As of December 31, 2011, our subsidiaries included insurance companies licensed to write insurance policies in 40 states, underwriting agencies, retail agencies with 201 owned stores and a relationship with two unaffiliated underwriting agencies. We are currently active in offering insurance directly to individual consumers through retail stores in 9 states (Louisiana, Texas, Illinois, Alabama, Missouri, Indiana, South Carolina, Kansas and Wisconsin) and distributing our own insurance policies through our owned retail stores and 5,000 independent agents or brokers in 8 states (Louisiana, Texas, Illinois, Alabama, California, Missouri, Indiana and South Carolina). In March 2011, we discontinued writing new business in the state of Michigan, and in June 2011 we discontinued writing renewals. In May 2010, we discontinued writing new and renewal policies in the state of Florida. In July 2010, we discontinued writing new and renewal insurance policies in New Mexico.
We estimate IBNR losses and ultimate loss adjustment expenses quarterly using detailed statistical analyses and judgment including adjustment for deviations in trends caused by internal and external variables that may affect the resulting reserves. The underlying processes require the use of estimates and informed judgment, and as a result the establishment of loss and loss adjustment expenses reserves is an inherently uncertain process. The following generally accepted actuarial loss and loss adjustment expenses (LAE) reserving methodologies are used in our analysis:
The range of potential ultimate values for any accident year diminishes with the age of the accident year. A recent accident year will tend to have a wider range of potential values as the claims may have only recently been reported or details as to the injuries are still unknown. As the accident year ages, the number of open claims diminishes and the specifics of the injury become clearer.
Beginning in mid-2009, the Company instituted a series of claims initiatives with the goal of producing an improved claims process that emphasized acceleration in claims closings, faster claim recognition and appropriate claim payments that were effectively completed in 2010. These initiatives caused a number of distortions in the loss development patterns. As it takes a number of quarters for normal reserving patterns to reflect the impact of these types of claims practice changes, additional uncertainty has been introduced into the reserve review process.
As of December 31, 2011 and 2010, we had no reserve for uncollectible reinsurance recoverables. We assessed the collectibility of our year-end receivables and believe all amounts are collectible based on currently available information.
Gains and losses realized on the disposition of investment securities are determined on the specific-identification basis and credited or charged to income. Premium and discount on investment securities are amortized and accreted using the interest method and charged or credited to investment income.
Key inputs in our valuation model are projected cash flows, future inflationary trends, future tax rates, and the risk-adjusted discount rates. The risk-adjusted discount rate was developed using a capital asset pricing model to estimate our weighted-average cost of capital and was estimated at 14.5%. The relative weight of capital for debt was estimated at approximately 20 percent based on observed industry averages.
Due to prior period adverse loss development on our Michigan business recorded in the fourth quarter of 2011 and recent negative premium production trends, we revised our five-year forecast and updated our discounted cash flow model to assess the recoverability of recorded goodwill at December 31, 2011. A discount rate of 14.5% was used at December 31, 2011, which we believe remained an appropriate risk-adjusted discount rate based on our overall cost of capital. Based on this updated discounted cash flow analysis, we concluded that the carrying amount of goodwill was not recoverable. In step two of the goodwill impairment analysis, we determined the fair values of the Company’s assets and liabilities (including any unrecognized intangible assets) as if the Company had been acquired in a business combination. The resulting implied fair value was compared to the carrying value of goodwill with the excess carrying value resulting in an impairment. The step two analysis resulted in the recognition of a non-cash, pretax goodwill impairment charge of $140.1 million. Additionally, if the fair value of the Company decreases additional impairment of goodwill may occur. Factors that could adversely affect the fair value of the Company are premium growth rates lower than forecasted and higher loss ratios and expenses than forecasted.
Indefinite-lived intangible assets primarily consist of trade names. In measuring the fair value for these intangible assets, we utilize the relief-from-royalty method. This method assumes that trade names have value to the extent that their owner is relieved of the obligation to pay royalties for the benefits received from them. This method requires us to estimate the future revenue for the related brands, the appropriate royalty rate and the weighted average cost of capital. This analysis indicated no impairment of indefinite-lived intangible assets as of December 31, 2011.
Intangible assets with definite lives consisted of agency relationships acquired through various business combinations or asset acquisitions. Significant declines in the fourth quarter of 2011 in premiums written in the markets corresponding to the recorded agency relationship compared with prior periods and forecast, as well as customer attrition rates indicated that the carrying amounts of definite-lived intangible assets were not recoverable, resulting in a non-cash impairment charge of $1.7 million.
Deferred acquisition costs. Deferred acquisition costs represent the deferral of expenses that we incur acquiring new business or renewing existing business. Policy acquisition costs (primarily commissions, advertising, premium taxes and underwriting and agency expenses related to issuing a policy) are deferred and charged against income ratably over the terms of the related policies. Management regularly reviews the categories of acquisition costs that are deferred and assesses the recoverability of this asset. A premium deficiency and a corresponding charge to income is recognized if the sum of the expected losses and loss adjustment expenses, unamortized acquisition costs and maintenance costs exceeds related unearned premiums and anticipated investment income. At December 31, 2011, there was no premium deficiency. At December 31, 2010, we determined a premium deficiency existed and recorded a $0.5 million reduction of deferred acquisition costs. Judgments as to the ultimate recoverability of such deferred costs are highly dependent upon estimated future loss costs associated with unearned premiums.
Income taxes. Significant management judgment is required in determining the provision for income taxes, deferred tax assets and liabilities, and the valuation allowance recorded against net deferred tax assets. The process involves summarizing temporary differences resulting from differing treatment of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included within the consolidated balance sheet. In addition, we assess whether valuation allowances should be established against deferred tax assets based on consideration of all available evidence using a “more likely than not” standard. To the extent a valuation allowance is established in a period, an expense must be recorded within the income tax provision in the consolidated statement of operations. We carry a full valuation allowance as of December 31, 2011 that was initially established as of December 31, 2009.
For 2011, we had a net loss of $164.2 million, which included a goodwill impairment charge of $140.1 million and losses from our Michigan business of $14.7 million. For 2010 and 2009, we had net losses of $88.9 million and $38.9 million, respectively.
Total gross premiums written for 2011 decreased $124.7 million, or 35.2%, compared with 2010. This decrease was due to a number of actions taken during 2010 and into 2011 to increase prices and strengthen underwriting standards to improve profitability. Improved processes and monitoring of pricing activity have been put in place. We suspended or constrained new business production for unprofitable independent agent relationships, which included our withdrawal from the Michigan market. Total gross premiums written for 2010 decreased $13.9 million, or 3.8%, compared with 2009 primarily due to a decline in production from our retail distribution channel.
We introduced a multivariate pricing product in May 2011 for new business in Louisiana, in June 2011 for new business in Alabama and Texas, and in September 2011 for new business in Illinois. The new product is expected to result in an improvement in profitability through better segment pricing.
The following table displays our net premiums written by distribution channel (in thousands):
In 2011, we entered into an additional quota-share agreement with a third-party reinsurance company under which we ceded 10% of business produced in Louisiana, Alabama, Texas and Illinois from September 1, 2011 through December 31, 2011. At December 31, 2011, this contract converted to a 40% quota-share reinsurance contract on the in-force business for the applicable states throughout 2012. Written premiums ceded under this agreement totaled $22.9 million during 2011.
The Michigan Catastrophic Claims Association (MCCA) is the mandatory reinsurance facility that covers no-fault medical losses above a specific retention amount in Michigan. For policies effective in 2011 and 2010, the retention amount was $0.5 million. For policies effective July 1, 2009 to June 30, 2010, the retention amount was $0.5 million. For policies effective July 1, 2008 to June 30, 2009, the retention amount was $0.4 million. As a writer of personal automobile policies in the state of Michigan, we ceded premiums and claims to the MCCA. Funding for MCCA comes from assessments against active automobile insurers based upon their proportionate market share of the state’s automobile liability insurance market. Insurers are allowed to pass along this cost to Michigan automobile policyholders.
We entered into an excess of loss reinsurance contract effective August 1, 2010 that provides coverage for individual losses in excess of $100,000 up to $1 million primarily to reduce our exposure to no-fault medical losses in Michigan. This contract terminated July 31, 2011 on a run-off basis. In addition, we entered into a reinsurance agreement effective June 1, 2011 (as we have previously done on an annual basis) to provide coverage for catastrophic events that may involve multiple insured losses.
Policy, installment, premium finance and agency fees are earned for business written or assumed by our insurance companies both through independent agents and our retail agencies. Generally, we can increase or decrease agency fees, installment fees, and interest rates subject to limited regulatory restrictions, but policy fees must be approved by the applicable state’s department of insurance. Premium finance fees are financing fees earned by our premium finance subsidiaries, and consist of origination and servicing fees as well as interest on premiums that customers choose to finance.
Commission income and fees for 2011 decreased $15.6 million, or 18.7%, compared with 2010. Policyholder fees decreased $15.3 million, or 38.6%, due to the lower overall volume of premiums written and a change in mix of states. Premium finance revenue decreased $0.5 million, or 2.3%, due to decreases in the number of policies financed. Commissions and fees increased $0.7 million, or 4.6%, due to more of our retail customers choosing third-party products due to pricing and underwriting actions on our products and an expansion of our ancillary product sales.
Commission income and fees for 2010 increased $4.1 million, or 5.2%, compared with 2009. Premium finance revenue has increased due to the continued emphasis on providing premium financing solutions for our
Net Investment Income and Other Income. Net investment income includes income on our portfolio of debt securities and net lease income from our investment in real property. Net investment income for 2011 increased $0.1 million, or 1.3%, compared with 2010. The increase was primarily due to a $1.3 million increase in income from our investment in real estate and from our investment in a hedge fund, which was partially offset by a 31.4% decrease in total average invested assets to $159.4 million during 2011 from $232.3 million during 2010 and a reduction in yields. The average investment yield was 2.3% (2.4% on a taxable equivalent basis) in 2011, compared with 2.3% (2.6% on a taxable equivalent basis) in 2010. The $1.3 million net increase in income from our investment in real estate is due to a new long-term lease with a federal agency for our Baton Rouge building that commenced in the fourth quarter of 2010. We entered into an investment in a hedge fund in the fourth quarter of 2010, which increased $0.3 million in fair value during 2011.
Net investment income for 2010 decreased $4.5 million, or 47.8%, compared with 2009. The decrease was primarily due to a reduction in yields and a 12.9% decrease in total average invested assets to $232.3 million during 2010 from $266.7 million during 2009. The average investment yield was 2.3% (2.6% on a taxable equivalent basis) in 2010, compared with 3.0% (4.0% on taxable equivalent basis) in 2009. In addition, investment income for our investment in real estate declined $1.9 million for 2010 compared with 2009. This decrease was due to the vacancy of the property while we made improvements for a new long-term lease, which commenced in the fourth quarter of 2010.
In 2010, we redeemed all remaining auction-rate securities, at par, of $46.4 million and realized gains of $9.0 million during 2010 offset by a corresponding reduction in fair value of the settlement recorded in other income (loss).
Net Realized Gains (Losses) and Other Income (Loss). Net realized gains (losses) for 2011 decreased $10.5 million, or 99.0%, compared with 2010. Other income (loss) for 2011 increased $6.8 million, or 104.0%, compared with 2010. Net realized gains (losses) for 2010 increased $7.8 million, or 276.1%, compared with 2009. Other income (loss) for 2010 decreased $5.7 million, or 703.7%, compared with 2009. The 2010 activity was primarily due to the settlement of the auction-rate municipal securities.
For the year ended December 31, 2010, other income included $0.6 million related to a settlement received from legal proceedings.
In 2010, the increase in the accident year loss ratio was due to increased losses on the Texas and Michigan businesses as well as significantly increased severity, which was primarily due to the claims transformation project that began in the third quarter of 2009. Significant pricing and underwriting actions were taken to address Texas and Michigan profitability in 2010 and 2011. Also, additional controls were instituted in the handling of claims to mitigate the significant increases in severity that occurred.
In 2009, adverse development on reserve estimates for prior accident years was $14.8 million. This was primarily due to the Florida business, due to a decision to promote our full coverage product, which had inadequate pricing and product management. The Company ceased writing business in Florida in May 2010.
Our losses and loss adjustment expenses are a blend of the specific estimated and actual costs of providing the coverage contracted by the purchasers of our insurance policies. We maintain reserves to cover our estimated ultimate liability for losses and related loss adjustment expenses for both reported and unreported claims on the insurance policies issued by our insurance companies. The establishment of appropriate reserves is an inherently uncertain process, involving actuarial and statistical projections of what we expect to be the cost of the ultimate settlement and administration of claims based on historical claims information, estimates of future trends in claims severity and other variable factors such as inflation. The change in claims practices that began in the third quarter of 2009 and throughout 2010 added additional uncertainty to the reserving process. Due to the inherent uncertainty of estimating reserves, reserve estimates can be expected to vary from period to period. To the extent that our reserves prove to be inadequate in the future, we would be required to increase our reserves for losses and loss adjustment expenses and incur a charge to earnings in the period during which such reserves are increased. The historic development of our reserves for losses and loss adjustment expenses is not necessarily indicative of future trends in the development of these amounts.
Our losses, loss adjustment expense reserves and deposit liabilities of $183.8 million on a gross basis and $105.3 million on a net basis are our best estimates as of December 31, 2011. The analysis provided by our internal valuation methods indicated that the expected range for the ultimate liability for our losses and loss adjustment expense reserves, as of December 31, 2011, was between $170.7 million and $222.8 million on a gross basis and between $101.8 million and $132.9 million on a net basis.
The following table presents the development of reserves for unpaid losses and loss adjustment expenses from 2001 through 2011 for our insurance company subsidiaries, net of reinsurance recoveries or recoverables. The first line of the table presents the reserves at December 31 for each indicated year. This represents the estimated amounts of losses and loss adjustment expenses for claims arising in that year and all prior years that are unpaid at the balance sheet date, including losses incurred but not reported to us. The upper portion of the table presents the cumulative amounts subsequently paid as of successive years with respect to those claims. The lower portion of the table presents an update of the estimated amount of the previously recorded reserves based upon the experience as of the end of each succeeding year. The estimates are revised as more information becomes known about the payments, frequency and severity of claims for individual years. A redundancy (deficiency) exists when the reestimated reserves at each December 31 is less (greater) than the prior reserve estimate. The cumulative redundancy (deficiency) depicted in the table, for any particular calendar year, represents the aggregate change in the initial estimates over all subsequent calendar years.
Our historical net liabilities for losses and loss adjustment expenses are impacted by our 100% quota-share reinsurance contract with VFIC. For the years 2001, 2002 and 2003 we reinsured 100% of business written or assumed by our insurance companies to VFIC. The following table summarizes the development of reserves for unpaid losses and loss adjustment expenses (in thousands):
Selling, general and administrative expenses for 2010 increased $4.2 million, or 2.6%, compared with 2009 primarily related to a $5.6 million increase in employee compensation and benefits, including $2.6 million increase in base employee costs, $1.3 million in severance, and $1.1 million increase in temporary and contract labor costs, a $6.2 million increase in amortization of policy acquisition costs due to increased commissions resulting from independent agent sales volumes, which were partially offset by ceding commissions on the quota-share reinsurance agreement of $9.7 million.
Deferred policy acquisition costs represent the deferral of expenses that we incur in acquiring new business or renewing existing business. Policy acquisition costs, consisting of primarily commission, advertising, premium taxes, underwriting and retail agency expenses, are initially deferred and then charged against income ratably over the terms of the related policies through amortization of the deferred policy acquisition costs. Thus, the amortization of deferred acquisition costs is correlated with earned premium and the ratio of amortization of deferred acquisition costs to earned premium in an accounting period is another measurement of performance.
Additions to deferred acquisition costs in 2010 decreased by $14.6 million and additions to the related amortization increased by $0.2 million compared with 2009. This decrease reflects the ceding commissions from the quota-share reinsurance agreement received of $17.3 million, which was partially offset by increased independent agent commissions for the year.
ASU 2010-26, Financial Services-Insurance (Topic 944), modifies the types of costs incurred by insurance entities that can be capitalized in the acquisition of new and renewal insurance contracts. We will adopt this guidance on January 1, 2012 using retrospective application. Upon adoption, a cumulative effect adjustment will be recorded, based on amounts that would have been recognized if this guidance had been applied from the beginning of fiscal year 2010. As a result of retrospective adoption of this standard, the Company will write off against the retained deficit previously deferred acquisition costs of $13.3 million, net of tax, as of January 1, 2010. If the Company had been under the new guidance from the beginning of 2010, selling, general and administrative expenses would have been lower by $1.6 million for 2011 and $2.0 million for 2010, on a pretax basis, and deferred acquisition costs, net of ceding commission, as of December 31, 2011 would have been lower by $9.7 million.
decrease in commission income and fees. Net expenses as a percentage of net premiums earned increased to 27.9% in 2010 compared with 25.4% in 2009. The increase was primarily due to an 8.8% decrease in net premiums earned and a 2.6% increase in SG&A expenses, which were partially offset by a 5.2% increase in commission income and fees. The following table sets forth the components of the net expenses and the computation of the net expense ratios (in thousands):
Loss on Interest Rate Swaps. Loss on interest rate swaps for 2011 decreased $0.9 million compared with 2010. The loss relates to the impact on the determination of fair value associated with the decline in short-term interest rates implied in the forward yield curve. One swap instrument expired in February 2011 and the remaining swap instrument expired in April 2011.
Loss on interest rate swaps for 2010 decreased $5.5 million, or 85.0%, compared with 2009. The loss relates to the impact on the determination of fair value associated with the decline in short-term interest rates implied in the forward yield curve.
Interest Expense. Interest expense for 2011 decreased $1.2 million, or 5.3%, compared with 2010. This decrease was due to a decrease in the amortization of debt discount, a decrease in the average debt outstanding and lower interest rates on the notes payable, which were partially offset by increases in the interest rate on the senior secured credit facility and interest expense on the lease obligation entered into in May 2010. The average principal balance of our senior secured credit facility was $105.2 million during 2011, a decrease of $13.8 million, or 11.6%, from the average principal balance during 2010. In 2011, we repaid $9.8 million of the senior secured facility. Amortization of debt discount was $4.5 million in 2011 as compared with $6.1 million in 2010.
Interest expense for 2010 decreased $0.8 million, or 3.2%, compared with 2009. This decrease was due to a decrease in the average debt outstanding, which was partially offset by higher interest rates on the senior secured credit facility and the amortization of debt discount of $6.1 million in 2010. The average principal balance of our senior secured credit facility was $119.0 million during 2010, a decrease of $14.3 million, or 10.7%, from the average principal balance during 2009. In 2010, we repaid $21.6 million of the senior secured facility.
Goodwill and Other Intangible Asset Impairment Charges. Due to prior period adverse loss development on our Michigan business recorded in the fourth quarter of 2011 and recent negative premium production trends, we revised our five-year forecast and updated our discounted cash flow model to assess the recoverability of recorded goodwill at December 31, 2011. A discount rate of 14.5% was used at December 31, 2011, which we believe remained an appropriate risk-adjusted discount rate based on our overall cost of capital. Based on this updated analysis, we concluded that the carrying amount of goodwill was not recoverable. In step two of the goodwill impairment analysis, we determined the fair values of the Company’s assets and liabilities (including any unrecognized intangible assets) as if the Company had been acquired in a business combination. The resulting implied fair value was compared to the carrying value of goodwill with the excess carrying value resulting in an impairment. The step two analysis resulted in the recognition of a non-cash, pretax goodwill impairment charge of $140.1 million.
Income Taxes. Income tax benefit for 2011 was $9.0 million as compared to expense of $1.7 million for 2010. The income tax benefit was related to the reduction of deferred tax liabilities from the goodwill and other intangible asset impairment charges.
Our net deferred tax assets prior to recognition of valuation allowance were $82.6 million and $53.4 million at December 31, 2011 and December 31, 2010, respectively. In assessing the realizability of our deferred tax assets, we considered whether it was more likely than not that our deferred tax assets will be realized based upon all available evidence, including scheduled reversal of deferred tax liabilities, historical operating results, projected future operating results, tax carry-back availability, and limitations pursuant to Section 382 of the Internal Revenue Code, among others. Based on this assessment, we began recording a valuation allowance against deferred taxes in December 2009. The valuation allowance was $85.5 million and $65.6 million at December 31, 2011 and 2010, respectively.
State insurance laws restrict the ability of our insurance company subsidiaries to declare stockholder dividends. These subsidiaries may not make an “extraordinary dividend” until 30 days after the applicable commissioner of insurance has received notice of the intended dividend and has not objected in such time or until the commissioner has approved the payment of the extraordinary dividend within the 30-day period. In most states, an extraordinary dividend is defined as any dividend or distribution of cash or other property whose fair market value, together with that of other dividends and distributions made within the preceding 12 months, exceeds the greater of 10.0% of the insurance company’s surplus as of the preceding year-end or the insurance company’s net income for the preceding year, in each case determined in accordance with statutory accounting practices. In addition, dividends may only be paid from unassigned earnings and an insurance company’s remaining surplus must be both reasonable in relation to its outstanding liabilities and adequate to its financial needs. As of December 31, 2011, our insurance companies could not pay ordinary dividends to us without prior regulatory approval due to a negative unassigned surplus position of Affirmative Insurance Company. However, as mentioned previously, our non-insurance company subsidiaries provide adequate cash flow to fund their own operations.
The Illinois Insurance Code includes a reserve requirement that an insurer maintain an amount of qualifying investments, as defined, at least equal to the lesser of $250.0 million or 100% of its adjusted loss reserves and loss adjustment expenses reserves, as defined. As of December 31, 2011, Affirmative Insurance Company was deficient in meeting the qualifying investments requirement by $18.9 million. As a result of various actions that have occurred through March 2012, including a $10.0 million extraordinary dividend received from one of AIC’s insurance company subsidiaries, the deficit has been reduced to $2.2 million. Management has available means to cure the remaining deficiency and based on discussions with the Illinois Department of Insurance, management believes that its plan to cure the deficiency will be approved by the Illinois Department of Insurance with ample time to implement the plan and meet the qualifying investments requirement.
To supplement our consolidated financial statements presented in accordance with U.S. GAAP, we have prepared a net cash loss for our ongoing operations for the year ended December 31, 2011, which is a non-GAAP measure. This non-GAAP measure is provided to enhance the understanding of our current financial performance and prospects for the future. This measure should be considered in addition to results prepared in conformity with GAAP and should not be considered substitute for, or superior to, GAAP results.
A reconciliation of the net loss as contained in our consolidated statement of loss to net cash loss from ongoing operations is as follows (in millions):
We believe that existing cash and investment balances, as well as cash flows generated from operations, and other actions taken by the Company will be adequate to meet our liquidity needs, planned capital expenditures and the debt service requirements of the senior secured credit facility and notes payable, during the 12-month period following the date of this report at both the holding company and insurance company levels. For the year ended December 31, 2011, our net cash used in operations was $78.7 million. We believe that this amount will be significantly reduced for the year ending December 31, 2012 due to our exit from the Michigan business, premium production stabilizing and quota-share reinsurance already being in place in 2011. These items had a substantial impact on the net cash used in operations during 2011. We do not currently know of any events that could cause a material increase or decrease in our long-term liquidity needs other than the 2014 expiration of our senior secured credit facility.
In March 2011, we entered into an amendment to the facility. The amendment included the following significant items:
Effective April 1, 2011, the pricing under the agreement changed to if the leverage ratio is greater than 2.3, the pricing is LIBOR plus 9.00%. If the leverage ratio is greater than 2.0 and less than or equal to 2.3, the pricing is LIBOR plus 7.50%. If the leverage ratio is greater than 1.8 and less than or equal to 2.0, the pricing is LIBOR plus 6.25%. The pricing for leverage ratios less than or equal to 1.8 was unchanged.
The leverage ratio covenant calculation has been changed to include only amounts borrowed under the facility. In addition, the quarterly requirements have been changed for the remaining term of the facility.
A sale and leaseback transaction of capitalized technology assets is allowed for up to $30 million.
The revolving facility was reduced from $20 million to $10 million. This facility terminated as of January 2010.
The following table summarizes our contractual obligations at December 31, 2011 (in thousands):
(1) As of December 31, 2011, we leased an aggregate of approximately 437,627 square feet of office space for our agencies, insurance companies and retail stores in various locations throughout the United States. These amounts represent our minimum future operating lease commitments.
(3) All of the outstanding notes payable at December 31, 2011 are redeemable in whole or in part after five years from issuance. For this disclosure, it is assumed that none of these notes will be redeemed before their contractual maturities and interest rates on these notes will remain at their current levels. The difference between future cash payments and the carrying value of the notes represents fair value adjustment at the date of acquisition of USAgencies that is being amortized into interest expense over the notes outstanding period.
(4) The principal amount of the senior secured credit facility is payable in quarterly installments with the remaining balance due on the seventh anniversary of the closing of the facility. We are also required to make additional annual principal payments that are to be calculated based upon our financial performance during the preceding fiscal year. In addition, certain events, such as the sale of material assets or the issuance of significant new equity, necessitate additional required principal repayments.
(5) We outsource substantially all of our IT operations, including our data center, field support and application management. The remaining term of the agreement is five years, although it may be terminated for
Investments • Investment securities consist of debt securities, and are recorded at fair value on the consolidated balance sheet. These investments are classified as available-for-sale, based on management’s intent and ability to hold to maturity. Unrealized gains and losses, net of income taxes, are recorded in accumulated other comprehensive income (loss), a separate component of stockholders’ equity (deficit). The Investment Committee periodically reviews investment portfolio results and evaluates strategies to maximize yields, to match maturity durations with anticipated needs, and to maintain compliance with investment guidelines.
Fair value is based on quoted prices in active markets when available or third-party valuation sources when observable market prices are not available. Gains and losses realized on the disposition of investment securities
are determined on the specific-identification basis and credited or charged to income. Premium and discount on investment securities are amortized and accreted using the interest method and charged or credited to investment income.
Other invested assets is comprised of an investment in a hedge fund, which primarily invests in mortgage-backed securities with the strategy of seeking attractive yields on commercial and residential mortgage-backed securities. The Company elected the fair value option for its investment in the hedge fund and measures the fair value of this investment using the net asset value of the fund as reported by the fund manager. The financial statements of the hedge fund are subject to annual audits evaluating the net asset positions of the underlying investments. The fair value is included in the Level 3 fair value hierarchy. The Company records changes in the value of its other invested assets as a component of net investment income.
Amounts Due from/to Reinsurers • The Company collects premiums from insureds and after deducting its authorized commissions, the Company remits these premiums to the appropriate insurance and reinsurance companies. The Company’s obligation to remit these premiums is recorded as amounts due reinsurers in its consolidated balance sheet. The Company records the amounts it expects to receive from reinsurers for paid and unpaid losses as an asset on its consolidated balance sheet.
Property and Equipment, Net • Property and equipment is stated at cost, less accumulated depreciation. Depreciation is recognized using the straight-line method over the estimated useful lives of the Company’s assets, typically ranging from three to five years. Leasehold improvements are depreciated over the shorter of the estimated useful lives of the assets or the remainder of the lease term.
Variable Interest Entities • Affirmative Insurance Holdings Statutory Trust I (“Trust I”), is an unconsolidated trust subsidiary, for the sole purpose of issuing $30.0 million trust preferred securities in 2004. Trust I used the proceeds from the sale of these securities and the Company’s initial capital contribution to purchase $30.9 million of subordinated debt securities from the Company. The debt securities are the sole assets of Trust I, and the payments under the debt securities are the sole revenues of Trust I.
legislative activities. Unpaid losses and loss adjustment expenses have not been reduced for amounts recoverable from reinsurers. Changes in estimates of liabilities for unpaid losses and loss adjustment expenses are reflected in the consolidated statement of income (loss) in the period in which determined. Ultimately, the actual losses and loss adjustment expenses may differ materially from recorded estimates.
Net Income Per Common Share • Basic net income per common share is computed by dividing net income available to common stockholders by the weighted average number of common shares outstanding during the year. Diluted net income per share is computed by giving effect to the potential dilution that could occur if securities or other contracts to issue common shares were exercised and converted into common shares during the year.
impairment test shall be performed to measure the amount of the impairment loss, if any, when it is more likely than not that a goodwill impairment exists. In considering whether it is more likely than not that a goodwill impairment exists, a qualitative assessment will be performed. If an entity concludes it is not more likely than not that the fair value of a reporting unit is less than its carrying amount, it need not perform the two-step impairment test. This standard is effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011. We do not expect the adoption of this standard to have a material impact on our consolidated financial position, results of operations or cash flows.
The following table summarizes the Company’s available-for-sale securities in an unrealized loss position at December 31, 2011 and 2010, the fair value and amount of gross unrealized losses, aggregated by investment category and length of time those securities have been continuously in an unrealized loss position (in thousands):
In 2010, the Company entered into a quota-share reinsurance agreement with a third-party reinsurance company ceding 40% of premiums and losses on policies in-force in certain states on October 1, 2010 and policies written through December 31, 2010 on a run-off basis. The Company receives provisional ceding commission which may be adjusted based on the fully-developed loss ratio of the reinsured policies. Written premiums ceded under this agreement totaled $60.8 million through December 31, 2011.
The Company’s quota-share ceding commission rate structure varies based on loss experience for quota-share agreements. The estimates of loss experience are continually reviewed and adjusted, and the resulting adjustments to ceding commissions are reflected in current operations.
In August 2010, the Company entered into a one-year excess of loss reinsurance contract with third-party reinsurers which provides coverage for individual losses in excess of $100,000 up to $1 million. This contract terminated July 31, 2011 on a run-off basis.
The quota-share reinsurers for 2011 and 2010, and the excess of loss reinsurers all have A ratings from A.M. Best. Accordingly, the Company believes there is minimal credit risk related to these reinsurance receivables. Under the reinsurance agreement with Vesta Insurance Group (VIG), including primarily Vesta Fire Insurance Corporation (VFIC), the Company’s wholly-owned subsidiaries, Affirmative Insurance Company (AIC) and Insura Property and Casualty Insurance Company (Insura), had the right, under certain circumstances, to require VFIC to provide a letter of credit or establish a trust account to collateralize gross amounts due from VFIC under the reinsurance agreement. Accordingly, AIC, Insura and VFIC entered into a Security Fund Agreement effective September 2004. In August 2005, AIC received a letter from VFIC’s President that irrevocably confirmed VFIC’s duty and obligation under the Security Fund Agreement to provide security sufficient to satisfy VFIC’s gross obligations under the reinsurance agreement (the VFIC Trust). At December 31, 2011, the VFIC Trust held $16.8 million (after cumulative withdrawals of $8.7 million through December 31, 2011), consisting of $14.6 million of a U.S. Treasury money market account and $2.2 million of corporate bonds rated BBB+ or higher, to collateralize the $10.1 million net recoverable (net of $2.9 million payable) from VFIC.
At December 31, 2011, $2.6 million was included in reserves for losses and loss adjustment expenses that represented the amounts owed by AIC and Insura under reinsurance agreements with the VIG affiliated companies, including Hawaiian Insurance and Guaranty Company, Ltd (Hawaiian). Affirmative established a trust account to collateralize this payable, which currently holds $20.7 million in securities (the AIC Trust). The Special Deputy Receiver in Texas had cumulative withdrawals from the AIC Trust of $0.4 million through December 2011, and the Special Deputy Receiver in Hawaii had cumulative withdrawals from the AIC Trust of $1.7 million through December 2011.
Policy acquisition costs, consisting of primarily commissions, advertising, premium taxes, underwriting and agency expenses, net of ceding commission income, are deferred and charged against income ratably over the terms of the related policies. The components of deferred policy acquisition costs and the related amortization expense were as follows (in thousands):
Property and equipment, net, consisted of the following as of December 31, 2011 and 2010 (in thousands):
The Company’s depreciation expense was $9.5 million, $9.3 million and $8.9 million for the years ended December 31, 2011, 2010 and 2009, respectively.
Changes in the carrying value of goodwill for the year ended December 31, 2011 and 2010 were as follows (in thousands):
The $30.9 million notes payable due 2035 are redeemable in whole or in part by the Company. The notes bore an initial interest rate of 7.545% until March 15, 2010. Since March 15, 2010, the securities adjust quarterly to the three-month LIBOR rate plus 3.60%. The interest rate as of December 31, 2011 was 4.15%.
The $25.8 million notes payable due 2035 are redeemable in whole or in part by the Company. The notes bore an initial interest rate of 7.792% until June 15, 2010. Since June 15, 2010, the securities adjust quarterly to the three-month LIBOR rate plus 3.55%. The interest rate as of December 31, 2011 was 4.10%.
The $20.2 million notes payable due 2035 are redeemable in whole or in part by the Company. The notes bore an initial interest rate of the three-month LIBOR rate plus 3.95% not exceeding 12.50% through March 2010 with no limit thereafter. The interest rate as of December 31, 2011 was 4.50%.
The quarterly requirements for the leverage ratio covenant calculation were changed for the first three quarters of 2011.
At every quarter end, the Company will make a payment to the lenders equal to the excess of cash at the non-regulated entities of $12 million at December 31 and March 31 and $10 million at June 30 and September 30.
The facility provides that on any interest payment date, the Company has the option to capitalize some of the interest payable and therefore increase the outstanding principal balance of the credit facility. The amount of interest eligible to be capitalized with each payment represents the excess interest above a minimum cash amount. During 2011, the Company elected this option at certain interest payment dates and capitalized interest totaling $1.0 million.
The interest coverage ratio covenant calculation was changed to include only interest expense paid in cash. In addition, the quarterly requirements were changed for the remaining term of the facility;
The combined ratio covenant was replaced with a loss ratio covenant;
Pricing depends on the amount of the leverage ratio. If the leverage ratio is greater than 2.0, the pricing is LIBOR plus 6.25%. If the leverage ratio is greater than 1.5 and less than or equal to 2.0, the pricing is LIBOR plus 6.00%. If the leverage ratio is less than or equal to 1.5, the pricing is LIBOR plus 5.75%;
The revolving facility was reduced from $20.0 million to $10.0 million.
The Company recorded a $19.4 million pretax, non-cash gain on extinguishment of debt as a result of this transaction, which is included in a separate line item in the accompanying consolidated statement of income (loss) for the year ended December 31, 2009. The $19.4 million debt extinguishment gain resulted from a $24.2 million discount representing the difference between the carrying value of the original credit agreement and the fair value of the new modified credit agreement, net of $0.7 million of term lender consent fees and the write-off of $4.1 million of deferred debt issuance costs relating to the original credit agreement. As of December 31, 2011, the unamortized debt extinguishment gain balance was $7.9 million.
The principal amount of the term loan is payable in quarterly installments, with the remaining balance due on the seventh anniversary of the closing of the facility. The Company is also required to make additional annual principal payments that are to be calculated based upon the Company’s financial performance during the preceding fiscal year after deducting voluntary prepayments made during the year. The Company does not expect to have an additional required principal payment due March 2012. In addition, certain events, such as the sale of material assets or the issuance of significant new equity, necessitate additional required principal repayments.
The March 2009 amendment to the senior secured credit facility, discussed above, changed the pricing to include a LIBOR floor of 3.0%, thus creating a basis difference in the hedging relationship since the hedged debt has a floor and the swap does not. With this amendment, the Company could no longer assume that the interest swap agreements would be highly effective in hedging the variability of interest payments on the Company’s senior secured credit facility. As a result, as of March 27, 2009, the qualifying criteria to elect hedge accounting were no longer met. Accordingly, the Company reclassified the accumulated other comprehensive loss associated with the interest rate swaps to earnings and began recognizing subsequent changes in fair value of the swaps in earnings.
In May 2010, the Company entered into a capital lease obligation related to certain computer software, software licenses, and hardware used in the Company’s insurance operations. The Company received cash proceeds from the financing in the amount of $28.2 million. As required by the lease agreements, the Company purchased $28.2 million of FDIC-insured certificates of deposit held in brokerage accounts and pledged such securities as collateral against all of the Company’s obligations under the lease. The dollar amount of collateral pledged is set to decline over the term of the lease as the Company makes the scheduled lease payments. The lease term is 60 months with monthly rental payments totaling approximately $0.6 million. At the end of the initial term, the Company will have the right to purchase the software for a nominal fee, after which all rights, title and interest would transfer to the Company.
As of December 31, 2011, the Company has available for income tax purposes federal net operating loss carryforwards (NOL’s), which may be used to offset future taxable income. The Company’s NOL’s expire as follows (in thousands):
At December 31, 2011, the Company had available approximately $0.4 million of capital loss carryforwards expiring in 2012. Capital loss carryforwards, which may be carried forward five years, may only be used to offset future realized capital gains. The Company recorded a valuation allowance for the full amount of the deferred tax asset resulting from these capital loss carryforwards.
In 2006, the Company entered into an IT outsourcing contract with a data processing services provider under which the Company outsourced substantially all of its IT operations, including the Company’s data center, field support and application management. The initial term of the agreement was ten years, although it may be terminated for convenience by the Company at any time upon six month’s notice after the first two years, subject to the payment of certain stranded costs and other termination fees. The Company’s IT outsourcing expenses were $13.0 million, $14.2 million and $12.7 million for the years ended December 31, 2011, 2010 and 2009, respectively.
Affirmative Insurance Company is a party to a 100% quota-share reinsurance agreement with Hawaiian Insurance and Guaranty Company, Ltd (Hawaiian). In November 2004, Hawaiian was named in a complaint filed in the Superior Court of the State of California for the County of Los Angeles alleging various causes of action relating to the alleged bad faith denial of coverage and defense for Hawaiian’s former insured resulting in a default judgment against the insured in the amount of $35 million. In January 2006, Hawaiian obtained summary judgment on all claims in its favor. Plaintiff appealed, but in October 2006, Hawaiian obtained a stay of the appellate proceedings by virtue of the Order of Liquidation for Hawaiian entered in August 2006. The Supreme Court of California denied plaintiff’s attempt to lift the stay in July 2007, and the matter has been inactive since that time. The Company believes that an unfavorable outcome in this matter is remote.
The following table sets forth the reconciliation of numerators and denominators for the basic and diluted earnings per share computation for each of the years ended December 31, 2011, 2010 and 2009 (in thousands, except per share amounts):
On March 18, 2011, 433,500 shares of Affirmative’s common stock were issued on a restricted basis, and the voting rights for all of the shares were assigned to New Affirmative, LLC via a written irrevocable proxy at the time the stock awards were made. On August 10, 2011, the restricted shares were repurchased at par and 1,272,500 stock options were awarded to various executives.
In May 2004, the Company’s board of directors adopted and its stockholders approved the 2004 Stock Incentive Plan (2004 Plan) to enable the Company to attract, retain and motivate eligible employees, directors and consultants through equity-based compensatory awards, including stock options, stock bonus awards, restricted and unrestricted stock awards, performance stock awards, stock appreciation rights and dividend equivalent rights. The maximum number of shares of common stock reserved for issuance under the 2004 Plan, as amended, is 3,000,000, subject to adjustment to reflect certain corporate transactions or changes in the Company’s capital structure. At December 31, 2011, 1,069,194 shares were reserved for future grants under the 2004 Plan.
Under the 2004 Plan, the board or Compensation committee may fix the term and vesting schedule of each stock option, but no incentive stock option will be exercisable more than ten years after the date of grant. Vested stock options generally remain exercisable for up to three months after a participant’s termination of service or up to 12 months after a participant’s death or disability. Typically, the exercise price of each incentive stock option must not be less than 100% of the fair market value of the Company’s common stock on the grant date, and the exercise price of a nonqualified stock option must not be less than 20% of the fair market value of the Company’s common stock on the grant date. In the event that an incentive stock option is granted to a 10% stockholder, the term of such stock option may not be more than five years and the exercise price may not be less than 110% of the fair market value on the grant date. The exercise price of each stock option granted under the 2004 Plan may be paid in cash or in other forms of consideration in certain circumstances, including shares of common stock, deferred payment arrangements or pursuant to cashless exercise programs. A stock option award
A summary of stock option activity for each of the three years ended December 31 follows (shares in thousands):
The stock options outstanding and exercisable at December 31, 2011 had aggregate intrinsic values of zero as the aggregate exercise price was greater than the aggregate market value. No stock options were exercised during 2011, 2010 or 2009.
The Company sponsors a defined contribution retirement plan under Section 401(k) of the Internal Revenue Code. The plan covers substantially all employees who meet specified service requirements. Under the plan, the Company may, at its discretion, match 100% of each employee’s contribution, up to 3% of the employee’s earnings, plus 50% of each employee’s contribution for the next 2% of the employee’s salary. The Company’s total contribution to the 401(k) plan was $0.5 million in 2009. In July 2009, the Company suspended matching contributions to the 401(k) plan. There were no employer matching contributions to the 401(k) plan in 2011 or 2010.
Any failure by one of the Company’s insurance company subsidiaries to meet the applicable risk-based capital or minimum statutory capital requirements imposed by the laws of Illinois, Louisiana, Michigan, and New York or other states where the Company does business could subject it to further examination or corrective action imposed by state regulators, including limitations on the Company’s writing of additional business, state supervision or liquidation. Any changes in existing risk-based capital requirements or minimum statutory capital requirements may require the Company to increase its statutory capital levels, which the Company may be unable to do. As of December 31, 2011, each of the Company’s insurance company subsidiaries maintained a risk-based capital level in excess of an amount that would require any corrective actions.
State insurance laws restrict the ability of the Company’s insurance company subsidiaries to declare stockholder dividends. These subsidiaries may not make an “extraordinary dividend” until 30 days after the
applicable commissioner of insurance has received notice of the intended dividend and has not objected in such time or until the commissioner has approved the payment of the extraordinary dividend within the 30-day period. In most states, an extraordinary dividend is defined as any dividend or distribution of cash or other property whose fair market value, together with that of other dividends and distributions made within the preceding 12 months, exceeds the greater of 10.0% of the insurance company’s surplus as of the preceding year-end or the insurance company’s net income for the preceding year, in each case determined in accordance with statutory accounting practices. In addition, dividends may only be paid from unassigned earnings and an insurance company’s remaining surplus must be both reasonable in relation to its outstanding liabilities and adequate to its financial needs. As of December 31, 2011, the Company’s insurance companies could not pay ordinary dividends to the Company without prior regulatory approval due to a negative unassigned surplus position of Affirmative Insurance Company. In February 2009, the Company obtained approval from the New York Department of Insurance for one of its insurance subsidiaries to retire one million shares of its stock for $2.9 million and approved payment of an extraordinary dividend for $100,000.
The Illinois Insurance Code includes a reserve requirement that an insurer maintain an amount of qualifying investments, as defined, at least equal to the lesser of $250.0 million or 100% of its adjusted loss reserves and loss adjustment expenses reserves, as defined. As of December 31, 2011, Affirmative Insurance Company was deficient in meeting the qualifying investments requirement by $18.9 million. As a result of various actions that have occurred through March 2012, including a $10.0 million extraordinary dividend received from one of AIC’s insurance company subsidiaries, the deficit has been reduced to $2.2 million. The Company has available means to cure the remaining deficiency and based on discussions with the Illinois Department of Insurance, the Company believes that its plan to cure the deficiency will be approved by the Illinois Department of Insurance with ample time to implement the plan and meet the qualifying investments requirement.
The Company utilizes a hierarchy of valuation techniques for the disclosure of fair value estimates based on whether the significant inputs into the valuation are observable. In determining the level of hierarchy in which the estimate is disclosed, the highest priority is given to unadjusted quoted prices in active markets and the lowest priority to unobservable inputs that reflect the Company’s significant market assumptions. The Company measures certain assets and liabilities at fair value on a recurring basis, including investment securities classified as available-for-sale, cash equivalents and other invested assets. Following is a brief description of the type of valuation information that qualifies a financial asset or liability for each level:
Where possible, the Company utilizes quoted market prices to measure fair value. For assets and liabilities that have quoted market prices in active markets, the Company uses the quoted market prices as fair value and includes these prices in the amounts disclosed in Level 1 of the hierarchy. When quoted market prices in active markets are unavailable, the Company determines fair values based on independent external valuation information obtained from independent pricing services, which utilizes various models and valuation techniques based on a range of inputs including pricing models, quoted market prices of publicly traded securities with similar duration and yield, time value, yield curve, prepayment speeds, default rates and discounted cash flows. In most cases, these estimates are determined based on independent third-party valuation information, and the amounts are disclosed as Level 2 or Level 3 of the fair value hierarchy depending on the level of observable market inputs. Additional pricing services are used as a comparison to ensure that realistic fair values are used in pricing the investment portfolio.
Financial assets and financial liabilities measured at fair value on a recurring basis
The following table provides information as of December 31, 2010 about the Company’s financial assets and liabilities measured at fair value on a recurring basis (in thousands):
Financial assets classified as Level 1 in the fair value hierarchy include U.S. Government bonds and certain government agencies securities and cash and cash equivalents. These securities are actively traded and the Company estimates the fair value of these securities using unadjusted quoted market prices. Cash equivalents primarily consist of highly liquid money market funds, which are reflected within Level 1 of the fair value hierarchy.
Financial assets classified as Level 2 in the fair value hierarchy include mortgage-backed securities, tax-exempt securities, corporate bonds and FDIC-insured certificates of deposit. The fair value of these securities is determined based on observable market inputs provided by independent third-party pricing services and the Company discloses the fair values of these investments in Level 2 of the fair value hierarchy. To date, the Company has not experienced a circumstance where it has determined that an adjustment is required to a quote or price received from independent third-party pricing sources. To the extent the Company determines that a price or quote is inconsistent with actual trading activity observed in that investment or similar investments, the Company would determine a fair value using this observable market information and disclose the occurrence of this circumstance. All of the fair values of securities disclosed in Level 2 are estimated based on independent third-party pricing services.
At December 31, 2011, the Company’s Level 3 financial assets include other invested assets related to an investment in a hedge fund, which is presented as a separate line item in the consolidated balance sheets. The Company measured the fair value of other invested assets on the basis of the net asset value of the fund as reported by the fund manager.
The Company did not have any transfers between Levels 1 and 2 during the year ended December 31, 2011.
Fair value measurements for liabilities in category Level 3 for the year ended December 31, 2010 were as follows (in thousands):
Fair values represent the Company’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. The following financial liabilities are not required to be recorded at fair value, but their fair value is disclosed.
Notes payable - The fair values of the notes payable were determined using a third-party valuation source and were estimated to be $17.4 million in the aggregate with a total carrying value of $76.9 million at December 31, 2011. The fair values of the notes payable were estimated to be $24.3 million in the aggregate with a total carrying value of $76.9 million at December 31, 2010.
Senior secured credit facility - The fair value of the senior secured credit facility was determined using a third-party valuation source and was estimated to be $79.6 million with a carrying value of $91.7 million at December 31, 2011. The fair value of the senior secured credit facility was estimated to be $88.3 million with a carrying value of $96.0 million at December 31, 2010.
The summarized statements of loss from discontinued operations were as follows (in thousands):
The Company assigned store operating leases to the purchaser, but remain contingently liable on store leases in the event of default by the assignee. These stores have future lease related payments totaling approximately $0.2 million through August 2012. The Company believes the likelihood of a liability being triggered under these leases is remote, and, therefore, no liability has been accrued for these lease obligations as of December 31, 2011.
On February 28, 2012, the Company exercised its right to defer interest payments on selected Notes Payable beginning with the scheduled interest payment due in March 2012 and continuing for a period of up to five years. The affected notes are associated with obligations to the Company’s unconsolidated trusts. The outstanding balance of the affected notes was $56.7 million as of December 31, 2011. The Company will continue to accrue interest on the principal during the extension period and the unpaid deferred interest will also accrue interest. Deferred interest will be due and payable at the expiration of the extension period.