The process of determining significant estimates is fact specific and takes into account factors such as historical experience, current and expected economic conditions, and in the case of unpaid loss and LAE, an actuarial valuation. Management regularly reevaluates these significant factors and makes adjustments where facts and circumstances dictate. In selecting the best estimate, we utilize various actuarial methodologies. Each of these methodologies is designed to forecast the number of claims we will be called upon to pay and the amounts we will pay on average to settle those claims. In arriving at our best estimate, our actuaries consider the likely predictive value of the various loss development methodologies employed in light of underwriting practices, premium rate changes and claim settlement practices that may have occurred, and weight the credibility of each methodology. Our actuarial methodologies take into account various factors, including, but not limited to, paid losses, liability estimates for reported losses, paid allocated loss adjustment expenses, salvage and other recoveries received, reported claim counts, open claim counts and counts for claims closed with and without payment of loss.
In June 2006, the Financial Accounting Standards Board (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. 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 is currently evaluating the impact, if any, that FIN 48 will have on its Consolidated Financial Statements. Additionally, we are developing a process to capture and quantify any such effect that FIN 48 could have on the Company.
In September 2006, FASB issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans.” This statement requires an employer to recognize the overfunded or underfunded status of a single-employer defined benefit postretirement plan as an asset or liability in its statement of financial position and to recognize changes in the funded status in the year in which the changes occur through comprehensive income. SFAS No. 158 will become effective for years ending after December 15, 2006. There was no impact on our consolidated financial statements with respect to the adoption of SFAS No. 158.
We did not hold any non-traded investment securities during 2006 or 2005.
During December 2005, we classified $19.7 million 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 to establish an irrevocable letter of credit in order to facilitate business opportunities in connection with our commercial general liability program. During April 2006, American Vehicle finalized the irrevocable letter of credit in conjunction with the 100% Quota Share Reinsurance Agreement with Republic Underwriters Insurance Company.
The investments held at December 31, 2006 and December 31, 2005 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. All of the equity holdings are in income funds.
Cash and short term investments, which include cash, certificates of deposits, and money market accounts increased $11.8 million, or 195.1%, to $17.9 million as of December 31, 2006, as compared to $6.1 million as of December 31, 2005. These balances are held primarily in money market accounts and are available for the settlement of hurricanes related claims.
Finance contracts receivable, net of allowance for credit losses, decreased $5.5 million, or 75.0%, to $1.8 million as of December 31, 2006, as compared to $7.3 million as of December 31, 2005. 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 investments.
Premiums receivable, net of allowance for credit losses, decreased $0.3 million, or 3.8%, to $7.2 million as of December 31, 2006, as compared to $7.5 million as of December 31, 2005.
Our commercial general liability insurance premiums receivable increased $0.4 million, or 19.0%, to $2.7 million as of December 31, 2006, as compared to $2.3 million as of December 31, 2005.
Reinsurance recoverable, net, decreased to nothing as of December 31, 2006, as compared to $136.7 million as of December 31, 2005. The decrease is due to the timing of settlements with our reinsurers in connection with the adjustment of loss and LAE claims as they relate to costs recoverable under our reinsurance agreements.
Deferred policy acquisition costs increased $2.0 million, or 21.4%, to $11.2 million as of December 31, 2006, as compared to $9.2 million as of December 31, 2005. The increased production volume for both the homeowners’ and commercial general liability product lines is the reason for the increase to this asset.
Income taxes receivable increased to $0.8 million as of December 31, 2006, as compared to nothing as of December 31, 2005. The change is due to tax payment patterns in connection with our tax liabilities.
Other assets remained at $4.6 million as of December 31, 2006, as compared to $4.6 million as of December 31, 2005. Major components of other assets are as follows:
Factors that affect unpaid losses and LAE include the estimates made on a claim-by-claim basis known as “case reserves” coupled with bulk estimates known as IBNR. Periodic estimates by management of the ultimate costs required to settle all claim files are based on the Company’s analysis of historical data and estimations of the impact of numerous factors such as (i) per claim information; (ii) company and industry historical loss experience; (iii) legislative enactments, judicial decisions, legal developments in the awarding of damages, and changes in political attitudes; and (iv) trends in general economic conditions, including the effects of inflation. 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 increased $16.0 million, or 25.9%, to $77.8 million as of December 31, 2006, as compared to $61.8 million as of December 31, 2005. The increase was due to an $18.9 million increase in unearned homeowners’ insurance premiums, a $4.5 million increase in unearned commercial general liability premiums, and a $7.4 million decrease in unearned automobile premiums. These changes reflect our continued emphasis in 2006 on property and commercial general liability insurance products.
Due to reinsurers, net increased to $4.2 million as of December 31, 2006, as compared to nothing as of December 31, 2005 at which time the Company had an asset, Reinsurance recoverable, net. Due to the lack of catastrophic events in 2006, loss recoveries were not sufficiently greater than premiums due reinsurers, resulting in a net payable for the year ended December 31, 2006.
Premium deposits and customer credit balances increased $1.6 million, or 76.8%, to $3.8 million as of December 31, 2006, as compared to $2.1 million as of December 31, 2005. Premium deposits are monies received on policies not yet in force as of December 31, 2006. The change is due to our policyholders purchasing patterns, the Company’s marketing efforts and our policies renewal patterns.
Revolving credit outstanding decreased to nearly nothing as of December 31, 2006, as compared to $0.2 million as of December 31, 2005. The decrease is due to our cash management efforts, our requested credit reduction, and sale in December 2004 of our assets related to our non-standard automobile insurance agency business in Florida and the derived finance contracts receivable.
Bank overdraft decreased $4.1 million, or 33.8%, to $8.1 million as of December 31, 2006, as compared to $12.2 million as of December 31, 2005. The bank overdraft relates to primarily to loss and LAE disbursements paid but not yet presented for payment by the policyholder or vendor. The decrease relates to our payment patterns in relationship to the rate at which those cash disbursements are presented to the bank for payment.
Income taxes payable decreased to nothing as of December 31, 2006, as compared to $3.0 million as of December 31, 2005. The change is due to tax payment patterns in connection with our tax liabilities.
As noted above, the Company’s efforts to expand commercial general liability lines of insurance products are coming to fruition, as reflected by increased premiums written of $9.6 million, or 42.6 % to $32.2 million for the year ended December 31, 2006, as compared to $22.6 million for the year ended December 31, 2005.
The Company’s sale of homeowners’ policies increased $38.2 million, or 50.2%, to $114.4 million for the year ended December 31, 2006, as compared to $76.2 million for year ended December 31, 2005. The increase in homeowners’ gross premiums written is primarily due to the Company’s rate increase, with only a slight increase in the number of policy holders.
The Company’s sale of auto insurance policies decreased $14.6 million, or 70.7%, to $6.1 million for the year ended December 31, 2006, as compared to $20.7 million for year ended December 31, 2005.
The (increase) in unearned premiums was ($16.0) million for the year ended December 31, 2006, as compared to ($11.7) million for year ended December 31, 2005. The change was due to an $18.9 million increase in unearned homeowners’ insurance premiums, a $4.6 million increase in unearned commercial general liability premiums, and a $7.4 million decrease in unearned automobile premiums. These changes reflect our continued growth along our homeowners’ and commercial general liability lines of business. For further discussion, see “Analysis of Financial Condition - Unearned Premiums” on page 47.
Net premiums earned increased $6.4 million, or 7.7%, to $89.3 million for the year ended December 31, 2006, as compared to $83.0 million for year ended December 31, 2005. The following table denotes net premiums earned by major product line.
Net investment income increased $2.1 million, or 54.5%, to $5.9 million for the year ended December 31, 2006, as compared to $3.8 million for year ended December 31, 2005. The increase in investment income is primarily a result of the additional amounts of invested assets. Also affecting our net investment income was an increase in overall yield to 6.22% for the year ended December 31, 2006 as compared to a yield of 4.66% for the year ended December 31, 2005.
Net realized investment gains increased $0.6 million, or 131.9%, to $1.1 million for the year ended December 31, 2006, as compared to $0.5 million for year ended December 31, 2005. The table below depicts the gains (losses) by investment category.
Loss and LAE decreased by $3.9 million, or 8.1%, to $44.4 million for the year ended December 31, 2006, as compared to $48.3 million for year ended December 31, 2005. The decrease is attributable to the increase in loss and LAE incurred during the year ended December 31, 2005 which was in connection with the adverse development associated with the 2004 hurricanes.
The following table reflects the changes during the year ended December 31, 2006 in connection with the four hurricanes that occurred in August and September of 2004. A charge of $5.4 million occurred during the year ended December 31, in connection with these storms.
Interest expense decreased $0.7 million, or 53.1%, to $0.7 million for the year ended December 31, 2006, as compared to $1.4 million for year ended December 31, 2005. The change is primarily attributed to our decreased reliance upon outside sources for financing our contracts receivable.
Year Ended December 31, 2005 as Compared to Year Ended December 31,
Gross premiums ceded increased $15.9 million, or 102.9%, to $31.4 million for the year ended December 31, 2005, as compared to $15.5 million for the year ended December 31, 2004. The change is associated with our increased homeowners’ insurance premium volume and our reinsurance costs.
Managing general agent fees increased $0.4 million, or 18.6%, to $2.4 million for the year ended December 31, 2005, as compared to $2.0 million for the year ended December 31, 2004. The change reflects an overall increase in the production of insurance policies with higher rates.
Management continues to revise our estimates of the ultimate financial impact of these storms. The revisions to our estimates are based on our analysis of subsequent information that we receive regarding various factors, including: (i) per claim information; (ii) Company and industry historical loss experience; (iii) legislative enactments, judicial decisions, legal developments in the awarding of damages, and changes in political attitudes; and (iv) trends in general economic conditions, including the effects of inflation. 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.
The table below reflects a charge to current year earnings of $8.9 million, net of reinsurance recoveries of $146.6 million, stemming from the four hurricanes that occurred during the year ended December 31, 2005 as indicated below.
As a result of the foregoing, the Company’s net income for the year ended December 31, 2005 was $12.1 million, as compared to net loss of $10.9 million for year ended December 31, 2004.
For the year ended December 31, 2006, operations provided net operating cash flow of $27.5 million, as compared to $19.4 million for year ended December 31, 2005.
For the year ended December 31, 2006, net financing activities provided $4.0 million, as compared to using $4.0 million for the year ended December 31, 2005. For the year ended December 31, 2006, the sources of cash in connection with financing activities included $10.7 million from the exercise of warrants, $2.6 million from the exercise of stock options and a $1.6 million tax benefit related to non-cash compensation. The uses of cash in connection with financing activities included $4.4 million for the regularly scheduled principal and interest payments on our Notes, $4.3 million in dividends paid, $2.0 million for the acquisition of common stock and $0.2 million in connection with the reduction of our outstanding revolving credit.
Federated Premium’s operations are partially funded by the revolving loan agreement with FlatIron. The effective interest rate on this line of credit, based on our average outstanding borrowings under the Revolving Agreement, was 7.82%, 6.39%, and 5.71% for the years ended December 31, 2006, 2005, and 2004, respectively. Interest expense on this revolving credit line for the years ended December 31, 2006, 2005, and 2004 totaled approximately $8,000 $75,000, and $178,000, respectively.
As an alternative to premium finance, we offer direct billing in connection with our automobile program, where the insurance company accepts from the insured, as a receivable, a promise to pay the premium, as opposed to requiring the full amount of the policy, either directly from the insured or from a premium finance company. The advantage of direct billing a policyholder by the insurance company is that we are not reliant on our credit facility, but remain able to charge and collect interest from the policyholder.
On July 31, 2003, we completed a private placement of our 6% Senior Subordinated Notes (the “July 2003 Notes”), which were offered and sold to accredited investors as units consisting of one July 2003 Note with a principal amount of $1,000 and warrants (the “2003 Warrants”) to purchase shares of our Common Stock. We sold an aggregate of $7.5 million of July 2003 Notes in this placement, which resulted in proceeds to us (net of placement agent fees of $450,724 and offering expenses of $110,778) of $6,938,498.
A material weakness is a control deficiency, or combination of control deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. The following material weaknesses have been identified and included in management’s assessment: (i) the recognition and accounting of unrecorded premium transactions and (ii) an income tax issue relating to computing the Company’s income tax liability where the Company failed to consider a prior year tax refund applied to the current year. These material weaknesses were considered in determining the nature, timing, and extent of audit tests applied in our audit of the 2006 financial statements, and this report does not affect our report dated March 16, 2007 on those financial statements.
In our opinion, management’s assessment that 21st Century Holding Company did not maintain effective internal control over financial reporting as of December 31, 2006, is fairly stated, in all material respects, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Also, in our opinion, because of the effect of the material weaknesses described above on the achievement of the objectives of the control criteria, 21st Century Holding Company has not maintained effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
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 shall contract with general agents to market our commercial general liability insurance product beyond the state of Florida. 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. 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 from the marketing of company products through the Company’s distribution network. 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.
On September 7, 2004, we completed a three-for-two stock split in the form of a stock dividend, whereby shareholders received three shares of common stock for every two shares of our common stock held on the record date. Just prior to the three-for-two stock split, we had approximately 3,957,000 shares outstanding, and following the stock split, we had approximately 5,936,000 shares outstanding.
We consider all short-term highly liquid investments with original maturities of three months or less to be short term investments.
The estimates of unpaid losses and LAE are subject to the effect of trends in claims severity and frequency and are continually reviewed. As part of the process, we review historical data and consider various factors, including known and anticipated legal developments, changes in social attitudes, inflation and economic conditions. As experience develops and other data becomes available, these estimates are revised, as required, resulting in increases or decreases to the existing unpaid losses and LAE. Adjustments are reflected in results of operations in the period in which they are made and the liabilities may deviate substantially from prior estimates.
Interest and service income, resulting from the financing of insurance premiums, is recognized using a method that approximates the effective interest method. Late charges are recognized as income when chargeable.
Provisions for credit losses are provided in amounts sufficient to maintain the allowance for credit losses at a level considered adequate to cover anticipated losses. Generally, accounts that are over 90 days old are written off to the allowance for credit losses. We have been increasing our reliance on direct billing of our policyholders for their insurance premiums. Direct billing is when the insurance company accepts from the insured, as a receivable, a promise to pay the premium, as opposed to requiring payment of the full amount of the policy, either directly from the insured or from a premium finance company. We manage the credit risk associated with our direct billing program through our integrated computer system which allows us to monitor the equity in the unearned premium to the underlying policy. Underwriting criteria are designed with down payment requirements and monthly payments that create policyholder equity, also called unearned premium, in the insurance policy. The equity in the policy is collateral for the extension of credit to the insured. The decrease during the years ended December 31, 2006 and 2005 in the allowance for credit losses can be primarily attributed to the decline in homeowner and mobile homeowner policyholder receivables greater than ninety days old as compared to December 31, 2004. The increase during the year ended December 31, 2004 in the allowance for credit losses can be primarily attributed to homeowner and mobile homeowner policyholder receivables greater than ninety days old due in part to a cancellation moratorium in effect for non-payment of insurance premiums.
If substantially all the costs associated with the MGA contracts which do not involve affiliated insurers are incurred during the underwriting process, then the MGA fees and the related acquisition costs are recognized at the time the policy is underwritten, net of estimated cancellations. If the MGA contract requires significant involvement subsequent to the completion of the underwriting process, then the MGA fees and related acquisition costs are deferred and recognized over the life of the policy. Included in Managing General Agent Fees are policy fees, charged by the insurance companies and passed through to Assurance MGA. Policy fees are discussed below.
We recognize the income and expense on reinsurance contracts principally on a pro-rata basis over the term of the reinsurance contracts or until the reinsurers maximum liability is exhausted, whichever comes first. We are reinsured under separate reinsurance agreements for the different lines of business underwritten. Reinsurance contracts do not relieve us from our obligations to policyholders. We continually monitor our reinsurers to minimize our exposure to significant losses from reinsurer insolvencies. We only cede risks to reinsurers whom we believe to be financially sound. At December 31, 2006, all reinsurance recoverables are considered collectible.
In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements”, which defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. The provisions of SFAS No. 157 are effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. The Company does not expect any impact upon the adoption of SFAS No. 157 on our consolidated financial statements.
The following is a description of the most significant risks facing us and how we mitigate those risks:
LEGAL/REGULATORY RISKS--the risk that changes in the regulatory environment in which an insurer operates will create additional expenses not anticipated by the insurer in pricing its products. That is, regulatory initiatives designed to reduce insurer profits, restrict underwriting practices and risk classifications, mandate rate reductions and refunds, and new legal theories or insurance company insolvencies through guaranty fund assessments may create costs for the insurer beyond those recorded in the financial statements. We attempt to mitigate this risk by monitoring proposed regulatory legislation and by assessing the impact of new laws. As we write business in the states of Florida, Louisiana and Georgia, Texas, Kentucky, South Carolina and Virginia and in the near future in Missouri and Alabama, we are more exposed to this risk than some of our more geographically balanced competitors.
As of December 31, 2006 and 2005, both Federated National and American Vehicle were in compliance with all regulatory requirements. However, as a result of the hurricanes striking Florida in August and September 2004, we were technically not in compliance with certain regulatory requirements in 2004. To retain our certificates of authority, Florida insurance laws and regulations require that our insurance company subsidiaries, Federated National and American Vehicle, maintain capital surplus equal to the greater of 10% of its liabilities or the 2004 statutory minimum capital and surplus requirement of $4.00 million as defined in the Florida Insurance Code. As of December 31, 2004, Federated National was not in compliance with its requirement to maintain minimum capital surplus primarily based on the incurred losses associated with the four hurricanes that occurred in August and September 2004. Under the provisions afforded Federated National according to Statement of Statutory Accounting Principles No 72 titled “Surplus and Quasi-reorganizations”, compliance with this provision was restored by way of a surplus infusion from 21st Century. American Vehicle remains in compliance with statutory minimum capital and surplus requirement. The insurance companies are also required to adhere to prescribed premium-to-capital surplus ratios. As of December 31, 2004, Federated National did not comply with the prescribed premium-to-capital surplus ratio, primarily based on the incurred losses associated with the four hurricanes that occurred in August and September 2004. Under the provisions afforded Federated National according to Statement of Statutory Accounting Principles No 72, compliance with this provision was also restored. American Vehicle remains in compliance with statutory premium-to-capital surplus ratios.
CREDIT RISK--the risk that issuers of securities owned by us will default or that other parties, including reinsurers to whom business is ceded, which owe us money, will not pay. We attempt to minimize this risk by adhering to a conservative investment strategy, maintaining reinsurance agreements with financially sound reinsurers, and by providing for any amounts deemed uncollectible. Additonally, the Company carries current ledger balances exceeding Federal Deposit Insurance Corporation coverage of approximately $1.0 million. Management believes that this is not a significant risk.
CATASTOPHIC EVENT RISK-the risk associated with writing insurance policies covering automobile owners, homeowners, and business owners for losses that result from catastrophes, including hurricanes, tropical storms, tornadoes or other weather related events. As of December 31, 2006 we had 41,600 homeowner policies in force, primarily in the South Florida area. We mitigate our risk of catastrophic events through the use of reinsurance, forecast modeling techniques and the monitoring of concentrations of risk, all designed to protect the statutory surplus of the insurance companies.
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, 2006 and 2005. Changes in interest rates subsequent to December 31, 2006 may affect the fair value of our investments. Refer to Note 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, 2006 and 2005 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.
At December 31, 2006, the Company has two stock-based employee compensation plans and one stock-based franchise compensation plan, which are described later in footnote 8, 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 APB Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations, as permitted by FASB Statement No. 123, Accounting for Stock-Based Compensation. 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, 2006.
The following table shows the realized gains (losses) for fixed and equity securities for the years ended December 31, 2006 and 2005.
A summary of the amortized cost, estimated fair value, gross unrealized gains and losses of fixed maturities and equity securities at December 31, 2006 and 2005 is as follows:
The investments held at the end of the year 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 however, sensitive to interest rate changes. There is a smaller concentration of corporate bonds predominantly held in the financial, automotive, and conglomerate industries.
Depreciation of property, plant, and equipment was $342,108, $444,744, and $457,224 during 2006, 2005 and 2004, respectively.
At December 31, 2006 and 2005, the Company had an unsecured aggregate recoverable for paid and unpaid losses and LAE and unearned premiums with the following reinsurers:
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 $9,294,096 for the year ended December 31, 2006 and increased (decreased) the liability for losses and LAE for claims occurring in prior years by $6,094,843 and ($1,430,278) for the years ended December 31, 2005 and 2004, respectively. The adjustments in the liability were primarily attributable to loss development in connection with the four hurricanes of 2004 There can be no assurance concerning future adjustments of reserves, positive or negative, for claims through December 31, 2006.
The annual interest rate on advances under the Revolving Agreement is the prime rate plus additional interest varying from 1.25% to 3.25% based on the prior month’s ratio of contracts receivable related to insurance companies with an A.M. Best rating of B or worse to total contracts receivable. The effective interest rate on this line of credit, based on our average outstanding borrowings under the Revolving Agreement, was 7.82%, 6.39%, and 5.71% for the years ended December 31, 2006, 2005 and 2004, respectively.
As of December 31, 2004, Federated National was not in compliance with its requirement to maintain minimum capital surplus primarily based on the incurred losses associated with the four hurricanes that occurred in August and September 2004. Under the provisions afforded Federated National according to Statement of Statutory Accounting Principles No. 72 titled “Surplus and Quasi-reorganizations” compliance with this provision was restored. American Vehicle remains in compliance with statutory minimum capital and surplus requirement. As of December 31, 2004, Federated National did not comply with the prescribed premium-to-capital surplus ratio, primarily based on the incurred losses associated with the four hurricanes that occurred in August and September 2004. Under the provisions afforded Federated National according to Statement of Statutory Accounting Principles No. 72, compliance with this provision was also restored. American Vehicle remained in compliance with statutory premium-to-capital surplus ratios.
As of December 31, 2006 and 2005, to meet regulatory requirements, we had bonds with a carrying value of approximately $2.0 million pledged to the Insurance Commissioner of the State of Florida.
Based upon the December 31, 2006 and 2005 statutory financial statements for American Vehicle statutory surplus exceeded all regulatory action levels established by the NAIC’s risk-based capital requirements. As of the year ended December 31, 2006 and 2005, statutory financial statements for Federated National did not exceed company action levels as established by the NAIC. Federated National’s 2006 results require us to submit a plan containing corrective actions during 2007. Federated National has not submitted its plan for corrective action yet, however we will submit a plan in the near future.
Based on Risk Based Capital requirements, the extent of regulatory intervention and action increases as the ratio of an insurer’s statutory surplus to its ACL, as calculated under the NAIC’s requirements, decreases. The first action level, the Company Action Level, requires an insurer to submit a plan of corrective actions to the insurance regulators if statutory surplus falls below 200.0% of the ACL amount. The second action level, the Regulatory Action Level, requires an insurer to submit a plan containing corrective actions and permits the insurance regulators to perform an examination or other analysis and issue a corrective order if statutory surplus falls below 150.0% of the ACL amount. The third action level, ACL, allows the regulators to rehabilitate or liquidate an insurer in addition to the aforementioned actions if statutory surplus falls below the ACL amount. The fourth action level is the Mandatory Control Level, which requires the regulators to rehabilitate or liquidate the insurer if statutory surplus falls below 70.0% of the ACL amount. Federated National’s ratio of statutory surplus to its ACL was 165.4 %, 154.0% and 125.5% at December 31, 2006, 2005 and 2004, respectively. American Vehicle’s ratio of statutory surplus to its ACL was 444.2%, 329.7% and 545.1% at December 31, 2006, 2005 and 2004, respectively.
As of December 31, 2006, American Vehicle was outside NAIC’s usual range for one of thirteen ratios. The exception was in connection with the net increase in adjusted policyholders’ surplus. During 2006, net income and a decrease in non admitted securities were the major contributors to the 2006 change to policyholder surplus.
We do not currently believe that the Florida OIR will take any significant action with respect to Federated National or American Vehicle regarding the IRIS ratios, although there can be no assurance that will be the case.
GAAP differs in some respects from reporting practices prescribed or permitted by the Florida OIR. Federated National's statutory capital and surplus was $15.2 million and $11.2 million as of December 31, 2006 and 2005, respectively. Federated National's statutory net income (loss) was $1.9 million, ($2.2) million and ($25.4) million for the years ended December 31, 2006, 2005 and 2004, respectively. Federated National’s statutory non-admitted assets were approximately $11.0 million and $10.5 million as of December 31, 2006 and 2005, respectively.
In June 2000, a lawsuit was filed against us, our directors and our executive officers seeking compensatory damages in an undisclosed amount on the basis of allegations that our amended registration statement dated November 4, 1998 was inaccurate and misleading concerning the manner in which we recognized ceded insurance commission income, in violation of Sections 11 and 15 of the Securities Act of 1933 and Sections 10(b) and 20(a) of the Securities Exchange Act of 1934. The lawsuit was filed in the United States District Court for the Southern District of New York. The plaintiff class purportedly included purchasers of our common stock between November 5, 1998 and August 13, 1999. The Court granted the plaintiffs class status. Specifically, the plaintiffs alleged that we recognized ceded commission income on a written basis, rather than amortized on a pro rata basis. The plaintiffs allege that this was contrary to the Statement of Financial Accounting Concepts Nos. 1, 2 and 5. We believe, however, that the lawsuit is without merit and we have vigorously defended the action, because we reasonably relied upon outside subject matter experts to make these determinations at the time. We have also since accounted for ceded commission on a pro rata basis and have done so since these matters were brought to our attention in 1998. Nevertheless, we have also continued to actively participate in settlement negotiations with the plaintiffs and have agreed to settle the case. The parties have negotiated the final terms of a Memorandum of Understanding, which was executed by the parties and then approved by the court in late February 2005. We reserved and charged against forth quarter 2003 earnings $600,000 for the potential settlement and associated costs. Our active involvement in this case has been concluded.
As a direct premium writer in the State of Florida, we are required to participate in certain insurer solvency associations under Florida Statutes 631.57(3) (a). Participation in these pools is based on our written premium by line of business to total premiums written statewide by all insurers. Participation may result in assessments against us as it did in 2006. During 2006 we were assessed $3.9 million in connection with the association. For statutory accounting purposes these assessments are not charged to operations in contrast GAPP treatment to charge current operations for the assessments. Through policyholder surcharges, as approved by the OIR, we will begin to recoup these assessments during the first quarter of 2007. There was no assessment made for the years ended December 31, 2005 or 2004.
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 motor vehicle 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. During the year ended December 31, 2006 Federated National and American Vehicle were assessed $221,765 and $1,579, respectively by the JUA Plan based on its January 2007 Cash Activity Report. During the year ended December 31, 2005 Federated National and American Vehicle were assessed $44,350 and $1,615, respectively. These charges are contained in Operating and Underwriting Expenses in the Statement of Operations. Future assessments by this association are undeterminable at this time.
Bonds totaling $17.7 million secure a $15.0 million irrevocable letter of credit in order to facilitate business opportunities in connection with our commercial general liability program.
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 $258,000, $192,000 and $327,000 for the years ended December 31, 2006, 2005 and 2004, respectively.
A summary of the numerator and denominator of the basic and fully diluted (2006 and 2005 only) net income (loss) per share is presented below:
We implemented a stock option plan in November 1998 that provides for the granting of stock options to officers, key employees and consultants. The objectives of this plan includes attracting and retaining the best personnel, providing for additional performance incentives, and promoting our success by providing employees the opportunity to acquire common stock. Options outstanding under this plan have been granted at prices, which are either equal to or above the market value of the stock on the date of grant, typically vest over a four-year period, and expire six or ten years after the grant date. Under this plan, we are authorized to grant options to purchase up to 900,000 common shares, and, as of December 31, 2006, we had outstanding exercisable options to purchase 44,750 shares.
In 2001, we implemented a franchisee stock option plan that provides for the granting of stock options to individuals purchasing Company owned agencies which are then converted to franchised agencies. The purpose of the plan is to advance our interests by providing an additional incentive to encourage managers of Company owned agencies to purchase the agencies and convert them to franchises. Options outstanding under the plan have been granted at prices, which are above the market value of the stock on the date of grant, vest over a ten-year period, and expire ten years after the grant date. Under this plan, we are authorized to grant options to purchase up to 988,500 common shares, and, as of December 31, 2006, we had no outstanding exercisable options to purchase 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 for the year ended September 30, 2006, are lower by approximately $539,000 and $336,000, respectively, than if it had continued to account for share-base compensation under ABP Opinion No. 25. For the three months ended December 31, 2006, income from continuing operations before provision for income taxes and net income are lower by approximately $143,000 and $90,000, 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, 2006 would have been $1.85 and $1.73, respectively, if the Company had not adopted SFAS No. 123R, compared to reported basic and diluted earnings per share of $1.84 and $1.72, respectively.
Because the change in income taxes payable includes the effect of excess tax benefits, those excess tax benefits also must be shown as a separate operating cash outflow so that operating cash flows exclude the effect of excess tax benefits. SFAS No. 123R requires the cash flows resulting from the tax benefits resulting from tax deductions in excess of the compensation cost recognized for those options (excess tax benefits) to be classified as financing cash flows.
During December 2005 we reclassified $19.7 million of our bond portfolio as held-to-maturity. The decision to classify this layer of our bond portfolio as held-to-maturity was predicated upon our intention to establish an irrevocable letter of credit in order to facilitate business opportunities in connection with our commercial general liability program. Unrealized loss in connection with the reclassification totaled $0.26 million, net of a $0.16 income tax effect.
Reclassification adjustments related to the investment securities sold and previously included in comprehensive income (loss) for the years ended December 31, 2006, 2005 and are as follows:
Our Amended and Restated Articles of Incorporation authorize the issuance of one million shares of preferred stock with designations, rights and preferences determined from time to time by our board of directors. Accordingly, our board of directors is empowered, without shareholder approval, to issue preferred stock with dividends, liquidation, conversion, voting or other rights that could adversely affect the voting power or other rights of the holders of common stock. We have not issued preferred shares as of December 31, 2006.
21st Century Holding Company (the Parent Company only) has no long term obligations, guarantees or material contingencies as of December 31, 2006.
The following summarizes the major categories of the parent company's financial statements:
The 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 Company retains the privilege of repaying these notes in cash or by the issuance of common stock. Through the quarter ended March 31, 2005, we made our quarterly installment payments by issuing common stock. Our regularly scheduled payments of principal and interest in connection with the July 2003 and September 2004 Notes due on April 30, 2006 were paid by issuance of 38,420 shares and 68,696 shares of our Common Stock, respectively. Our regularly scheduled payments of principal and interest in connection with the July 2003 and September 2004 Notes due on July 31, 2006 and October 31, 2006 were paid in cash.
For the September 2004 Notes, the quarterly principal and interest payments, totaling approximately $1.1 million per payment, are due quarterly with the last installment due on September 30, 2007.
Additionally, on the same day, the Company also announced a definitive agreement to sell the assets of its subsidiaries, Federated Agency Group 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.