(1) Excludes premiums of $35,000 in 2003 and $1,727,000 in 2002 from the Company’s fronting arrangements for others, the commercial auto plans of Arkansas, California, Louisiana, Mississippi, and Pennsylvania under which the Company was a servicing carrier and the reinsurance arrangement in Florida whereby MGA premiums were ceded to a non-affiliated reinsurer and assumed by General Agents.
The Company is engaged in the property and casualty insurance business through its insurance company and managing general agency subsidiaries. Insurance operations include ongoing nonstandard personal auto insurance and the runoff of the commercial lines business, which was discontinued in 2002. The principal sources of revenues for the Company are premiums on nonstandard personal auto insurance, net investment income from the Company’s investment portfolio and fee income from insurance agency operations.
(2) The Expense and Combined ratios do not reflect expenses of the holding company.
The Company incurred substantial costs throughout 2005 and 2006 in amounts greater than in previous periods to build its nonstandard personal auto insurance operations. These expenditures include but are not limited to: hiring, relocation and incremental office space and wage and benefit costs, including costs for qualified additional personnel; furniture, fixtures, equipment, software and systems; additional marketing costs, such as agency compensation incentives, advertising and promotional expenses, including the Daytona Prototype Series racing team sponsorship; increased audit fees, and financing costs and higher fees for services; and non-cash expenses associated with the Company’s 2005 Long-Term Incentive Compensation Plan.
In the first quarter of 2006, the Company issued $25 million of 30 year subordinated debentures, which enabled the Company to redeem its outstanding Series A Preferred Stock due in January 2011, and provided additional capital of $5 million. In the fourth quarter of 2006, the Company issued $18 million of 30 year subordinated debentures, which the Company intends to use the proceeds for general corporate purposes. See “Capital Transaction - Subordinated Debentures.”
The Company continues to settle and reduce its inventory of commercial lines claims. At December 31, 2006, there were 73 claims associated with the Company’s runoff book outstanding, compared to 149 as of December 31, 2005. As of December 31, 2006, in respect of its runoff lines, the Company had $15,864,000 in net Unpaid claims and claims adjustment expenses (“C & CAE”) compared to $28,713,000 as of December 31, 2005. For the periods presented, the Company has recorded favorable development in unpaid C & CAE from the runoff lines with the settlement and reduction in the inventory of commercial lines claims. See “Results of Operations - Claims and claims adjustment expenses.” Due to the long tail and litigious nature of these claims, the Company anticipates it will take a substantial number of years to complete the adjustment and settlement process with regard to existing claims and the additional claims it expects to receive in the future from its past business writings. Most of the remaining claims are in suit and the Company’s future results may or may not be impacted either negatively or positively based on its ability to settle the remaining claims and new anticipated claims within its established reserve level.
Gross premiums written in 2006 increased 74% above 2005 which was 154% above 2004 as the Company continued its planned growth of nonstandard personal auto in targeted states. The following table presents gross premiums written by region in thousands of dollars:
Agency revenues increased $6,405,000 (107%) in 2006 and $3,596,000 (152%) in 2005 primarily as a result of the increase in writings.
Other income has decreased in 2006 and 2005 as a result of the continued runoff of the commercial auto claims under the reserve reinsurance cover agreement. This item is primarily comprised of recognition of the deferred reinsurance gain from the reserve reinsurance cover agreement. At December 31, 2006, $144,000 remained to be recognized in Other income in the future.
Underwriting and operating expenses increased $10,862,000 in 2006 from 2005 and increased $12,884,000 in 2005 from 2004 primarily due to additional expenses incurred in the infrastructure expansion for increased premium production capability, specifically additional personnel. The increase also includes non-cash compensation expense of approximately $1.1 million and $1.5 million in 2006 and 2005, respectively, associated with the grant of restricted shares and restricted share units of Common Stock under the Company’s 2005 Long-Term Incentive Compensation Plan. In 2006, the Company began to achieve economies of scale from its infrastructure expansion. Underwriting and operating expenses as a percent of Net premiums earned and Agency revenues were 17% for 2006 and 25% for 2005 and 2004.
The Company recorded a deferred tax benefit in 2006 and 2005 primarily as a result of a reduction in the valuation allowance for Deferred Federal income taxes of $5.5 million and $3.6 million, respectively. The Company considered it appropriate to reduce the valuation allowance, see “Liquidity and Capital Resources - Net Operating Loss Carryforwards.”
On January 21, 2005, the Company consummated a recapitalization pursuant to agreements entered into on August 27, 2004 and approved by our shareholders on January 18, 2005. The agreements were with GMSP, then holder of our Series A and Series C Preferred Stock and approximately 5% of our outstanding Common Stock; Robert W. Stallings, the Chairman of the Board and then holder of our Series B Preferred Stock; and First Western Capital, LLC (“First Western”), owned by James R. Reis. The recapitalization substantially reduced, as well as extended, our existing Preferred Stock redemption obligations and resulted in cash proceeds to us of approximately $3.1 million (after approximately $2.2 million in transaction costs and approximately $3.4 million used to redeem the Series C Preferred Stock). The recapitalization was negotiated on our behalf by a Special Committee of the Board comprised of disinterested, independent directors (the “Special Committee”). The events leading up to, and the transactions constituting, the recapitalization are described further in Note 11 to the Company’s Consolidated Financial Statements which appear in Item 8 of this Report).
In November 2006, the Company completed a rights offering which raised approximately $17.9 million in net proceeds. The Common Stock available through the rights offering, which included an over-subscription privilege in, was fully subscribed. As a result of this rights offering, the number of shares of Common Stock outstanding increased from 21,843,620 as of December 31, 2005 to 24,924,825 as of December 31, 2006. At December 31, 2006, GMSP owns approximately 33% of the outstanding Common Stock, Mr. Stallings owns approximately 22% and Mr. Reis and First Western collectively own approximately 11%.
In general, the application of Section 382 occurs when the aggregate stock ownership percentage (determined on the basis of value) of “5% shareholders” has increased by more than 50 percentage points over such shareholders’ lowest ownership percentages within a “testing period” (generally a three year period ending on the date in which a transaction gives rise to a “testing date”).
A testing date generally occurs whenever the percentage stock ownership (by value) of any 5% shareholder changes. Thus, a disproportionate issuance of stock to existing shareholders or to new investors would give rise to a testing date, as would the transfer by an existing 5% shareholder of some or all of its stock to a third party or an existing shareholder.
The Company believes that the transactions described above did not cause a greater than 50 percentage point ownership shift, thus Section 382 did not apply and impose a § 382 Limitation on our net operating loss carryforwards for federal income tax purposes. However, the transactions described above did result in a substantial ownership shift. Future transactions in Common Stock by the Company or others could affect the Company’s ability to utilize the net operating loss carryforwards.
With regard to liquidity, the average duration of the investment portfolio is approximately 1 year. The fair value of the fixed maturity portfolio at December 31, 2006 was $413,000 below amortized cost, before taxes. Unrealized losses were not material at December 31, 2006 (see Note 2 of Notes to Consolidated Financial Statements). Various insurance departments of states in which the Company operates require the deposit of funds to protect policyholders within those states. At December 31, 2006 and December 31, 2005, the balance on deposit for the benefit of such policyholders totaled $10,401,000 and $10,386,000, respectively.
Net cash provided by operating activities was $20,615,000 for 2006 versus $12,045,000 in 2005 and cash used for operating activities of $7,217,000 in 2004. The increases in cash provided between 2006 and 2005 of $8,570,000 and between 2005 and 2004 of $19,262,000 were primarily attributable to the growth in premium writings in 2006.
Investments and Cash increased in 2006 primarily as a result of positive cash flows from operations and funds raised in the issuance of the Subordinated debentures and in the rights offering. At December 31, 2006, 99% of the Company’s investments were rated investment grade with an average duration of approximately 1 year, including approximately 42% that were held in short-term investments. The return on average investments was 4.5%, 3.3% and 2.2% in 2006, 2005 and 2004, respectively. The Company classifies its bond securities as available for sale. The net unrealized loss associated with the investment portfolio was $273,000 (net of tax effects) at December 31, 2006.
Premiums receivable increased due to the increase in premium writings. This balance is comprised primarily of premiums due from insureds. Most of the policies are written with a down payment and monthly payment terms of up to four months on six month policies. The Company recorded an allowance for doubtful accounts of $880,000 and $440,000 as of December 31, 2006 and 2005, respectively, which it considers adequate. The increase in the allowance for doubtful accounts was due to growth in premium receivables and an increase in the South Central and Southwest regions share of premiums written. Balances written off in these two regions were higher than in the Southeast region.
Reinsurance balances receivable decreased primarily as a result of a decrease in ceded unpaid C & CAE under the reserve reinsurance cover agreement as a result of settling commercial auto claims in the normal course. An allowance for doubtful accounts of $146,000 and $148,000 as of December 31, 2006 and 2005, respectively, had been recorded regarding the collectibility of amounts due, which the Company considers adequate. Balances written off in previous years have been immaterial.
Other assets increased primarily due to deferred expenses incurred in conjunction with the issuance of the Subordinated debentures.
Deferred Federal income taxes increased primarily as a result of a reduction in the valuation allowance for Deferred Federal income taxes. The Company considered it appropriate to reduce the valuation allowance, see “Liquidity and Capital Resources - Net Operating Loss Carryforwards.”
As of December 31, 2006, in respect of its runoff lines, the Company had $15,864,000 in net unpaid C & CAE. Historically, the Company has experienced significant volatility in its reserve projections for its commercial lines. This volatility has been primarily attributable to its commercial auto and general liability product lines. On February 7, 2002, the Company announced it had decided to discontinue writing commercial lines insurance due to continued adverse claims development and unprofitable results. The Company has been settling and reducing its remaining inventory of commercial claims. See “Business Operations-“Discontinuance of Commercial Lines.” As of December 31, 2006, 73 runoff claims remained versus 149 at December 31, 2005. The average runoff claim reserve was approximately $217,000 per claim and $192,000 per claim at December 31, 2006 and December 31, 2005, respectively.
Unearned premiums increased primarily as a result of the growth in premium writings, mentioned previously.
Retained deficit decreased primarily as a result of net income offset by the redemption of the Preferred stock.
The following table summarizes the Company’s contractual obligations as of December 31, 2006:
See Item 1, “Business - Unpaid Claims and Claim Adjustment Expenses” and Note 8 of Notes to Consolidated Financial Statements with respect to liabilities to policyholders in respect of insurance policies written by the Company.
In May 2005, the Company entered into an Office Lease (the “Lease”) with Crescent Real Estate Funding VIII, L.P., a Delaware limited partnership (“Crescent Funding”) in order to consolidate its operations and provide for growth following the Company’s recapitalization. The Lease (recorded in “Operating leases” in the table above) is for a term of ten years, and the Company has the option of terminating the Lease at the end of the fifth year of the term subject to payment of a penalty. Pursuant to the Lease, the Company is renting space in the office building located at 3333 Lee Parkway in Dallas, where the Company has moved its executive offices and relocated all of its operations previously located in Fort Worth, Texas and certain operations previously conducted in Miami, Florida.
The Lease has been amended to include additional office space to accommodate the Company’s growth and currently covers approximately 52,000 square feet (including additional space which the Company agreed to occupy pursuant to an amendment to the Lease executed in February 2007).
In December 2006, the Company entered into a Sponsorship Agreement with Stallings Capital Group Consultants, Ltd. dba Bob Stallings Racing (“Stallings Racing”), continuing the Company’s role as the primary sponsor of a Daytona Prototype Series racing team through December 31, 2007. The Sponsorship Agreement provides that, in consideration of the payment by the Company of a sponsorship fee of $1.5 million, the Company will receive various benefits customary for sponsors of Daytona Prototype Series racing teams, including rights relating to signage on team equipment and access for customers and agents to certain race facilities. The sponsorship fee of $1.5 million is paid and expensed in equal payments commencing January 1, 2007 and continuing until the final installment on December 1, 2007.
Critical accounting policies are defined as those that are reflective of significant judgments and uncertainties, and potentially result in materially different results under different assumptions and conditions. The Company’s critical accounting policies are described below. For a detailed discussion on the application of these and other accounting policies. See Note 1 of Notes to Consolidated Financial Statements.
Accidents generally result in insurance companies paying under the insurance policies written by them amounts to individuals or companies for the risks insured. Months and sometimes years may elapse between the occurrence of an accident, reporting of the accident to the insurer and payment of the claim. Insurers record a liability for estimates of claims that will be paid for accidents reported to them, which are referred to as “case reserves”. In addition, since accidents are not always reported promptly upon the occurrence and because the assessment of existing known claims may change over time with the development of new facts, circumstances and conditions, insurers estimate liabilities for such items, which are referred to as “IBNR” reserves (Incurred But Not Reported).
In September 2006, the Securities Exchange Commission (“SEC”) issued Staff Accounting Bulletin (“SAB”) No. 108, “Considering the Effect of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements,” which provides interpretive guidance on the consideration of the effects of prior year misstatements in quantifying current year misstatements for the purpose of a materiality assessment. SAB No. 108 is effective for fiscal years ending after November 15, 2006. The implementation of the guidance in the SAB did not have a significant effect on the Company’s consolidated financial position or results of operations.
In September 2006, the FASB issued Statement No. 157, “Fair Value Measurements.” Statement No. 157 defines fair value, establishes a framework for measuring fair value in U.S. generally accepted accounting principles and expands disclosures about fair value investments. Statement No. 157 applies under other accounting pronouncements that require or permit fair value measurements, the FASB having previously concluded in those accounting pronouncements that fair value is the relevant measurement attribute. Accordingly, Statement No. 157 does not require any new fair value measurements. Statement No. 157 is effective for fiscal years beginning after November 15, 2007. Management is currently evaluating the impact, if any, the adoption of Statement No. 157 will have on our consolidated results of operations.
In June 2006, the Financial Accounting Standards Board (“FASB”) issued FIN 48, “Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109, Accounting for Income Taxes.” FIN 48 prescribes a comprehensive financial statement model of how a company should recognize, measure, present, and disclose uncertain tax positions that the Company has taken or expects to take in its income tax returns. Guidance is also provided on derecognition, classification, interest and penalties, interim accounting, and disclosure. FIN 48 requires that only income tax benefits that meet the “more likely than not” recognition threshold be recognized or continue to be recognized on the effective date. Initial derecognition amounts would be reported as a cumulative effect of a change in accounting principle, as an adjustment to the opening balance of retained earnings for the 2007 fiscal year. FIN 48 applies to all tax positions and is effective for the Company beginning in fiscal year 2007. The Company does not expect the adoption of FIN 48 to have a material impact on its consolidated financial position or results of operations and financial condition.
In February 2006, the FASB issued Statement No. 155, “Accounting for Certain Hybrid Financial Instruments-an amendment of Statements No. 133 and 140”. Statement No. 155 (i) permits fair value remeasurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation, (ii) clarifies which interest-only strips and principal-only strips are not subject to the requirements of Statement No. 133, (iii) establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation, (iv) clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives, and (v) amends Statement No. 140 to eliminate the exemption from applying the requirements of Statement No. 133 on a qualifying special-purpose entity from holding a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument. Statement No. 155 is effective for all financial instruments acquired or issued after the beginning of an entity’s first fiscal year that begins after September 15, 2006 (the fiscal year beginning January 1, 2007 for the Company). The Company is currently evaluating the impact, if any, that may result from the adoption of Statement No. 155.
In May 2005, the FASB issued Statement No. 154 “Accounting Changes and Error Corrections,” which changes the requirements for the accounting and reporting of a change in accounting principle. Statement No. 154 applies to all voluntary changes in accounting principle as well as to changes required by an accounting pronouncement that does not include specific transition provisions. Statement 154 requires that changes in accounting principle be retrospectively applied. Under retrospective application, the new accounting principle is applied as of the beginning of the first period presented as if that principle had always been used. The cumulative effect of the change is reflected in the carrying value of assets and liabilities as of the first period presented and the offsetting adjustments would be recorded to opening retained earnings. Statement No. 154 replaces APB Opinion No. 20 and Statement No. 3. Statement No. 154 is effective for the Company beginning in fiscal year 2006.
These forward-looking statements reflect our current views, but they are based on assumptions and are subject to risks, uncertainties, and other variables which you should consider in making an investment decision, including, in addition to the terms discussed under “PART I. ITEM 1A. Risk Factors” of this document, (a) operational risks and other challenges associated with rapid growth into new and unfamiliar markets and states, (b) adverse market conditions, including heightened competition, (c) factors considered by A.M. Best in the rating of our insurance subsidiaries, and the acceptability of our current rating, or a future rating, to agents and customers, (d) the Company’s ability to adjust and settle the remaining claims associated with its runoff business on terms consistent with its estimates and reserves, (e) the adoption or amendment of legislation, uncertainties in the outcome of litigation and adverse trends in litigation and regulation, (f) inherent uncertainty arising from the use of estimates and assumptions in decisions about pricing and reserves, (g) the effects on claims levels or business operations resulting from natural disasters and other adverse weather conditions, (h) the availability of reinsurance and the Company’s ability to collect reinsurance recoverables, (i) the availability and cost of capital, which may be required in order to implement the Company’s strategies, and (j) limitations on the Company’s ability to use net operating loss carryforwards.
Consolidated Statements of Operations for the Years Ended December 31, 2006, 2005 and 2004