The selected consolidated financial data presented in the following tables for, and as of the end of each of the years ended December 31, have been derived from the consolidated financial statements of the Company which have been audited by KPMG LLP, independent certified public accountants. The consolidated balance sheets as of December 31, 2003 and 2002, and the consolidated statements of operations, shareholders’ equity and comprehensive income (loss) and cash flows for each of the years in the three-year period ended December 31, 2003, and the independent auditors report thereon are included elsewhere in this document. The information presented below should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” consolidated financial statements and the notes thereto, and the other financial information included herein.
Includes after tax net realized gains (losses) from securities transactions of $1,353,000, $1,352,000, $2,822,000, $(1,258,000) and $400,000 for 2003, 2002, 2001, 2000 and 1999, respectively.
Based on 21,169,736 shares of Common Stock outstanding at the end of 2003, 2002, 2001 and 2000 and 20,919,833 shares at the end of 1999. This assumes redemption would occur on all series of Preferred Stock. Future changes in Shareholders’ equity will impact these numbers. See Note 7 of Notes to Consolidated Financial Statements.
In 2003 the Company recorded net income of $3,375,772 as it experienced profitable operating results from its nonstandard personal auto business in Florida, compared with a 2002 net loss of $8,761,087 attributable primarily to unfavorable claims experience and goodwill impairment. Management continued in 2003 to implement actions intended to enhance the profit potential of the Company’s only active insurance line, nonstandard personal auto. Significant improvement in the combined ratio for this business is the primary reason for its level of profitability. This business is currently profitable and the Company believes that meaningful potential opportunities exist through a geographic diversification strategy. Previously the business has been written primarily in the state of Florida. However, in furtherance of the objective to diversify the business to targeted territories, the Company began writing nonstandard personal auto policies in Texas during the fourth quarter of 2003 and has begun its market introduction in Arizona in 2004. The Company’s focus on its obligations to the holders of its Preferred Stock, however, is limiting the Company’s ability to pursue opportunities to further expand its personal auto business. See “Liquidity and Capital Resources - Focus on Obligations to Preferred Stock.”
In 2003, the Company continued its exit from commercial lines. The loss of $75,607,047 recorded in 2001 was primarily a result of unfavorable claims experience, goodwill impairment and a valuation allowance for deferred Federal income taxes. The Company recorded GAAP combined ratios of 105.1% in 2003, 125.9% in 2002 and 173.0% in 2001.
On December 2, 2002, the Company completed the sale and transfer of the management contract controlling GAINSCO County Mutual Insurance Company (“GCM”) to an affiliate of Liberty Mutual Insurance Company (“Liberty”), for a purchase price of up to $10 million, of which $1 million was paid at closing and the balance is payable in contingent payments through September 2009, but each payment is contingent on there being no material adverse change in the regulatory treatment of GCM specifically, or county mutuals generally, from legislative or regulatory administrative actions prior to the applicable payment date.
In the session of the Texas Legislature ended June 2, 2003, changes were made in the statutes governing the regulatory treatment of county mutual insurance companies in Texas. These changes prejudice the rights of the Company to receive contingent payments from Liberty, depending upon how the statutory changes and the Company’s agreement with Liberty are interpreted. The Company contacted Liberty to discuss its obligation to make the contingent payments in light of the recent legislation. Liberty’s position is that they have no obligation to make any of the $9 million contingent payments under the agreement. The Company has fully reserved its receivable due from Liberty of $484,967 (representing the excess of the Company’s cost basis in GCM over the $1,000,000 received from Liberty at the closing of the sale transaction) as potentially uncollectible because of the recent statutory changes in 2003.
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 GNAC.
Gross premiums written in 2003 were 22% below 2002 and in 2002 they were 62% below 2001. The Company’s decision in the first quarter of 2002 to discontinue writing commercial lines is primarily the reason for the decrease in 2003 and 2002. In the first quarter of 2002 nonstandard personal auto, which is included in Personal Lines, became the only line of insurance marketed by the Company. The following table compares the major product lines between the years for gross premiums written:
Commercial lines decreased 85% in 2003 and 82% in 2002. The Company’s decision to discontinue writing commercial lines insurance in the first quarter of 2002 due to continued adverse claims development and unprofitable results is the reason for the decrease in 2003 and in 2002. Virtually no direct commercial premiums were written in 2003, almost all of the commercial premiums written came from assumed premiums the Company received in conjunction with the commutation of several reinsurance agreements with one reinsurance participant.
Net investment income decreased 28% and 47% in 2003 and 2002, respectively. The decrease for both years was primarily attributed to the decline in investment balances, due to principal payments on the note payable, commercial claim payments and declining premiums written, and the short-term investments comprising a significantly greater portion of investments each year.
The Company recorded net realized capital gains of $2,050,236, $2,048,848 and $4,275,192 in 2003, 2002 and 2001, respectively. Variability in the timing of realized investment gains should be expected. During 2002, the Company reduced the carrying value of a non-rated commercial mortgage backed security to $0 resulting in a write down of $2,010,670 (recorded as a realized loss in the statement of operations) as a result of a significant increase in the default rate in the underlying commercial mortgage portfolio, which has disrupted the cash flow stream sufficiently to make future cash flows unpredictable. This write-down was offset by net realized gains of $3,604,462 recorded from the sale of various bond securities and other investments in 2002 and the gain of $455,056 recognized from the sale of the home office building.
During the second quarter of 2003 the Company reclassified the revenues and expenses of the personal auto agency operation because of its increasing materiality. This reclassification was made for all periods presented and had no impact on net income. The revenues of this operation are now presented as a component of Other income and the expenses are presented as a component of Underwriting and operating expenses. Previously the revenues and expenses were netted and shown as a component of Other income in 2002 and as a component of Commissions in the first quarter of 2003. Other income decreased $2,085,012 from 2002, primarily as a result of amortization of deferred reinsurance recoveries from claim payments under the reserve reinsurance cover agreement of $1,544,410 in 2003. Amortization is based upon claims recovered from the reinsurer in relation to the amount of the reinsured layer under the reserve reinsurance cover agreement. In accordance with GAAP, the reinsurance recoveries from these reserve increases are recorded as deferred revenue and not immediately recognized as reductions to C & CAE. Other income increased $3,957,583 in 2002 over 2001, primarily as a result of amortization of deferred reinsurance recoveries. For 2002, $4,082,469 was recognized from deferred reinsurance recoveries, while only $1,112,469 was recognized in 2001. At December 31, 2003, $2,310,652 remains as deferred reinsurance recoveries that will ultimately be amortized into Other income in future periods.
Securities litigation has been filed in United States District Court, Southern District of Florida against the Company and two of its officers (one of whom is also a director). The plaintiffs seek class certification for the litigation and principally allege violations of securities laws in respect of the Company’s previously acquired and divested of Tri-State, Ltd. subsidiary. The plaintiffs have not specified the amount of damages they seek. The Company believes the allegations are without merit and intends to vigorously defend the proceedings.
The agreement with GMSP in connection with the 2001 GMSP Transaction was conditioned upon the following changes in the securities currently held by GMSP. The exercise prices of the Series A Warrant and the Series B Warrant held by GMSP were reduced to $2.25 per share and $2.5875 per share, respectively. Each of these warrants provides for the purchase of 1,550,000 shares of Common Stock, subject to adjustment. The Series A Preferred Stock is convertible into 6,200,000 shares of Common Stock at a conversion price of $5.10 per share and, should the Company pay dividends on its Common Stock, the Series A Preferred Stock would be entitled to dividends as if converted into Common Stock. On March 23, 2001, the Series A Preferred Stock was called for redemption by the Company so that on January 1, 2006 the Company will be obligated to pay $1,000 per share for 31,620 shares ($31.6 million) to the holder to the extent that it can legally do so and, to the extent it cannot do so, the Company will be obligated to pay quarterly an amount equal to 8% interest per annum on any unpaid balance. See “Liquidity and Capital Resources - Focus on Obligations to Preferred Stock.”
The 2001 agreement with GMSP provided an opportunity to convert the Company’s illiquid investments with a cost of $4.2 million to cash as of November 2002, as follows: the Company could at its option require GMSP to purchase the illiquid investments for $2.1 million, less any future cash received prior to November 2002 from the investments. GMSP could at its option require the Company to sell the illiquid investments to GMSP for $4.2 million, less any future cash received prior to November 2002 from the investments. During the second quarter of 2001, the Company recognized a permanent impairment of these investments and wrote down the carrying value to the amount recoverable from GMSP under the put option. In February 2002, GMSP consented to the early exercise of the Company’s option, and the Company exercised its option to require GMSP purchase the illiquid investments for approximately $2.1 million.
On March 23, 2001, the Company sold to Robert W. Stallings, for $3 million in cash, 3,000 shares of its newly created Series B Preferred Stock (stated value of $1,000 per share) and a warrant expiring March 23, 2006 to purchase an aggregate of 1,050,000 shares of Common Stock at $2.25 per share (the “Stallings Transaction”). 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. Mr. Stallings also entered into a consulting agreement pursuant to which he provides consulting services (including strategic planning advice, analysis of the subsidiaries’ performance in various sectors of their respective business
and recommendations for growth strategies and opportunities for new markets and products) to the Company’s insurance subsidiaries for a period of five years ending on March 22, 2006 for $300,000 per annum. Mr. Stallings was elected non-executive Vice Chairman of the Board and a director of the Company, and on September 6, 2001, he was elected non-executive Chairman of the Board.
GAINSCO, INC. (“GNAC”) is a holding company that provides administrative and financial services for its wholly owned subsidiaries. GNAC needs cash during the next twelve months primarily for: (1) preferred stock dividends, (2) administrative expenses, and (3) investments. The primary source of cash to meet these obligations are statutory permitted payments from its insurance subsidiary, General Agents Insurance Company of America, Inc. (“General Agents”), an Oklahoma corporation. Statutes in Oklahoma restrict the payment of dividends by the insurance company to the available surplus funds. The maximum amount of cash dividends that General Agents 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 March 22, 2004, General Agents paid dividends to GNAC of $4,171,727, based upon 10% of its surplus amounts at December 31, 2003. GNAC believes the cash dividends from General Agents should be sufficient to meet its expected obligations for 2004.
Preferred Stock in Relation to Capital Base. At December 31, 2003, the capital base (total assets less total liabilities) of the Company was $45,535,405 and consisted of Shareholders’ Equity of $13,412,885 and three series of Redeemable Preferred Stock, which are classified under GAAP as mezzanine financing in the aggregate amount of $32,122,520. At December 31, 2003, $7,370,001 was included within Additional paid-in capital, and had yet to be charged to Shareholders’ Equity, related to the accretion of the discount on the redeemable Preferred Stock. Almost all of this unaccreted discount will be charged to Shareholders’ Equity by January 1, 2006, the redemption date of the Series A Preferred Stock. At December 31, 2003, the per common share Shareholders’ Equity was approximately $0.63, including unaccreted discount on Redeemable Preferred Stock of $0.34; less such unaccreted discount, the per common share Shareholders’ Equity was approximately $0.29. The aggregate redemption value of the Preferred Stock was $39,492,520 ($37,620,000 stated value plus accrued dividends of $1,872,520) at December 31, 2003.
Obligation to Redeem Series B and Series C Preferred Stock on March 23, 2007. The Series B and Series C Preferred Stock become redeemable at the option of holders commencing March 23, 2007 for the aggregate liquidation amount of $6,000,000 plus accrued dividends, subject to conditions on the Company’s obligation to redeem the Series B and Series C Preferred Stock similar to those conditions on the Company’s obligation to redeem the Series A Preferred Stock.
Through March 15, 2004, the Company had spent approximately $400,000 including financial advisory and legal fees, in respect of the Special Committee’s consideration of alternatives for dealing with its obligations to the holders of its Preferred Stock. These amounts will be expensed in the first quarter of 2004.
As a result of losses in prior years, as of December 31, 2003 the Company has net operating loss carryforwards for tax purposes aggregating $72,692,450. These net operating loss carryforwards of $1,639,333, $22,806,147, $33,950,174, $13,686,532 and $610,264, if not utilized, will expire in 2018, 2020, 2021, 2022 and 2023, respectively. The tax benefit of the net operating loss carryforwards is $24,715,433, which is calculated by applying the Federal statutory income tax rate of 34% against the net operating loss carryforwards of $72,692,450.
Reinsurance balances receivable decreased primarily as a result of C & CAE claims paid under the reserve reinsurance cover agreement for commercial lines. This balance is primarily comprised of ceded unpaid claims and claims adjustment expenses under the reserve reinsurance cover agreement and claims and claim adjustment expenses paid by the Company and due from reinsurers under the Company’s various reinsurance agreements which was $13,785,337. An allowance for doubtful accounts of $122,484 was recorded for 2003 and $1,001,461 had been recorded for 2002 as a result of concern regarding the collectibility of amounts due from specific reinsurers. The decrease in the allowance for doubtful accounts in 2003 was due to the successful recovery of an amount that had been included in the allowance in 2002 from a reinsurer whose participation was commuted on several reinsurance agreements in the fourth quarter of 2003. Balances written off in previous years have been immaterial. The Company considers the allowance adequate at the present time.
Current Federal income taxes at December 31, 2002 were received in January 2003. 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. See earlier discussion under “Results of Operations.” 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. See “Net Operating Loss Carryforwards.”
Unpaid claims and claim adjustment expenses (“C&CAE”) decreased primarily as a result of the settlement of claims in the normal course and a decrease in the ultimate expected liabilities in personal auto, which were partially offset by an increase in ultimate expected liabilities in commercial lines. As of December 31, 2003, the Company had $75,569,400 in net unpaid claims and claim adjustment expenses. This amount represents management’s best estimate, as derived from the actuarial analysis and was set equal to the selected reserve estimate as established by an independent actuary. The independent actuary identified the recent adverse development in the Company’s unpaid C&CAE and the Company’s decision in 2002 to discontinue writing commercial lines as risk factors. In consideration of these risk factors the independent actuary believes that there are significant risks and uncertainties that could result in material adverse deviation of the unpaid C&CAE. The independent actuary has opined that the unpaid C&CAE: (a) meets the requirements of the insurance laws of the states, (b) are consistent with amounts computed in accordance with the Casualty Actuarial Society Statement of Principles Regarding Property and Casualty Loss and Loss Adjustment Expense Reserves and relevant standards of practice promulgated by the Actuarial Standards Board; and (c) make a reasonable provision for all unpaid C&CAE obligations of the Company under the terms of its contracts and agreements. Management has reviewed and discussed the results of the actuarial analysis with the actuary and believes the reserve estimate selected by the actuary to be the best estimate of reserves at this time.
Commissions payable decreased primarily due to contingent commission settlements made with the commercial quota share reinsurers during the second quarter of 2003.
Note payable decreased due to the Company paying in full the remaining principal amount in the fourth quarter of 2003.
Accumulated other comprehensive income of $1,955,141 was recorded at December 31, 2003 as a result of the unrealized gains on bonds available for sale, net of tax.
The Company is not aware of any current recommendations by regulatory authorities, which if implemented, would have a material effect on the Company’s liquidity, capital resources or results of operations. The Company’s statutory capital exceeds the benchmark capital level under the Risk Based Capital formula for its insurance companies. Risk Based Capital is a method for establishing the minimum amount of capital appropriate for an insurance company to support its overall business operations in consideration of its size and risk profile. The tragic events of September 11, 2001 did not impact the Company’s financial results for 2001, 2002 and 2003.
The following table summarizes the Company’s contractual obligations as of December 31, 2003.
On January 1, 2006 the Company will be obligated to pay $31,620,000 to the holder of the Series A Preferred Stock, subject to conditions as described in Liquidity and Capital Resources - “Obligation to Redeem Series A Preferred Stock on January 1, 2006.” On March 23, 2007 the Company will be obligated to pay $6,000,000 plus accrued dividends to the holders of the Series B and Series C Preferred Stock, subject to similar conditions. From and after April 1, 2004 dividends on the Series B and Series C Preferred Stock accrue at a rate of 20% per annum, of which at least half (or at least $150,000) must be paid quarterly.
See Item 1, “Business - Unpaid Claims and Claim Adjustment Expenses” and Note 1(k) of Notes to Consolidated Financial Statements with respect to liabilities to policy holders in respect of insurance policies written by the Company.
The discussion and analysis of the Company’s financial condition and results of operations are based upon the Company’s consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). The preparation of these financial statements 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 from those estimates under different assumptions or conditions.
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).
Policy acquisition costs, principally commissions, premium taxes and certain marketing and underwriting expenses, are deferred and charged to operations over periods in which the related premiums are earned. Ceding commission income, which is realized on a written basis, is deferred and recognized over periods in which the related premiums are earned. Deferred ceding commission income is netted against deferred policy acquisition costs. The change in the resulting deferred asset is charged (credited) to operations. The Company utilizes investment income when assessing recoverability of deferred policy acquisition costs. Recoverability is based upon assumptions as to loss ratios, investment income and maintenance expenses and would vary with changes in these estimates.
Accidents generally result in insurance companies paying under the insurance policies written by them amounts to individuals or companies for the risks insured. Months and sometimes years may elapse between the occurrence of an accident, reporting of the accident to the insurer and payment of the claim. Insurers record a liability for estimates of claims that will be paid for accidents reported to them, which are referred to as “case reserves”. In addition, since accidents are not always reported promptly upon the occurrence and because the assessment of existing known claims may change over time with the development of new facts, circumstances and conditions, insurers estimate liabilities for such items, which are referred to as “IBNR” reserves.
The process of establishing claims reserves is an imprecise science and reflects significant judgmental factors. In many liability cases, significant periods of time, ranging up to several years or more, may elapse between the occurrence of an insured claim and the settlement of the claim. The actual emergence of claims and claim adjustment expenses may vary, perhaps materially, from the Company’s estimate thereof, because (a) estimates of claims and claim adjustment expense liabilities are subject to large potential errors of estimation as the ultimate disposition of claims incurred prior to the financial statement date, whether reported or not, is subject to the outcome of events that have not yet occurred (e.g., jury decisions, court interpretations, legislative changes (even after coverage is written and reserves are initially set) that broaden liability and policy definitions and increase the severity of claims obligations, subsequent damage to property, changes in the medical condition of claimants, public attitudes and social/economic conditions such as inflation), (b) estimates of losses do not make provision for
extraordinary future emergence of new classes of losses or types of losses not sufficiently represented in the Company’s historical data base or which are not yet quantifiable, and (c) estimates of future costs are subject to the inherent limitation on the ability to predict the aggregate course of future events.
Ultimate liability may be greater or lower than current reserves. Reserves are monitored by the Company using new information on reported claims and a variety of statistical techniques. The Company does not discount to present value that portion of its claim reserves expected to be paid in future periods. Beginning in the third quarter of 2002 and for each quarter thereafter, the Company set reserves equal to the selected reserve estimate as established by an independent actuarial firm. Formerly reserves were set based upon its actuarial analysis by an actuary who was an employee of the Company and these reserves were reviewed annually by an independent actuarial firm.
Statements made in this report that are qualified with words such as “will be,” “may,” “anticipates,” “intends to engage,” “expects,” etc., are forward-looking statements. Investors are cautioned that important factors, representing certain risks and uncertainties, could cause actual results to differ materially from those contained in the forward-looking statements. These factors include, but are not limited to, (a) the Company’s ability to effectively adjust and settle remaining claims associated with it’s exit from the commercial insurance business, (b) heightened competition from existing competitors and new competitor entrants into the Company’s markets, (c) the extent to which market conditions firm up, the acceptance of higher prices in the market place and the Company’s ability to realize and sustain higher rates, (d) contraction of the markets for the Company’s business, (e) acceptability of the Company’s A.M. Best rating to its end markets,(f) the Company’s ability to meet its obligations in respect of its Redeemable Preferred Stock, (g) the ongoing level of claims and claims-related expenses and the adequacy of claim reserves, (h) the outcome of pending litigation, (i) the effectiveness of investment strategies implemented by the Company’s investment manager, (j) continued justification of recoverability of goodwill in the future, (k) the availability of reinsurance and the ability to collect reinsurance recoverables, including amounts that may become recoverable from two reinsurers with less than A.M. Best “Secure” ratings, (l) the Company’s ability to invest in new endeavors that are successful, (m) the limitation on the Company’s ability to use net operating loss carryforwards as a result of constraints caused by ownership changes within the meaning of Internal Revenue Code
Section 382, (n) the ability of the Company to realize contingent acquisition payments in connection with its sale of the management contract controlling GCM, which was prejudiced by legislation passed in the session of the Texas Legislature ended June 2, 2003 and (o) general economic conditions, including fluctuations in interest rates. In addition, the actual emergence of losses and loss expenses may vary, perhaps materially, from the Company’s estimate thereof, because (a) estimates of loss and loss expense liabilities are subject to large potential errors of estimation as the ultimate disposition of claims incurred prior to the financial statement date, whether reported or not, is subject to the outcome of events that have not yet occurred (e.g., jury decisions, court interpretations, legislative changes, subsequent damage to property, changes in the medical condition of claimants, public attitudes and social/economic conditions such as inflation), (b) estimates of losses do not make provision for extraordinary future emergence of new classes of losses or types of losses not sufficiently represented in the Company’s historical data base or which are not yet quantifiable, and (c) estimates of future costs are subject to the inherent limitation on the ability to predict the aggregate course of future events. A forward-looking statement is relevant as of the date the statement is made. The Company undertakes no obligation to update any forward-looking statements to reflect events or circumstances arising after the date on which the statements are made.