The following tables provide selected historical consolidated financial and operating data of the Company at the dates and for the periods indicated. In conjunction with the data provided in the following tables and in order to more fully understand our historical consolidated financial and operating data, you should also read our “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and the accompanying notes included in this report. As previously announced, on November 15, 2011, our Board of Directors approved a change in fiscal year end from June 30 to December 31, effective December 31, 2011. As a result of this change, this Annual Report on Form 10-K is a transition report and includes financial information for the six-month transition period from July 1, 2011 to December 31, 2011 (the “Transition Period”). The comparative financial information provided for the six months ended December 31, 2010 is unaudited, since it represented an interim period of the fiscal year ended June 30, 2011 and includes all normal recurring adjustments necessary for a fair statement of the results for that period. Subsequent to this transition report on Form 10-K, our reports on Form 10-K will cover the calendar year from January 1 to December 31, with historical periods remaining unchanged. We derived our selected historical consolidated financial data at December 31, 2011 and June 30, 2011 and for the six months ended December 31, 2011 and each of the three years in the period ended June 30, 2011 from our consolidated financial statements included in this report. We derived our selected historical consolidated financial data at June 30, 2010, 2009 and 2008 and for the year ended June 30, 2008 from our consolidated financial statements which are not included in this report. The results for past periods are not necessarily indicative of the results to be expected for any future period.
At February 29, 2012, we leased and operated 378 retail locations (or “stores”) staffed by employee-agents who primarily sell non-standard personal automobile insurance products underwritten by us as well as certain commissionable ancillary products. In most states, our employee-agents also sell a complementary tenant homeowner insurance product underwritten by us. At February 29, 2012, we wrote non-standard personal automobile insurance in 12 states and were licensed in 13 additional states.
On December 23, 2011, we announced the resignation of Stephen J. Harrison from all positions with the Company, including as a member of the Board of Directors and the Chief Executive Officer of the Company. In addition, Thomas J. Harrison resigned from all positions with the Company, including as a director of the Company. In connection with these resignations, the Board of Directors of the Company appointed Mark A. Kelly, the Company’s Interim President, as Interim Chief Executive Officer and approved a reduction in the number of directors from nine to seven in accordance with the Second Amended and Restated Bylaws of the Company. Also, in connection with the resignation of Mr. Stephen J. Harrison on December 23, 2011, the Company repurchased 7,049,515 shares of Company common stock beneficially owned by Mr. Harrison at $1.45 per share. For a more detailed description of these items, see our Current Report on Form 8-K filed with the United States Securities and Exchange Commission (“SEC”) on December 23, 2011.
Excluding the severance and related benefits charges incurred in connection with the separation of certain executive officers of $1.3 million during March 2011, the expense and combined ratios for the year ended June 30, 2011 were 27.2% and 101.8%, respectively.
investment in our sales management organization to improve the quality and consistency of the customer experience in our retail stores,
development of a new brand logo and cohesive brand strategy, and
investment in rebranding our store fronts and refurbishing our stores interiors.
development of a consumer-based website that reflects our branding strategy, improves the customer experience, and allows for full-service capabilities including quoting, binding and receiving payments.
We have also been focused on expanding our potential customer base through improvements to our insurance products and product offerings. Our product initiatives include:
The following table summarizes our investment securities at December 31, 2011 (in thousands).
The following table sets forth the scheduled maturities of our fixed maturity securities at December 31, 2011 based on their fair values (in thousands). Actual maturities may differ from contractual maturities because certain securities may be called or prepaid by the issuers.
The issuer-specific factors considered in reaching the conclusion that securities with declines are not other-than-temporary include (i) the extent and duration of the decline in fair value, including the duration of any significant decline in value, (ii) whether the security is current as to payments of principal and interest, (iii) a valuation of any underlying collateral, (iv) current and future conditions and trends for both the business and its industry, (v) changes in cash flow assumptions for CMOs and (vi) rating agency actions. Based on these factors, we make a determination as to the probability of recovering principal and interest on the security.
Revenues from insurance operations were $99.0 million for the six months ended December 31, 2011, compared with $104.7 million for the six months ended December 31, 2010. Loss before income taxes from insurance operations for the six months ended December 31, 2011 was $26.7 million, compared with loss before income taxes from insurance operations of $1.5 million for the six months ended December 31, 2010.
Premiums earned decreased by $5.8 million, or 7%, to $80.6 million for the six months ended December 31, 2011, from $86.5 million for the six months ended December 31, 2010. The decrease in premiums earned was primarily due to a decline in the number of PIF from 144,582 at December 31, 2010 to 141,862 at December 31, 2011, which was impacted by the closure of underperforming stores. At December 31, 2011, we operated 382 stores, compared with 393 stores at December 31, 2010. Although the number of PIF sold through our open stores decreased from 139,187 at December 31, 2010 to 137,842 at December 31, 2011, for those policies quoted, we continue to experience a higher close ratio for the six months ended December 31, 2011 compared with the same period in the prior year. In addition, we experienced increases in both new policies sold during the most recent quarter on a year-over-year basis and the number of PIF at December 31, 2011 compared to September 30, 2011.
Net realized losses on investments, available-for-sale during the six months ended December 31, 2011 included $0.1 million in net realized losses on redemptions and $0.1 million of charges related to OTTI on certain non-agency backed CMOs. Net realized losses on investments, available-for-sale during the six months ended December 31, 2010 included $0.1 million in net realized gains on sales offset by $0.3 million of charges related to OTTI on certain non-agency backed CMOs. For additional information with respect to the determination of OTTI losses on investment securities, see “Critical Accounting Estimates - Investments” below and Note 3 to our consolidated financial statements.
In December 2011, we completed the process of implementing a new multivariate pricing program. We believe this new pricing program provides us with greater pricing segmentation and improves our pricing relative to the risk we are insuring. Currently, approximately 50% of our PIF have been underwritten using this new pricing program.
We recorded a non-cash, pre-tax goodwill impairment charge during the six months ended December 31, 2011 of $21.1 million. We are required to perform periodic impairment tests of our goodwill and intangible assets. The goodwill impairment test is a two-step process that requires us to make judgments in determining what assumptions to use in the calculation. The first step of the process consists of estimating the fair value of each
ended June 30, 2011 was $56.8 million, compared with net income of $7.0 million for the year ended June 30, 2010. Basic and diluted net loss per share were $1.18 for the year ended June 30, 2011, compared with basic and diluted net income per share of $0.15 for the year ended June 30, 2010.
Revenues from insurance operations were $210.6 million for the year ended June 30, 2011, compared with $223.1 million for the year ended June 30, 2010. Loss before income taxes from insurance operations for the year ended June 30, 2011 was $50.4 million, compared with income before income taxes from insurance operations of $14.6 million for the year ended June 30, 2010.
Commission and fee income increased 2% to $29.5 million for the year ended June 30, 2011, from $28.9 million for the year ended June 30, 2010. This increase in commission and fee income was a result of higher fee income related to commissionable ancillary products sold through our retail locations offset by the decrease in the number of PIF.
We recorded a non-cash, pre-tax goodwill and intangible assets impairment charge in fiscal year 2011 of $52.4 million. We are required to perform periodic impairment tests of our goodwill and intangible assets. The fair value of our reporting unit, from a market participant’s perspective, was estimated utilizing both (i) a cash flow projection derived from our long-range strategic plan using a discount rate of 14.5%, which was based on an estimated weighted average cost of capital adjusted for the risks associated with our operations and (ii) recent industry transaction and trading trends in price to tangible book multiples and related returns on tangible equity. As a result of recent trends in industry transaction and trading multiples, we recognized a non-cash, pre-tax goodwill impairment charge of $50.9 million in the fourth quarter of fiscal year 2011, which included a $1.9 million addition to deferred tax liabilities.
Our primary sources of funds are premiums, fees and investment income from our insurance company subsidiaries and commissions and fee income from our non-insurance company subsidiaries. Our primary uses of funds are the payment of claims and operating expenses. Net cash used in operating activities for the six months ended December 31, 2011 was $7.3 million, compared with net cash used in operating activities of $3.1 million for the six months ended December 31, 2010. Net cash used in operating activities for both periods was primarily the result of a decrease in cash collected from premiums written. Net cash provided by investing activities for the six months ended December 31, 2011 was $12.8 million compared with net cash provided by investing activities of $6.0 million for the six months ended December 31, 2010. The six months ended December 31, 2011 and 2010 included net reductions in our investment portfolio of $14.3 million and $6.3 million, respectively. The net reductions in both periods were primarily a result of increased maturities and redemptions. Net cash used in financing activities for the six months ended December 31, 2011 included $11.0 million related to repurchases of common stock held by former executive officers in separately negotiated transactions.
The National Association of Insurance Commissioners Model Act for risk-based capital provides formulas to determine each December 31 on an annual basis the amount of statutory capital and surplus that an insurance company needs to ensure that it has an acceptable expectation of not becoming financially impaired. There are also statutory guidelines that suggest that on an annual calendar year basis an insurance company should not exceed a ratio of net premiums written to statutory capital and surplus of 3-to-1. On a combined basis, the ratios for our insurance company subsidiaries of net premiums written for the last twelve months to statutory capital and surplus were 1.79-to-1 at December 31, 2011. Based on our current forecast on a combined basis, we anticipate that our risk-based capital levels will be adequate and that our ratio of net premiums written to statutory capital and surplus will not exceed the 3-to-1 statutory guideline for the reasonably foreseeable future. We therefore believe that our insurance company subsidiaries have sufficient statutory capital and surplus available to support their net premium writings in this time frame.
(1) Loss and loss adjustment expense reserves do not have contractual maturity dates; however, based on historical payment patterns, the amount presented is our estimate of the expected timing of these payments. The timing of these payments is subject to significant uncertainty. We maintain a portfolio of marketable investments with varying maturities and a substantial amount of cash and cash equivalents intended to provide adequate cash flows for such payments.
(2) Payments due by period assume a contractual fixed interest rate of 9.277% until July 30, 2012, after which the rate becomes variable (LIBOR plus 375 basis points, or 4.333% at January 3, 2012).
Our evaluation includes multiple assumptions that may change over time. If future discounted cash flows become less than those projected by us or unfavorable trends continue, further identifiable intangible assets impairment charges may become necessary that could have a materially adverse impact on our results of operations in the period in which the write-off occurs.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of First Acceptance Corporation and subsidiaries at December 31, 2011 and June 30, 2011 and 2010, and the consolidated results of their operations and their cash flows for the six months ended December 31, 2011 and each of the three years in the period ended June 30, 2011, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule referred to above, when considered in relation to the basic financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.
We have audited First Acceptance Corporation and subsidiaries’ (the “Company”) internal control over financial reporting as of December 31, 2011, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the “COSO criteria”). The Company’s management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Annual Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.
Investments, available-for-sale at fair value, include bonds with fixed principal payment schedules and mortgage-backed securities which are amortized using the retrospective method. These securities and the investment in the mutual fund are carried at fair value with the corresponding unrealized appreciation or depreciation, net of deferred income taxes, reported in other comprehensive income.
Effective April 1, 2009, the Company adopted the provisions of Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 320-10, Investments - Debt and Equity Securities (“FASB ASC 320-10”). Under this guidance, if management can assert that it does not intend to sell an impaired fixed maturity security and it is more likely than not that it will not have to sell the security before recovery of its amortized cost basis, then an entity must separate other-than-temporary impairments (“OTTI”) into the following two components: (i) the amount related to credit losses (charged against income) and (ii) the amount related to all other factors (recorded in other comprehensive income). The credit-related portion of an OTTI is measured by comparing a security’s amortized cost to the present value of its current expected cash flows discounted at its effective yield prior to the impairment charge. If management intends to sell an impaired security, or it is more likely than not that it will be required to sell the security before recovery, an impairment charge is required to reduce the amortized cost of that security to fair value. As a result of the adoption of this pronouncement, the cumulative effect resulted in an adjustment in fiscal year 2009 of $0.6 million to reclassify the non-credit component of previously recognized impairments from accumulated deficit to accumulated other comprehensive loss.
The Company accounts for income tax uncertainties under the provisions of FASB ASC 740, Income Taxes. The Company has recognized no additional liability or reduction in deferred tax assets for unrecognized tax benefits at December 31, 2011 and June 30, 2011 and 2010. Any interest and penalties incurred in connection with income taxes are recorded as a component of the provision for income taxes. The Company is generally not subject to U.S. federal, state or local income tax examinations by tax authorities for taxable years prior to 2007.
Advertising costs are expensed when incurred. Advertising expense for the six months ended December 31, 2011 and the years ended June 30, 2011, 2010 and 2009 was $2.4 million, $6.9 million, $8.3 million and $9.6 million, respectively, and are included within insurance operating expenses in the accompanying consolidated statements of operations. At December 31, 2011 and June 30, 2011 and 2010, prepaid advertising costs, which are included within other assets in the accompanying consolidated balance sheets, were $0.3 million, $0.8 million and $1.2 million, respectively.
The goodwill impairment test is a two-step process that requires management to make judgments in determining what assumptions to use in the calculation. The first step of the process consists of estimating the fair value of each reporting unit based on valuation techniques, including a discounted cash flow model using revenue and profit forecasts and recent industry transaction and trading multiples of the Company’s peers, and comparing those estimated fair values with the carrying values of the assets and liabilities of the reporting unit, which includes the allocated goodwill. If the estimated fair value is less than the carrying value, a second step is performed to compute the amount of the impairment, if any, by determining an “implied fair value” of goodwill. The determination of the “implied fair value” of goodwill of a reporting unit requires the Company to allocate the estimated fair value of the reporting unit to the assets and liabilities of the reporting unit. Any unallocated fair value represents the “implied fair value” of goodwill, which is compared to its corresponding carrying value.
As a part of the Company’s periodic impairment test to evaluate the recoverability of goodwill at December 31, 2011, the fair value of the Company’s reporting unit, from a market participant’s perspective, was estimated utilizing both (i) a cash flow projection derived from the Company’s long-range strategic plan using a discount rate of 14.5%, which was based on an estimated weighted average cost of capital adjusted for the risks associated with its operations and (ii) recent industry transaction and trading trends in price to tangible book multiples and related returns on tangible equity. As a result of the adverse impact of operating losses, the decline in the Company’s common stock trading prices, and the negotiated price of separate stock transactions with former executive officers that represented a significant percentage of the Company’s shares outstanding, during the most recent quarter, the Company recognized a non-cash, pre-tax goodwill impairment charge of $21.1 million in the second quarter of the six months ended December 31, 2011. This impairment charge resulted in no remaining goodwill on the Company’s consolidated balance sheet.
In October 2010, the FASB issued Accounting Standards Update (“ASU”) No. 2010-26, Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts (a consensus of the FASB Emerging Issues Task Force) (Topic 944), which clarifies what costs should be deferred by insurance companies when issuing or renewing insurance contracts. This guidance is effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2011. Upon adoption, it is anticipated that less acquisition costs will be deferred under this new standard. The Company currently estimates that approximately $0.5 million to $0.7 million of deferred acquisition costs at December 31, 2011 will no longer meet the criteria for deferral as of January 1, 2012. The Company expects to adopt this standard on a prospective basis and, therefore, will recognize the effect of this accounting change into income primarily over the first six months of 2012, consistent with the Company’s insurance policy terms.
In May 2011, the FASB issued ASU No. 2011-04, Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs, which amends certain measurement and disclosure requirements related to fair value measurements to improve consistency with international reporting standards. This guidance is effective prospectively for public entities for interim and annual reporting periods beginning after December 15, 2011, with early adoption by public entities prohibited. The adoption of this standard is not expected to have a material effect on the Company’s future consolidated financial statements.
The fair values of the Company’s investments are determined by management after taking into consideration available sources of data. All of the portfolio valuations classified as Level 1 or Level 2 in the above tables are priced exclusively by utilizing the services of independent pricing sources using observable market data. The Level 2 classified security valuations are obtained from a single independent pricing service. There were no transfers between Level 1 and Level 2 for the six months ended December 31, 2011 and the years ended June 30, 2011 and 2010. The Company’s policy is to recognize transfers between levels at the end of the reporting period. The Company has not made any adjustments to the prices obtained from the independent pricing sources.
(a) Transferred from Level 3 to Level 2 as observable market data became available during the period presented due to the increase in market activity for these securities.
The following table reflects the number of fixed maturity securities with gross unrealized gains and losses. Gross unrealized losses are further segregated by the length of time that individual securities have been in a continuous unrealized loss position.
Realized gains and losses on sales and redemptions are computed based on specific identification. The non-credit related portion of OTTI is included in other comprehensive income (loss). The amounts of non-credit OTTI for securities still owned was $1.0 million for non-agency backed residential CMOs and $0.2 million for non-agency backed commercial CMOs at December 31, 2011, $1.1 million for non-agency backed residential CMOs and $0.2 million for non-agency backed commercial CMOs at June 30, 2011 and $1.2 million for non-agency backed residential CMOs and $0.5 million for non-agency backed commercial CMOs at June 30, 2010.
In accordance with FASB ASC 320-10, the Company separates OTTI into the following two components: (i) the amount related to credit losses, which is recognized in the consolidated statement of operations and (ii) the amount related to all other factors, which is recorded in other comprehensive income (loss). The credit-related portion of an OTTI is measured by comparing a security’s amortized cost to the present value of its current expected cash flows discounted at its effective yield prior to the impairment charge.
The Company believes that the remaining securities having unrealized losses at December 31, 2011 were not other-than-temporarily impaired. The Company also does not intend to sell any of these securities and it is more likely than not that the Company will not be required to sell any of these securities before the recovery of their amortized cost basis.
At December 31, 2011, the Insurance Companies had unsecured aggregate reinsurance receivables of $0.2 million. During the six months ended December 31, 2011, ceded premiums earned and reinsurance recovered on losses and loss adjustment expenses (“LAE”) were both $0.1 million, respectively.
The Company has issued stock options (“Stock Option Awards”) and restricted common stock (“Restricted Stock Awards”) to employees and directors under its Amended and Restated First Acceptance Corporation 2002 Long Term Incentive Plan (the “Plan”) and accounts for such issuances in accordance with FASB ASC 718, Compensation - Stock Compensation. At December 31, 2011, there were 2,858,086 shares remaining available for issuance under the Plan. Stock Option Awards are generally granted with an exercise price equal to the market price of the Company’s stock at the date of grant. Stock Option Awards expire over ten years and generally vest equally in annual installments over five years through March 2013, while the Restricted Stock Awards vest in designated installments through November 2014. Certain awards provide for accelerated vesting if there is a change in control (as defined in the Plan).
Compensation expense related to Stock Option Awards is calculated under the fair value method and is recorded on a straight-line basis over the vesting period. There were no Stock Option Awards granted during the six months ended December 31, 2011 and the years ended June 30, 2011, 2010 and 2009. At December 31, 2011, the weighted average remaining contractual life of options outstanding and exercisable/vested is approximately 1.9 years and 1.7 years, respectively.
There were no Restricted Stock Awards granted during the six months ended December 31, 2011 and the year ended June 30, 2011. The aggregate fair values of Restricted Stock Awards vested during the six months ended December 31, 2011 and the years ended June 30, 2011 and 2010 were $44 thousand, $0.8 million and $0.9 million, respectively, at the date of vesting. There were no Restricted Stock Awards that vested during the year ended June 30, 2009. Expected future compensation expense related to the issuance of Restricted Stock Awards is $0.3 million, which will be amortized through November 2014.
Depreciation and amortization expense related to property and equipment was $0.8 million, $1.6 million, $2.0 million and $1.9 million for the six months ended December 31, 2011 and the years ended June 30, 2011, 2010 and 2009, respectively. Included within the furniture and equipment and leasehold improvements categories at December 31, 2011 above are capitalized assets totaling $0.6 million not yet in service. These assets are related to the Company’s strategic refurbishment of retail stores and development of the expanded consumer-based website.
The Company had a valuation allowance of $27.2 million, $22.1 million and $16.9 million at December 31, 2011 and June 30, 2011 and 2010, respectively, to reduce deferred tax assets to the amount that is more likely than not to be realized. The change in the total valuation allowance for the six months ended December 31, 2011 was an increase of $5.1 million. For the six months ended December 31, 2011, the change in the valuation allowance included reductions of $0.3 million related to the unrealized change on investments included in other comprehensive income (loss) and increases of $0.7 million related to deferred state income taxes.
In assessing the realization of deferred tax assets, management considered whether it was more likely than not that some portion or all of the deferred tax assets will not be realized. The Company is required to assess whether a valuation allowance should be established against the Company’s net deferred tax assets based on the consideration of all available evidence using a more likely than not standard. In making such judgments, significant weight is given to evidence that can be objectively verified. In assessing the Company’s ability to support the realizability of its deferred tax assets, management considered both positive and negative evidence. The Company placed greater weight on historical results than on the Company’s outlook for future profitability and established a deferred tax valuation allowance at December 31, 2011 and June 30, 2011 and 2010. The deferred tax valuation allowance may be adjusted in future periods if management determines that it is more likely than not that some portion or all of the deferred tax assets will be realized. In the event the deferred tax valuation allowance is adjusted, the Company would record an income tax benefit for the adjustment.
At December 31, 2011, the Company had gross state NOL carryforwards of $37.1 million that begin to expire in 2019 and AMT credit carryforwards of $1.6 million that have no expiration date. At December 31, 2011, the Company had gross NOL carryforwards for federal income tax purposes of $25.5 million, which are available to offset future federal taxable income. On a tax-affected basis, all remaining federal and substantially all state NOL carryforwards at December 31, 2011 have been fully reserved for through a valuation allowance.
The gross federal NOL carryforwards will expire in 2012 through 2031, as shown in the following table (in thousands).
FASB ASC 260, Earnings Per Share, specifies the computation, presentation and disclosure requirements for earnings per share (“EPS”). Basic EPS are computed using the weighted average number of shares outstanding. Diluted EPS are computed using the weighted average number of shares outstanding adjusted for the incremental shares attributed to outstanding securities with a right to purchase or convert into common stock.