Management’s Discussion and Analysis of Financial Condition and Results of Operations addresses the financial condition of Alfa Corporation and its subsidiaries (the Company) as of December 31, 2005, compared with December 31, 2004 and the results of operations for each of the three years ended December 31, 2005. The following discussion should be read in conjunction with the Consolidated Financial Statements and Notes to Consolidated Financial Statements that are included in Item 8 of this Form 10-K.
The Company’s revenue consists mainly of premiums earned, policy charges, net investment income and fee income. Benefit and settlement expenses consist primarily of claims paid and claims in
process and pending and include an estimate of amounts incurred but not yet reported along with loss adjustment expenses. Other operating expenses consist primarily of compensation expenses, and other overhead business expenses, net of deferred policy acquisition costs.
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America (GAAP) requires the Company’s management to make significant estimates and assumptions based on information available at the time the financial statements are prepared. In addition, management must ascertain the appropriateness and timing of any changes in these estimates and assumptions. Certain accounting estimates are particularly sensitive because of their significance to the Company’s financial statements and because of the possibility that subsequent events and available information may differ markedly from management’s judgments at the time financial statements are prepared. For the Company, the areas most subject to significant management judgments include reserves for property casualty losses and loss adjustment expenses, reserves for future policy benefits, deferred policy acquisition costs, valuation of investments, and reserves for pending litigation. The application of these critical accounting estimates impacts the values at which
or industry related events, and for which the Company has the intent to hold the investment for a period of time believed to be sufficient to allow a market recovery or to maturity, are considered to be temporary. Future adverse investment market conditions, or poor operating results of underlying investments, could result in an impairment charge in the future. Where a decline in fair value of an investment below its cost is deemed to be other than temporary, a charge is reflected in income for the difference between the cost or amortized cost and the estimated net realizable value. As a result, writedowns of approximately $1.0 million and $1.0 million were recorded in 2005 on equity securities and fixed maturities, respectively. During 2004, writedowns of approximately $111,000 were recorded on fixed maturities with no writedowns on equity securities.
Net investment income increased 6% in 2005 due to increased partnership earnings and a slightly lower yield on increased balances of fixed income securities, while net investment income grew 8% in 2004 due to increased earnings from fixed income securities and partnerships. Positive cash flows resulted in an increase in invested assets of 8% and 5% in the twelve months since December 31, 2005 and 2004, respectively.
Noninsurance operating income decreased $2.2 million or 102% in 2005 after declining 47% in 2004. Starting in 2005, this segment contains all agency operations, which include Vision, AAG and AAM. Due to unanticipated delays in licensing for AVIC, Vision experienced lower revenues than expected. By the end of the fourth quarter of 2005, all licenses were in place. Also impacting this segment was the reduction in commercial leasing activities as a result of management’s decision to hold this division for sale as of December 31, 2004 and which was subsequently sold on December 31, 2005. Rising interest rates also contributed to reduced margins within Financial’s portfolio. ABC’s operations resulted in an operating loss for 2005 as the result of recognition of a deferred tax asset and subsequent charge to earnings for the change in the deferred tax asset arising from the formation of the entity in 1999.
Effective January 1, 2005, the property casualty insurance Pooling Agreement (refer to Note 2-Pooling Agreement in the Notes to Consolidated Financial Statements) was modified as follows:
Fire’s quota share reinsurance agreement with Virginia Mutual was retroceded to the pool.
Index to Financial Statements AVIC, a direct writer of nonstandard risk automobile business in Missouri, Indiana, Ohio, Virginia, Tennessee, Arkansas, Kentucky and Florida, and assumes business in Texas, contributed $53 million of written premium and $32 million of earned premium to the pool during 2005. Virginia Mutual, a direct writer of personal and commercial automobile business, homeowners, and other personal and commercial business in Virginia and North Carolina, through the quota share agreement, contributed $50.2 million of written premium, of which $16.9 million was related to unearned premium existing at December 31, 2004 with $33.3 written during 2005. In addition, Virginia Mutual contributed $33.5 million of earned premium to the pool during 2005. The Company’s pooled share of AVIC and Virginia Mutual premium is reported as $20.0 million of personal lines earned premiums and $22.6 million of reinsurance assumed earned premiums in the table above.
The loss ratio for the year related to the AVIC business was 61.4% and Virginia Mutual was 49.6%, which represents 4.2% of the overall loss ratio of 60.1%. Also included in the loss ratio are 2.1% of catastrophe losses. Alfa had eight events totaling $293.9 million in gross catastrophe losses during 2005 and five events totaling $347.5 million in 2004 due to the impact of hurricanes, tornadoes and other severe weather. The effect of claims from these events impacted underwriting results by $0.09 and $0.07 per share in 2005 and 2004, respectively, after taxes, based upon the pooling agreement and the catastrophe protection program. For additional information on the pooling agreement, refer to Note 2-Pooling Agreement in the Notes to Consolidated Financial Statements.
The overall higher expense structures of AVIC and Virginia Mutual, along with the impact of technology costs has produced a slightly lower underwriting margin of 10.0% in 2005, compared with 10.3% in 2004. Underwriting margin, a non-GAAP financial measure, represents the percentage of each premium dollar earned which remains after losses, loss adjustment expenses and other operating expenses.
Pretax operating income increased $4.5 million and operating income, net of tax, increased $2.9 million as a result of the addition of AVIC and Virginia Mutual business.
Net income increased 22.5% for 2005, compared to 27.0% in 2004, with AVIC and Virginia Mutual contributing $2.9 million in 2005. Return on equity was 18.6% for 2005 compared to 16.7% in 2004.
Earned premiums increased $31.1 million, or 6.8% in 2004, due to an increase in sales production of new business and the positive impact of homeowner rate increases offset by increases in ceded catastrophe premium of approximately $1.8 million. These factors contributed to the growth in personal lines earned premiums of 7.3% and 7.5% in 2004 and 2003, respectively.
Total life insurance inforce for 2005 increased $1.4 billion, with term insurance increasing $1.2 billion, or 12.4%. Annualized premiums for inforce business increased 6%, or $7.2 million, for the year, with term insurance increasing 11.6% or $3.4 million. The persistency ratio remained steady at 91.2%.
The Company’s life insurance premiums and policy charges increased $5.1 million, or 7.6% in 2004. Universal life policy charges and traditional premiums increased by $1.3 million and $3.6 million, respectively. The increase in traditional premiums was due to continued increases in term product production and a decline in termination rates. In addition, interest sensitive life policy charges grew by $279,000 or 2.7% as a result of re-pricing the product and adding a preferred underwriting class. New business premium increased 1.4% while persistency declined from 92.9% to 91.2%.
At December 31, 2004, the life subsidiary’s Adjusted Capital calculation in accordance with NAIC RBC guidelines was $173.6 million compared to the Authorized Control Level (Required) RBC amount of $11.6 million.
Results of operations for this segment have been impacted by the following events in 2005:
On December 31, 2005, the Company completed the sale of a substantial portion of its commercial lease portfolio and other assets, net of related liabilities, to OFC Servicing Corporation, a wholly-owned subsidiary of MidCountry Financial Corporation (MidCountry).
All agency operations, Vision, AAM and AAG, are included in this segment.
of the portfolio was syndicated in 2004, and new lease production was limited in 2005, creating a significant reduction in leasing income for 2005 of 46.9%. In addition, the change in interest rates during the year increased interest expense 12.9%. Results were also negatively impacted by additional bad debt reserves established in the commercial lease portfolio. The net loss for OFC Capital for the year was $2.2 million. No gain or loss was recognized on the sale and all revenue and expenses are included in continuing operations instead of discontinued operations due to the Company’s significant continuing involvement with MidCountry. The Company retained a small portion of the commercial lease portfolio which OFC Servicing Corporation will service. All of the results of operations relating to the retained portfolio activities will continue to be reported in this segment.
ABC had an operating loss of $931 thousand for 2005 as a result of recognition of a deferred tax asset and subsequent charge to earnings for the change in the deferred tax asset.
Noninsurance operations were down 47% due primarily to unfavorable results in the finance subsidiary. Collateral loans grew by 10.4% to $110.8 million at December 31, 2004 while the yield on the portfolio increased 59 basis points in 2004. The commercial lease portfolio decreased by 31.0% to $81.3 million at December 31, 2004 as the commercial leasing division sold portions of its portfolio. Commercial lease operations experienced a decrease in earnings of approximately $2.5 million after reserves were established related to the Chapter 7 bankruptcy filing of NorVergence, a telecommunications provider who previously supplied essential services to approximately 340 of the Company’s leasing customers. In addition, the finance subsidiary’s investment in MidCountry yielded pretax income of approximately $540,000 during 2004 compared to $965,000 in 2003. This decline is attributable to acquisition activity and stock offering expenses incurred in 2004 by MidCountry as well as interest costs associated with the additional investment of $36.1 million by the finance subsidiary. Operating income from the Company’s subsidiary covering certain employee benefits increased by approximately $1.1 million to $1.25 million in 2004. The sales of the Company’s real estate and construction subsidiaries in February 2004 created unfavorable earnings comparisons since these business units incurred losses of approximately $47,000 prior to their dispositions in 2004 compared to earnings of approximately $364,000 during 2003.
Corporate expenses, including the impact of eliminations, increased $2.0 million in 2005 due primarily to an increase in borrowing costs and the elimination of profits generated by transactions between the property casualty segment and Vision. Unfavorable increases in short-term interest rates and an increase in the commercial paper borrowings attributable to corporate functions and the purchase of Vision led the Company’s interest expense to rise by approximately $1.9 million from levels experienced in 2004. The weighted average rate increased from 2.3% to 4.3% with corporate debt increasing from $58.1 million at the end of 2004 to $77.6 million on December 31, 2005.
As a result of the overall positive cash flows from operations, invested assets grew 7.9% since December 31, 2004 while net investment income increased 6.2%. The decrease in cash flow from operations in 2005 was due primarily to the increase in liabilities from higher partnership commitments in 2004 offset by increases in policy liabilities impacted by catastrophes during 2005. Property casualty underwriting income of $55.9 million in 2005, $50.2 million in 2004 and $35.2 million in 2003 positively impacted cash flow from operations. In addition, the COLI plan in the life insurance subsidiary provided approximately $15 million in additional cash flow in 2005, $15 million in 2004 and $16 million in 2003. Net increases in cash resulting from increased borrowings were primarily used to support growth in the loan portfolio of the finance subsidiary and to fund a portion of the acquisition costs of Vision. During 2005, the Company also increased its investment in fixed maturity securities by approximately $89.5 million. The Company’s increase in net investment income resulted primarily from earnings on fixed maturities, equity-method investments and partnerships offset by increased borrowing costs and lower lease revenues.
The overall yield rate, calculated using amortized cost, remained unchanged during 2005 at 6.0%. The Company had net realized investment gains before income taxes of approximately $6.1 million in 2005 compared to realized investment gains of approximately $7.0 million during 2004. These gains are primarily from sales of equity securities. Such realized gains on sales of equity securities are the result of market conditions and therefore can fluctuate from period to period.
The rating of the Company’s portfolio of fixed maturities using the Standard & Poor’s rating categories is as follows at December 31, 2005 and 2004:
At December 31, 2005, all securities in the fixed maturity portfolio were rated by an outside rating service. The Company considers bonds with a quality rating of BB+ and below to be below investment grade or high yield bonds (also called junk bonds).
We have audited management’s assessment, included in the accompanying Report on Internal Control Over Financial Reporting, that Alfa Corporation and Subsidiaries (the Company) maintained effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.
During 2003, one of Financial’s investments, MidCountry Financial Corporation (MidCountry), pursued the opportunity to purchase Bayside Financial Corp. In order for this purchase to take place, approval had to be secured from the Office of Thrift Supervision. Consequently, due to ownership levels, this transaction qualified Financial and the Company as unitary thrift holding companies. As a condition of approval, the Company agreed to sell its residential and commercial construction subsidiary, Alfa Builders, Inc. (Builders) and its real estate sales subsidiary Alfa Realty, Inc. (Realty) to Southern Boulevard Corporation (Southern), a wholly-owned subsidiary of Alfa Mutual Insurance Company (Mutual) for their independently-determined fair values of approximately $5.5 million and $2.6 million, respectively. Southern subsequently became Alfa Properties, Inc. (Alfa Properties) during the first quarter of 2004. No gain or loss was recorded on these transactions. The financial statements and notes to the financial statements contained within this report include the results of these subsidiaries for the first two months of 2004 as well as the year 2003.
As more fully discussed in Note 2-Pooling Agreement, the Company’s property casualty insurance business is pooled with that of the Mutual Group which writes property casualty business in Alabama. The Company’s pooled business is concentrated geographically in Alabama, Georgia and Mississippi. Approximately $514 million of premiums and policy charges representing 81% of such amounts in 2005 were from policies written in Alabama. Accordingly, unusually severe storms or other disasters in this state might have a more significant effect on the Company than on a more geographically diversified insurance company and could have an adverse impact on the Company’s financial condition and operating results. Increasing public interest in the availability and affordability of insurance has prompted legislative, regulatory and judicial activity in several states. This includes efforts to contain insurance prices, restrict underwriting practices and risk classifications, mandate rate reductions and refunds, eliminate or reduce exemptions from antitrust laws and generally expand regulation. Because of Alabama’s low automobile rates as compared to rates in most other states, the Company does not expect the type of punitive legislation and initiatives found in some states to be a factor in its primary market in the immediate future.
Universal Life Products: Universal life products include universal life insurance and other interest-sensitive life insurance policies. Universal life revenues, which are considered operating cash flows, consist of policy charges for the cost of insurance, policy administration, and surrender charges that have been assessed against policy account balances during the period. The timing of revenue recognition is determined by the nature of the charge. Cost of insurance and policy administrative charges are assessed on a monthly basis and recognized as revenue when remittances are processed. Percent of premium charges are assessed at the time of payment by the policyholder and recognized as revenue when processed. Surrender charges are recognized as revenue upon surrender of a contract by the policyholder in accordance with contractual terms. Benefit reserves for universal life represent policy account balances before applicable surrender charges. Policy benefits and claims that are charged to expense include interest credited to policy account balances on a monthly basis and death claims reported in the period in excess of related policy account balances.
The Company’s method of accounting for income taxes is the liability method. Under the liability method, deferred tax assets and liabilities are adjusted to reflect changes in statutory tax rates resulting in income adjustments in the period such changes are enacted. Deferred income taxes are recognized for temporary differences between the financial reporting basis and income tax basis of assets and liabilities, based on enacted tax laws and statutory tax rates applicable to the periods in which the temporary difference is expected to reverse. The method of allocation between subsidiaries is subject to a written agreement, approved by the Board of Directors. Current taxes are allocated to each subsidiary within the consolidated group based upon the ratio of the subsidiary’s taxable income to the consolidated taxable income with no credit to subsidiaries with a taxable loss.
Basic EPS is computed by dividing net income by the weighted average number of shares outstanding. Diluted EPS is computed similarly except that the shares outstanding are increased to give effect to all potentially dilutive shares that would have been outstanding if such shares had been issued. The weighted average diluted shares outstanding include, on a post-split basis, potentially dilutive shares which total 571,855 shares in 2005, 504,851 in 2004 and 581,332 shares in 2003. All dilutive shares are the result of stock options outstanding with the exception of 9,149 dilutive shares resulting from restricted stock awards in 2005 (refer to Note 15-Stock-Based Compensation).
Fixed Maturities: Fixed maturities held for investment include investments that the Company has both the ability and positive intent to hold until maturity; such securities are reported at amortized cost. Securities available for sale include bonds and redeemable preferred stocks that the Company may elect to sell prior to maturity and are reported at their current fair value. The unrealized gains or losses on these securities are reflected as accumulated other comprehensive income within stockholders’ equity, net of taxes. Furthermore, deferred policy acquisition costs for universal and other interest sensitive life insurance products are adjusted to reflect the effect that would have been recognized had the unrealized holding gains and losses been realized. This adjustment to deferred acquisition costs results in a corresponding adjustment to comprehensive income. During 2005, the amount of this adjustment before taxes was $3,553,657. Amortization of premium or discount is calculated using the scientific (constant yield) interest method and is recorded as an adjustment to investment income. The interest method results in a constant effective yield equal to the prevailing rate at the time of purchase or at the time of subsequent adjustments to book value. Fixed maturities containing call provisions (where the issue can be called away from the Company at the issuer’s discretion) are amortized to the call or maturity value/date that produces the lowest asset value (yield to worst). For mortgage-backed securities, the amortization period reflects estimates of the period over which repayment of principal is expected to occur, not the stated maturity period.
Collateral Loans and Commercial Leases: Collateral loans and lease financings including commercial leases classified as held for sale are reported in the balance sheet at outstanding principal balance adjusted for charge-offs and the allowance for losses in accordance with Statement of Position (SOP) 01-6, Accounting by Certain Entities That Lend to or Finance the Activities of Others. The allowance for losses on collateral loans and commercial leases represents the Company’s best estimate of probable losses inherent in the portfolios based on relevant observable data that include, but are not limited to, historical experience, collateral type, account balance and delinquency. Credit losses are deducted from the allowance and charged off in the period in which the loans or leases are deemed uncollectible. Recoveries previously charged off are recorded when received. The Company considers an account to be delinquent if it is thirty or more days late in its scheduled payments. If the account is over 90 days late, the Company considers repossession of the collateral. If collateral is repossessed, the loan or lease is written down against the allowance for losses and the asset is transferred to other assets and carried at the lower of cost or estimated fair value less the cost to dispose. Loans are placed on a nonaccrual status when a bankruptcy is reported or the collateralized assets are repossessed. The Company uses the effective interest method to recognize income on loans and leases. Deferred fees are amortized over the term of the commercial lease.
Short-term Investments: Short-term investments with maturities of three months or less are considered to be investments and are not considered to be cash or cash equivalents. The Company’s short-term investments are predominately money market funds. Money market mutual funds seek to maintain a stable net asset value of $1.00 per share. There is no assurance that funds will be able to maintain a stable asset value of $1.00 per share. However, our policy is to invest in money market funds that are rated AAAm and/or Aaa by Standard & Poor’s and/or Moody’s Investor Service, Inc., respectively, or are rated by the NAIC Securities Valuation Office as Class 1. These funds are diversified money market funds investing in Tier 1 commercial paper and bank obligations, U.S. Treasury, U.S. government obligations, certificates of deposits and repurchase agreements.
At December 31, 2005, Vision (refer to Note 17-Business Combinations and Divestitures) had a carrier contract requiring them to fund a collateral trust based on a percentage of written premiums. The primary purpose was to provide collateral for the payment of all obligations and performance of all duties set forth in the contract. The amount in the trust is reviewed on an annual basis and adjusted accordingly. The amount of cash restricted at December 31, 2005 was $957,368.
Life Insurance Products: Commissions and other costs of acquiring insurance that vary with and are primarily related to the production of new and renewal business have been deferred. Traditional life insurance acquisition costs are being amortized over the premium payment period of the related policies using assumptions consistent with those used in computing policy benefit reserves. Acquisition costs for universal life type policies are being amortized over a thirty-year period in relation to the present value of estimated gross profits that are determined based upon surrender charges and investment, mortality and expense margins. The life insurance segment deferred $18,815,613 and recorded amortization expense of $9,277,108 related to acquisition costs leaving a balance of $171,107,909 at December 31, 2005. Included in this balance is a reduction of $1,529,460 which represents an offset to unrealized holding gains that is required as an adjustment to deferred policy acquisition costs under SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities, when amortization expense is determined under the gross profits method described in SFAS No. 97, Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments.
A premium deficiency reserve is recognized by recording an additional liability for the deficiency, with a corresponding charge to operations when anticipated losses, loss adjustment expenses, commissions and other acquisition costs, and maintenance costs exceed the recorded unearned premium reserve, and any future installment premiums on existing policies. The Company had no liability related to premium deficiency reserves at December 31, 2005 or December 31, 2004. The Company utilizes anticipated investment income as a factor in the premium deficiency calculation.
Cash Flow Hedges: The Company uses variable-rate debt to partially fund its consumer loan and commercial lease portfolios. In particular, it has issued variable-rate long-term debt and commercial paper. These debt obligations expose the Company to variability in interest payments due to changes in interest rates. If interest rates increase, interest expense increases. Conversely, if interest rates decrease, interest expense also decreases.
The Company assesses interest rate cash flow risk by continually identifying and monitoring changes in interest rate exposures that may adversely impact expected future cash flows and by evaluating hedging opportunities.
The Company maintains risk management control systems to monitor interest rate cash flow risk attributable to both the Company’s outstanding or forecasted debt obligations as well as the Company’s offsetting hedge position. The risk management control systems involve the use of analytical techniques, including cash flow sensitivity analysis, to estimate the expected impact of changes in interest rates on the Company’s future cash flows.
Changes in fair value of the interest rate swap designated as a hedging instrument of the variability of cash flows associated with floating-rate, long-term debt obligation are reported in accumulated other comprehensive income, net of taxes. The Company accounts for the hedging instrument using the short-cut method and has not reclassified any of the gains or losses to interest expense in the subsequent periods. The fair value of the interest rate swap contract decreased by $2,146,896 in 2005 prior to a tax benefit of $751,414.
Other Derivative Instruments: Covered call options are contracts that grant the purchaser, for a premium payment, the right, but not the obligation, to purchase a financial instrument at a specified price within a specified period of time. The Company writes (sells) call options on certain common stocks it already owns to enhance returns to the extent of the premium received. The premium received for a written call option is recorded in other liabilities until the option is exercised, expires, or is otherwise terminated. On disposition, gains (losses) are recognized immediately, with gains (losses) on exercise combined with gains (losses) on the covering asset. The liability is marked to market at each statement date with the changes in the market value of the open options recognized as realized gains (losses) and recorded in the statement of income. The Company had $49,700 and $169,450 in options outstanding at December 31, 2005 and 2004, respectively.
The Company is subject to lawsuits in the normal course of business related to its insurance and noninsurance products. In accordance with SFAS No. 5, Accounting for Contingencies, management evaluates the merits of each case and determines the need for establishing estimated reserves for potential settlements or judgments as well as reserves for potential costs of defending the Company against the allegations of the complaint at the time a lawsuit becomes known. These reserves may be adjusted as the case develops. Periodically, and at least quarterly, management assesses all pending cases as a basis for evaluating reserve levels. At that point, any necessary adjustments are made to
Effective August 1, 1987, the Company’s property casualty insurance subsidiaries entered into a reinsurance Pooling Agreement (the “Pooling Agreement”) with the Mutual Group.
Effective January 1, 2005, the Pooling Agreement was amended and restated, commuting certain pools from August 1, 1987 through December 31, 2001. In addition, AVIC was added as a participant in the Pooling Agreement with other companies in the Alfa Group and Fire began retroceding the quota share business it receives from Virginia Mutual to the pool.
Approximately 72.9%, 80.5% and 80.7% of the Company’s property casualty premium income and 66.5%, 70.3% and 70.6% of its total premium income were derived from the Company’s participation in the Pooling Agreement in 2005, 2004 and 2003, respectively.
A committee consisting of two members of the Boards of Directors of the Mutual Group, two members of the Board of Directors of Specialty, two members of the Board of Directors of the Company and Jerry A. Newby, as chairman of each such Board, has been established to review and approve any changes in the Pooling Agreement. The committee is responsible for matters involving actual or potential conflicts of interest between the Company, Specialty and the Mutual Group and for attempting to ensure that, in operation, the Pooling Agreement is equitable to all parties. Conflicts in geographic markets are currently minimal because the Mutual Group writes property casualty insurance only in Alabama and at present all of such insurance written by the Company is outside of Alabama. The Pooling Agreement is intended to reduce conflicts that could arise in the selection of risks to be insured by the participants by making the results of each participant’s operations dependent on the results of all of the pooled business. Accordingly, the participants should have substantially similar loss ratios for the pooled business excluding catastrophes as long as the Pooling Agreement remains in effect.
Under a Management and Operating Agreement, Mutual provides substantially all facilities, management and other operational services to the Company and its subsidiaries and to other companies associated with Mutual. Most of the personnel providing management services to the Company are full-time employees of, and are directly compensated by, Mutual. The Company’s business is substantially integrated with that of Mutual, Fire and General. Mutual periodically conducts time usage and other special expense allocation studies. Mutual charges the Company for its allocated and direct salaries, employee benefits and other expenses, including those for the use of office facilities. The amounts paid by the Company to Mutual under the Management and Operating Agreement were approximately $61.8 million in 2005, $50.7 million in 2004 and $46.9 million in 2003. The Company reimburses Mutual for the full amount of all its agents’ commissions paid by Mutual for the sale of the Company’s insurance products.
The Mutual Group is a partner in a real estate partnership, which in 2000 established a revolving line of credit with Financial of $4.0 million at a rate of interest equal to the prime lending rate less 1.0%. During 2002, this line of credit was increased to $5.0 million. At December 31, 2005 and 2004, the amount loaned to the partnership under the line of credit was $4,000,000 and $4,535,000, respectively. Interest paid by the partnership was $230,589, $154,331 and $140,850 in 2005, 2004, and 2003, respectively.
On February 1, 1997, Mutual began covering its employees with a Corporate Owned Life Insurance (COLI) plan utilizing Life’s universal life product. Premiums paid to Life totaled approximately
$17.9 million in 2005, $17.9 million in 2004 and $18.7 million in 2003. Policy charges recorded from such premiums totaled approximately $3.8 million in 2005, $3.5 million in 2004 and $3.2 million in 2003. Policy reserves and insurance in force on the COLI plan at December 31, 2005 were approximately $149.0 million and $709.9 million, respectively. Certain of Mutual’s employees and those of the Mutual Group’s sponsoring organization, the Alabama Farmers Federation (Federation), not covered by the COLI plan are covered by group life insurance provided by Life. During 2002, certain retired employees of Virginia Mutual, also began being covered by group life insurance provided by Life. Contingency reserves held for this group as of December 31, 2005 and 2004 were $165,739 and $220,226, respectively. Group life insurance premiums paid to Life totaled $516,752 in 2005, $492,449 in 2004 and $542,167 in 2003. Insurance inforce under this plan at December 31, 2005 was approximately $47.3 million. Reserves for group life insurance represent the excess present value of future guaranteed benefits over future premiums plus any unearned premium. Since this one-year term contract renews on January 1 of each year at the discretion of each party, there is no future excess present value of future guaranteed benefits over future premiums at December 31. Since all of the certificates have a renewal date of January 1, the premium for each certificate is fully earned on the following December 31 and no unearned premium liability is present. This reserving method has been used since the Company’s inception. The only change in resulting reserves in recent years occurred when the plan year was adjusted to coincide with the calendar year.
During 1999, the Company formed a subsidiary, ABC, in an effort to improve the controls over employee benefits and related payments, to simplify and consolidate the accounting and recordkeeping function, and to improve operating efficiencies. As a result, the accrued benefit liabilities held by the various Alfa property casualty entities and their related assets were transferred to ABC at that time. The amounts of net transfers from ABC to Mutual in 2005 and 2004 for payments of benefits totaled approximately $763,000 and $554,000, respectively.
Financial leases equipment, automobiles, furniture and other property to the Mutual Group and its affiliates. The Mutual Group and its affiliates paid $3,367,415 in 2005, $3,367,326 in 2004 and $3,460,011 in 2003 under these leases. Periodically, the Mutual Group invests in automobile and other installment loans issued and serviced by Financial. However, the Mutual Group held no such investment in these loans at either December 31, 2005 or December 31, 2004. Interest paid by Financial to the Mutual Group on these loans was $199,897 in 2005, $320,900 in 2004 and $434,304 in 2003. The Alabama Farmers Federation (Federation) and Alfa Services, Inc. (Services), a Federation subsidiary, invest in short-term lines of credit with the Company and Financial. The balance outstanding on these lines of credit included in notes payable to affiliates was $20,887,635 and $15,887,635 at December 31, 2005 and 2004, respectively. Interest paid by the Company and Financial to the Federation and its subsidiary was $502,302 in 2005, $166,398 in 2004 and $99,104 in 2003.
In 2004 prior to its being sold, the Company’s real estate construction subsidiary, Builders, purchased 6 residential lots at fair value for $292,207 and 11 residential lots in 2003 at fair value for $542,796 from a partnership in which the Mutual Group is a partner. Builders also purchased one lot
during the first two months of 2004 at fair value for $20,750 from a partnership in which Alfa Properties is a member. Alfa Properties paid $21,199 in other commissions to Realty in 2003. Builders purchased 4 residential lots in 2003 at fair value for $213,000 from Alfa Properties.
Alfa Properties has a partnership interest in Marshall Creek, Ltd., a real estate development. Financial established capital leases with this entity during 2002 and received payments of $183,900 and $157,646 under these leases in 2005 and 2004, respectively.
Applicable deferred income taxes on net unrealized gains for equity securities aggregated $3,639,602 and $5,705,870 at December 31, 2005 and 2004, respectively.
Of the 166 fixed maturities in an unrealized loss position at December 31, 2005, the majority are mortgage-backed securities. Of the $10.2 million in unrealized losses on mortgage-backed securities, the majority was issued by governmental agencies. Therefore, return of principal is not currently an issue. Similarly, the interest rate environment has been the primary cause of the other fixed maturity loss positions in the portfolio. While unrealized gains and losses will fluctuate with interest rate changes, receipt of principal is highly probable if these securities are held to maturity. The Company reviews
The amortized cost and estimated fair value of fixed maturities available for sale at December 31, 2005 by contractual maturity are shown below. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
Proceeds from sales of fixed maturities available for sale were $108,372,196 in 2005, $61,425,800 in 2004 and $68,916,066 in 2003. Gross gains of $426,899 in 2005, $391,408 in 2004 and $1,644,188 in 2003 and gross losses of $2,231,672 in 2005, $952,108 in 2004 and $2,519,043 in 2003 were realized on those sales. In addition, the Company recorded a loss of $1,046,867 in 2005 and $111,279 in 2004 for fixed maturities available for sale whose valuation was deemed to be an other than temporary decline. No fixed maturities available for sale were written down during 2003. At December 31, 2005, the Company’s mortgage-backed securities were comprised of CMO’s and pass through securities. The valuation of such securities is subject to significant fluctuations due to changes in interest rates. The Company has a history of positive cash flow and has the ability to hold such investments to maturity. Management performs periodic assessments of the portfolio to monitor interest rate fluctuations. At December 31, 2005, the Company had $5,501,747 in fixed maturities available for sale on deposit with regulatory agencies in order to meet statutory requirements.
The Company’s policy loans are carried at the outstanding balance and earn interest predominately at 8.0% but range from 5.0% to 8.0%. Policy loans have no stated maturity and are often repaid by reductions to benefits and surrenders. Therefore, the carrying amount approximates the fair value of the policy loan portfolio.
Partnerships and Equity Method Investments: Investments in partnerships, joint ventures and unconsolidated investee companies are stated at the underlying audited equity value based on accounting principles generally accepted in the United States of America. Income is recognized based on reported earnings by the partnerships, joint ventures and companies. Partnership interests represent 77.5%, or approximately $48.0 million, of other long-term investments at December 31, 2005 and 78.6%, or approximately $52.5 million at December 31, 2004. Similarly, partnership interests represent 15.6%, or approximately $21.6 million, of other long-term investments in affiliates at December 31, 2005 and 24.9%, or approximately $19.4 million at December 31, 2004.
Ownership in partnership interests range from less than 1% to 62.5%. The Company’s investment in MidCountry is also accounted for using the equity method. In addition to earnings reflected within the statements of income, this investment has generated gross accumulated other comprehensive loss of $607,015 before a tax benefit of $212,455 since the investment was made in 2002. The table below summarizes the company’s primary long-term investment interests at December 31, 2005 and related operating results for 2005.
The Company had net investment income from partnerships and other equity method investments of approximately $7.9 million in 2005 and $4.1 million in 2004 after net investment losses of approximately $2.5 million in 2003. At December 31, 2005 and 2004, partnerships yielding tax credits from investments in low-income housing of approximately $43.0 million and $47.1 million are included in the Company’s other long-term investments. The Company realized losses from its
SFAS No. 107, Disclosures about Fair Value of Financial Instruments, requires disclosures of fair value information of financial instruments. Information about specific valuation techniques and related fair value detail is provided in Note 1-Summary of Significant Accounting Policies, Note 4-Investments and Note 8-Commercial Paper and Notes Payable. The cost and estimated fair value of financial instruments as of December 31 are as follows:
The Company did not establish a valuation allowance related to the deferred tax assets due to the existence of sufficient taxable income related to future reversals of existing temporary differences.
At December 31, 2005 and 2004, the Company had an income tax payable of $1.1 million and an income tax receivable of $2.6 million, respectively.
The Company had $213.8 million in commercial paper outstanding at a weighted average rate of 4.30% at December 31, 2005. Rates ranged from 4.24% to 4.33% with maturities from January 9,
2006 to January 23, 2006. At December 31, 2004, the Company had $204.3 million in commercial paper outstanding at a weighted average rate of 2.32%. Rates ranged from 1.83% to 2.38% with maturities from January 4, 2005 to February 2, 2005. The Company intends to continue to use the commercial paper program to fund its short-term needs. However, backup lines of credit are in place up to $300 million to cover up to $230 million in commercial paper and the $70 million variable-rate demand note described below. Commitment fees related to the backup lines were $304,167 in 2005 and $305,000 in 2004. The backup lines agreements contain usual and customary covenants requiring the Company to meet certain operating levels. Included in the financial covenants are requirements that the Company maintain minimum levels of stockholders’ equity and perform at a level that produces acceptable ratios of credit losses to reserves and indebtedness to capitalization. The Company has maintained full compliance with all such covenants. The Company has A-1+ and P-1 commercial paper ratings from Standard & Poor’s and Moody’s Investors Service, respectively. The commercial paper is guaranteed by two affiliates, Mutual and Fire. Due to the short-term nature of the Company’s commercial paper borrowings, the fair value approximates the carrying value.
The Company issued a variable-rate $70 million long-term obligation maturing on June 1, 2017 in the second quarter of 2002 as a means of funding the collateral loan and commercial lease portfolios. Refer to Note 1-Summary of Significant Accounting Policies for discussions about the Company’s cash flow hedge.
Guarantees: The Company’s property casualty subsidiaries entered into an agreement with Fire in 2000 with respect to a loan guarantee on Fire’s part, on behalf of EastChase Land Company, LLC to Whitney Bank. Fire’s guarantee amount to Whitney Bank is $1,000,000. In the unlikely event of a guarantee call, the Company’s property casualty subsidiaries would be liable to reimburse Fire a maximum of $200,000. Similarly, in 2003, the Company’s property casualty subsidiaries entered into a second agreement with Fire which agreed to guarantee, on behalf of Alfa Ventures II, LLC, the lesser of $25,000,000 or 50% of the total obligations of The Shoppes at EastChase, LLC and EastChase Plaza, LLC with Columbus Bank & Trust Company (CB&T). This second guarantee is known as the “bucket” guarantee, and supercedes all previous CB&T guarantees for each of these EastChase entities. In the unlikely event of a guarantee call, the Company’s property casualty subsidiaries would be liable to reimburse Fire a maximum of $1,393,232. During 2004, the Company’s property casualty subsidiaries entered into a third agreement with Fire in which Fire agreed to guarantee, on behalf of EastChase Office, LLC, an amount of $3,180,077 to CB&T. In the unlikely event of a guarantee call, the property casualty subsidiaries would be liable to reimburse Fire a maximum of $636,016.
The Company maintains a variety of funding agreements in the form of lines of credit with affiliated entities. The chart below depicts, at December 31, 2005, the cash outlay by the Company representing the potential full repayment of lines of credit it has outstanding with others. Also included with the amounts shown as “lines of credit” are the potential amounts the Company would have to supply to other affiliated entities if they made full use of their existing lines of credit during 2006 with the Company’s finance subsidiary. Other commercial commitments of the Company shown below include commercial paper outstanding, scheduled fundings of partnerships, potential performance payouts related to Vision and funding of a policy administration system project of the life subsidiary.
Components of comprehensive income are depicted in the Consolidated Statements of Stockholders’ Equity. The tax expense or (benefit) allocated to each component of accumulated other comprehensive income in 2005 was ($8,465,520) for change in fair value of securities available for sale, $1,243,779 for change in deferred acquisition cost adjustment, $751,414 for change in unrealized gain on interest rate swap contract, ($221,375) for change in unrealized loss on other long-term investments and $2,117,805 for reclassification adjustment for realized investment gains.
The Company’s investment in MidCountry has resulted in cumulative earnings of $2,787,667 that are included as a part of retained earnings.
The Company increased capital in excess of par value by $4.8 million for the establishment of future tax benefits in ABC resulting from the transfer of liabilities to ABC when it was formed in 1999 (refer to Note 7-Income Taxes).
Alfa Corporation is a holding company with no operations and, accordingly, any cash available for dividends or other distributions must be obtained by it from borrowings or in the form of distributions from its operating subsidiaries. Distributions to the Company from its insurance subsidiaries are subject to regulatory restrictions. Under applicable regulatory requirements, the Company’s insurance subsidiaries can distribute to the Company an aggregate of approximately $84.4 million without prior regulatory approval.
At December 31, 2005, the life subsidiary’s Adjusted Capital calculated in accordance with NAIC Risk-Based Capital guidelines was $189.9 million, compared to the Authorized Control Level amount of $12.9 million, and the property casualty subsidiaries’ Adjusted Capital was $407.5 million, compared to the Authorized Control Level amount of $30.3 million. The Risk-Based Capital analysis serves as the benchmark for the regulation of insurance enterprises’ solvency by state insurance regulators.
In October 1989, the Company’s Board of Directors approved a stock repurchase program authorizing the repurchase of up to 4,000,000 shares of its outstanding common stock in the open market or in negotiated transactions in such quantities and at such times and prices as management may decide. In March 1999 and in September 2001, the Company’s Board of Directors increased the number of shares authorized to be repurchased by 4,000,000 shares, bringing the total number of shares authorized to be repurchased to 12,000,000.
At December 31, 2005, the aggregate minimum rental payments to be received under leases having initial or remaining lease terms in excess of one year are $2,855,609 in 2006, $1,409,879 in 2007, $166,867 in 2008, $14,507 in 2009 and $0 thereafter.
The Company’s finance subsidiary leases certain equipment to Marshall Creek, Ltd., a joint real estate venture with Mutual (refer to Note 3-Related Party Transactions). These equipment leases have various expiration dates through 2009.
At December 31, 2005 and 2004, future minimum lease payments to be received on leases are $11,726,254 and $102,668,528, respectively; with separate deductions for allowance for uncollectible minimum lease payments receivable of $8,083,758 and $9,727,546, respectively. Unguaranteed residual values accruing to the benefit of the lessor total $895,277 and $1,241,083 at December 31, 2005 and 2004, respectively. Initial direct costs and unearned income at December 31, 2005 are $0 and $2,022,689, respectively. Initial direct costs and unearned income at December 31, 2004 are $578,174 and $12,522,740, respectively.
The following table summarizes the effects of reinsurance on premiums and losses for the years ended December 31, 2005, 2004 and 2003:
Segment profit or loss for the property casualty segment is measured by underwriting profits and losses as well as by operating income. Segment profit or loss for the life insurance segment, the noninsurance segment and the corporate segment is measured by operating income. Management believes operating income serves as a meaningful tool for assessing the profitability of the Company’s ongoing operations. Operating income, a non-GAAP financial measure, is defined by the Company as net income excluding net realized investment gains and losses, net of applicable taxes. Realized investment gains and losses are somewhat controllable by the Company through the timing of decisions to sell securities. Therefore, realized investment gains and losses are not indicative of future operating performance. Segment information for the previous periods has been restated to reflect the change in composition of reportable operating segments.
On October 25, 1993, the Company established a Stock Incentive Plan (the “1993 Plan”), pursuant to which a maximum aggregate of 4,000,000 shares of common stock were reserved for grant
to key personnel. On April 26, 2001, the 1993 Plan was amended to increase the maximum aggregate number of shares available for grant to 6,400,000 shares. Consistent with the provisions of SFAS No. 123, Accounting for Stock-Based Compensation, the Company uses the intrinsic value based method to account for stock options issued under the 1993 Plan and provides pro forma disclosures as if the fair value based method had been applied (refer to Note 1-Summary of Significant Accounting Policies).
On April 28, 2005, the Company’s stockholders approved the 2005 Amended and Restated Stock Incentive Plan (the “2005 Plan”). This Plan amends and restates the 1993 Plan. The 2005 Plan permits the grant of a variety of equity-based incentives based upon the Company’s common stock, par value $1.00 per share. These include stock options, which may be either “incentive stock options” as that term is defined in Section 422 of the Internal Revenue Code of 1986, as amended or “nonqualified options”. The 2005 Plan also permits awards of Stock Appreciation Rights, Restricted Shares, Restricted Share Units and Performance Shares. A maximum of 3,800,000 shares of stock may be issued under the 2005 Plan. The Company accounts for the 2005 Plan under SFAS No. 123 using the recognition and measurement principles of the fair value method.
The Company discloses the pro forma effect on net income and earnings per share in accordance with SFAS No. 148, Accounting for Stock-Based Compensation-Transition and Disclosure, in Note 1, Summary of Significant Accounting Policies.
Expected life of the stock options granted is derived from historical analysis and represents the period of time that share options are expected to be outstanding.
The Company’s tests of its goodwill for impairment in accordance with SFAS No. 142, Goodwill and Other Intangible Assets, resulted in no writedowns for the year ended December 31, 2005.
Vision is a full-service managing general agency that currently writes nonstandard automobile insurance policies in nine states. The company is headquartered in Brentwood, Tennessee and provides all underwriting, claims, actuarial and financial services on behalf of its contracted carriers.
In December 2004, the FASB issued SFAS No. 123 (revised 2004), Share-Based Payment, which is a revision of SFAS No. 123, Accounting for Stock-based Compensation. SFAS 123(R) supersedes
SFAS 123(R) originally required adoption no later than July 1, 2005. In April 2005, the Securities and Exchange Commission (“SEC”) issued a release that amends the compliance dates for SFAS 123(R). Under the SEC’s new rule, the Company will be required to apply SFAS 123(R) as of January 1, 2006.
The Company will adopt SFAS 123(R) using the modified prospective method.
As permitted by SFAS 123, the Company currently accounts for share-based payments to employees using the intrinsic value method described in APB Opinion No. 25 and, as such, generally recognizes no compensation cost for employee stock options. Accordingly, the adoption of SFAS 123(R)’s fair value method will impact the Company’s results of operations, although it will have no impact on the Company’s overall financial position. The Company will share compensation cost with Mutual based on the Management and Operating Agreement (refer to Note 3-Related Party Transactions). The total impact of SFAS 123(R) on 2006 results of operations for Alfa is expected to be $2.5 million, with $1.6 million allocated to the Company, based on historical levels of activity.
In December 2004, the FASB issued SFAS No. 153, Exchanges of Nonmonetary Assets, an amendment of APB No. 29, Accounting for Nonmonetary Transactions. This statement requires that exchanges of nonmonetary assets be measured based on fair value and eliminates the exception for exchanges of nonmonetary, similar productive assets, and adds an exemption for nonmonetary exchanges that do not have commercial substance. SFAS No. 153 was effective for nonmonetary asset exchanges in periods beginning after June 15, 2005. This statement has not had a significant impact on the Company’s financial position or results of operations.
rather than recognition in the net income of the current period. Retrospective application requires restatements of prior period financial statements as if that accounting principle had always been used. This statement carries forward without change the guidance contained in Opinion 20 for reporting the correction of an error in previously issued financial statements and a change in accounting estimate. The provisions of SFAS No. 154 are effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005.
In addition, the FASB issued FASB Staff Position (FSP) SOP 78-9-1, Interaction of AICPA Statement of Position 78-9 and EITF Issue No. 04-5 in June 2005. The guidance in this FSP was effective after June 29, 2005 for general partners of all new partnerships formed and for existing partnerships for which the partnership agreements are modified. For general partners in all other partnerships, the guidance in this FSP is effective no later than the beginning of the first reporting period in fiscal years beginning after December 15, 2005, and the application of either transition method as described in the FSP is permitted.
In August 2005, the FASB issued FSP Financial Accounting Standard (FAS) 123(R)-1, Classification and Measurement of Freestanding Financial Instruments Originally Issued in Exchange for Employee Services under FASB Statement No. 123(R). This staff position defers the requirement under SFAS No. 123(R) that a freestanding financial instrument become subject to the recognition and measurement requirements of other applicable generally accepted accounting principles when the rights conveyed by the instrument to the holder are no longer dependent on the holder being an employee of the entity. The Company does not anticipate that this staff position will have a significant impact on its financial position or results of operations at the time SFAS No. 123(R) is adopted.
In September 2005, the American Institute of Certified Public Accountants issued Statement of Position 05-1, Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection With Modifications or Exchanges of Insurance Contracts. This statement provides guidance on accounting for deferred acquisition costs on an internal replacement, defined as a modification in product benefits, rights, coverages, or features that occurs by the exchange of an existing contract for a new contract, or by amendment, endorsement, or rider to an existing contract, or by the election of a benefit, right, coverage, or feature within an existing contract. The guidance in this pronouncement is effective for fiscal years beginning after December 15, 2006. The Company plans to adopt this statement for internal replacements beginning January 1, 2007. Due to its recent issuance, the Company is still assessing the impact this statement will have on its financial position or results of operations.