We believe that the facilities are well maintained, in substantial compliance with environmental laws and regulations, and adequately covered by insurance. We also believe that these leased facilities are not unique and could be replaced, if necessary, at the end of the lease term.
21st Century is an insurance holding company, which, through our subsidiaries and our contractual relationships with our independent agents and general agents, controls substantially all aspects of the insurance underwriting, distribution and claims processes. We are authorized to underwrite fire, allied lines, homeowners’ property and casualty insurance, commercial general liability insurance, commercial multi peril, inland marine, personal automobile insurance and commercial automobile insurance in various states with various lines of authority through our wholly owned subsidiaries, Federated National and American Vehicle. We market and distribute our own and third-party insurers’ products and our other services primarily in Florida, through contractual relationships with a network of approximately 1,500 independent agents and a select number of general agents.
The most significant accounting estimates inherent in the preparation of our financial statements include estimates associated with management’s evaluation of the determination of liability for unpaid losses and LAE and the amount and recoverability of amortization of Deferred Policy Acquisition Costs (“DPAC”). In addition, significant estimates form the basis for our reserves with respect to finance contracts, premiums receivable and deferred income taxes. Various assumptions and other factors underlie the determination of these significant estimates, which are described in greater detail at Footnote 2 in this Form 10-K.
Accounting for loss contingencies pursuant to Statements of Financial Accounting Standards (“SFAS”) Number 5, Accounting for Contingencies (“SFAS No. 5”) involves the existence of a condition, situation or set of circumstances involving uncertainty as to possible loss that will ultimately be resolved when one or more future event(s) occur or fail to occur. Additionally, accounting for a loss contingency requires management to assess each event as probable, reasonably possible or remote. Probable is defined as the future event or events are likely to occur. Reasonably possible is defined as the chance of the future event or events occurring is more than remote but less than probable, while remote is defined as the chance of the future event or events occurring is slight. An estimated loss in connection with a loss contingency shall be recorded by a charge to current operations if both of the following conditions are met: First, the amount can be reasonably estimated, and second, the information available prior to issuance of the financial statements indicates that it is probable that a liability has been incurred at the date of the financial statements. It is implicit in this condition that it is probable that one or more future events will occur confirming the fact of the loss or incurrence of a liability.
SFAS Number 115, Accounting for Certain Investments in Debt and Equity Securities (“SFAS No. 115”) addresses accounting and reporting for (a) investments in equity securities that have readily determinable fair values and (b) all investments in debt securities. SFAS No. 115 requires that these securities be classified into one of three categories, Held-to-maturity, Trading securities or Available-for-sale.
The estimated Ultimate Loss and Defense & Cost Containment Expense (“DCCE”) is based on an analysis by line of business, coverage and by accident quarter performed using data as of December 31, 2008. The analysis relies primarily on four actuarial methods: Incurred Loss & DCCE Development Method, Paid Loss & DCCE Development Method, Bornhuetter-Ferguson Incurred Method, and Bornhuetter-Ferguson Paid Method. Each method relies on company experience, and, where relevant, the analysis includes comparisons to industry experience. The following is a description of each of these methods:
We select an estimate of ultimate loss & DCCE for each accident quarter after considering the results of each projection method for the quarter and the relative maturity of the quarter (the time elapsed between the start of the quarter and December 31, 2008). Reserves for unpaid loss & DCCE for each quarter are the differences between these ultimate estimates and the amount already paid. The reserves for each quarter and each coverage are summed, and the result is the overall estimate of unpaid loss & DCCE liability for the company.
Interim - During 2008 our interim approach was very similar to the annual process noted above. During 2007 for Federated National’s homeowners’ program, our selection of loss reserves was weighted more to the Paid Loss Development Method and the Incurred Loss Development Method. American Vehicle’s commercial general liability program relied upon the Cape Cod Method on a paid and incurred basis as well as the Paid Loss Development Method and the Incurred Loss Development Method. During the year-end process for 2007, we were able to employ long-tail methodologies to our commercial general liability program’s loss reserve process based on no specific event other than newly available in-house resources.
Loss trend factors which are used to establish expected loss ratios for subsequent accident years based on the projected loss ratio for prior accident years.
In practice there are factors that change over time; however, many (such as inflation) are intrinsically reflected in the historical development patterns, and others typically do not materially affect the estimate of the reserve for unpaid loss and LAE. Therefore, no specific adjustments have been incorporated for such contingencies projecting future development of losses and LAE. There are no key assumptions as of December 31, 2008 premised on future emergence inconsistent with historical loss reserve development patterns.
For the year ended December 31, 2007 the actuarial firm engaged by the Company determined range of loss and LAE reserves on a net basis range from a low of $37.9 million to a high of $45.6 million, with a best estimate of $42.1 million. The Company’s net loss and LAE reserves are carried at $40.0 million. Management’s point estimate of reserves are 5.2% below our actuary’s best estimate in recognition of the inherent uncertainty in assessing the potential ultimate liabilities given legal developments as well as evolution in its operations.
In March 2008, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 161, Disclosures about Derivative Instruments and Hedging Activities - an amendment of FASB Statement No. 133 (“SFAS No. 161”). SFAS No. 161 changes the disclosure requirement for derivative instruments and hedging activities. Entities are required to provide enhanced disclosures about how and why an entity uses derivative instruments, how derivative instruments and related hedged items are accounted for under SFAS No. 133 Accounting for Derivatives Instruments and Hedging Activities (“SFAS No. 133”) and its related interpretations, and, how derivative instruments and related hedged items affect an entity’s financial position, financial performance, and cash flows. The Company does not utilize derivative instruments, as such; there is no impact to our consolidated financial statements for the year ended December 31, 2008.
In June 2006, FASB issued Interpretation No. 48 (“FIN 48”), Accounting for Uncertainty in Income Taxes which clarifies the accounting for income tax reserves and contingencies recognized in an enterprise’s financial statements in accordance with SFAS No. 109, Accounting for Income Taxes (“SFAS No. 109”). This Interpretation also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. We adopted FIN 48 as of January 1, 2007. A tax position is recognized as a benefit only if it is “more likely than not” that the tax position would be sustained in a tax examination, with a tax examination being presumed to occur. The amount recognized is the benefit that is greater than 50% likely of being realized on examination. For tax positions not meeting the “more likely than not” test, no benefit is recorded. The Company evaluated the impact that FIN 48 will have on its Consolidated Financial Statements. Additionally, we have developed a process to capture and quantify any such effect that FIN 48 could have on the Company and concluded there was no impact on our consolidated financial statements for the year ended December 31, 2008.
SFAS No. 115 addresses accounting and reporting for (a) investments in equity securities that have readily determinable fair values and (b) all investments in debt securities. SFAS No. 115 requires that these securities be classified into one of three categories: (i) held-to-maturity, (ii) trading securities or (iii) available-for-sale.
Total Investments decreased $110.2 million, or 80.9%, to $26.1 million as of December 31, 2008, compared with $136.2 million as of December 31, 2007. Our fixed income portfolio contained callable features exercised in 2008. The proceeds from these called securities are currently in cash and short-term investments, of which approximately $121.4 million are invested in the MTB Prime Money Market-Inst Fund Number 142. We are currently evaluating long and short- term investment options for best yields that match our liquidity needs.
Below is a summary of net unrealized gains and (losses) at December 31, 2008 and December 31, 2007 by category.
Pursuant to FASB SFAS No. 115, the Company records the unrealized losses, net of estimated income taxes that are associated with that part of our portfolio classified as available for sale through the shareholders' equity account titled “Other Comprehensive Income”. Management periodically reviews the individual investments that comprise our portfolio in order to determine whether a decline in fair value below our cost either is other than temporary or permanently impaired. Factors used in such consideration include, but are not limited to, the extent and length of time over which the market value has been less than cost, the financial condition and near-term prospects of the issuer and our ability and intent to keep the investment for a period sufficient to allow for an anticipated recovery in market value.
In reaching a conclusion that a security is either other than temporary or permanently impaired we consider such factors as the timeliness and completeness of expected dividends, principal and interest payments, ratings from nationally recognized statistical rating organizations such as Standard and Poor’s and Moody's, as well as information released via the general media channels. In 2008, in connection with this process, we have charged to operations a net realized investment loss totaling approximately $9.9 million with an estimated provisional tax effect of approximately $3.7 million. The charge relates to short-term investments in connection with the common stocks of financial and pharmaceutical industries.
Cash and short term investments, which include cash, certificates of deposits, and money market accounts, increased $102.1 million, or 453.1%, to $124.6 million as of December 31, 2008, compared with $22.5 million as of December 31, 2007. Our excess cash and cash equivalents are invested in accordance with our long-term liquidity requirements.
Receivable for investments sold decreased to nothing, as of December 31, 2008, compared with $6.4 million as of December 31, 2007.
Finance contracts receivable, net of allowance for credit losses, decreased $0.2 million, or 52.3%, to $0.2 million as of December 31, 2008, compared with $0.4 million as of December 31, 2007. The decrease is primarily due to our sale in December 2004 of our assets related to our non-standard automobile insurance agency business in Florida and the associated financed contracts. We anticipate a continued decline in the financed contracts receivable, net over the future short term and its related conversion to cash and short term investments and investments.
Premiums receivable, net of allowance for credit losses, decreased $0.4 million, or 11.7%, to $3.4 million as of December 31, 2008, compared with $3.8 million as of December 31, 2007.
Other assets decreased $0.6 million, or 22.2%, to $2.3 million as of December 31, 2008, compared with $2.9 million as of December 31, 2007. Major components of other assets are as follows:
Management revises its estimates based on the results of its analysis. This process assumes that past experience, adjusted for the effects of current developments and anticipated trends, is an appropriate basis for estimating the ultimate settlement of all claims. There is no precise method for subsequently evaluating the impact of any specific factor on the adequacy of the reserves, because the eventual redundancy or deficiency is affected by multiple factors.
Unearned premiums decreased $15.9 million, or 28.2%, to $40.5 million as of December 31, 2008, compared with $56.4 million as of December 31, 2007. The decrease was due to a $13.1 million decrease in unearned homeowners’ insurance premiums, a $4.0 million decrease in unearned commercial general liability premiums, a $1.7 million increase in Federal Flood unearned premiums and a $0.4 million decrease in unearned automobile premiums. Generally, as is in this case, a decrease in unearned premium directly relates to a decrease in written premium on a rolling twelve-month basis. Conversely, in periods of increased written premium on a rolling twelve-month basis, unearned premium generally would be expected to rise. Competition could continue to negatively affect our unearned premium.
Premium deposits and customer credit balances decreased $1.1 million, or 38.4%, to $1.7 million as of December 31, 2008, compared with $2.8 million as of December 31, 2007. Premium deposits are monies received on policies not yet in force as of December 31, 2008.
Accounts payable and accrued expenses decreased $0.6 million, or 14.9%, to $3.7 million as of December 31, 2008, compared with $4.3 million as of December 31, 2007. This decrease is due to our cash management efforts and timing of payments with our trade vendors.
The Company experienced a decrease in homeowners’ gross premiums written in 2008 primarily because of the effects of state mandated homeowner’s rates reduction and wind mitigation discounts.
Federated National and American Vehicle are currently rated by Demotech as "A" ("Exceptional"), which is the third of seven ratings, and defined as “Regardless of the severity of a general economic downturn or deterioration in the insurance cycle, insurers earning a Financial Stability Rating of “A” possess “Exceptional” financial stability related to maintaining surplus as regards to policyholders”. Demotech’s ratings are based upon factors of concern to agents, reinsurers and policyholders and are not primarily directed toward the protection of investors. However, our Demotech rating could be jeopardized by such other factors including adverse development and various surplus related ratio exceptions.
The Company’s sale of commercial general liability policies decreased by $8.4 million to $23.8 million in 2008, compared with $32.2 million in 2007. This decrease is due to increased competition in the commercial general liability market. The following table sets forth the amounts and percentages of our gross premiums written in connection with our commercial general liability program by state:
Gross premiums ceded decreased $10.0 million, or 22.4%, to $34.6 million in 2008, compared with $44.6 million in 2007.
The decrease (increase) in unearned premiums was $15.9 million in 2008, compared with $21.4 million in 2007. The change was due to a $13.1 million decrease in unearned homeowners’ insurance premiums, a $4.0 million decrease in unearned commercial general liability premiums, a $1.7 million increase in Federal Flood unearned premiums and a $0.4 million decrease in unearned automobile premiums. These changes are a result of our decreased premium volume during this period. See Gross Premiums Written.
The recurring components of our 2007 commission income totaled $1.4 million. Non-reoccurring components of our 2007 commission income totaled $5.8 million stemming from two separate events. First and pursuant to provisions contained in the three-year reinsurance treaties, we were afforded the right to cancel the remaining two years and be entitled to receive a no loss experience commission. In connection with this treaty, we reported approximately $2.8 million in 2007. The second non-reoccurring operating event was in connection with commission income totaling approximately $3.0 million in connection with our participation in a Citizens take out program which we began in 2004, wherein the commission was earned by us upon the successful retention of the policyholder for thirty-six months.
In 2008 we marked certain equity investments to market value pursuant to guidelines prescribed in SFAS No. 115. In reaching a conclusion that a security is either other than temporary or permanently impaired we consider such factors as the timeliness and completeness of expected dividends, principal and interest payments, ratings from nationally recognized statistical rating organizations such as Standard and Poor’s and Moody’s, as well as information released via the general media channels. The pretax charge to operations was approximately $9.9 million in connection with our estimates of the net realizable value of these investments. A significant number of these investments were subsequently sold in 2008, and we recognized an additional pretax charge to operations of $0.2 million.
Regulatory Assessments Recovered increased $0.4 million, or 27.2%, to $2.1 million in 2008, compared with $1.7 million in 2007.
Policy acquisition costs, net of amortization, decreased $4.7 million, or 24.0%, to $14.8 million in 2008, compared with $19.4 million in 2007. Policy acquisition costs, net of amortization, consists of the actual policy acquisition costs, including commissions, payroll and premium taxes, less commissions earned on reinsurance ceded and policy fees earned. The recent decreased production volume for both the homeowners’ and commercial general liability product lines is the reason for the decrease in this asset.
Gross premiums ceded decreased $23.0 million, or 34.0%, to $44.6 million in 2007, compared with $67.5 million in 2006.
The (decrease) increase in prepaid reinsurance premiums was ($11.3) million in 2007, compared with $20.2 million in 2006. The change in this account is primarily associated with the timing of our reinsurance payments measured against the term of the underling reinsurance policies.
Regulatory assessments recovered increased $1.5 million to $1.7 million in 2007, compared with $0.1 million in 2006.
Other income decreased $0.8 million, or 55.7%, to $0.6 million in 2007, compared with $1.4 million in 2006. Major components of other income in 2007 included approximately $0.5 million in partial recognition of our gain on the sale of our Lauderdale Lakes property and $0.1 million of rental income, interest income and miscellaneous income.
Loss and LAE increased by $3.2 million, or 7.3%, to $47.6 million in 2007, compared with $44.4 million in 2006. The increase includes $1.2 million adverse development associated with the 2004 hurricanes.
The following table reflects the changes in 2007 in connection with the four hurricanes that occurred in August and September of 2004. A charge of $1.2 million occurred in 2007 in connection with these storms.
Salaries and wages decreased $0.3 million, or 4.0%, to $6.7 million in 2007, compared with $7.0 million in 2006.
Policy acquisition costs, net of amortization, increased $2.0 million, or 11.6%, to $19.4 million in 2007, compared with $17.4 million in 2006. The increase is primarily in connection with a more generous commission structure during 2007. Policy acquisition costs, net of amortization, consists of the actual policy acquisition costs, including commissions, payroll and premium taxes, less commissions earned on reinsurance ceded and policy fees earned.
The provision for income tax expense increased $3.8 million, or 51.8%, to $11.2 million in 2007, compared with $7.4 million in 2006. The effective rate for income tax expense is 34.5% in 2007, compared with 34.7% in 2006.
As a result of the foregoing, the Company’s net income in 2007 was $21.3 million compared with net income of $13.9 million in 2006.
A summary of long-term contractual obligations as of December 31, 2008 follows. The amounts represent estimates of gross undiscounted amounts payable over time.
In 2008, operations used net operating cash flow of $22.3 million, as compared with provided $32.8 million and $27.5 million in 2007 and 2006, respectively.
In 2008, operations used $40.3 million of gross cash flow primarily due to a $15.9 million decrease in unearned premiums, $10.6 million of net realized investment losses, a $4.2 million decrease in income taxes payable and a $2.9 million increase in deferred income tax expense. Additional operational uses of cash include a $2.3 million increase in income taxes recoverable, a $1.1 million decrease in premium deposits and customer credit balances, a $0.6 million decrease in accounts payable and accrued expenses, $0.2 million of amortization of investment discount, all in conjunction with a net loss of $2.5 million.
As of December 31, 2008, 2007, and 2006, we did not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as “structured finance” or “special purpose” entities, which were established for the purpose of facilitating off-balance-sheet arrangements or other contractually narrow or limited purposes. As such, management believes that we currently are not exposed to any financing, liquidity, market or credit risks that could arise if we had engaged in transactions of that type requiring disclosure herein.
We have audited the accompanying balance sheets of 21st Century Holding Company as of December 31, 2008 and 2007, and the related statements of income, stockholders’ equity and comprehensive income, and cash flows for each of the years in the three-year period ended December 31, 2008. We also have audited 21st Century Holding Company’s internal control over financial reporting as of December 31, 2008, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). 21st Century Holding Company’s management is responsible for these financial statements, 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 Certification Report included in the Company’s 2008 Form 10-K. Our responsibility is to express an opinion on these financial statements and an opinion on the company’s internal control over financial reporting based on our audits.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of 21st Century Holding Company as of December 31, 2008 and 2007, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2008 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, 21st Century Holding Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2008, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
The accompanying consolidated financial statements include the accounts of the Company and its subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation.
A non-admitted carrier is not licensed by the state, but is allowed to do business in that state and is strictly regulated to protect policyholders from a variety of illegal and unethical practices, including fraud. Sometimes, non-admitted carriers are referred to as “excess and surplus” lines carriers. Non-admitted carriers are subject to considerably less regulation with respect to policy rates and forms. Additionally, both Federated National and American Vehicle are authorized to underwrite personal and commercial automobile insurance in Florida as an admitted carrier.
During 2007 American Vehicle applied for and was granted, by the State of Florida in 2008, a license to underwrite commercial multiple peril and inland marine lines of business as an admitted carrier. We believe these new lines of authority will bode well with American Vehicle’s existing customers. Operations under American Vehicle’s newly granted lines of authority are expected to begin in 2009.
Our business, results of operations and financial condition are subject to fluctuations due to a variety of factors. Abnormally high severity or frequency of claims in any period could have a material adverse effect on our business, results of operations and financial condition. In addition, if our estimated liabilities for unpaid losses and LAE are less than actual losses and LAE, we will be required to increase reserves with a corresponding reduction in our net income in the period in which the deficiency is identified. We internally process claims made by our insureds through our wholly owned claims adjusting company, Superior.
Assurance MGA, a wholly owned subsidiary, acts as Federated National’s and American Vehicle’s exclusive managing general agent in the state of Florida. As American Vehicle continues its expansion into other states, we intend to retain other general agents to market our commercial general liability insurance products. In 2008, Assurance MGA became licensed in the states of Alabama, Arkansas, Georgia, Illinois, Mississippi, Missouri, Nevada, North Carolina, Texas and Virginia.
Assurance MGA currently provides underwriting policy administration, marketing, accounting and financial services to Federated National and American Vehicle, and participates in the negotiation of reinsurance contracts. For the above-mentioned services, Assurance MGA generates revenue through a 6% commission fee from the insurance companies’ gross written premium, policy fee income of $25 per policy and other administrative fees. The 6% commission fee from Federated National and American Vehicle was made effective January 1, 2005. Assurance MGA plans to establish relationships with additional carriers and add additional insurance products in the future.
Deferred acquisition costs primarily represent commissions paid to outside agents at the time of policy issuance (to the extent they are recoverable from future premium income) net of ceded premium commission earned from reinsurers, salaries and premium taxes net of policy fees, and are amortized over the life of the related policy in relation to the amount of premiums earned. The method followed in computing deferred acquisition costs limits the amount of such deferred costs to their estimated realizable value, which gives effect to the premium to be earned, related investment income, unpaid loss and LAE and certain other costs expected to be incurred as the premium is earned. There is no indication that these costs will not be fully recoverable in the near term.
In October 2008, the FASB issued FASB Staff Position (“FSP”) FAS 157-3, “Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active” (“FSP FAS 157-3”). The purpose of FSP FAS 157-3 was to clarify the application of SFAS No. 157 Fair Value Measurements (“SFAS No. 157”) in a market that is not active. It also allows for the use of management’s internal assumptions about future cash flows with appropriately risk-adjusted discount rates when relevant observable market data does not exist. FSP FAS 157-3 did not change the objective of SFAS No. 157 which is the determination of the price that would be received in an orderly transaction that is not a forced liquidation or distressed sale at the measurement date. FSP FAS 157-3 was effective upon issuance, including prior periods for which financial statements had not been issued. Our adoption of FSP FAS 157-3 for the period ended September 30, 2008 did not have a material effect on our financial position, results of operations, cash flows or disclosures.
In December 2007, the FASB issued SFAS No. 141R, Business Combinations (“SFAS No. 141R”). SFAS No. 141R clarifies the definitions of both a business combination and a business. All business combinations will be accounted for under the acquisition method (previously referred to as the purchase method). This standard defines the acquisition date as the only relevant date for recognition and measurement of the fair value of consideration paid. SFAS No. 141R requires the acquirer to expense all acquisition related costs. SFAS No. 141R will also require acquired loans to be recorded net of the allowance for loan losses on the date of acquisition. SFAS No. 141R defines the measurement period as the time after the acquisition date during which the acquirer may make adjustments to the “provisional” amounts recognized at the acquisition date. This period cannot exceed one year, and any subsequent adjustments made to provisional amounts are done retrospectively and restate prior period data. The provisions of this statement are effective for business combinations during fiscal years beginning after December 15, 2008. The Company has not determined the impact that SFAS No. 141R will have on its financial position and results of operations and believes that such determination will not be meaningful until the Company enters into a business combination.
In February 2007, FASB issued SFAS No. 159 The Fair Value Option for Financial Assets and Financial Liabilities - Including an Amendment of SFAS No. 115 (“SFAS No. 159”), which permits an entity to measure many financial assets and financial liabilities at fair value that are not currently required to be measured at fair value. Entities that elect the fair value option will report unrealized gains and losses in earnings at each subsequent reporting date. The fair value option may be elected on an instrument-by-instrument basis, with a few exceptions. SFAS No. 159 amends previous guidance to extend the use of the fair value option to available-for-sale and held-to-maturity securities. The Statement also establishes presentation and disclosure requirements to help financial statement users understand the effect of the election. We adopted SFAS No. 159 on its effective date, January 1, 2008. The Company did not elect to measure any financial assets and liabilities with SFAS No. 159 fair value option, and accordingly, to date, there is no impact to our consolidated financial statements.
In September 2006, FASB issued SFAS No. 157, which enhances existing guidance for measuring assets and liabilities using fair value and requires additional disclosure about the use of fair value for measurement. SFAS No. 157 was originally effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. The adoption of SFAS No. 157 has not had a material impact, to date, on our financial position or results of operations.
In June 2006, FASB issued FASB FIN 48 that clarifies the accounting for income tax reserves and contingencies recognized in an enterprise’s financial statements in accordance with SFAS No. 109, Accounting for Income Taxes. This Interpretation also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. This Interpretation is effective for fiscal years beginning after December 15, 2006. The Company has adopted and concluded that the impact of FIN 48 will be minimal and includes a policy of classifying interest and penalties related to income tax as elements of income tax expense in the consolidated financial statements. As required by FIN 48, this change was done prospectively. Previously, penalties and interest were classified as operating and underwriting expenses.
In February 2006, FASB issued SFAS No. 155, Accounting for Certain Hybrid Financial Instruments (“SFAS No. 155”). This accounting standard permits fair value re-measurement for any hybrid financial instrument containing an embedded derivative that otherwise would require bifurcation; clarifies which interest-only strips and principal-only strips are not subject to the requirements of SFAS No. 133; establishes a requirement to evaluate interests in securitized financial assets to identify them as freestanding derivatives or as hybrid financial instruments containing an embedded derivative requiring bifurcation; clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives; and amends SFAS No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities - a replacement of FASB Statement No. 125 (“SFAS No. 140”), to eliminate the prohibition on a qualifying special-purpose entity from holding a derivative financial instrument pertaining to a beneficial interest other than another derivative financial instrument. SFAS No. 155 is effective for all financial instruments acquired or issued after the beginning of an entity’s first fiscal year beginning after September 15, 2006. There was no impact on our consolidated financial statements with respect to the adoption of SFAS No. 155.
We may experience a loss due to the concentration of credit risk.
We face risks in connection with potential material weakness resulting from our Sarbanes-Oxley Section 404 management report and any related remedial measures that we undertake.
The failure of any of the loss limitation methods we employ could have a material adverse effect on our financial condition or our results of operations.
If we are unable to continue our growth because our capital must be used to pay greater than anticipated claims, our financial results may suffer.
We may require additional capital in the future which may not be available or only available on unfavorable terms.
Our largest shareholders currently control approximately 8.6% of the voting power of our outstanding common stock, which could discourage potential acquirers and prevent changes in management.
The fair value of our investments is estimated based on prices published by financial services or quotations received from securities dealers and is reflective of the interest rate environment that existed as of the close of business on December 31, 2008 and 2007. Changes in interest rates subsequent to December 31, 2008 may affect the fair value of our investments. Refer to Footnote 3(a) of the Notes to Consolidated Financial Statements for details.
The carrying amounts for the following financial instrument categories approximate their fair values at December 31, 2008 and 2007 because of their short-term nature: cash and short term investments, premiums receivable, finance contracts, due from reinsurers, revolving credit outstanding, bank overdraft, accounts payable, accrued expenses and subordinated debt.
During the year ended December 31, 2008, the Company had two stock-based employee compensation plans and one stock-based franchise compensation plan, which are described later in Footnote 16, Stock Compensation Plans. Prior to January 1, 2006, we accounted for those plans under the recognition and measurement provisions of stock-based compensation using the intrinsic value method prescribed by Accounting Principles Board (“APB”) Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations, as permitted by SFAS No. 123, Accounting for Stock-Based Compensation (“SFAS No. 123”). Under these provisions, no stock-based employee compensation cost was recognized in the Statement of Operations for the year ended December 31, 2005 as all options granted under those plans had an exercise price equal to or less than the market value of the underlying common stock on the date of grant.
Property, plant and equipment is stated at cost less accumulated depreciation. Depreciation on property, plant and equipment is calculated on a straight-line basis over the following estimated useful lives: building and improvements - 30 years and furniture and fixtures - 7 years. We capitalize betterments and any other expenditure in excess of $500 if the asset is expected to have a useful life greater than one year. The carrying value of property, plant and equipment is periodically reviewed based on the expected future undiscounted operating cash flows of the related item. Based upon our most recent analysis, we believe that no impairment of property, plant and equipment exists at December 31, 2008.
The fixed maturities and the equity securities that are available for sale and carried at fair value represent 48% of total investments as of December 31, 2008, compared with 85% as of December 31, 2007. The investments held at December 31, 2008 and December 31, 2007 were comprised mainly of United States government and agency bonds, as well as municipal bonds which are viewed by the Company as conservative and less risky holdings, though sensitive to interest rate changes. There is a smaller concentration of corporate bonds, predominantly held in the financial and conglomerate industries. At December 31, 2008, approximately 89% of the equity holdings are in mutual funds and 11% are in equities related to the financial industry and insurance industry.
As of December 31, 2008 and 2007 we have classified $13.5 million and $20.2 million, respectively, of our bond portfolio as held-to-maturity. The decision to classify this layer of our bond portfolio as held-to-maturity was predicated on our intention and ability to hold these securities until maturity. Additionally, we have and may continue to use this position to secure irrevocable letters of credit to facilitate business opportunities in connection with our commercial general liability program. During April 2006, American Vehicle finalized a $15.0 million irrevocable letter of credit in conjunction with the 100% Quota Share Reinsurance Agreement with Republic which was terminated in April 2007. As of December 31, 2007 the letter of credit in favor of Republic totaled $10.0 million. During January 2008 this letter of credit was reduced to $3.0 million.
In connection with our equity securities, we determined that certain securities qualified for other than temporary impairment status in 2008. In connection with this process we charged to operations a net realized investment loss that totaled approximately $9.9 million, net of an estimated provisional tax effect of approximately $3.7 million. Most of these investments were subsequently sold during the third and fourth quarter of the year, and, we recognized an additional $0.2 million loss, net of an estimated tax benefit of approximately $0.1 million.
The following table summarizes, by type, our investments as of December 31, 2008 and 2007.
The following table shows the realized (losses) gains for fixed and equity securities for the years ended December 31, 2008 and 2007.
Below is a summary of fixed maturities at December 31, 2008 and 2007 by contractual or expected maturity periods. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
United States Treasury Notes with a book value of $1,043,000 and $1,050,000, both maturing in 2012, were on deposit with the Florida OIR as of December 31, 2008, as required by law for American Vehicle and Federated National respectively, and are included with other investments held until maturity.
Proceeds from sales of fixed maturities and equity securities in 2008, 2007 and 2006 were approximately $150.3 million, $202.2 million and $271.3 million, respectively.
As a result of our review of our liability for losses and LAE, which includes a re-evaluation of the adequacy of reserve levels for prior year’s claims, we increased the liability for loss and LAE for claims occurring in prior years by $4,815,265, $9,166,491 and $9,294,096 for the years ended December 31, 2008, 2007 and 2006, respectively. The adjustments in the liability were primarily attributable to loss development in connection with the series of hurricanes that occurred in Florida during 2005 and 2004. There can be no assurance concerning future adjustments of reserves, positive or negative, for claims through December 31, 2008.
Federated Premium’s operations were funded by the revolving loan agreement with FlatIron. The Revolving Agreement was structured as a sale of contracts receivable under a sale and assignment agreement with WPAC, which gave them the right to sell or assign these contracts receivable. Federated Premium, which serviced these contracts, recorded transactions under the Revolving Agreement as secured borrowings. There were no outstanding borrowings under the Revolving Agreement as of December 31, 2008. Outstanding borrowings under the Revolving Agreement as of December 31, 2007 and 2006 were approximately nothing and $0.01 million, respectively. This credit facility terminated, at our request, during 2007.
Finance contracts receivable decreased $0.2 million, or 52.3%, to $0.2 million as of December 31, 2008, compared with $0.4 million as of December 31, 2007. We anticipate a continued decline in the short-term in connection with premiums financed contracts. The Company anticipates continued use of the direct bill feature associated with the two insurance companies and their automobile lines of business.
A summary of the provision for income tax expense is as follows:
The Company’s consolidated federal income tax returns for 2003 and 2002 have been examined by the IRS and there have been no material changes in the tax liability for those years.
In 2008, approximately $30,000 penalties and interest were paid in conjunction with our 2007 Federal Income Tax Return.
The insurance companies are also required to adhere to prescribed premium-to-capital surplus ratios. As of December 31, 2008, 2007 and 2006, both Federated National and American Vehicle were in compliance with the prescribed premium-to-surplus ratio.
As of December 31, 2008, to meet regulatory requirements, we had bonds with a carrying value of approximately $2.0 million pledged to the Florida OIR.
In order to enhance the regulation of insurer solvency, the NAIC established risk-based capital requirements for insurance companies that are designed to assess capital adequacy and to raise the level of protection that statutory surplus provides for policy holders. These requirements measure three major areas of risk facing property and casualty insurers: (i) underwriting risks, which encompass the risk of adverse loss developments and inadequate pricing; (ii) declines in asset values arising from credit risk; and (iii) other business risks from investments. Insurers having less statutory surplus than required will be subject to varying degrees of regulatory action, depending on the level of capital inadequacy. The Florida OIR, which follows these requirements, could require Federated National or American Vehicle to cease operations in the event they fail to maintain the required statutory capital.
Federated National’s 2004 regularly scheduled statutory triennial examination for the three years ended December 31, 2004 was performed by the Florida OIR in 2005. American Vehicle's examination was for the three years ended December 31, 2005 was also performed by the Florida OIR, in 2006. A loss reserve deficiency totaling approximately $1.3 million (net of income taxes) was recorded in the fourth quarter of 2006 on American Vehicle in connection with the Florida OIR examination. We may be the subject of additional targeted examinations or analysis. These examinations or analysis may result in one or more corrective orders being issued by the Florida OIR.
The table below reflects the range and test results for both Federated National and American Vehicle for the years ended December 31 2008 and 2007, respectively.
During a subsequent regularly scheduled meeting on or about December 18, 2006, Citizens board determined an additional 2004 plan year deficit existed in the High Risk Account. Citizens decided that a $515 million Regular Assessment was in the best interest of Citizens and consistent with Florida Statutes. On this basis, Citizens certified for a Regular Assessment. Federated National’s participation in this assessment totaled $0.3 million. Provisions contained in our excess of loss reinsurance policies provide for participation of our reinsurers totaling $1.5 million. There was no assessment made for the year ended December 31, 2008.
Pursuant to Section 627.3512, Florida Statutes, insurers are permitted to recoup the assessment by adding a surcharge to policies in an amount not to exceed the amount paid by the insurer to Citizens. Federated National is currently underwriting the recoupment in connection with the Citizens assessments and has recouped approximately $0.1 million, $0.1 million and $1.6 million during 2008, 2007 and 2006, respectively. As noted above, Federated National subrogated $1.5 million to the reinsurers.
Federated National and American Vehicle are also required to participate in an insurance apportionment plan under Florida Statutes Section 627.351, which is referred to as a JUA Plan. The JUA Plan provides for the equitable apportionment of any profits realized, or losses and expenses incurred, among participating automobile insurers. In the event of an underwriting deficit incurred by the JUA Plan which is not recovered through the policyholders in the JUA Plan, such deficit shall be recovered from the companies participating in the JUA Plan in the proportion that the net direct written premiums of each such member during the preceding calendar year bear to the aggregate net direct premiums written in this state by all members of the JUA Plan.
One of our directors is a partner at a law firm that handles some of the Company’s claims litigation. Fees paid to this law firm amounted to approximately $145,000, $80,000 and $258,000 in 2008, 2007 and 2006, respectively, and is included in LAE.
Net income (loss) per share is computed by dividing net income (loss) by the weighted average number of shares of common stock and common stock equivalents outstanding during the periods presented.
A summary of the numerator and denominator of the basic and fully diluted 2008, 2007 and 2006 net income (loss) per share is presented below:
SFAS No. 131, Disclosures About Segments of an Enterprise and Related Information (“SFAS No. 131”), requires that the amount reported for each segment item be based on what is used by the chief operating decision maker in formulating a determination as to how many resources to assign to a segment and how to appraise the performance of that segment. The term chief operating decision maker may apply to the chief executive officer or chief operating officer or to a group of executives. Note: The term of chief operating decision maker may apply to a function and not necessarily to a specific person. This is a management approach rather than an industry approach in identifying segments. The segments are based on the Company’s organizational structure, revenue sources, nature of activities, existence of responsible managers, and information presented to the Board of Directors.
If any one of the following exists, a segment must be reported on:
In 2002, we implemented the 2002 Stock Option Plan. The purpose of this plan is to advance our interests by providing an additional incentive to attract, retain and motivate highly qualified and competent persons who are key to the Company, including key employees, consultants, independent contractors, Officers and Directors. Our success is largely dependent upon their efforts and judgment therefore, by authorizing the grant of options to purchase common stock we encourage stock ownership. Options outstanding under the plan were granted at prices that are above the market value of the stock on the date of grant, vest over a five-year period, and expire six years after the grant date. Under this plan, we are authorized to grant options to purchase up to 1,800,000 common shares, and, as of December 31, 2008 and December 31, 2007, we had outstanding exercisable options to purchase 658,151 and 660,309 shares, respectively.
Options outstanding as of December 31, 2008 are exercisable as follows:
During the year ended December 31, 2008, the Company had two stock-based employee compensation plans and one stock-based franchise compensation plan, which are described above. Prior to January 1, 2006, we accounted for those plans under the recognition and measurement provisions of stock-based compensation using the intrinsic value method prescribed by APB Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations, as permitted by SFAS No. 123. Under these provisions, no stock-based employee compensation cost was recognized in the Statement of Operations as all options granted under those plans had an exercise price equal to or less than the market value of the underlying common stock on the date of grant.
Upon the exercise of options, the Company issues previously outstanding shares.
As a result of adopting SFAS No. 123R on January 1, 2006, the Company’s income from continuing operations before provision for income taxes and net income in 2008 are lower by approximately $483,000 and $301,000, respectively, than if it had continued to account for share-base compensation under ABP Opinion No. 25.
As a result of adopting SFAS No. 123R on January 1, 2006, the Company’s income from continuing operations before provision for income taxes and net income for the year ended December 31, 2007, are lower by approximately $618,000 and $405,000, respectively, than if it had continued to account for share-base compensation under ABP Opinion No. 25.
Basic and diluted earnings per share for the year ended December 31, 2008 would have been ($0.27) if the Company had not adopted SFAS No. 123R, compared with reported basic and diluted earnings per share of ($0.31).
Basic and diluted earnings per share for the year ended December 31, 2007 would have been $2.74 and $2.70, respectively, if the Company had not adopted SFAS No. 123R, compared with reported basic and diluted earnings per share of $2.69 and $2.65, respectively.
The weighted average fair value of options granted during 2008, 2007 and 2006 estimated on the date of grant using the Black-Scholes option-pricing model was $0.59 to $3.63; $2.92 to $5.59 and $3.62 to $5.73, respectively.
We have established a profit sharing plan under Section 401(k) of the Internal Revenue Code. This plan allows eligible employees, except key and highly compensated employees, to contribute up to 100 percent of their compensation not to exceed statutory limits. We contributed $0.1 million in 2008. In 2007 and 2006 we did not contribute to the plan. Our contributions, if any, are vested incrementally over five years.
As of December 31, 2008 and 2007 we have classified $13.5 million and $20.2 million, respectively, of our bond portfolio as held-to-maturity. The decision to classify this layer of our bond portfolio as held-to-maturity was predicated on our intention and ability to hold these securities until maturity.
The 2003 Warrants issued in this placement to the purchasers of the July 2003 Notes and to the placement agent in the offering, J. Giordano Securities Group (“J. Giordano”), each entitled the holder to purchase ¾ of one share of our Common Stock at an exercise price of $12.744 per whole share (as adjusted for the Company’s three-for-two stock split) until July 31, 2006. The total number of shares issuable upon exercise of 2003 Warrants issued to the purchasers of the July 2003 Notes and to J. Giordano totaled 612,074. GAAP required that detachable warrants be valued separately from debt and included in paid-in capital. Based on the terms of the purchase agreement with the investors in the private placement, management determined that the July 2003 Warrants had zero value at the date of issuance.
The September 2004 Notes paid interest at the annual rate of 6%, matured on September 30, 2007, and ranked pari passu in terms of payment and priority to the July 2003 Notes. Quarterly payments of principal and interest due on the September 2004 Notes, like the July 2003 Notes, were made in cash or, at our option, in shares of our Common Stock. When paid in shares of Common Stock, the number of shares issued was determined by dividing the payment due by 95% of the weighted-average volume price for the Common Stock on NASDAQ as reported by Bloomberg for the 20 consecutive trading days preceding the payment date.
In October 2008, the FASB issued FSP FAS 157-3. The purpose of FSP FAS 157-3 was to clarify the application of SFAS No. 157 in a market that is not active. FSP FAS 157-3 did not change the objective of SFAS No. 157. FSP FAS 157-3 was effective upon issuance, including prior periods for which financial statements had not been issued. Our adoption of FSP FAS 157-3 for the year ended December 31, 2008 did not have a material effect on our financial position, results of operations, cash flows or disclosures.
In September 2006, FASB issued SFAS No. 157. SFAS No. 157 defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. SFAS No. 157 also establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. SFAS No. 157 categorizes assets and liabilities at fair value into one of three different levels depending on the observability of the inputs employed in the measurement, as follows:
Level 1 - inputs to the valuation methodology are quoted prices (unadjusted) for identical assets or liabilities in active markets. A quoted price for an identical asset or liability in an active market provides the most reliable fair value measurement because it is directly observable to the market.
Level 2 - inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, and inputs are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument.
Level 3 - inputs to the valuation methodology are unobservable and significant to the fair value measurement
On December 22, 2004, the Company announced a definitive agreement to sell the assets of its subsidiaries, Federated Agency Group, Inc. and Fed USA, Inc., to affiliates of Affirmative Insurance Holdings, Inc. (“Affirmative”) (NASDAQ: AFFM) for approximately $9.5 million. The sale of assets to Affirmative closed on December 31, 2004, at which time the Company received $7 million cash, with up to an additional $2.5 million due in the first quarter of 2006, subject to certain performance criteria being met.