We lease an aggregate of approximately 324,000 square feet of office space in numerous cities throughout the United States. Our most significant leased office spaces are located in Davie, Florida with approximately 100,000 square feet; Independence, Ohio with approximately 60,000 square feet; Orange, California with approximately 39,000 square feet; Phoenix, Arizona with approximately 24,000 square feet; and Centennial, Colorado with approximately 29,000 square feet. During 2005, we terminated the lease for the Anaheim, CA office, with approximately 50,000 square feet, and relocated the office to leased facilities in Orange, CA, with approximately 39,000 square feet.
The following table presents our historical financial and operating data as of the dates or for the periods indicated (see Note About Trade Ratios below). We derived the data as of and for each of the five years ended December 31, 2005 from our consolidated financial statements. The results of operations for past accounting periods are not necessarily indicative of the results to be expected for any future accounting periods. You should read this summary in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the financial statements and related notes appearing elsewhere in this Annual Report on Form 10-K.
+ Commissions and other underwriting expenses + Other operating and general expenses
All trade ratios included in this Annual Report on Form 10-K reflect this revised methodology.
policy service fee revenues, which are composed primarily of policy origination fees and installment fees billed to our policyholders; and
In the aggregate, our gross written premium decreased by 18% in 2005 compared to 2004. Included in these figures is a change in the provision for expected policy cancellations that increased gross written premium by 3% for the year ended December 31, 2005 and by 6% for the year ended 2004. The purpose of the provision is to reduce installment premiums due in the future from policyholders as well as the related unearned premiums to the amount we expect to ultimately collect and earn. Changes in the provision are generally driven by observed changes in the cancellation rate of in force policies and changes in the balance of unearned premium. There appear to be several reasons for the improvement in the cancellation rate. A greater proportion of our business is renewal business, which has better payment performance than new business. In addition, our stepped up retention efforts are positively affecting both the persistency of our business and our collection of past due balances. The decrease in the provision added $18.9 million and $46.3 million to gross written premium during 2005 and 2004, respectively, and a similar amount to reported unearned premiums and premiums receivable. The decrease has no effect on earned premium, and therefore, no direct effect upon reported net income.
Gross written premium before and after the change in the provision for cancellations for the three years ended December 31, 2005, 2004 and 2003 is set forth below.
The average number of policies in force is a significant driver of our gross earned premium. For the year ended December 31, 2005, the average number of policies in force decreased 9% to 446,140 from 487,652 for the comparable period of 2004, while our gross earned premium declined 7% over the same period. The table below shows our average number of policies in force and gross earned premium for the year ended December 31, 2005 compared to the corresponding period of 2004.
In Florida, our second largest state, gross written premium declined by 10% for the year ended December 31, 2005 compared to 2004. Although we experienced a decline in our year-to-year premium volume, we observed improvement in this market, especially in the last quarter of 2005, during which we tracked 32 rate increases, two rate decreases, and six revenue-neutral rate filings by companies with which we compete. We raised our rates by about 11% in this market on December 30, 2004, and some of the companies with which we compete raised their rates during the latter part of 2005. We continue to increase our producer representation in Florida with 1,289 producers and 1,582 locations as of December 31, 2005, up from 1,044 producers with 1,276 locations as of December 31, 2004.
Texas is our fourth largest state, and we experienced a very strong growth rate of 35% in our premium volume for the year ended December 31, 2005 compared to 2004. Our producer representation in Texas grew to 841 producers with 1,318 locations as of December 31, 2005, up from 521 producers with 867 locations as of December 31, 2004, increases of 61% and 52%, respectively. During the last quarter of 2005, we observed increasingly competitive market conditions in Texas, as we noted that filed rate decreases by companies with which we compete outnumbered rate increases. These rate decreases caused our competitive position to erode during the fourth quarter
We closely monitor staffing levels in relation to volume in our claims and policy service divisions. We also utilize various metrics to track service performance to ensure that service levels are meeting or exceeding our benchmarks. We continue to stress productivity as staff count had decreased by 9% to 1,213 as of December 31, 2005 compared to 1,326 as of December 31, 2004. This compares to a 7% decline in our gross earned premium for the year.
We modified rates 62 times during the year ended December 31, 2005. Six such modifications were for rate increases, 17 were decreases, and 39 were revenue neutral. In 2005, we decreased our overall rate level by 0.3%. We continuously monitor our rate levels and will continue to seek rate changes in states where warranted. In addition, we believe we can continue to improve our product structure by filing class plan changes that, through segmentation, we design to attract certain market segments that we have observed to produce favorable results relative to the overall market in a given state.
Estimation of Unpaid Losses and Loss Adjustment Expenses. Our actuarial staff reviews our insurance subsidiaries' loss and loss adjustment expense reserves. When estimating our liability for losses and loss adjustment expenses under the terms of our insurance policies, we rely heavily on our historical loss and loss adjustment expense experience. We periodically adjust our loss and loss adjustment expense reserves for changes in product mix, underwriting standards and rules, loss cost trends and other factors. We also incorporate into our analyses factors such as the rate of inflation, claims settlement patterns and legislative activities and litigation trends that may impact our loss and loss adjustment expense reserves. As our experience develops or we learn additional information, we increase or decrease our loss and loss adjustment expense reserve levels, as necessary. These changes to our loss and loss adjustment expense reserves are reflected in our results of operations in the period in which our estimates change. Ultimately, our actual losses and loss adjustment expenses may differ materially from the estimates we have recorded.
In establishing our best estimate of unpaid losses and loss adjustment expenses, we determine the number of claims that have been reported as of the financial reporting date and make an estimate of claims that have been incurred but not yet reported to us as of that date. Because our evaluations are based upon historical patterns, if the rate of claims reported to us or paid by us differs from our historical patterns, our evaluations may underestimate the number of claims that will ultimately be paid, and therefore, the amount of unpaid losses and loss adjustment expenses recorded for the period.
For the year ended December 31, 2005, we experienced an insignificant amount of adverse development on loss and loss adjustment expense reserves related to prior years compared to $2.5 million of adverse development during the year ended December 31, 2004.
If our estimate of gross unpaid losses and loss adjustment expenses of $221.4 million at December 31, 2005 decreases or increases in 2006 by one percent, our net income or loss for 2005 would decrease or increase by $1.4 million after tax (assuming an effective tax rate of 35.17%). If the increase were to be wholly or partly caused by gross losses ceded to the MCCA state reinsurance facility, the impact on net income would be reduced because the covered portion of the loss would be ceded to the MCCA.
Accounting and Reporting for Reinsurance. Pursuant to SFAS No. 113, "Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts," we are required to review the contractual terms of all our reinsurance purchases to ensure compliance with that statement. The statement establishes the conditions required for a contract with a reinsurer to be accounted for as reinsurance and prescribes accounting and reporting standards for those contracts. Contracts that do not result in the reasonable possibility that the reinsurer may realize a significant loss from the insurance risk assumed generally do not meet the conditions for reinsurance accounting and must be accounted for as deposits.
Gross Written Premium. Gross written premium decreased to $617.9 million for the twelve months ended December 31, 2005, or by 18%, compared to $752.9 million for 2004. The decline in gross written premium emanated primarily from California where written premium declined by 30% for the year. Generally, we observed increasingly competitive conditions during 2005 in the states where we do business. As we have exercised underwriting and pricing discipline, we have seen our volume of business decline in several states, most notably, California and Florida, and grow more slowly in many other states compared to 2004. We provide for expected policy cancellations in order to adjust written premium to amounts we expect to ultimately collect and earn (see “Operating Results - Key States” above). During 2005, we reduced the provision by $18.9 million, which added 3% to our reported gross written premium for the year.
Losses and Loss Adjustment Expenses Incurred. Losses and loss adjustment expenses incurred increased to $394.6 million for the twelve months ended December 31, 2005 compared to $219.4 million for the same period of 2004. Our loss ratio improved 1.1 points to 66.3% for 2005 from 67.4% for 2004 (please see Note About Trade Ratios included in Item 6 above).
Other Operating and General Expenses. Other operating and general expenses were $38.1 million for the twelve months ended December 31, 2005 compared to $31.4 million for the same period of 2004, an increase of $6.7 million. Costs associated with governmental investigations concerning our reinsurance agreements added $2.7 million before taxes during the twelve months ended December 31, 2005. Consulting, audit fees and regulatory examination fees increased by $3.5 million. Of this amount, Sarbanes-Oxley compliance accounted for approximately $1.8 million. Additionally, depreciation expense, principally related to enterprise software, was also $0.6 million higher during the twelve months ended December 31, than in the comparable period of 2004.
Ratios. Our combined ratio was 87.6% for the twelve months ended December 31, 2005 compared to 71.5% for same period of 2004 (please see Note About Trade Ratios included in Item 6 above). Our combined ratio was only minimally affected by reinsurance during the twelve months ended December 31, 2005, while it was significantly affected by reinsurance during the comparable period of 2004. We ceded only 8% of our gross earned premium in 2005 compared to 53% in 2004. The following table provides information about our combined ratio before and after reinsurance for the twelve months ended December 31, 2005 and 2004.
Our gross combined ratio for the twelve months ended December 31, 2005 was 88.2% compared to 84.6% for the same period of 2004. Our gross loss ratio was up 0.2 points to 66.7% for the twelve months ended December 31, 2005 compared to 66.5% for the comparable period of 2004. Exclusive of $2.5 million of losses associated with Hurricanes Katrina, Rita, and Wilma in 2005 and $1.0 million of losses associated with Hurricanes Charley, Frances, Ivan, and Jeanne in 2004, our gross loss ratio was 66.4% for both 2005 and 2004.
Income Taxes. Income taxes for the twelve months ended December 31, 2005 were $29.7 million, or 35.17% of income before income taxes. This effective tax rate of 35.17% comprises 33.55% federal income taxes and 1.62% state income taxes. Income taxes for the twelve months ended December 31, 2004 were $34.8 million, or 36.25% of income before income taxes. This effective tax rate of 36.25% comprises 34% federal income taxes and 2.25% state income taxes.
Gross Written Premium. Gross written premium increased to $752.9 million for the twelve months ended December 31, 2004, or by 16.2%, compared to $648.2 million for the same period of 2003. The increase is primarily attributable to increased market penetration evidenced by the 11.5% growth in average policies in force from 437,200 for 2003 to 487,650 for 2004. We provide for expected policy cancellations in order to adjust premium written to amounts we expect to ultimately collect. During 2004, in response to improved persistency of our business, we reduced the provision by $46.3 million, which added 6.6% to the growth in our reported gross premiums written for the year.
Net Investment Income and Realized Losses and Gains on Investments. Net investment income was $9.0 million for the twelve months ended December 31, 2004 compared to $6.7 million for the same period of 2003. Most of the increase is attributable to the investment of $110.0 million of the proceeds from our initial public offering, which took place in February 2004. Operating cash flows aggregated $45.9 million for the year, which also contributed to the growth in invested assets and increased net investment income. The average pre-tax equivalent investment yield on the portfolio fell from 4.57% as of December 31, 2003 to 4.30% as of year-end 2004.
Policy Service Fee Revenue. Policy service fee revenue was $74.1 million for the twelve months ended December 31, 2004, an increase of $4.9 million, or 7.1%, compared to the same period of 2003. The growth was attributable to the growth in average policies in force. The growth in policy service fee revenue was slightly less than the growth in gross earned premium as our premiums declined in California and grew in other states and the fees we charge related to policy premiums were on average, higher in California than in the other states in which we operate.
The decline in the loss ratio was primarily attributable to a reduction in adverse development on loss and loss adjustment expense reserves for prior years to $2.5 million in2004 from $9.3 million in 2003, or 2.6 points of the improvement. Adverse development occurs when loss and LAE reserves established for accidents that took place in years prior to the current year prove to be inadequate and management increases those reserves to reflect the revised estimate of the ultimate losses related to such accidents. Such increases result in a charge to loss and LAE in the current year. The remainder of the decrease in the loss ratio was due to a 2.9 point improvement in our claims experience for accident year 2004 compared to 2003.
Commissions and Other Underwriting Expenses. Commissions and other underwriting expenses increased to $58.4 million for the twelve months ended December 31, 2004 compared to $51.8 million for the twelve months ended December 31, 2003, an increase of $6.6 million or 12.7%. The growth was less than the growth in net earned premiums, fees and other income, which increased by 16.6%. This category of expenses comprises items such as producers’ commissions, premium taxes and company expenses that relate to the production of and vary with gross earned premium, reduced by ceding commission income. In the aggregate, these expenses represented 18.0% of net earned premium in 2004 down by 0.9 points from 18.9% in 2003. On a line by line basis: direct commission expense was 15.3% of direct premium compared to 15.2% in 2003; ceding commission income was 30.4% of ceded premium compared to 28.7% in 2003; and other underwriting expenses, including premium taxes, were 9.2% of gross earned premium compared to 9.1% in 2003.
Interest Expense. Interest expense was $3.0 million for the twelve months ended December 31, 2004 compared to $3.2 million for the same period of 2003. Interest incurred pertains to our bank debt, which we refinanced in February 2004. Amortization of deferred financing fees is lower under our current credit facility than under the prior one.
Ratios. Our combined ratio was 71.5% for the twelve months ended December 31, 2004 compared to 74.8% for the comparable period of 2003, an improvement of 3.3 points (please see Note About Trade Ratios included in Item 6 above). The reduction in adverse development accounted for 2.6 points of the improvement; the current accident year loss ratio for 2004 was 2.9 points lower than in 2003; and the overall expense ratio increased by 2.1% in 2004 compared to 2003. Our combined ratio was significantly affected by our reinsurance treaties. We ceded 50% and 60% of our gross written premium in 2004 and 2003, respectively. The following table provides information about our combined ratio before and after reinsurance for 2004 and 2003.
38% of income before income taxes. Our effective tax rate of 38% for 2003 comprised 35% federal income taxes and 3% state income taxes.
We are organized as a holding company. All of our operations are conducted by our insurance subsidiaries, which underwrite the risks associated with our insurance policies, and our non-insurance subsidiaries, which provide our policyholders and our insurance subsidiaries a variety of services related to the insurance policies we provide. We have continuing cash needs for the payment of principal and interest on borrowings, dividends on common stock, taxes and administrative expenses. We fund these ongoing obligations with dividends from our non-insurance subsidiaries. Each subsidiary pays its share of taxes through an inter-company tax allocation agreement.
Our insurance subsidiaries' primary sources of funds are premiums received, investment income and proceeds from the sale and redemption of investment securities. Our non-insurance subsidiaries' primary source of funds is the commissions collected from our insurance companies for services provided under general agency agreements. Our subsidiaries use funds to pay claims and operating expenses, make payments under the tax allocation agreement, purchase investments and pay dividends to us.
On March 14, 2005, our Board of Directors authorized the repurchase of $30 million of outstanding Common Stock. Under this program, we made share purchases from time to time in the open market depending on share price, market conditions and other factors. We concluded this program during the third quarter of 2005 after repurchasing 1,808,723 shares of Common Stock at a cost of $30 million.
On October 28, 2005, our Board of Directors authorized the repurchase of an additional $20 million of our outstanding Common Stock. Under this program, we may make share purchases from time to time in the open market depending on share price, market conditions and other factors. Bear, Stearns & Co. Inc. administers this stock repurchase program. During the fourth quarter of 2005, we repurchased 51,100 shares at a cost of $1.0 million and an average per share cost of $18.63.
After our initial public offering in February 2004, we began paying quarterly dividends. We paid $0.26 per common share for a total dividend payout with respect to our Common Stock of $8.0 million during the year ended December 31, 2005 and $0.15 per common share for a total dividend payout with respect to our Common Stock of $4.7 million during the year ended December 31, 2004. The declaration and payment of dividends is subject to the discretion of our Board of Directors. The Board considers our financial condition, results of operations, capital and cash requirements, future prospects, regulatory and contractual restrictions on the payment of dividends by our subsidiaries, restrictions under our credit facility and other factors they deem relevant.
On February 21, 2006, our Board of Directors declared a dividend of $0.07 per common share that will result in a total payout of approximately $2.1 million on or before March 22, 2006 to shareholders of record on March 8, 2006.
Net cash provided by operating activities was $252.9 million, $45.9 million, and $17.9 million for the years ended December 31, 2005, 2004 and 2003, respectively. The increase in cash flow generated from operations for the year ended December 31, 2005 compared to the same period of 2004 was primarily the result of the termination and commutation of our 2002-2004 quota share reinsurance agreement, which resulted in a payment to us from our reinsurers of $196.6 million in January 2005. Absent this payment, operating cash flow was $56.3 million in 2005 compared to $45.9 million in 2004. The increase in cash flow generated from operations for the year ended December 31, 2004 compared to same period of 2003 was due to the increased scale of our operations, a reduction in the percentage of our business ceded to our quota share reinsurers to 50% in 2004 from 60% in 2003, a reduction in paid class action litigation costs, and the tax benefit we received in relation to the exercise of stock options during 2004. The net amounts we received from or (paid) to our reinsurers were $183.3 million, $(63.5) million and $(89.3) million in 2005, 2004 and 2003, respectively.
Net cash (used in) provided by financing activities was $(42.2) million, $114.0 million, and $0.3 million for the years ended December 31, 2005, 2004 and 2003, respectively. For the year ended December 31, 2005, cash used in financing activities consisted of the repurchase of 1,859,823 shares of our Common Stock at a cost of $31.0 million, as well as the payment of stockholder dividends of $8.0 million, and debt repayments of $3.5 million. The cash provided by financing activities in 2004 was principally due to our initial public offering proceeds of $113.4 million.
For the years ended December 31, 2005, 2004, and 2003, we paid $17.9 million, $18.1 million, and $12.8 million, respectively, in federal and state income taxes.
We elected to terminate and commute the 2002 to 2004 quota share reinsurance agreement on a cut-off basis effective January 1, 2005. The termination and commutation resulted in the reinsurers’ release from all future liability and settlement of the net balance due us of $196.6 million. We have invested these monies in high-quality fixed income securities.
We entered into a quota share reinsurance agreement effective January 1, with National Union Fire Insurance Company of Pittsburgh, PA (“National Union”), a subsidiary of AIG. We elected to cede 10% of business written during 2005 under this agreement. Effective January 1, 2006, we terminated and commuted this agreement on a cut-off basis. As a result, we released National Union from all liability on the contract as of January 1, 2006 and we settled all balances between the companies resulting in our receipt of $11.0 million on January 31, 2006. The termination and commutation will impact certain balance sheet accounts during the first quarter of 2006. See “Note 15 - Subsequent Events” to the Consolidated Financial Statements included herein. We have concluded that we no longer need quota share reinsurance because we have sufficient surplus to support our anticipated gross and net premium writings.
the vesting period). SFAS No. 123R will also require companies to measure the cost of employee services received in exchange for employee stock purchase plan awards. SFAS No. 123R will be effective for our fiscal quarter beginning January 1, 2006. The transition methods include prospective and retrospective adoption options. The prospective method requires that compensation expense be recorded for all unvested stock-based awards including those granted prior to adoption of the fair value recognition provisions of SFAS No. 123, Accounting for Stock-Based Compensation, at the beginning of the first quarter of adoption of SFAS No. 123R; while the retrospective methods would record compensation expense for all unvested stock-based awards beginning with the first period restated. We will adopt SFAS No. 123R in the fiscal quarter beginning January 1, 2006 using the modified prospective method. The modified prospective method applies to new awards and awards modified, repurchased, or cancelled after the effective date of this statement. We will recognize compensation costs based on the fair value at grant date for any unvested awards over the remaining requisite service period. Based on the stock options granted since our initial public offering and the number of such stock options outstanding as of December 31, 2005, the effect of the adoption of SFAS No. 123R will be additional expense of $10,000 after taxes in 2006.
In September 2004, the FASB staff issued clarifying guidance for comment in FASB Staff Position (“FSP”) EITF Issue No. 03-1-a, “Implementation Guidance for the Application of Paragraph 16 of EITF Issue No. 03-1” (“FSP Issue No. 03-1-a”) and subsequently voted to delay the implementation of the impairment measurement and recognition guidance contained in paragraphs 10-20 of EITF Issue No. 03-1 in order to deliberate again certain aspects of the consensus as well as the implementation guidance included in FSP Issue No. 03-1-a. The disclosure requirements, including quantitative and qualitative information regarding investments in an unrealized loss position, remain effective and are included in the notes to the consolidated financial statements.
In November 2005, the FASB released FASB Staff Position Nos. FAS 115-1 and FAS 124-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” (“FSP 115-1”), which effectively replaces EITF Issue No. 03-1. FSP 115-1 contains a three-step model for evaluating impairments and carries forward the disclosure requirements in EITF Issue No. 03-1 pertaining to securities in an unrealized loss position is considered impaired; an evaluation is made to determine whether the impairment is other-than-temporary; and, if an impairment is considered other-than-temporary, a realized loss is recognized to write the security’s cost or amortized cost basis down to fair value. FSP 115-1 references existing other-than-temporary impairment guidance for determining when an impairment is other-than-temporary and clarifies that, subsequent to the recognition of an other-than-temporary impairment loss for debt securities, an investor shall account for the security using the constant effective yield method. FSP 115-1 is effective for reporting periods beginning after December 15, 2005, with earlier application permitted. We adopted FSP 115-1 upon issuance, which did not have a material effect on our consolidated financial statements.
In September 2005, the AICPA issued Statement of Position 05-1, "Accounting by Insurance Enterprises for Deferred Acquisition Costs in connection with Modifications or Exchanges of Insurance Contracts" (“SOP 05-1”). This statement provides guidance to insurance entities that incur deferred acquisition costs on internal replacements of insurance and investment contracts other than those specifically 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. SOP 05-1 defines internal replacements as modifications in product benefits, features, rights, or coverages that occur by the exchange of a contract for a new contract, or by amendment, endorsement, or rider to a contract, or by the election of a feature or coverage with a contract. The accounting treatment for such replacements depends on whether, under the provisions of the SOP, the replacement contract is considered substantially changed from the replaced contract. A substantial change would be treated as the extinguishment of the replaced contract, and all unamortized deferred acquisition costs, unearned revenue liabilities, and deferred sales inducement assets from the replaced contract would no longer be deferred in connection with the replacement contract. A replacement contract that is substantially unchanged should be accounted for as a continuation of the original contract. SOP 05-1 will be effective for internal replacements occurring in fiscal years beginning after December 15, 2006, with earlier adoption encouraged. We plan to adopt this statement beginning with the fiscal quarter beginning January 1, 2006. We do not expect that adoption of this SOP will have a material impact on our net income in 2006.
Effective July 10, 1998, we entered into a contract with Kohlberg Kravis Roberts & Co. L.P. ("KKR") for management, consulting and certain other services to be provided to us by KKR. Pursuant to the KKR contract, we pay KKR an annual fee of $500,000 and reimburse KKR for all reasonable expenses they incur. The KKR contract continues in effect from year to year unless KKR agrees with us to amend or terminate the contract. We have included purchase obligations of $500,000 with respect to the KKR contract under each of the columns, including "2011 or Later." Nevertheless, it is possible that our payments under the KKR contract could extend beyond 2011.
Effective July 9, 1998, we entered into a contract with Fisher Capital Corp. LLC ("Fisher Capital") for management, consulting and certain other services to be provided to us by Fisher Capital. Pursuant to the Fisher Capital contract and all amendments thereto, we pay Fisher Capital an annual fee of $95,000 and reimburse Fisher Capital for all reasonable expenses they incur. The Fisher Capital contract continues in effect from year to year unless Fisher Capital agrees with us to amend or terminate the contract. We have included purchase obligations of $95,000 with respect to the Fisher Capital contract under each of the columns, including "2011 or Later." Nevertheless, it is possible that our payments under the Fisher Capital contract could extend beyond 2011.
The payouts of loss and loss adjustment expense reserves by year included in the above table are estimated based upon historical loss payment patterns. Since there are not definitive due dates for the payments, payments by year and in the aggregate are subject to uncertainties. See "Item 1. Business - Loss and Loss Adjustment Expense Reserves."
We do not believe that inflation has had a material effect on our results of operations. Inflation affects interest rates and claim costs. We also consider the effects of inflation in pricing and in estimating reserves for unpaid claims and claim expenses. We cannot accurately determine the actual effects of inflation on our results. In addition to general price inflation, we are exposed to a persisting long-term upward trend in the cost of judicial awards for damages. We endeavor to take inflation into account in our pricing and in establishing loss and loss adjustment expense reserves.
Our consolidated financial statements together with the report of the independent registered public accounting firm are set forth beginning on page .