We believe that our properties have been adequately maintained, are in generally good condition and are suitable for our business as presently conducted. We believe our existing facilities sufficiently provide for both our present and presently anticipated needs. We also believe that, with respect to leased properties, upon the expiration of our current leases, we will be able to either secure renewal terms or enter into leases for alternative locations on acceptable market terms.
Premium finance companies, which provide payment alternatives to individual customers of our retail agencies.
We utilize different processes to determine our best estimate for unpaid losses and unpaid loss adjustment expenses. We establish a standard system-generated case loss reserve that varies by state, program, coverage and, in some instances for certain coverages, elapsed time since date of loss. The only variation to this methodology for setting case loss reserves exists in the instance where we believe our financial exposure for a particular loss event is significant and in fact may approach or be equal to our policy limits. In these instances, we will establish a case loss reserve to reflect claims’ view regarding the potential cost of this exposure to us. The system automatically adjusts the case loss reserves downward in the event a partial payment is made and a claim remains open. We will re-adjust the case loss reserves in an instance where a partial payment is made if we believe the facts of the claim justify a different reserve. This activity is generally limited to our personal injury protection coverage, where we have a significant amount of this type of activity and the settlement time is longer than for our normal business.
Incurred Loss Development - We use historical case incurred loss and loss adjustment expense (i.e., the sum of cumulative loss or loss adjustment expense payments plus outstanding case loss reserves) over discrete periods of time to estimate future losses. Incurred development methods assume that the case loss and loss adjustment expense reserving practices are consistently applied over time.
ratios are typically developed based upon the information used in pricing and are multiplied by the total amount of premiums earned to calculate ultimate loss and loss adjustment expense which is then proportionately added to the actual incurred to date.
Frequency and Severity Methods - We use historical claim count development over discrete periods of time to estimate future claim count development. We utilize internal and external information to determine trends in loss severity and select ultimate severity by accident period. A ratio of ultimate claim counts to earned car years is applied to the ultimate severity per claim for each accident quarter.
There are numerous factors, both internal and external, that we consider when evaluating the reasonableness of the various methods used to determine the actuarial best estimate of loss and loss adjustment expense reserves. Many of the factors vary for different states, programs, coverage groups, and accident periods. Some examples of internal factors considered are changes in product mix, changes in claims-handling practices, loss cost trends and underwriting standards and rules. With the most recent change in claims practices, a key variable that we are monitoring is the decrease in claim duration and the affect on the claims tail and severity. External factors considered include frequency, severity, the effect of inflation on medical hospitalization, material repair and replacement costs, as well as general economic and legal trends.
The final outcome may fall below or above these amounts. There can be no assurance that actual future loss and LAE development variability will be consistent with any potential variation indicated by our historical loss and LAE development experience.
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.
We conduct regular reviews to assess whether our investments are impaired and if any impairment is other than temporary. Factors considered by us in assessing whether an impairment is other than temporary include the credit quality of the investment, the duration of the impairment, our ability and intent to hold the investment until recovery or maturity and overall economic conditions. Under Financial Accounting Standards Board (FASB) guidance adopted in the second quarter of 2009, an other-than-temporary impairment is triggered in circumstances where (1) an entity has an intent to sell the security, (2) it is more likely than not that the entity will be required to sell the security before recovery of its amortized cost basis, or (3) the entity does not expect to recover the entire amortized cost basis of the security (that is, a credit loss exists). Other-than-temporary impairments are separated into amounts representing credit losses which are recognized in earnings and amounts related to all other factors which are recognized in other comprehensive income (loss), a component of stockholders’ equity. All impairments on our available-for-sale investment securities were considered temporary in nature as of December 31, 2010 and 2009, respectively. Accordingly, unrealized losses are recorded in other comprehensive income on our consolidated balance sheet.
Deferred acquisition costs. Deferred acquisition costs represent the deferral of expenses that we incur acquiring new business or renewing existing business. Policy acquisition costs (primarily commissions, advertising, premium taxes and underwriting and agency expenses related to issuing a policy) are deferred and charged against income ratably over the terms of the related policies. Management regularly reviews the categories of acquisition costs that are deferred and assesses the recoverability of this asset. A premium deficiency and a corresponding charge to income is recognized if the sum of the expected losses and loss adjustment expenses, unamortized acquisition costs and maintenance costs exceeds related unearned premiums and anticipated investment income. At December 31, 2010, we determined a premium deficiency existed and recorded a $0.5 million reduction of deferred acquisition costs. Judgments as to the ultimate recoverability of such deferred costs are highly dependent upon estimated future loss costs associated with unearned premiums.
Income taxes. Significant management judgment is required in determining the provision for income taxes, deferred tax assets and liabilities, and the valuation allowance recorded against net deferred tax assets. The process involves summarizing temporary differences resulting from differing treatment of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included within the consolidated balance sheet. In addition, we assess whether valuation allowances should be established against deferred tax assets based on consideration of all available evidence using a “more likely than not” standard. To the extent a valuation allowance is established in a period, an expense must be recorded within the income tax provision in the consolidated statement of operations. The Company carries a full valuation allowance as of December 31, 2010 that was established as of December 31, 2009.
If actual results differ from these estimates or these estimates are adjusted in future periods, the valuation allowance may need to be adjusted, which could materially impact our financial position and results of
We also adopted in the second quarter of 2009 FASB standards that provide guidance on how to determine the fair value of assets and liabilities when the volume and level of activity for the asset or liability has significantly decreased. These new standards also provide guidance on identifying circumstances that indicate a transaction is not orderly. In addition, we are required to disclose in interim as well as annual reporting periods the inputs and valuation techniques used to measure fair value and discussion of changes in valuation techniques. Adoption of these standards did not have a material effect on our consolidated financial position, results of operations or cash flows.
ASU 2010-06 requires additional disclosures about fair value measurements, including transfers in and out of Levels 1 and 2 and activity in Level 3 on a gross basis, and clarifies certain other existing disclosure requirements including level of disaggregation and disclosures around inputs and valuation techniques. The provisions of the new standards are effective for interim or annual reporting periods beginning after December 15, 2009, except for the additional Level 3 disclosures which will become effective for fiscal years beginning after December 15, 2010. These standards are disclosure only in nature and do not change accounting requirements. Accordingly, adoption of the new standard had no impact on the Company’s consolidated financial position, results of operations or cash flows.
ASU 2009-17 amended the standards for determining whether to consolidate a variable interest entity. These new standards amended the evaluation criteria to identify the primary beneficiary of a variable interest entity and require ongoing reassessment of whether an enterprise is the primary beneficiary of the variable interest entity. The provisions of the new standards are effective for annual reporting periods beginning after November 15, 2009 and interim periods within those fiscal years. The adoption of this new standard effective January 1, 2010 did not impact the Company’s consolidated financial position, results of operations or cash flows.
In our independent agency distribution channel, gross premiums written for 2010 increased $12.7 million, or 9.3%, compared with 2009. The increase was due to an initiative to target the expansion of certain independent agent relationships.
In addition, we expect to introduce a multivariate pricing product in 2011 for new business in the states of Louisiana, Alabama, Texas and Illinois. The new product is expected to result in an improvement in profitability through better segment pricing.
Since insurance premiums are earned over the service period of the policies, the revenue in the current period includes premiums earned on insurance products written through our three distribution channels in both current and previous periods. Net premiums earned during the current period on policies sold through our affiliated underwriting agencies (including retail and independent agencies) decreased by $26.9 million, or 7.9%. Net premiums earned on insurance products sold through the unaffiliated underwriting agencies distribution channel decreased by $5.3 million, or 20.8%, compared with the prior year.
We assume reinsurance from a Texas county mutual insurance company (the county mutual) whereby we have assumed 100% of the policies issued by the county mutual for business produced by our owned MGAs.
A quota-share reinsurance agreement was put in place effective October 1, 2010. Under the terms of the quota-share agreement, we cede 40% of the unearned premium except for Michigan business as of the effective date and 40% of the gross premium written except for Michigan business through December 31, 2010. Premiums ceded under the quota-share agreement reduced net written premiums and net earned premiums in 2010 by $65.0 million and $38.8 million, respectively. A separate quota-share reinsurance agreement was put in place effective January 1, 2011. Under the terms of the 2011 agreement, we cede 28% of gross written premium in all states other than Michigan through December 31, 2011. Our quota-share ceding commission rate structure varies based on loss experience for both agreements. The estimates of loss experience are continually reviewed and adjusted, and the resulting adjustments to ceding commissions are reflected in current operations.
The amount of recoveries pertaining to reinsurance contracts that were deducted from losses and loss adjustment expenses incurred during 2010, 2009 and 2008 was approximately $75.2 million, $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 was as follows (in thousands):
Commission Income and Fees. Another measurement of our performance is the relative level of production of commission income and fees. Commission income and fees consist of (a) policy, installment, premium finance and agency fees earned for business written or assumed by our insurance companies both through independent agents and our retail agencies and (b) the commission, premium finance and agency fee income earned on sales of unaffiliated, third-party companies’ insurance policies or other products sold by our retail agencies. These various types of commission income and fees are impacted in different ways by the decisions we make in pursuing our corporate strategy.
The following sets forth the components of consolidated commission income and fees earned for the years ended December 31, 2010, 2009 and 2008 (in thousands):
In 2009, commission income and fees increased $2.9 million, or 3.8%, compared with 2008. Policyholder fees decreased in 2009 compared with 2008 due to the lower volume of premiums written in states where we collect policyholder fees. Commissions and fees increased as a result of a revised rate structure in 2009, more of our retail customers choosing third party products due to the market conditions, and a concerted effort to sell more ancillary products.
Net investment income for 2009 decreased $4.3 million, or 31.3%, compared with 2008, consisting of a $4.6 million decrease in investment income on debt securities, partially offset by a $0.5 million increase in lease income from investment in real property. The decrease was primarily due to a reduction in yields and a 14.2%
decrease in total average invested assets to $266.7 million during 2009 from $310.7 million during 2008. The average investment yield was 3.0% (4.0% on a taxable equivalent basis) in 2009 as compared to 4.1% (5.6% on a taxable equivalent basis) in 2008.
At December 31, 2010, our fixed-income investments were invested in the following: corporate debt securities 59.2%; FDIC-insured certificates of deposit 12.8%; U.S. Treasury and government agencies securities 12.2%; states and political subdivisions securities 10.7%; and mortgage-backed securities 5.1%. The average quality of our portfolio was A+ at December 31, 2010. 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, 2010, the effective duration of our fixed-income investment portfolio was 2.1 years.
Our investment strategy is to conservatively manage our investment portfolio by primarily investing in readily marketable, investment-grade, fixed-income securities. We currently do not invest in common equity securities and we have no exposure to foreign currency risk. The Investment Committee of our Board of Directors has established investment guidelines and periodically reviews portfolio performance for compliance with our guidelines.
Our losses, loss adjustment expense reserves and deposit liabilities of $252.1 million on a gross basis and $158.8 million on a net basis are our best estimates as of December 31, 2010. The analysis provided by our internal valuation methods indicated that the expected range for the ultimate liability for our losses and loss adjustment expense reserves, as of December 31, 2010, was between $328.1 million and $240.6 million on a gross basis and between $230.7 million and $149.5 million on a net basis.
The gross cumulative deficiency in 2009 increased as a result of revised case reserves on our Michigan business due to increased estimates of ultimate losses.
Deferred policy acquisition costs represent the deferral of expenses that we incur in acquiring new business or renewing existing business. Policy acquisition costs, consisting of primarily commission, advertising, premium taxes, underwriting and retail agency expenses, are initially deferred and then charged against income ratably over the terms of the related policies through amortization of the deferred policy acquisition costs. Thus,
Additions to deferred acquisition costs decreased in 2010 by $14.6 million and additions to the related amortization increased by $0.2 million in 2010. This decrease reflects the ceding commissions from the quota- share reinsurance agreement received of $17.3 million, which was partially offset by increased independent agent commissions for the year.
In 2011, we have terminated a number of our independent agents that agency bill (the agent bills our insurance customer instead of our insurance company) that do not have significant production numbers with us. In addition, we have offered reduced commission rates for other agencies that agency bill. As a result of these actions as well as the anticipated decline in production in 2011, we expect to reduce independent agent commission costs significantly in 2011.
We have undertaken a number of measures to significantly reduce other SG&A expenses. As a result, we anticipate that SG&A expenses will decline in 2011 due to a decline in personnel and other actions.
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 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 in 2007.
Other Intangible Asset Impairment Charges. We incurred an impairment charge of $4.6 million in the third quarter of 2008 resulting from the annual review of goodwill and other intangible assets. Based on our assessment, we concluded that the carrying value of other intangible assets exceeded its fair value primarily for the Florida operations.
Income Taxes. Income tax expense for 2010 was $1.7 million as compared to $22.4 million for 2009. The income tax expense for the current period was primarily due to an increase in the deferred tax liability related to goodwill and state tax expense, and the change in valuation allowance.
Our effective tax rate from continuing operations was (14.4%) for the year ended December 31, 2008 which differed from the statutory rate primarily due to a relatively high proportion of the investment income generated by tax-exempt securities.
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
The Illinois Insurance Code includes a reserve requirement that requires an insurer to maintain an amount of qualifying investments as defined at least equal to the lesser of $250.0 million or 100% of adjusted loss reserves and loss adjustment reserve expenses. As of December 31, 2010, Affirmative Insurance Company was deficient in qualifying assets by $29.5 million. We submitted our plan to the Illinois Department of Insurance in March 2011. The plan that we proposed included a $3.8 million ordinary dividend and a $21.0 million extraordinary distribution from two of AIC’s insurance company subsidiaries, which were completed in March 2011 and an extraordinary dividend from one of AIC’s insurance company subsidiaries, which is subject to its state insurance department approval. If the state insurance department does not approve the extraordinary dividend we have other means available to us to cure the deficiency.
In May 2010, we entered into a capital lease obligation related to certain computer software, software licenses, and hardware currently used by and on the books of Affirmative Insurance Company and received cash from the financing in the amount of $28.2 million. As required by the lease agreements, we purchased $28.2 million of FDIC-insured certificates of deposit with the lease financing proceeds. These investments are pledged as collateral against our lease obligation and are scheduled to decrease as we make the scheduled lease payments. The lease term is 60 months with monthly rental payments totaling approximately $0.6 million.
We believe that existing cash and investment balances, as well as cash flows generated from operations, will be adequate to meet our liquidity needs, planned capital expenditures and the debt service requirements of the senior secured credit facility and notes payable, during the 12-month period following the date of this report at both the holding company and insurance company levels. We do not currently know of any events that could cause a material increase or decrease in our long-term liquidity needs.
The assets and stock of Affirmative Premium Finance Company will be pledged and this entity will become a guarantor of the debt.
At every quarter end, we will pay to the lenders a payment equal to the excess of cash at the non-regulated entities of $12 million at December 31 and March 31 and $10 million at June 30 and September 30.
In addition, we paid 0.50% to all lenders that approved the amendment.
(1) As of December 31, 2010, we leased an aggregate of approximately 466,041 square feet of office space for our agencies, insurance companies and retail stores in various locations throughout the United States. These amounts represent our minimum future operating lease commitments.
(3) All of the outstanding notes payable at December 31, 2010 are redeemable in whole or in part after five years from issuance. For this disclosure, it is assumed that none of these notes will be redeemed before their contractual maturities and interest rates on these notes will remain at their current levels. The difference between future cash payments and the carrying value of the notes represents fair value adjustment at the date of acquisition of USAgencies that is being amortized into interest expense over the notes outstanding period.
We have audited the accompanying consolidated balance sheets of Affirmative Insurance Holdings, Inc. and subsidiaries (the Company) as of December 31, 2010 and 2009, and the related consolidated statements of income (loss), stockholders’ equity, comprehensive income (loss), and cash flows for each of the years in the three-year period ended December 31, 2010. 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.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Affirmative Insurance Holdings, Inc. and subsidiaries as of December 31, 2010 and 2009, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2010, in conformity with U.S. generally accepted accounting principles.
Fiduciary and Restricted Cash • In the Company’s capacity as an insurance agency, it collects premiums from customers and, after deducting authorized commissions, remits these premiums to the appropriate insurance companies. Unremitted insurance premiums are held in a fiduciary capacity until disbursed to third parties or to the Company’s consolidated insurance subsidiaries. In certain states where the Company operates, the use of investment alternatives for these funds is regulated by various state agencies. The Company invests these unremitted funds only in cash and money market accounts and reports such amounts as restricted cash on the consolidated balance sheet. The Company reports the unremitted portion of these funds as amounts due to reinsurers on the consolidated balance sheet. Interest income earned on these unremitted funds is reported as investment income in the consolidated statement of income.
Investments • Investment securities consist primarily of debt securities, and are recorded at fair value on the consolidated balance sheet. These investments are classified as either available-for-sale or trading securities, based on management’s intent and ability to hold to maturity. For available-for-sale securities, unrealized gains and losses, net of income taxes, are recorded in accumulated other comprehensive income (loss), a separate component of stockholders’ equity. For trading securities, unrealized gains and losses are reported in current period earnings. The Investment Committee periodically reviews investment portfolio results and evaluates strategies to maximize yields, to match maturity durations with anticipated needs, and to maintain compliance with investment guidelines.
Fair value is based on quoted prices in active markets when available or third-party valuation sources when observable market prices are not available. Gains and losses realized on the disposition of investment securities are determined on the specific-identification basis and credited or charged to income. Premium and discount on investment securities are amortized and accreted using the interest method and charged or credited to investment income.
The Company also adopted in the second quarter of 2009 FASB standards which provide guidance on how to determine the fair value of assets and liabilities when the volume and level of activity for the asset or liability has significantly decreased. These standards also provide guidance on identifying circumstances that indicate a transaction is not orderly. In addition, the Company is required to disclose in interim as well as annual reporting periods the inputs and valuation techniques used to measure fair value and discussion of changes in valuation techniques. Adoption of these standards did not have a material effect on the Company’s consolidated financial position, results of operations or cash flows.
Amounts Due from/to Reinsurers • The Company collects premiums from insureds and after deducting its authorized commissions, the Company remits these premiums to the appropriate insurance and reinsurance companies. The Company’s obligation to remit these premiums is recorded as amounts due reinsurers in its consolidated balance sheet. The Company records the amounts it expects to receive from reinsurers as an asset on its consolidated balance sheet. The Company’s insurance companies report as assets the estimated reinsurance recoverable on paid losses and unpaid losses, including an estimate for losses incurred but not reported and ceded unearned premium.
The results of operations of acquired businesses are included in the consolidated financial statements from the respective dates of acquisition.
Settlement Agreement • In November 2008, the Company elected to participate in a settlement agreement with its broker related to auction-rate securities. Management elected to report this settlement agreement at fair value in other assets in the consolidated balance sheet with changes in fair value reported in other income in the consolidated statement of income (loss).
Variable Interest Entities • In December 2004, the Company formed Affirmative Insurance Holdings Statutory Trust I (“Trust I”), an unconsolidated trust subsidiary, for the sole purpose of issuing $30.0 million in trust preferred securities. Trust I used the proceeds from the sale of these securities and the Company’s initial capital contribution to purchase $30.9 million of subordinated debt securities from the Company. The debt securities are the sole assets of Trust I, and the payments under the debt securities are the sole revenues of Trust I.
Reserves for Losses and Loss Adjustment Expenses • The Company maintains reserves for the estimated ultimate liability for unpaid losses and loss adjustment expenses related to incurred claims and estimates of 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.
Recently Issued Accounting Standards • ASU 2010-26 modifies the types of costs incurred by insurance entities that can be capitalized in the acquisition of new and renewal insurance contracts. The Task Force reached a final Consensus that requires costs to be incremental or directly related to the successful acquisition of new or renewal contracts to be capitalized as a deferred acquisition cost. This standard is effective for interim and annual periods beginning after December 15, 2011 and may be early adopted as of the beginning of an annual reporting
ASU 2010-20, Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses, an amended guidance for disclosures about the credit quality of financing receivables and the allowance for credit losses was issued in July 2010 by the FASB. This update amends existing guidance by requiring more robust and disaggregated disclosures by an entity about the credit quality of its financing receivables and its allowance for credit losses. These disclosures will provide additional information about the nature of credit risks inherent in a company’s financing receivables, how a company analyzes and assesses credit risk in determining its allowance for credit losses, and the reasons for any changes a company may make in its allowance for credit losses. This update is generally effective for interim and annual reporting periods ending on or after December 15, 2010; however, certain aspects of the update pertaining to activity that occurs during a reporting period are effective for interim and annual reporting periods beginning on or after December 15, 2010. The adoption of the new guidance had no significant effect on the Company’s financial statements.
ASU 2009-16 eliminated 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. The provisions of the new standards are effective for fiscal years beginning after November 15, 2009. The adoption of the new standard effective January 1, 2010 did not impact on our consolidated financial position, results of operations or cash flows.
The amortized cost, net realized losses and estimated fair value of the Company’s trading securities portfolio at December 31, 2009, were as follows (in thousands):
At December 31, 2009, associated with the auction-rate securities was a settlement agreement that required the Company’s broker to purchase eligible securities at par, at any time during a two-year period beginning June 30, 2010. The Company had carried the settlement agreeement at fair value, which was $8.8 million at December 31, 2009, recorded in other assets in the consolidated balance sheets. Changes in fair value were recorded in other income in the consolidated statement of income (loss).
The unrealized losses at December 31, 2010 and 2009 were attributable to changes in market interest rates since the securities were purchased. Management systematically evaluates investment securities for other-than-temporary declines in fair value on a quarterly basis. This analysis requires management to consider various factors, which include (1) duration and magnitude of the decline in value, (2) the financial condition of the issuer or issuers, (3) structure of the security and (4) 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. At December 31, 2010 and 2009, management performed its quarterly analysis of all securities with an unrealized loss and concluded no individual securities were other-than-temporarily impaired.
Effective October 1, 2010, the Company entered into a quota-share reinsurance agreement with a third-party reinsurance company ceding 40% of certain premiums and losses on policies in-force in certain states on October 1, 2010 and policies written through December 31, 2010. The Company receives provisional ceding commission which may be adjusted based on the fully-developed loss ratio of the reinsured policies. Written premiums ceded under this agreement totalled $65.0 million during 2010.
On June 1, 2010, the Company entered into a reinsurance agreement with third-party reinsurers which provides coverage for catastrophic events that may involve multiple insured losses.
Under certain of the Company’s reinsurance transactions, the Company has received ceding commissions. The ceding commission rate structure varies based on loss experience. The estimates of loss experience are continually reviewed and adjusted, and the resulting adjustments to ceding commissions are reflected in current operations. Ceding commissions recognized were reflected as a (reduction) increase of selling, general and administrative expenses follows (in thousands):
The following table summarizes the ceded incurred losses and loss adjustment expenses (consisting of ceded paid losses and loss adjustment expenses and change in reserves for loss and loss adjustment expenses ceded) to various reinsurers for the years ended December 31, 2010, 2009 and 2008 (in thousands):
The Michigan Catastrophic Claims Association (MCCA) is the mandatory reinsurance facility that covers no-fault medical losses above a specific retention amount in Michigan. For policies effective in 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 $3.3 million, $2.4 million and $1.9 million in 2010, 2009 and 2008, respectively. The Company’s ceded losses to the MCCA were $50.7 million, $4.3 million and $4.5 million in 2010, 2009 and 2008, respectively. The increase was primarily due to an increase in ceded case reserves due to revised estimates of ultimate losses.
Quota-share reinsurer for agreement effective in fourth quarter of 2010, and excess of loss reinsurers all have A ratings from A.M. Best. Accordingly, the Company believes there is minimal credit risk related to these reinsurance receivables. Under the reinsurance agreement with Vesta Insurance Group (VIG), including primarily Vesta Fire Insurance Corporation (VFIC), the Company’s wholly-owned subsidiaries, Affirmative Insurance Company (AIC) and Insura Property and Casualty Insurance Company (Insura), had the right, under certain circumstances, to require VFIC to provide a letter of credit or establish a trust account to collateralize gross amounts due from VFIC under the reinsurance agreement. Accordingly, AIC, Insura and VFIC entered into a Security Fund Agreement effective September 2004. In August 2005, AIC received a letter from VFIC’s President that irrevocably confirmed VFIC’s duty and obligation under the Security Fund Agreement to provide security sufficient to satisfy VFIC’s gross obligations under the reinsurance agreement (the VFIC Trust). At December 31, 2010, the VFIC Trust held $16.7 million (after cumulative withdrawals of $8.7 million through December 31, 2010), consisting of $12.9 million of a U.S. Treasury money market account and $3.8 million of corporate bonds rated BBB+ or higher, to collateralize the $13.2 million net recoverable (net of $2.9 million payable) from VFIC.
The Company assumes reinsurance from a Texas county mutual insurance company (the county mutual) whereby the Company has assumed 100% of the policies issued by the county mutual for business produced by the Company’s owned MGAs. The county mutual does not retain any of this business and there are no loss limits other than the underlying policy limits. The county mutual reinsurance agreement may be terminated by either party on any annual anniversary upon prior written notice of not less than 90 days. In the event of such termination, the MGA agrees that for ten years the MGA shall produce automobile insurance business in the State of Texas solely for the benefit of the county mutual. The county mutual reinsurance agreement automatically terminates on January 1, 2014. AIC has established a trust to secure the Company’s obligation under this reinsurance contract with a balance of $52.0 million and $40.2 million as of December 31, 2010 and 2009, respectively.
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, 2010 and 2009 (in thousands):
Policy acquisition costs, consisting of primarily 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 was $72.2 million for 2008. At December 31, 2010, the Company determined a premium deficiency existed and recorded a $0.5 million reduction of deferred acquisition costs.
The Company completed its annual goodwill and indefinite lived intangible asset impairment analysis as of September 30, 2010. The Company reports under a single reporting segment and, as such, the goodwill analysis is measured at the consolidated company level. Consistent with prior assessments, the fair value of the Company was determined using an internally developed discounted cash flow methodology and other relevant indicators of value available in the market place such as market transactions and trading values of similar companies. Based upon the results of the assessment, the Company concluded that the carrying values of goodwill and other intangible assets were not impaired as of September 30, 2010.
Amortization expense for the intangible assets was 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 bore an initial interest rate of 7.545% until March 15, 2010. Since March 15, 2010, the securities adjust quarterly to the three-month LIBOR rate plus 3.60%. The interest rate as of December 31, 2010 was 3.90%.
The $20.2 million notes payable due 2035 are redeemable by the issuer in whole or in part anytime after March 15, 2010. The notes were issued in March 2005 and bore an initial interest rate of the three-month LIBOR rate plus 3.95% not exceeding 12.50% through March 2010 with no limit thereafter. The interest rate as of December 31, 2010 was 4.25%.
In conjunction with the 2007 acquisition of USAgencies, the Company entered into a $220.0 million senior secured credit facility (the facility) with a syndicate of lenders that consisted of a $200.0 million senior term loan facility, and a revolving facility of up to $20.0 million, depending on the Company’s borrowing capacity.
The leverage ratio covenant calculation was changed to include only amounts borrowed under the facility. In addition, the quarterly requirements were changed for the remaining term of the facility;
The fixed charge coverage ratio was changed to include only interest expense paid in cash. In addition, the annual requirements were changed for the remaining term of the facility;
The Company recorded a $19.4 million pretax, non-cash gain on extinguishment of debt as a result of this transaction, which is included in a separate line item in the accompanying consolidated statement of income (loss) for the year ended December 31, 2009. The $19.4 million debt extinguishment gain resulted from a $24.2 million discount representing the difference between the carrying value of the original credit agreement and the fair value of the new modified credit agreement, net of $0.7 million of term lender consent fees and the write-off of $4.1 million of deferred debt issuance costs relating to the original credit agreement. During 2010, the Company made its scheduled quarterly payments of $1.2 million and additional payments of $20.4 million. As of December 31, 2010, the principal balance of the senior secured credit facility was $108.4 million. The revolving portion of the facility expired in January 2010.
The Company’s obligations under the facility are guaranteed by its material operating subsidiaries (other than the Company’s insurance companies) and are secured by a first lien security interest on all of the Company’s assets and the assets of its material operating subsidiaries (other than the Company’s insurance companies), including a pledge of 100% of the stock of AIC. The facility contains certain financial covenants, which include capital expenditure limitations, minimum interest coverage requirements, maximum leverage ratio requirements, minimum risk-based capital requirements, maximum loss ratio limitations, minimum fixed charge coverage ratios and a minimum consolidated net worth requirement, as well as other restrictive covenants. As time passes, certain of the financial covenants become increasingly more restrictive.
The principal amount of the term loan is payable in quarterly installments, with the remaining balance due on the seventh anniversary of the closing of the facility. The Company is also required to make additional annual principal payments that are to be calculated based upon the Company’s financial performance during the preceding fiscal year. The Company does not expect to have an additional required principal payment due March 2011 as a result of principal prepayments made during 2010. 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 recognized an income tax expense from continuing operations of $1.7 million for the year ended December 31, 2010 as compared to $22.4 million for the prior year. The Company’s effective tax rate from continuing operations of 2.0% for the year ended December 31, 2010 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.
At December 31, 2010, the Company had available approximately $0.5 million of capital loss carryforwards expiring in 2012 resulting primarily from sales of securities in 2006 and 2007 to adjust the duration of the Company’s investment portfolio. Capital loss carryforwards, which may be carried forward five years, may only be used to offset future realized capital gains. The Company recorded a valuation allowance for the full amount of the deferred tax asset resulting from these capital loss carryforwards.
In October 2006, the Company entered into an IT outsourcing contract with a data processing services provider under which the Company outsourced substantially all of its IT operations, including the Company’s data center, field support and application management. The initial term of the agreement was ten years, although it may be terminated for convenience by the Company at any time upon six month’s notice after the first two years, subject to the payment of certain stranded costs and other termination fees. The Company’s IT outsourcing expenses were $14.2 million, $12.7 million and $12.7 million for the years ended December 31, 2010, 2009 and 2008, respectively.
The following table summarizes the Company’s minimum future IT outsourcing and operating lease commitments at December 31, 2010 (in thousands):
From time to time, the Company and its subsidiaries are subject to random compliance audits from federal and state authorities regarding various operations within its business that involve collecting and remitting taxes or assessing taxes on certain activities, in one form or another. In 2006, two of the Company’s wholly-owned underwriting agencies were subject to a sales and use tax audit conducted by the State of Texas. The examiner for the State of Texas completed his audit report and delivered two companion audit assessments, for the period from January 2002 to December 2005, asserting collectively that the Company should have collected and remitted approximately $2.9 million in additional sales tax derived from allegedly taxable claims services performed by the Company’s underwriting agencies for policies sold by these underwriting agencies and issued by a county mutual insurance company through a fronting arrangement. The assessments included an additional $0.4 million for accrued interest and penalty for a total assessment of $3.3 million. In October 2006, the Company responded to the assessments by filing two petitions with the Comptroller of Public Accounts for the State of Texas requesting a re-determination of the taxes alleged to be due. On December 22, 2010, the parties filed a Joint Motion to Dismiss memorializing their agreement by which: (1) the full amount of the assessments would be upheld; (2) the Company would make one payment of $250,000 in full compromise and satisfaction of both the assessments and all related penalties and interest; and (3) upon receipt of the Company’s payment, all additional tax, penalties and interest remaining unpaid would be reduced to zero and the Company discharged from all remaining liability. On January 27, 2011, the Comptroller rendered its final decision approving the parties’ agreement and dismissing the Company’s petitions for redetermination. The $250,000 settlement was accrued in the Company’s consolidated balance sheet as of December 31, 2010.
and consultants through equity-based compensatory awards, including stock options, stock bonus awards, restricted and unrestricted stock awards, performance stock awards, stock appreciation rights and dividend equivalent rights. The maximum number of shares of common stock reserved for issuance under the 2004 Plan, as amended, is 3,000,000, subject to adjustment to reflect certain corporate transactions or changes in the Company’s capital structure. At December 31, 2010, 1,560,321 shares were reserved for future grants under the 2004 Plan.
Under the 2004 Plan, the board or Compensation committee may fix the term and vesting schedule of each stock option, but no incentive stock option will be exercisable more than ten years after the date of grant. Vested stock options generally remain exercisable for up to three months after a participant’s termination of service or up to 12 months after a participant’s death or disability. Typically, the exercise price of each incentive stock option must not be less than 100% of the fair market value of the Company’s common stock on the grant date, and the exercise price of a nonqualified stock option must not be less than 20% of the fair market value of the Company’s common stock on the grant date. In the event that an incentive stock option is granted to a 10% stockholder, the term of such stock option may not be more than five years and the exercise price may not be less than 110% of the fair market value on the grant date. The exercise price of each stock option granted under the 2004 Plan may be paid in cash or in other forms of consideration in certain circumstances, including shares of common stock, deferred payment arrangements or pursuant to cashless exercise programs. A stock option award may provide that if shares of the Company’s common stock are used to pay the exercise price, additional stock options will be granted to the participant to purchase that number of shares used to pay the exercise price. Generally, stock options are not transferable except by will or the laws of descent and distribution, unless the board or Compensation committee provides that a nonqualified stock option may be transferred.
There were no stock options issued in 2010, 2009 or 2008.
The Company sponsors a defined contribution retirement plan under Section 401(k) of the Internal Revenue Code. The plan covers substantially all employees who meet specified service requirements. Under the plan, the Company may, at its discretion, match 100% of each employee’s contribution, up to 3% of the employee’s earnings, plus 50% of each employee’s contribution for the next 2% of the employee’s salary. The Company’s total contribution to the 401(k) plan was $0.5 million and $1.0 million in 2009 and 2008, respectively. In July 2009, the Company suspended matching contributions to the 401(k) plan. There were no employer matching contributions to the 401(k) plan in 2010.
In the fourth quarter of 2010, the Company committed to invest $2.5 million in Varadero, a hedge fund, and entered into an investment management agreement for up to $10.0 million of the investment portfolio. The investment manager is Varadero Capital, L.P., of which Varadero GP, LLC is the general partner. Both the investment manager and general partner are partially-owned by an entity affiliated with Mr. Flowers. As of December 31, 2010, the Company had funded $2.5 million in the hedge fund and had $7.4 million under management by Varadero.
As part of the terms of the acquisition of AIC and Insura, VIG has indemnified the Company for any losses due to uncollectible reinsurance related to reinsurance agreements entered into with unaffiliated reinsurers prior to December 31, 2003. As of December 31, 2010, all such unaffiliated reinsurers had A.M. Best ratings of “A-” or better with a reinsurance recoverable of $3.0 million.
Assignment, Affirmative Property agreed to replace KRCC’s Letter of Credit at a future date with a Letter of Credit of like amount issued in favor of the Landlord on Affirmative Property’s behalf. In May 2007, Affirmative Insurance Holdings, Inc. entered into an irrevocable Letter of Credit in favor of the Landlord in the amount of $293,257 as a replacement for the KRCC Letter of Credit. Effective August 1, 2009, the Letter of Credit was decreased to $150,148.
The Company’s insurance company subsidiaries are subject to risk-based capital standards and other minimum capital and surplus requirements imposed under applicable state laws, including the laws of their state of domicile. The risk-based capital standards, based upon the Risk-Based Capital Model Act adopted by the National Association of Insurance Commissioners, or NAIC, require the Company’s insurance company subsidiaries to report their results of risk-based capital calculations to state departments of insurance and the NAIC.
The Illinois Insurance Code includes a reserve requirement that requires an insurer to maintain an amount of qualifying investments as defined at least equal to the lesser of $250.0 million or 100% of adjusted loss reserves and loss adjustment reserve expenses. As of December 31, 2010, Affirmative Insurance Company was deficient in qualifying assets by $29.5 million. The Company submitted its plan to the Illinois Department of Insurance in March 2011. The plan that the Company proposed included a $3.8 million ordinary dividend and a $21.0 million extraordinary distribution from two of AIC’s insurance company subsidiaries, which were completed in March 2011 and an extraordinary dividend from one of AIC’s insurance company subsidiaries, which is subject to its state insurance department approval. If the state insurance department does not approve the extraordinary dividend the Company has other means available to cure the deficiency.
The majority of the Company’s commission income and fees are directly related to the premiums written through its insurance subsidiaries from policies sold to individuals located in certain states. Accordingly, the Company could be adversely affected by economic downturns, natural disasters, and other conditions that may occur from time-to-time in these states.
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 invested assets, 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:
Financial assets classified as Level 2 in the fair value hierarchy include mortgage-backed securities, tax-exempt securities, corporate bonds and FDIC-insured certificates of deposit. The fair value of these securities is determined based on observable market inputs provided by independent third-party pricing services and the Company discloses the fair values of these investments in Level 2 of the fair value hierarchy. The Company determined that its corporate debt securities are more appropriately classified as Level 2 in the fair value hierarchy. Prior year amounts have been reclassified to conform to the current year presentation. 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 did not have any significant transfers between Levels 1 and 2 during the year ended December 31, 2010.
Derivative financial instruments are reported at fair value on the consolidated balance sheet. The Company’s current derivative instruments consist of two interest rate swaps with an aggregate notional amount of $90 million outstanding at December 31, 2010, previously designated as hedges against the variability of cash flows associated with that portion of the senior secured credit facility. The interest rate swap liability is recorded in other liabilities on the consolidated balance sheet. The credit risk associated with these swap agreements is limited to the uncollected interest payments due from counterparties. As of December 31, 2010, counterparty credit risk was minimal.
Fair values represent the Company’s best estimates and may not be substantiated by comparisons to independent markets and, in many cases, could not be realized in immediate settlement of the instruments. The following financial liabilities are not required to be recorded at fair value, but their fair value is being disclosed.
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 $88.3 million with a carrying value of $96.0 million at December 31, 2010.
The Company’s insurance subsidiaries are required to file statutory-basis financial statements with state insurance departments in all states where they are licensed. These statements are prepared in accordance with accounting practices prescribed or permitted by the applicable state of domicile. Each state of domicile requires that insurance companies domiciled in those states prepare their statutory-basis financial statements in accordance with the National Association of Insurance Commissioners Accounting Principles and Procedures Manual subject to any deviations prescribed or permitted by the insurance commissioner in each state of domicile.
The following is a summary of the Company’s unaudited quarterly consolidated results from continuing operations for the years ended December 31, 2010 and 2009 (in thousands, except per share data):