As of December 31, 2009, we leased an aggregate of approximately 461,046 square feet of office space for our agencies, insurance companies and retail stores in various locations throughout the United States. The office space includes a lease for approximately 56,875 aggregate square feet of office space in a common building in Burr Ridge, Illinois, and our Burr Ridge lease term expires in November 2016. We lease approximately 56,888 square feet of office space in Addison, Texas, and our Addison lease term expires in March 2015. We also have three leases of approximately 78,162 aggregate square feet of office space in Baton Rouge, Louisiana. One Baton Rouge lease is for approximately 20,117 square feet of office space with a term that expires in September 2012. The second lease is approximately 6,253 square feet with a term that expires in June 2010. The third Baton Rouge lease is for approximately 51,792 square feet of office space with a term that expires in December 2019. We also presently have one space in Melbourne, Florida with approximately 6,542 square feet which will expire in September 2012. We also have legal offices in Chicago, Baton Rouge and Dallas, which have 4,003, 3,394, and 2,619 square feet, respectively. In addition, we have 201 owned retail stores that presently lease space on an individual basis at various locations in the states in which we do business. None of these individual retail store leases are material to our operations.
In Baton Rouge, Louisiana, we own a building of approximately 177,469 square feet for investment purposes. The building is under a lease agreement with a federal agency. The lease expires on May 15, 2020. However, the federal agency may terminate the lease, in whole or part, upon one hundred twenty days’ written notice after May 15, 2015.
The following selected financial data should be read in conjunction with “
As of December 31, 2009, our subsidiaries included insurance companies licensed to write insurance policies in 40 states, underwriting agencies, and retail agencies with 201 owned stores and relationships 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 9,400 independent agents or brokers in 11 states (Louisiana, Texas, Illinois, Alabama, California, Michigan, Florida, Missouri, Indiana, South Carolina and New Mexico). In February 2010, we notified the Florida Insurance Commissioner of our intent to discontinue writing new and renewal policies in the state of Florida. We plan to begin issuing notices of non-renewal to insureds beginning on May 17, 2010.
Underwriting agencies, which supply centralized infrastructure and personnel required to design and service insurance policies that are distributed through retail agencies;
The preparation of our consolidated financial statements in conformity with U. S. generally accepted accounting principles (generally accepted accounting principles) requires us to make estimates and assumptions when applying our accounting policies. Critical accounting policies are defined as those that are reflective of significant judgments and uncertainties, and potentially result in materially different results under different assumptions and conditions. The Company’s critical accounting policies are described below. For a detailed discussion on the application of these and other accounting policies, see note 2 of Notes to Consolidated Financial Statements which appears in Item 8 of this Annual Report.
We track monthly the actual emergence of loss and loss adjustment expense data by accident period and compare it to the expected emergence. We review any deviations and determine if it is appropriate to revise any assumptions that they will use to develop loss and loss adjustment expense reserve estimates.
We review loss reserve adequacy quarterly by accident year at a state, program and coverage level. Carried reserves are adjusted as additional information becomes known. Such adjustments are reflected in our current year operations.
At December 31, 2009, our receivables from reinsurers included $14.7 million net recoverable from VFIC. At December 31, 2009, the VFIC Trust held $17.5 million to collateralize the $14.7 million net recoverable from VFIC. We have, with the approval of the VFIC Special Deputy Receiver and the District Court, Austin, Texas, withdrawn $7.6 million from the trust securing our reinsurance recoverables from VFIC, which represented 100% of the amount we paid in losses as of the date of the withdrawal covered by the VFIC reinsurance. We have made arrangements with the VFIC Special Deputy Receiver to submit quarterly statements for approval to withdraw additional funds from the trust based upon losses paid.
We routinely monitor the collectibility of the reinsurance recoverables of our insurance companies to determine if an amount is potentially uncollectible. Our evaluation is based on periodic reviews of our aged recoverables, as well as our assessment of recoverables due from reinsurers known to be in financial difficulty. Excluding VFIC, all reinsurers are currently rated A- or better by A. M. Best. Our estimates and judgment about collectibility of the recoverables and the financial condition of reinsurers can change, and these changes can affect the level of reserve required.
As of December 31, 2009 and 2008, 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.
period earnings. Fair value is estimated using third-party valuation sources. We entered into a settlement agreement with our broker on the auction-rate securities, whereby the broker will be required to buy back the securities at par. Such buybacks are expected to occur between July 2010 and two years thereafter.
Based upon the results of our September 30, 2009 evaluation, we concluded that the carrying values of goodwill and other intangible assets were not impaired as of September 30, 2009. In 2008, management concluded that the carrying value of other intangible assets related to the Company’s Florida operations exceeded their fair value, resulting in an impairment charge of $4.4 million for indefinite lived other intangible assets and $0.2 million for amortizing other intangible assets.
Key inputs in our valuation model are projected cash flows, future inflationary trends, future tax rates, and the risk-adjusted discount rate. The risk-adjusted discount rate was developed using a capital asset pricing model to estimate our weighted-average cost of capital. The relative mix of capital between debt and equity was estimated at approximately 34 percent based on observed industry averages.
Interim testing is not performed unless an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. Examples of such events or circumstances include significant adverse changes in the business climate, a decision to sell or dispose of all or a significant portion of a reporting unit, or a significant decline in the Company’s stock price. Management evaluated whether any other events occurred or circumstances changed that would trigger the requirement of an interim impairment
test of goodwill, and determined that there were none. Therefore no update of the goodwill impairment test was necessary at December 31, 2009.
The FASB issued the FASB Accounting Standards Codification (ASC or Codification) for financial statements issued for interim and annual periods ending after September 15, 2009. The Codification became the single authoritative source for GAAP. Accordingly, previous references to GAAP accounting standards are no longer used in our disclosures, including these Notes to the Consolidated Financial Statements. Adoption of the Codification did not affect the Company’s consolidated financial position, cash flows, or results of operations. Future updates to the ASC are referred to as Accounting Standards Updates (ASU’s).
ASU 2009-16 eliminates the concept of a qualifying special-purpose entity, creates more stringent conditions for reporting a transfer of a portion of a financial asset as a sale, clarifies other sale-accounting criteria, and changes the initial measurement of a transferor’s interest in transferred financial assets. This standard will be effective for fiscal years beginning after November 15, 2009. The adoption of the new standards is not expected to have an impact on our consolidated financial position, results of operations or cash flows.
The following table sets forth the components of consolidated statements of income (loss) from continuing operations as a percentage of revenues and certain operational information from continuing operations for the periods indicated (in thousands).
Total revenues for 2009 increased $9.8 million, or 2.2%, to $456.2 million from $446.5 million for 2008.
Total gross premiums written for 2009 decreased $17.2 million, or 4.5%, compared with 2008 primarily due to macroeconomic factors. In our retail distribution channel, gross premiums written consist of premiums written for our affiliated insurance carriers’ products only and do not include premiums written for third-party insurance carriers in our retail and franchised stores. We earn only commission income and fees in our retail distribution channel for sales of third-party insurance policies.
Gross premiums written in our retail distribution channel for 2009 decreased $27.8 million, or 11.9%, when compared with 2008. These declines were primarily due to the negative macroeconomic environment. In our independent agency distribution channel, gross premiums written for 2009 increased $15.5 million, or 12.8%,
compared with 2008. This increase was primarily due to the expansion of independent agency relationships. Gross premiums written by our unaffiliated underwriting agencies for 2009 decreased $4.9 million, or 16.1%, compared with 2008.
In the third quarter of 2009, we began to implement changes in pricing to improve our premium production levels and profitability. The states of Illinois, Indiana, Michigan and South Carolina were targeted for these changes. We expect it to take about one year before the full benefits from these actions are realized.
The following table displays our gross premiums written by state for the years ended December 31, 2009, 2008 and 2007 (in thousands):
The following table displays our net premiums written by distribution channel for 2009, 2008 and 2007 (in thousands):
The following table sets forth net premiums earned by distribution channel for 2009, 2008 and 2007 (in thousands):
Net premiums earned for 2008 decreased $38.7 million, or 9.8%, compared with 2007. This decline was due to the decline in gross written premiums. Net premiums earned during 2008 on policies sold through our affiliated underwriting agencies decreased by $30.5 million, or 8.6%. Net premiums earned on insurance products sold through the unaffiliated underwriting agencies distribution channel decreased by $8.3 million, or 20.7%, compared with 2007.
The amount of recoveries pertaining to quota-share reinsurance contracts that were deducted from losses and loss adjustment expenses incurred during 2009 and 2008 was approximately $7.1 million and $31.3 million, respectively. The amount of loss reserves and unearned premium we would remain liable for in the event our reinsurers are unable to meet their obligations is as follows for the years ended December 31, 2009, 2008 and 2007 (in thousands):
The Michigan Catastrophic Claims Association (MCCA) is a reinsurance facility that covers no-fault medical losses above a specific retention amount. For policies effective July 1, 2009 to June 30, 2010, the
The following sets forth the components of consolidated commission income and fees earned for the years ended December 31, 2009, 2008 and 2007 (in thousands):
Commission income and fees decreased $9.0 million, or 10.5%, in 2008 compared with 2007. The decrease was primarily due to a decline in policyholder fees due to the decline in premium production. Agency fees increased due to additional fees that we began collecting in April 2008.
At December 31, 2009, our fixed-income investments were invested in the following: U.S. Treasury and government agencies securities 9.8%, corporate debt securities 25.5%, residential mortgage-backed securities 1.9%, and states and political subdivisions securities 62.8%. The average quality of our portfolio was AA- at December 31, 2009. We attempt to mitigate interest rate risk by managing the duration of our fixed-income portfolio to a target range of three years or less. As of December 31, 2009, the effective duration of our fixed-income investment portfolio was 1.5 years.
Net investment income for 2008 decreased $2.7 million, or 16.4%, compared with 2007, consisting of a $2.1 million decrease in investment income on debt securities, slightly offset by a $0.2 million increase in lease income from investment in real property. The decrease was primarily due to a 10.6% decrease in total average invested assets to $310.7 million during 2008 from $347.5 million during 2007. The average investment yield was 4.1% (5.6% on a taxable equivalent basis) in 2008 as compared to 4.5% (5.9% on taxable equivalent basis) in 2007.
December 31, 2009, the fair value of the settlement was $8.8 million, which we reported in other assets with the decrease in fair value of $0.8 million during 2009, reported in other income (loss).
Losses and Loss Adjustment Expenses. Losses and loss adjustment expenses for 2009 increased $13.8 million, or 5.0%, compared with 2008. The percentage of losses and loss adjustment expense to net premiums earned (the loss ratio) was 78.9% in 2009, compared with 76.8% in 2008. The increase was primarily due to increased losses from adverse development on reserve estimates for prior accident years of $14.8 million primarily due to our Florida business.
In the third quarter of 2009, we undertook a study to assess how we carry out our claims administration activities. Through this review, we identified specific actions to achieve organizational efficiencies and reduce our loss and loss adjustment expenses. We started to implement these steps in the fourth quarter of 2009 and expect these actions to have a significant impact on mitigating our loss and loss adjustment expenses. We expect it to take about one year before the full benefits from these actions are realized.
Losses and loss adjustment expenses for 2008 decreased $15.3 million, or 5.3%, compared with 2007. The percentage of losses and loss adjustment expense to net premiums earned was 76.8% in 2008 compared with 73.2% in 2007. The loss ratio for the year increased to 76.8% in 2008, compared with 73.2% in 2007. This increase was primarily the result of having adverse development in 2008 compared with favorable development in 2007, an increase in the current accident year loss ratio and hurricane losses. The adverse development and increase in the current accident year loss ratio were primarily due to increased losses from Florida policies. The Florida losses were the result of our decision to push the full coverage product in Florida in 2007. The Company had $2.5 million in losses in 2008 related to Hurricanes Gustav and Ike.
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. 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.
The following table presents the development of reserves for unpaid losses and loss adjustment expenses from 1999 through 2009 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.
In July 2009, we suspended matching contributions to the 401(k) plan. This action is expected to decrease selling, general and administrative expenses by approximately $1.0 million annually. We are also in the process of implementing or have completed the following organizational changes including:
conducting a general business unit review to identify and implement additional expense savings opportunities.
Additions to deferred acquisition costs and the related amortization increased in 2009 by $8.9 million and $4.1 million, respectively. This increase reflects the reduction of ceding commissions received in 2009 of $13.1 million as a result of reducing our dependence on reinsurance, which includes the return of $2.6 million in ceding commissions in 2009 upon termination of the Louisiana and Alabama reinsurance contracts. The slight increase in amortization as a percentage of net premiums earned in 2009 from 2008 was the result of de-leveraging of certain costs relative to the decline in volume of gross premiums written as well as a shift from affiliate to third party policies written in 2009 over 2008.
Depreciation and Amortization. Depreciation and amortization expenses for 2009 increased $0.4 million, or 4.4%, compared with 2008. Depreciation expense increased by $1.6 million, or 21.9%, primarily due to the implementation of the insurance systems mentioned above and amortization expense decreased by $1.2 million, or 68.1%, for 2009 primarily as a result of decreasing amortization related to the purchase of USAgencies.
Depreciation and amortization expenses for 2008 decreased $2.0 million, or 17.8%, compared with 2007. Depreciation expense increased by $2.1 million or 40.5%. The increase was primarily due to the implementation of the agency management, premium finance and insurance systems. Amortization expense decreased $4.1 million or 69.8% for the current period. The decrease is primarily a result of agreements that were fully amortized in 2007.
Interest Expense. Interest expense for 2009 increased $5.1 million, or 27.9%, compared with 2008. This increase reflects the amortization of loan discount of $5.7 million resulting from the modification of the senior credit facility as well as the increased interest rate, which was partially offset by a lower loan balance due to principal reductions. The average principal balance of our senior secured credit facility was $133.3 million during 2009, a decrease of $19.5 million, or 12.8%, from the average principal balance during 2008. In 2009, we repaid $6.7 million of the senior secured facility. We have a mandatory principal payment due March 2010 of $0.8 million.
Interest expense for 2008 decreased $6.7 million, or 26.6%, compared with 2007. The decrease in interest expense was due to the lower level of average debt outstanding. The average balance of our senior secured credit facility was $152.8 million during 2008, a decrease of $46.3 million, or 23.3%, from the average balance during 2007. In 2008, we repaid $66.3 million of the senior secured facility.
Other Intangible Asset Impairment Charges. The Company incurred an impairment charge of $4.6 million in the third quarter of 2008 resulting from its annual review of goodwill and other intangible assets. Based on its assessment, the Company concluded that the carrying value of other intangible assets exceeded its fair value for the Florida operations.
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, 2009, our insurance companies could not pay ordinary dividends to us without prior regulatory approval due to a negative unassigned surplus position. However, as mentioned previously, our nonregulated entities provide adequate cash flow to fund their own operations. Dividend payments of $7.3 million were received from our insurance company subsidiaries in 2008. In February 2009, we obtained approval from the New York Department of Insurance for one of our insurance subsidiaries to retire one million shares of its stock for $2.9 million and approved payment of an extraordinary dividend for $100,000.
We believe that existing cash and investment balances, as well as new cash flows generated from operations and available borrowings under our other credit facilities, will be adequate to meet our capital and liquidity needs during the 12-month period following the date of this report at both the holding company and insurance company levels. We do not currently know of any events that could cause a material increase or decrease in our long-term
Asset sales are now allowed for transactions with less than 80% of cash proceeds. Financing is limited to $5 million per transaction and $10 million in the aggregate.
The following table summarizes our contractual obligations at December 31, 2009 (in thousands):
(2) All of the outstanding notes payable at December 31, 2009 are redeemable in whole or in part after five years of 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. 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.
(3) The principal amount of the Borrowing is payable in quarterly installments with the remaining balance due on the seventh anniversary of the closing of the facility. Beginning in 2008, 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. The Company has an additional required principal payment due March 2010 of $0.8 million.
We have audited the accompanying consolidated balance sheets of Affirmative Insurance Holdings, Inc. and subsidiaries (the Company) as of December 31, 2009 and 2008, and the related consolidated statements of income (loss), stockholders’ equity and comprehensive income (loss), and cash flows for each of the years in the three-year period ended December 31, 2009. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We have audited Affirmative Insurance Holdings, Inc. and subsidiaries’ (the Company) internal control over financial reporting as of December 31, 2009, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). 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 section of Item 9A. titled Management’s 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.
A material weakness is a deficiency, or combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the company’s annual or interim financial statements will not be prevented or detected on a timely basis. A material weakness related to ineffective controls over the preparation and review of the provision for income taxes has been identified and included in management’s assessment. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Affirmative Insurance Holdings, Inc. and subsidiaries as of December 31, 2009 and 2008, and the related consolidated statements of income (loss), stockholders’ equity and comprehensive income (loss), and cash flows for each of the years in the three-year period ended December 31, 2009. This material weakness was considered in determining the nature, timing, and extent of audit tests applied in our audit of the 2009 consolidated financial statements, and this report does not affect our report dated March 30, 2010, which expressed an unqualified opinion on those consolidated financial statements.
Cash and Cash Equivalents • Cash and cash equivalents are highly liquid investments with an original maturity of ninety days or less and include principally money market funds, repurchase agreements, and other bank deposits.
Investments are considered to be impaired when a decline in fair value is judged to be other-than-temporary. On a quarterly basis, the Company considers available quantitative and qualitative evidence in evaluating potential impairment of its investments. If the cost of an investment exceeds its fair value, the Company evaluates, among other factors, general market conditions, the duration and extent to which the fair value is less than cost, and the Company’s intent to sell the security or whether its more likely than not that the Company would be required to sell the security before its anticipated recovery in market value. The Company also considers potential adverse conditions related to the financial health of the issuer based on rating agency actions.
companies report as assets the estimated reinsurance recoverable on paid losses and unpaid losses, including an estimate for losses incurred but not reported.
Deferred Acquisition Costs • Deferred acquisition costs represent the deferral of expenses that we incur to acquire new business or renew existing insurance policies. Acquisition costs, consisting primarily of commissions, advertising, premium taxes, underwriting and agency expenses, are deferred and charged against income ratably over the terms of the related policies. We regularly review the categories of acquisition costs that are deferred and assess 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. Amounts received as expense allowances on reinsurance contracts that represent reimbursement of acquisition costs are recorded as reductions of deferred acquisition costs.
unreported claims. The estimation of the ultimate liability for unpaid losses and loss adjustment expenses is based on projections developed by the Company’s actuaries using analytical methodologies commonly used in the property-casualty insurance industry. Liabilities for unpaid claims and for expenses of investigation and adjustment of unpaid claims are based on: (1) the accumulation of estimates of individual claims for losses reported prior to the close of the accounting period; (2) estimates received from ceding companies, reinsurers and insurance pools and associations; (3) estimates of unreported losses based on past experience; (4) estimates based on past experience of expenses for investigating and adjusting claims; and (5) estimates of subrogation and salvage collections. Management periodically adjusts the losses and loss adjustment expense reserves for changes in product mix, underwriting standards, loss cost trends and other factors. Losses and loss adjustment expense reserves may also be impacted by factors such as the rate of inflation, claims settlement patterns, litigation and 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.
on a straight-line basis over the period in which the employee is required to provide service in exchange for the award.
In 2008, the Company adopted FASB ASC 825, Financial Instruments, which allows companies to choose to measure eligible financial instruments and certain other items at fair value that are not required to be measured at fair value. The Company elected the fair value option for the settlement rights associated with the Company’s auction-rate securities as discussed under Settlement Agreement above.
Segment Reporting • The Company’s operations consist of designing, selling, underwriting and servicing non-standard personal automobile insurance policies. The Company is a holding company, with no operating revenues and only interest expense on corporate debt. The Company’s subsidiaries consist of several types of legal entities: insurance companies, underwriting agencies, retail agencies, and a service company from which all employees are paid. Insurance subsidiaries possess the certificates of authority and capital necessary to transact insurance business and issue policies, but they rely on both affiliated and unaffiliated underwriting agencies to design, distribute and service those policies. Underwriting agencies primarily design, distribute and service policies issued or reinsured by the Company’s insurance subsidiaries and that are distributed by the Company’s retail entities and by independent agents. Given the homogeneity of the Company’s products, the regulatory environments in which the Company operates, the nature of the Company’s customers and distribution channels, Company management monitors, controls and manages the business as an integrated entity offering non-standard personal automobile insurance products through multiple distribution channels.
Recently Issued Accounting Standards • The FASB issued the FASB Accounting Standards Codification (ASC or Codification) for financial statements issued for interim and annual periods ending after September 15, 2009. The Codification became the single authoritative source for GAAP. Accordingly, previous references to GAAP accounting standards are no longer used in our disclosures, including these Notes to the Consolidated Financial Statements. Adoption of the Codification did not affect the Company’s consolidated financial position, cash flows, or results of operations. Future updates to the ASC are referred to as Accounting Standards Updates (ASU’s).
ASU 2009-16 eliminates the concept of a qualifying special-purpose entity, creates more stringent conditions for reporting a transfer of a portion of a financial asset as a sale, clarifies other sale-accounting criteria, and changes the initial measurement of a transferor’s interest in transferred financial assets. This standard will be effective for fiscal years beginning after November 15, 2009. The adoption of the new standards is not expected to have an impact on the Company’s consolidated financial position, results of operations or cash flows.
Generally, the interest rates for these securities are determined by bidding every 7, 28 or 35 days. When there are more sellers than buyers, an auction fails and bondholders that want to sell are unable to sell the securities. Auctions for these securities began to fail in early 2008 and investment banks stopped committing capital to auctions. Issuers remain obligated to pay interest and principal when due when an auction fails. Rates at failed auctions are set at a level established in the terms of the debt.
In August 2008, the Company’s broker announced settlements in principle with each of the Division of Enforcement of the U.S. Securities and Exchange Commission (SEC), the New York Attorney General and other state agencies to purchase all of its clients’ auction-rate securities at par and several other items, including fines. In October 2008, the Company’s broker filed a prospectus with the SEC, which published a legally-binding offer to all authorized holders of auction-rate securities in the Company’s broker’s accounts (“the settlement”). The time frames that the Company’s broker has set for buybacks have different start dates based upon the individual client’s size, which is determined by each client’s balance of investments held at the Company’s broker. For the majority of the Company’s auction-rate holdings, the buybacks are expected to occur between July 2010 and two years thereafter. In November 2008, the Company elected to participate in its broker’s offer to purchase the Company’s auction-rate securities at par. In November 2008, the Company classified its portfolio of auction-rate securities as trading. At December 31, 2009 and 2008, the fair value of the settlement was $8.8 million and $9.6 million, respectively, which is recorded in other assets in the consolidated balance sheets with changes in fair value recorded in other income in the consolidated statements of income (loss).
Expected maturities may differ from contractual maturities because certain borrowers may have the right to call or prepay obligations with or without penalties. The Company’s amortized cost and estimated fair value of trading securities at December 31, 2009 by contractual maturity are as follows (in thousands):
The amortized cost, gross unrealized gains (losses), and estimated fair value of the Company’s available-for-sale securities at December 31 were as follows (in thousands):
Major categories of net investment income for the years ended December 31 were as follows (in thousands):
The Company’s portfolio contains approximately 22 individual investment securities that are in an unrealized loss position.
At December 31, 2009 and 2008, investments in fixed-maturity securities with an approximate carrying value of $9.4 million and $9.6 million, respectively, were on deposit with regulatory authorities as required by insurance regulations.
On April 1, 2007, the Company exercised its option to terminate certain quota-share contracts on a “cut-off” basis. In April 2007, the Company received $31.0 million to settle the unearned premiums less return ceding commissions. Effective January 1, 2009, the Company terminated its quota-share reinsurance contract on a cut-off basis and received $10.5 million of returned unearned premiums, net of $2.6 million returned ceding commissions.
The Michigan Catastrophic Claims Association (MCCA) is a reinsurance facility that covers no-fault medical losses above a specific retention amount. For policies effective July 1, 2009 to June 30, 2010, the required retention is $0.5 million. As a writer of personal automobile policies in the state of Michigan, the Company cedes premiums and claims to the MCCA. Funding for MCCA comes from assessments against 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. The Company’s ceded premiums written to the MCCA were $2.4 million, $1.9 million and $3.6 million in 2009, 2008 and 2007, respectively.
At December 31, 2009, the Company’s total receivables from reinsurers were $42.1 million, consisting of $4.0 million from a quota-share reinsurer (rated A- by A.M. Best) for business reinsured in Louisiana and Alabama, $14.7 million net receivable (net of $2.5 million payable) from subsidiaries of Vesta Insurance Group (VIG), including primarily Vesta Fire Insurance Corporation (VFIC), $18.4 million receivable from the Michigan Catastrophic Claims Association, the mandatory reinsurance association in Michigan and $5.0 million receivables from other reinsurers. 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, 2009, the VFIC Trust held $17.5 million (after cumulative withdrawals of $7.6 million through December 31, 2009), consisting of $12.7 million of a U.S. Treasury money market account and $4.8 million of corporate bonds rated BBB or higher, to collateralize the $14.7 million net recoverable from VFIC.
In June 2006, the Texas Department of Insurance (TDI) placed VFIC, along with several of its affiliates, into rehabilitation and subsequently into liquidation (except for VIG which remains in rehabilitation). In accordance with the TDI liquidation orders, all VIG subsidiary reinsurance agreements were terminated. Prior to the termination, the Company assumed various quota-share percentages according to which managing general agents (MGAs) produced the business. With respect to business produced by certain MGAs, the Company assumed 100% of the contracts. For business produced by other MGAs, the Company’s assumption was net after VIG cession to other reinsurers. For this latter assumed business, the other reinsurers and their participation varied by MGA. Prior to the termination of the VIG subsidiary reinsurance agreements, the agreements contained no maximum loss limit other than the underlying policy limits. The ceding company’s retention was zero and these agreements could be terminated at the end of any calendar quarter by either party with prior written notice of not less than 90 days.
Premium finance receivables (related to policies of both the Company and third-party carriers) are secured by unearned premiums from the underlying insurance policies and consisted of the following at December 31, 2009 and 2008 (in thousands):
Policy acquisition costs, consisting primarily of commissions, advertising, premium taxes, underwriting and agency expenses, 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):
Amortization of deferred policy acquisition costs is recorded in SG&A expenses in the consolidated statement of income/(loss). Amortization of deferred policy acquisition costs was $70,182 for 2007.
Property and equipment, net, consisted of the following as of December 31, 2009 and 2008 (in thousands):
The Company recognized a gain on disposal of assets of $353,000 and $12,000 in 2009 and 2008, respectively. In 2007, the Company realized losses on disposal of assets of $146,000.
intangible assets were not impaired as of September 30, 2009. As of September 30, 2008, the Company concluded that the carrying value of other intangible assets related to the Company’s Florida operations exceeded their fair value, resulting in an impairment loss of $4.4 million for indefinite lived other intangible assets and $0.2 million for amortizing other intangible assets. The impairment loss is included in other intangible assets impairment in the consolidated statement of income.
Changes in the carrying value of goodwill for the year ended December 31, 2009 and 2008 were as follows (in thousands):
The Company had adverse reserve development relating to prior year losses of $14.8 million and $3.7 million in 2009 and 2008, respectively, primarily due to the Company’s Florida business. The Florida losses were the result of the Company’s decision to promote the full coverage product in Florida in 2007 in response to the Personal Injury Protection sunset in that state on October 1, 2007. Inadequate pricing and product management produced significantly higher losses than anticipated. The Company had favorable development of $5.0 million in 2007. These reserve changes resulted from revisions to the estimates of the ultimate liability for losses and related loss adjustment expense for claims reported in previous periods.
The Company’s long-term debt instruments and balances outstanding at December 31, 2009 and 2008 were as follows (in thousands):
The $30.9 million notes payable due 2035 are redeemable in whole or in part by the issuer after five years. The notes were issued in December 2004 and bear an initial interest rate of 7.545 percent until March 15, 2010, at which time the securities will adjust quarterly to the three-month LIBOR rate plus 3.6 percent.
The $25.8 million notes payable due 2035 are redeemable in whole or in part by the issuer after five years. The notes were issued in June 2005 and bear an initial interest rate of 7.792% until June 15, 2010, at which time they will adjust quarterly to the three-month LIBOR rate plus 3.55 percent.
On March 27, 2009, the Company entered into an amendment to the senior secured credit facility. The amendment included the following changes:
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. Beginning in 2008, the Company was 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. In addition, certain events, such as the sale of material assets or the issuance of significant new equity, necessitate additional required principal repayments. The Company has an annual additional required principal payment due March 2010 of $0.8 million.
The interest rate on the borrowings under the facility at December 31, 2009 was 9.25%, which is the sum of the LIBOR floor of 3.0% plus 6.25%, based on the Company’ s leverage ratio.
The Company recognized an income tax expense from continuing operations of $22.4 million for the year ended December 31, 2009 as compared to income tax benefit from continuing operations of $0.8 million for the year ended December 31, 2008. The Company’s effective tax rate from continuing operations of 152.8% for the year ended December 31, 2009 differed from the federal statutory rate primarily as a result of the recognition of a deferred tax asset valuation allowance and investment income generated by tax-exempt securities.
As of December 31, 2009, 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, 2009, the Company had available approximately $2.9 million of capital loss carryforwards resulting primarily from sales of securities in 2006 and 2007 to adjust the duration of the Company’s investment portfolio. These 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.
As of December 31, 2009, the Company leased office space for its agencies, insurance companies and retail stores in various locations throughout the United States. The Company’s operating lease rental expenses were $8.8 million, $9.6 million and $10.2 million for the years ended December 31, 2009, 2008 and 2007, respectively.
In September 2009, plaintiff Toni Hollinger filed a putative class action in the U.S. District Court for the Eastern District of Texas against several county mutual insurance companies and reinsurance companies, including Affirmative Insurance Company. The complaint alleges that defendants engaged in unfair discrimination and violated the Texas Insurance Code by charging different policy fees for the same class and hazard of insurance written through county mutual insurance companies. Defendants have filed motions to dismiss contesting jurisdiction and the merits of plaintiff’s claims. The Company believes that this claim lacks merit and intends to defend itself vigorously.
In January 2010, the Circuit Court of Cook County, Illinois granted plaintiff Valerie Thomas leave to amend her complaint to assert a putative class action against Affirmative Insurance Company. The complaint alleges that Affirmative failed to provide a statutory 5% premium discount to insureds who had anti-theft devices installed as standard equipment on their vehicles even when the insureds did not disclose the existence of such devices to Affirmative. The case has been consolidated with several identical class actions against other insurance companies. The defendants have filed motions to dismiss the class action complaints in their entirety. The Company believes that this claim lacks merit and intends to defend itself vigorously.
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. At this time, we are uncertain of the probability of the outcome of plaintiff’s appeal and therefore cannot reasonably estimate the ultimate liability.
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, 2009, 2008 and 2007 (in thousands, except per share amounts):
The weighted average grant date fair value of stock options granted during 2007 was $2.50.
Stock options outstanding and exercisable at December 31, 2009 were as follows (shares in thousands):
The stock options outstanding and exercisable at December 31, 2009 had aggregate intrinsic values of zero as the aggregate exercise price was greater than the aggregate market value. No stock options were exercised during 2009 or 2008. Stock options exercised during 2007 had an aggregate intrinsic value of $110,000.
The Company recognized total compensation expense related to the restricted stock awards of $379,000, $377,000 and $375,000 during 2009, 2008 and 2007, respectively. Compensation expense is included in selling, general and administrative expenses in the consolidated statement of income. As of December 31, 2009, there was approximately $586,000 of total unrecognized compensation cost related to unvested restricted stock awards, which will be recognized over a weighted average period of approximately 1.8 years.
The aggregate fair value of restricted stock awards vested during 2009, 2008 and 2007 was $101,000, $73,000 and $261,000, respectively, at the date of vesting.
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 or trading, cash equivalents, other receivables and interest rate swaps. Following is a brief description of the type of valuation information that qualifies a financial asset for each level:
Level 2 - Observable prices in active markets for similar assets or liabilities. Prices for identical or similar assets or liabilities in markets that are not active. Directly observable market inputs for substantially the full term of the asset or liability, e.g., interest rates and yield curves at commonly quoted intervals, volatilities, prepayment speeds, default rates, and credit spreads. Market inputs that are not directly observable but are derived from or corroborated by observable market data.
Financial assets classified as Level 1 in the fair value hierarchy include U.S. Government bonds and certain government agencies securities, corporate bonds, and cash or cash equivalents. U.S. Government bonds and corporate bonds are traded on a daily basis and the Company estimates the fair value of these securities using unadjusted quoted market prices. Cash and 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, and certain auction-rate tax-exempt securities that have auctions on a regular basis that do not fail. 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.
The Company’s Level 3 financial assets include certain illiquid auction-rate tax-exempt securities. Observable market inputs for certain auction-rate tax-exempt securities that have experienced failed auctions as a result of liquidity issues in the global credit and capital market are not readily available. The fair value of these securities is estimated using third-party valuation sources.
Fair value measurements for liabilities in category Level 3 for the year ended December 31, 2009 were as follows (in thousands):
Historically, the Company’s interest rate swaps qualified as cash flow hedges for hedge accounting. Accordingly, the Company recorded changes in fair value of the interest rate swaps in accumulated other comprehensive income (loss), net of tax. The credit risk associated with these swap agreements is limited to the uncollected interest payments due from counterparties. As of December 31, 2009, counterparty credit risk was minimal.
Gains and losses (realized and unrealized) for Level 3 assets and liabilities included in earnings for the year ended December 31, 2009, are reported in net investment income, other income and loss on interest rate swaps as follows:
Notes payable - The fair values of the notes payable were determined using a third-party valuation source and were estimated to be $25.5 million in the aggregate with a total carrying value of $76.9 million at December 31, 2009.
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 $98.9 million with a carrying value of $111.5 million at December 31, 2009.
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 $0.3 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, 2009.