company recorded an impairment of $13,360,603 on the goodwill associated with the 1998 acquisition of the Lalande Group. This action was taken to reflect estimated fair valuation levels of agencies in the personal automobile marketplace. The remaining $3,468,507 of goodwill is associated with Lalande.
GAINSCO, INC. ("GNA") is a holding company that provides administrative and financial services for its wholly owned subsidiaries. GNA needs cash for: (1) principal and interest on its bank note payable, (2) administrative expenses, and (3) investments. The primary sources of cash to meet these obligations are statutory permitted payments from its insurance subsidiaries, including (1) dividend payments, (2) surplus debenture interest payments, and (3) tax sharing payments. Statutes in Oklahoma and North Dakota restrict the payment of dividends by the insurance company subsidiaries to the available surplus funds derived from their realized net profits. The maximum amount of cash dividends that each subsidiary may declare without regulatory approval in any 12-month period is the greater of net income for the 12-month period ended the previous December 31 or ten percent (10%) of policyholders' surplus as of the previous December 31. On February 28, 2002, General Agents (the Oklahoma subsidiary) paid dividends to GNA of $7,238,000. Based on its surplus amounts at December 31, 2001 and generally without prior regulatory approval, in early 2003 General Agents may declare dividends to GNA of up to approximately $4,700,000 and in 2002 MCIC (the North Dakota subsidiary) may declare dividends to GNA of up to approximately $300,000. GNA believes the cash dividends from its insurance subsidiaries should be sufficient to meet its expected obligations for 2002.
As the Company exits from the commercial lines business, GNA may consider the sale of subsidiaries associated with that business. The Company also intends to reevaluate its personal lines business and may endeavor to increase, decrease or dispose of all or part thereof. See "Business Operations - Discontinuance of Commercial Lines and Redeployment of Capital."
With regard to long term liquidity, the average duration of the investment portfolio is approximately 3.3 years. The fair value of the fixed maturity portfolio at December 31, 2001 was $5,425,067 above amortized cost, before taxes. With regard to the availability of funds to the holding company, see Note (7) of Notes to Consolidated Financial Statements for restrictions on the payment of dividends by the insurance companies. Various insurance departments of states in which the Company operates require the deposit of funds to protect policyholders within those states. At December 31, 2001 and 2000, the balance on deposit for the benefit of such policyholders totaled $15,398,298 and $16,507,427, respectively.
Net cash used for operating activities was $61,384,654 for 2001 versus $4,649,539 and $13,775,750 in net cash provided by operating activities in 2000 and 1999, respectively. The large change in 2001 was primarily related to the decrease in premium writings, mentioned previously.
Ceded unpaid claims and claim adjustment expenses increased as a result of the increase in unpaid claims and claim adjustment expenses and the increase in cessions under the quota share reinsurance agreements for 2001. This balance represents unpaid claims and claim adjustment expense reserves which have been ceded to reinsurers under the Company's various reinsurance agreements. These amounts are not currently due from the reinsurers but are expected to become due in the future when the Company pays the claim and requests reimbursement from the reinsurers. If the Company experiences collectibility problems on paid claims (Reinsurance balances receivable) from a specific reinsurer it would record a corresponding allowance for doubtful accounts against the ceded unpaid claims and claim adjustment expenses from this reinsurer.
Ceded unearned premiums decreased primarily as a result of the decrease in ceded unearned premiums from the 2000 commercial quota share reinsurance agreement. This balance represents the portion of premiums ceded to reinsurers which are applicable to the unexpired terms of policies in force under the applicable reinsurance agreement. In the event the Company cancels policies, the reinsurer is required to return the premium to the Company. This type of action, on a material scale, is not expected to occur.
Current Federal income taxes are expected to be received no later than July 2002. Deferred Federal income taxes have a valuation allowance for its full amount recorded against the asset. This asset is primarily a tax benefit from net operating loss carry forwards which can be used to offset tax expense on future operating earnings or capital gains. A change in ownership of the Company's stock greater than 50% (as specified under Internal Revenue Code Section 382) could severely limit the Company's ability to recover this asset in future periods.
Goodwill decreased primarily as a result of the $5,086,283 impairment recorded in the second quarter of 2001 related to the January 2000 Tri-State acquisition and the $13,360,603 impairment recorded during the fourth quarter of 2001 related to the October 1998 Lalande acquisition. Tri-State was sold in the third quarter of 2001. The remaining goodwill of $3,468,507 reflects estimated fair valuation of agencies in the personal automobile marketplace. Effective in 2002, goodwill will no longer be amortized but will be subject to an impairment test based on its estimated fair value. Therefore, additional impairment losses could be recorded in future periods.
Accounts payable decreased primarily because of a payment made in January 2001 to Tri-State for meeting certain targets specified in the acquisition agreement. This balance is comprised primarily of premiums due to a nonaffiliated insurance company that was fronting for the Company in 2001 on personal lines in Florida.
Reinsurance balance payable decreased primarily due to the funding of the 2000 commercial quota share reinsurance agreement during the first six months of 2001. This balance is comprised primarily of premiums due reinsurers on business ceded to them under the Company's various reinsurance agreements.
Deferred revenues increased due to reserve development under the reserve reinsurance cover agreement. This balance is primarily comprised of C & CAE recoveries under this agreement which will be recognized as other income in future periods based upon the ratio of actual C & CAE paid to the total of potential C & CAE payable under this reinsurance agreement.
Funds held under reinsurance agreements is primarily the funds for payment of C & CAE on claims under the reinsurance reserve cover agreement. The Company is required to increase the fund balance at a 7.5% annual rate based upon the fund balance and the fund balance is decreased for C & CAE payments made on claims under the reinsurance reserve cover agreement. The Company is required to maintain assets in a trust fund with a fair value at least equal to the funds held liability. Because the Company's statutory policyholders' surplus fell below certain levels specified in the agreement, the reinsurer has the option to direct the trustee to transfer the assets of the trust to the reinsurer. If the reinsurer were to exercise its option, based upon December 31, 2001 balances, funds held under reinsurance agreements would be reduced by approximately $47,800,000.
With the reclassification of the Series A Convertible Redeemable Preferred Stock during the first quarter of 2001, preferred stock capital was reduced to $0 and additional paid-in capital was reduced by the discount on the convertible redeemable preferred stock. Common stock warrants decreased for the discount in value of the previously issued Series A and Series B Warrants offset by an increase for the issuance of the warrant in the Stallings Transaction. At December 31, 2001 $13,051,000 has yet to be charged to Retained Deficit related to the accretion of the discount on the preferred stock.
Accumulated other comprehensive income of $3,580,690 was recorded at December 31, 2001 as a result of the unrealized gains on bonds available for sale and common stocks. The decrease in retained earnings to a retained deficit of $71,977,743 is attributable to the net loss of $75,607,047 for the 2001 year.