We subleased an aggregate of 65,532 square feet of office space comprising of 38,341 square feet of the common building in Burr Ridge effective November 2012 through November 2016, 23,188 square feet of the common building in Baton Rouge effective November 2014 through December 2019 and 4,003 square feet of office space in Chicago effective October 2014 through July 2016.
As of December 31, 2014, our subsidiaries included insurance companies licensed to write insurance policies in 39 states, two underwriting agencies and a service company. We are also party to an agreement with an unaffiliated underwriting agency that distributes our policies in the state of California. We distribute and service non-standard insurance policies underwritten by a Texas county mutual insurance company. Prior to the sale of our retail agency distribution business on September 30, 2013, we also provided premium financing services and distributed third-party insurance products and services. We are currently distributing insurance policies through approximately 5,000 independent agents or brokers including the retail agency stores sold on September 30, 2013. We currently operate in seven states (Louisiana, Texas, California, Alabama, Illinois, Indiana and Missouri). We discontinued writing business in South Carolina in 2012.
The senior secured and subordinated credit facilities contain quarterly debt covenants that set forth, among other things, minimum risk-based capital requirements for our insurance subsidiaries as well as minimum cash flow requirements for our non-regulated businesses. The credit facilities have been amended to waive compliance with the risk-based capital measurement requirement as of December 31, 2014 and as of March 31, 2015, and to postpone the principal payment of $3.5 million due March 31, 2015 to June 30, 2015. Except for the minimum risk-based capital requirement for which we obtained a waiver, we were in compliance with these covenants as of December 31, 2014. However, it is probable we will not meet certain of these covenants in future periods. If we are unable to achieve compliance with the covenants or obtain a forbearance or waiver of any non-compliance or amend the agreements to change such covenants, the lenders could declare all amounts outstanding under the facilities to be immediately due and payable. Even if we were compliant with the covenants or, if not compliant, obtain additional forbearance or waivers from our lenders, there is still substantial uncertainty that we will be able to refinance or extend the maturity of the senior secured facility when it becomes due in March 2016. If our lenders declare the amounts outstanding to be immediately due and payable or if we were unable to refinance or extend the maturity of the senior secured credit facility when it becomes due, it would have a material adverse effect on our operations and our creditors and stockholders.
The accompanying consolidated financial statements do not include any adjustments to reflect the possible future effects of this uncertainty on the recoverability or classification of recorded asset amounts or the amounts or classification of liabilities.
We estimate loss and LAE reserves by using detailed statistical analyses and judgment, including adjustments for internal or external variables that may affect our loss exposure. The underlying methods require using estimates and informed judgment. As a result the loss and LAE reserve estimation process is inherently uncertain. We use the following generally accepted actuarial loss and LAE reserving methods in our analysis:
Incurred Loss Development - We use historical case incurred loss and LAE (the sum of cumulative loss and LAE payments plus outstanding case loss reserves) over discrete periods of time to estimate future loss and LAE. Incurred development methods assume that the case loss and LAE reserving practices are consistently applied over time.
Paid Bornhuetter/Ferguson - This method combines paid development and expected loss and LAE ratio methods. Expected loss ratio methods assume that ultimate losses vary proportionately with premiums. We use pricing information to develop expected loss and LAE ratios, which we combine with earned premium and undeveloped loss and LAE, and then add them to the actual loss and LAE paid to date.
We review loss reserve adequacy quarterly by accident year, state, program, and coverage. We adjust carried reserves as we learn additional information, and reflect these adjustments in our current year operations.
The range of potential ultimate values for any accident year diminishes with the age of the accident year. Recent accident years tend to have wider ranges of potential values because claims may still be emerging and injuries may still be unknown. As accident years age, the number of open claims decreases, injury specifics become clear, and the ranges of potential values narrow.
At December 31, 2014, our receivables from reinsurers included $9.3 million net recoverable from VFIC. At December 31, 2014, the VFIC Trust held $16.6 million to collateralize the $9.3 million net recoverable from VFIC. We have, with the approval of the VFIC Special Deputy Receiver and the District Court, Austin, Texas, withdrawn $9.0 million through December 31, 2014 from the trust securing our reinsurance recoverables from VFIC, which represented 100% of the amount we paid in losses as of the date of the withdrawal covered by the VFIC reinsurance. In March 2015, we received a notice of determination from the VFIC Special Deputy Receiver on multiple proofs of claim for an aggregate amount of $15.3 million for various reinsurance balances with VFIC. As part of the notice of determination, we entered into a settlement agreement and release with the VFIC Special Deputy Receiver. We expect to receive the $15.3 million in settlement proceeds by May 2015.
As of December 31, 2014 and 2013, we had no reserve for uncollectible reinsurance recoverables. We assessed the collectability of our year-end receivables and believe all amounts are collectible based on currently available information.
Deferred acquisition costs. Deferred acquisition costs represent the deferral of expenses that we incur in the successful acquisition of new business or renewing existing business. Policy acquisition costs (primarily commissions, premium taxes, net of ceding commission income, related to the successful issuance of a policy) are deferred and charged against income ratably over the terms of the related policies. Management regularly reviews the categories of acquisition costs that are deferred and assesses the recoverability of this asset. A premium deficiency and a corresponding charge to income is recognized if the sum of the expected losses and loss adjustment expenses, unamortized acquisition costs and maintenance costs exceeds related unearned premiums and anticipated investment income. At December 31, 2014 and 2013, there were no premium deficiencies. Judgments as to the ultimate recoverability of such deferred costs are highly dependent upon estimated future loss costs associated with unearned premiums.
If sufficient positive evidence arises in the future indicating that all or a portion of the deferred tax assets meet the more likely than not standard, the valuation allowance would be reversed accordingly in the period that such a conclusion is reached, which would materially impact our financial position and results of operations in a favorable manner.
Accounting Standards Update (ASU) No. 2014-15, Presentation of Financial Statements-Going Concern (Subtopic 205-40): Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern issued in August 2014 is intended to define management’s responsibility to evaluate whether there is substantial doubt about an organization’s ability to continue as a going concern and to provide related footnote disclosures. Specifically, this ASU provides guidance to an organization’s management, with principles and definitions that are intended to reduce diversity in the timing and content of disclosures that are commonly provided by organizations today in the financial statement footnotes. The amendments are effective for annual periods ending after December 15, 2016, and interim periods within annual periods beginning after December 15, 2016. Early application is permitted for annual or interim reporting periods for which the financial statements have not previously been issued. We do not expect the adoption of this standard to have a material impact on our consolidated financial position, results of operations, or cash flows.
The additional $20.0 million of proceeds may be used to pay down debt or infuse capital into Affirmative Insurance Company (AIC). The additional proceeds are contingent on AIC meeting certain risk-based capital thresholds and maintaining the obligations of the distribution agreement. The risk-based capital measurement begun as of June 30, 2014 for up to $10.0 million of additional proceeds and the remaining balance up to $20.0 million can be achieved on any following quarterly measurement date through December 31, 2015. These contingent proceeds will be recognized as risk-based capital measurement thresholds are achieved. In September 2014, $10.0 million of additional proceeds were received of which, $9.9 million was used to infuse capital into AIC and $0.1 million was used to pay down the senior secured credit facility.
We realized a pretax gain on the sale of $10.0 million and $65.0 million for the years ended December 31, 2014 and 2013, respectively. The Company’s consolidated results of operations as of December 31, 2013 include the retail business’s results of operations through the date of the sale, September 30, 2013.
In our other independent agency distribution channel, gross written premiums managed for 2014 increased $9.0 million, or 7.3% compared with 2013 and gross written premiums for 2013 increased $53.7 million, or 77.0%, compared with 2012. We believe the increases were primarily due to a reduction in competition from companies that were aggressive in pricing.
Gross written premiums managed by our unaffiliated underwriting agency for 2014 increased $8.2 million, or 11.1%, compared with 2013 and gross written premiums managed by our unaffiliated underwriting agency for 2013 increased $56.0 million, or 315.0%, compared with 2012. We believe the increases were primarily due to a reduction in competition from companies that were aggressive on pricing.
Effective December 31, 2013, we entered into a reinsurance agreement with four third-party reinsurance companies. Under this agreement, we ceded 20% of premiums and losses in Alabama, Illinois, Louisiana and Texas, and 60% in California on policies in force on December 31, 2013 or written or renewed on and after that date. Written premiums ceded under this agreement totaled $22.2 million as of December 31, 2013. On January 1, 2014, the quota-share rate increased to 60% for all business in force in these same states and for new and renewal business. On June 30, 2014, the reinsurance agreement was terminated, resulting in the return of $51.7 million of unearned premiums, net of $14.5 million of ceding commissions. Written premiums ceded under the agreement totaled $95.9 million. In March 2015, two of the quota share reinsurers commuted their participation on this agreement.
The amount of recoveries pertaining to reinsurance contracts that were deducted from losses and loss adjustment expenses incurred during 2014, 2013 and 2012 was approximately $160.0 million, $80.1 million and $49.8 million, respectively. The amount of loss reserves and unearned premium we would remain liable for in the event our reinsurers are unable to meet their obligations was as follows (in thousands):
The Michigan Catastrophic Claims Association (MCCA) is the mandatory reinsurance facility that covers no-fault medical losses above a specific retention amount in Michigan. We discontinued writing policies in Michigan in 2011. For policies effective in 2011, the retention amount was $0.5 million. When we wrote personal automobile policies in the state of Michigan, we ceded premiums and claims to the MCCA. Funding for MCCA comes from assessments against active automobile insurers based upon their proportionate market share of the state’s automobile liability insurance market. Insurers are allowed to pass along this cost to Michigan automobile policyholders.
Commission Income, Fees and Managing General Agent Revenue. Another measurement of our performance is the relative level of production of fee revenue. Policy origination fees and installment fees compensate us for the costs of policy administration and providing installment payment plans. Policy and installment fees are earned for business managed by our general agencies and must be approved by the applicable state’s department of insurance. Managing general agent revenues are earned for business produced for a Texas county mutual insurance company beginning January 1, 2013. We receive compensation for underwriting services and providing claims handling on the business. Premium finance, commission income, and agency fees represent revenues from the retail agency business prior to being sold on September 30, 2013. Premium finance fees consist of origination and servicing fees as well as interest on premiums that customers choose to finance. Commission income consist of the income earned on sales of unaffiliated, third-party companies’ insurance policies or other products sold by our retail agencies. Agency fees compensated the Company for the costs of policy cancellation, policy rewrite and reinstatement.
Commission income, fees and managing general agent revenue for 2013 increased $16.0 million, or 26.1%, compared with 2012. Policyholder fees increased $14.7 million, or 70.8%, due to the higher overall volume of premiums written and a change in mix of states. Managing general agent revenue is related to the Texas county mutual book of business that we manage, but no longer assume the underwriting risk beginning January 1, 2013.
Premium finance revenue for 2013 decreased $4.8 million, or 22.8%, compared to 2012 due to the sale of the retail business.
Net investment income for 2013 decreased $0.4 million, or 12.4%, compared with 2012. The decrease was primarily due to a 36.2% decrease in total average invested assets to $48.7 million during 2013 from $76.3 million during 2012. The annualized average investment yield was 1.4% in 2013, compared with 1.9% in 2012.
Losses and Loss Adjustment Expenses. Losses and loss adjustment expenses for 2014 decreased $32.1 million, or 21.7%, compared with 2013. Losses and loss adjustment expenses for 2013 increased $36.0 million, or 32.1%, compared with 2012.
Our losses and loss adjustment expenses are a blend of the specific estimated and actual costs of providing the coverage contracted by the purchasers of our insurance policies. We maintain reserves to cover our estimated ultimate liability for losses and related loss adjustment expenses for both reported and unreported claims on the insurance policies issued by our insurance companies. The establishment of appropriate reserves is an inherently uncertain process, involving actuarial and statistical projections of what we expect to be the cost of the ultimate settlement and administration of claims based on historical claims information, estimates of future trends in claims severity and other variable factors such as inflation. Due to the inherent uncertainty of estimating reserves, reserve estimates can be expected to vary from period to period. To the extent that our reserves prove to be inadequate in the future, we would be required to increase our reserves for losses and loss adjustment expenses and incur a charge to earnings in the period during which such reserves are increased. The historic development of our reserves for losses and loss adjustment expenses is not necessarily indicative of future trends in the development of these amounts.
The following table provides a reconciliation of the beginning and ending reserves for unpaid losses and loss adjustment expenses (in thousands):
The adverse prior period development recognized in 2014, 2013, 2012 and 2011 was primarily due to an increase in the estimated severity for Louisiana, Texas and/or California liability claims as well as growth, starting in 2013, of new business which typically has a higher loss ratio than renewal business. The gross cumulative redundancy in 2010 was primarily due to a reduction of Michigan case reserves for 2010 due to revised estimates of losses.
Depreciation and Amortization. Depreciation and amortization expenses for 2014 decreased $1.1 million, or 15.9%, compared with 2013. Depreciation and amortization expenses for 2013 decreased $3.0 million, or 29.6%, compared with 2012. The decrease was due to the sale of the retail business.
We recorded a $4.2 million pretax loss on extinguishment of debt as a result of this transaction for 2013. The $4.2 million debt extinguishment loss resulted from the write-off of $2.2 million of deferred debt issuance costs and unamortized debt discount relating to the senior secured credit facility effective January 2007, $1.4 million of legal fees and a $0.6 million prepayment premium.
Interest Expense. Interest expense for 2014 decreased $7.7 million, or 37.3%, compared with 2013. This decrease was primarily due to a decrease in financing costs associated with the new debt arrangement effective September 2013.
Income tax expense for 2013 was $0.9 million as compared to $0.3 million for 2012. Income tax expense for 2013 was primarily due to the sale of the retail business.
There are no restrictions on the payment of dividends by our non-insurance company subsidiaries other than state corporate laws regarding solvency. As a result, our non-insurance company subsidiaries generate revenues, profits and net cash flows that are generally unrestricted as to their availability for the payment of dividends and we have and expect to continue to use those revenues to service our corporate financial obligations, such as debt service and stockholder dividends. As of December 31, 2014, we had $3.5 million of cash and cash equivalents at our holding company and non-insurance company subsidiaries.
In December 2013, we entered into a capital lease obligation related to certain computer software, software licenses and hardware used in our insurance operations. A receivable for settlement of this transaction was included in other assets as of December 31, 2013. In January 2014, we received cash proceeds from the financing in the amount of $4.9 million. The transaction proceeds were pledged as collateral against all the Company’s obligations under the lease. The dollar amount of collateral pledged is set to decline over the term of the lease as the Company makes the scheduled lease payments. At the end of the initial term, we will have the right to purchase the software for a nominal fee, after which all rights, title and interest would transfer to us.
On February 28, 2012, we exercised our right to defer interest payments on selected Notes Payable beginning with the scheduled interest payment due in March 2012 and continuing for a period of up to five years. The affected notes are associated with obligations to our unconsolidated trusts. The outstanding balance of the affected notes was $56.7 million as of December 31, 2014. We will continue to accrue interest on the principal during the extension period and the unpaid deferred interest will also accrue interest. Deferred interest will be due and payable at the expiration of the extension period.
Our operating subsidiaries’ primary sources of funds are premiums received, commission, fee income and managing general agency revenue, investment income and the proceeds from the sale and maturity of investments. Funds are used to pay claims and operating expenses, to purchase investments and to pay dividends to our holding company.
We recorded a $4.2 million pretax loss on extinguishment of debt as a result of the refinancing on September 30, 2013. The $4.2 million debt extinguishment loss resulted from the write-off of $2.2 million of deferred debt issuance costs and unamortized discount relating to the senior secured credit facility effective January 2007, $1.4 million of legal fees and a $0.6 million prepayment premium.
Our obligations under the credit facilities are guaranteed by our material operating subsidiaries (other than the Company’s insurance companies) and are secured by a first lien security interest on all of our assets and the assets of our material operating subsidiaries (other than the Company’s insurance companies), including a pledge of 100% of the stock of AIC.
The following table summarizes our contractual obligations at December 31, 2014 (in thousands):
As of December 31, 2014, we leased an aggregate of approximately 160,420 square feet of office space for our insurance companies in various locations throughout the United States. We subleased an aggregate of approximately 65,532 square feet of office space. These amounts represent our net minimum future operating lease commitments.
All of the outstanding notes payable at December 31, 2014 are redeemable in whole or in part after five years from issuance. For this disclosure, it is assumed that none of these notes will be redeemed before their contractual maturities and interest rates on these notes will remain at their current levels.
We have audited the accompanying consolidated balance sheets of Affirmative Insurance Holdings, Inc. and subsidiaries (the Company) as of December 31, 2014 and 2013, and the related consolidated statements of operations, comprehensive income (loss), stockholders’ deficit, and cash flows for each of the years in the three-year period ended December 31, 2014. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
The Company’s insurance subsidiaries are subject to risk-based capital standards and other minimum capital and surplus requirements imposed under applicable state laws, including the laws of their state of domicile. The risk-based capital standards, based upon the Risk-Based Capital Model Act adopted by the National Association of Insurance Commissioners, or NAIC, require insurance companies to report their results of risk-based capital calculations to state departments of insurance and the NAIC. At December 31, 2014, the risk-based capital level of Affirmative Insurance Company (AIC) triggered a regulatory action level event under the NAIC standard. As a result, AIC is required to submit a plan to the Illinois Department of Insurance (IDOI) in April 2015 detailing corrective actions it will take to return its risk-based capital ratio to an acceptable level. Upon receipt of the plan, the IDOI may accept the plan, require further amendments to the plan or take additional regulatory action including, but not limited to, placing AIC in receivership. Such additional regulatory action by the Illinois Department of Insurance would have a material adverse effect on the Company’s operations and the interest of its creditors and stockholders. Such additional regulatory action by the Illinois Department of Insurance also would trigger a further event of default under the Company’s senior secured credit facility and subordinated credit facility allowing the Company’s lenders to declare all amounts outstanding under the facilities to be immediately due and payable, and if such amounts were declared immediately due and payable by the lenders, it would have a material adverse effect on the Company’s operations and the interests of its creditors and stockholders.
The Company has taken and will continue to pursue appropriate actions to improve the underwriting results. The Company is also pursuing various other actions to address these issues. However, there can be no assurance that these actions will be effective.
The Company’s recent history of recurring losses from operations, its failure to comply with certain financial covenants in its senior secured and subordinated credit facilities, its need to meet debt repayment requirements and its failure to comply with the Illinois Department of Insurance minimum risk-based capital requirements raise substantial doubt about the Company’s ability to continue as a going concern.
Cash and Cash Equivalents • Cash and cash equivalents are highly liquid investments with an original maturity of ninety days or less and include principally money market funds, repurchase agreements, and other bank deposits. Unless the right-of-setoff requirements have been met, bank overdrafts or negative book cash balances, if material, are recorded in other liabilities in the consolidated balance sheet. As of December 31, 2014 and 2013, $1.1 million and $1.6 million negative book cash balance was reflected in other liabilities in the consolidated balance sheets, respectively.
Fiduciary and Restricted Cash • Fiduciary and restricted cash consists of non-operating certificates of deposit required by state regulations and/or under various agreements with third parties.
Deferred Policy Acquisition Costs, net of ceding commission • Deferred policy acquisition costs represent the deferral of expenses that the Company incurs in the successful acquisition of new business or renewal of existing insurance policies. Policy acquisition costs, consisting of primarily commissions and premium taxes, net of ceding commission income, are deferred and charged against income ratably over the terms of the related policies. The Company regularly reviews the categories of acquisition costs that are deferred and assesses the recoverability of this asset. A premium deficiency, and a corresponding charge to income, is recognized if the sum of the expected losses and loss adjustment expenses, unamortized acquisition costs, and maintenance costs exceeds related unearned premiums and anticipated investment income. Amounts received as ceding commissions on reinsurance contracts are recorded as reductions of deferred acquisition costs and are recognized into income ratably as the related ceded premium is earned. Amortization of deferred policy acquisition costs is recorded in selling, general and administrative expenses in the consolidated statement of operations.
Affirmative Insurance Holdings Statutory Trust II (“Trust II”), is an unconsolidated trust subsidiary established for the sole purpose of issuing $25.0 million trust preferred securities in 2005. Trust II used the proceeds from the sale of these securities and the Company’s initial capital contribution to purchase $25.8 million of subordinated debt securities from the Company. The debt securities are the sole assets of Trust II, and the payments under the debt securities are the sole revenues of Trust II. The Company’s initial capital contribution consisted of the purchase of 774,000 common securities issued by Trust II for $774,000, which represented 3% of the total dollar amount of subordinated debentures issued.
Treasury Stock • Treasury stock purchases are accounted for using the cost method, whereby the entire cost of the acquired stock is recorded as treasury stock. When reissued, shares of treasury stock will be removed from the treasury stock account at the average purchase price per share of the aggregate treasury shares held.
Revenue Recognition • Premium income - Premiums, net of premiums ceded, is earned over the life of the underlying policies. Unearned premiums represent that portion of premiums written that are applicable to the unexpired terms of policies in force. Premiums receivable are recorded net of an estimated allowance for uncollectible amounts.
Fee Income - Policy origination fees and installment fees compensate the Company for the costs of policy administration and providing installment payment plans. Policy origination fees are recognized over the underlying policy terms. Other fees are recognized when services are provided.
Net Income (Loss) Per Common Share • Basic net income (loss) per common share is computed by dividing net income (loss) available to common stockholders by the weighted average number of common shares outstanding during the year. Diluted net income (loss) per share is computed by giving effect to the potential dilution that could occur if securities or other contracts to issue common shares were exercised and converted into common shares during the year.
Fair Value of Financial Instruments • The Company determines fair value for all financial assets and liabilities and non-financial assets and liabilities that are recognized or disclosed at fair value in the financial statements on a recurring basis. The Company defines fair value as the price that would be received from selling an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. When determining fair value, the Company considers the principal
or most advantageous market in which the Company would transact and the market-based risk measurements or assumptions that market participants would use in pricing the asset or liability, such as inherent risk, transfer restrictions and credit risk.
Segment Reporting • The Company’s operations consist of designing, underwriting and servicing non-standard personal automobile insurance policies. The Company is a holding company, with no operating revenues and only interest expense on corporate debt. The Company’s subsidiaries consist of several types of legal entities: insurance companies, underwriting agencies and a service company from which all employees are paid. Insurance subsidiaries possess the certificates of authority and capital necessary to transact insurance business and issue policies, but they rely on both affiliated and an unaffiliated underwriting agency to design, distribute and service those policies. Underwriting agencies primarily design, distribute and service policies issued or reinsured by the Company’s insurance subsidiaries and that are distributed by independent agents. Given the homogeneity of the Company’s products, the regulatory environments in which the Company operates, the nature of the Company’s customers and distribution channels, Company management monitors, controls and manages the business as an integrated entity offering non-standard personal automobile insurance products through multiple distribution channels.
On September 30, 2013, the Company sold its retail agency distribution business to Confie Seguros (Confie). The Company’s retail agency distribution business consisted of 195 retail locations in Louisiana, Alabama, Texas, Illinois, Indiana, Missouri, Kansas, South Carolina and Wisconsin and two premium finance companies (the retail business). Proceeds from the sale were $101.9 million in cash with the potential to receive an additional $20.0 million of cash proceeds. The initial cash proceeds included a working capital adjustment of $1.9 million that was received in 2013 and $20.0 million placed in an escrow account. The funds held in escrow were available, dependent upon the quarterly risk-based capital status of Affirmative Insurance Company (AIC), to be utilized to either infuse capital into AIC or pay down debt. As of the first risk-based measurement date of September 30, 2013, AIC met the risk-based capital target and in November 2013, $5.0 million was released from the escrow account and was used to pay down the senior secured credit facility. As of December 31, 2013, AIC met the risk-based capital target and in April 2014, an additional $5.0 million was released from the escrow account and was used to pay down the senior secured credit facility. In March 2014, the purchase agreement was amended to eliminate the measurement of risk-based capital as of March 31, 2014. In June 2014, the remaining $10.0 million in the escrow account was utilized to infuse capital into AIC.
For additional disclosures regarding methods and assumptions used in estimating fair values of these securities see Note 23.
Expected maturities may differ from contractual maturities because certain borrowers may have the right to call or prepay obligations with or without penalties. The Company’s amortized cost and estimated fair values of fixed-income securities at December 31, 2014 by contractual maturity were as follows (in thousands):
As of December 31, 2014 and 2013, certificates of deposit in the amount of $2.8 million and $4.9 million, respectively, were pledged as collateral associated with the capital lease related to certain computer software, software licenses, and hardware used in the Company’s insurance operations. See Note 12 for discussion of the associated capital lease obligation.
At December 31, 2014 and 2013, investments in fixed-maturity securities with an approximate carrying value of $7.0 million and $6.9 million, respectively, were on deposit with regulatory authorities as required by insurance regulations.
In 2013, the Company entered into a new quota-share agreement with the same third-party reinsurance company effective March 31, 2013, under which the Company ceded 40% for the same four states as the expiring agreement. This agreement was amended effective June 30, 2013, under which the Company ceded an additional 40% for the same four states for the remainder of 2013. This agreement was further amended to provide a $10.0 million reduction in ceded premiums in the fourth quarter. Written premiums ceded under this agreement totaled $145.8 million during the year ended December 31, 2013. This agreement terminated on January 1, 2014, resulting in the return of $47.2 million unearned premiums, net of $13.9 million of ceding commissions. Written premiums ceded under the agreement totaled $98.6 million.
The Company assumes reinsurance from a Texas county mutual insurance company (the county mutual) whereby the Company has assumed 100% of the policies issued by the county mutual for business produced by the Company’s owned general agents with policies in force prior to January 1, 2013. The county mutual does not retain any of this business and there are no loss limits other than the underlying policy limits. AIC has established a trust to secure the Company’s obligation under this reinsurance contract with a balance of $4.3 million and $15.0 million as of December 31, 2014 and 2013, of which $0.6 million and $3.6 million was held in cash equivalents as of December 31, 2014 and 2013, respectively. On January 1, 2013, the Company terminated this agreement on a cut-off basis and unearned premium of $11.8 million was returned to the ceding company.
The quota-share reinsurers and the excess of loss reinsurers all have at least A- ratings from A.M. Best. Accordingly, the Company believes there is minimal credit risk related to these reinsurance receivables. Under the reinsurance agreement with Vesta Insurance Group (VIG), including primarily Vesta Fire Insurance Corporation (VFIC), AIC had the right, under certain circumstances, to require VFIC to provide a letter of credit or establish a trust account to collateralize gross amounts due from VFIC under the reinsurance agreement. At December 31, 2014, the VFIC Trust held $16.6 million (after cumulative withdrawals of $9.0 million through December 31, 2014), consisting of a U.S. Treasury money market account held in cash and cash equivalents, to collateralize the $9.3 million net recoverable from VFIC. In March 2015, AIC received a notice of determination from the VFIC Special Deputy Receiver on multiple proofs of claim for an aggregate amount of $15.3 million for various reinsurance balances with VFIC. As part of the notice of determination, AIC entered into a settlement agreement and release with the VFIC Special Deputy Receiver. AIC expects to receive the $15.3 million in settlement proceeds by May 2015.
Property and equipment, net, consisted of the following as of December 31, 2014 and 2013 (in thousands):
Indefinite-lived intangible assets primarily consist of state insurance licenses. Prior to the sale of the retail business, intangible assets included brand names that were evaluated for impairment utilizing the relief-from-royalty method. This method assumes that trade names have value to the extent that their owner is relieved of the obligation to pay royalties for the benefits received from them. This method requires an estimate of future revenue for the related brands, the appropriate royalty rate and the weighted average cost of capital. This analysis indicated an impairment of indefinite-lived intangible assets of $0.2 million as of September 30, 2012. Impairment of intangible assets is recorded in goodwill and other intangible assets impairment on the consolidated statements of operations.
Other intangible assets at December 31, 2014 and 2013 were as follows (in thousands):
In 2014, the percentage of net losses and loss adjustment expense to net premiums earned (the net loss ratio) was 119.2% compared with 89.2% in 2013. The current year included $21.2 million of unfavorable prior period development primarily related to Louisiana, Texas and California losses from 2013 and 2012, which was primarily due to increases in estimated severity of liability claims. Excluding the prior year development, the current accident year net loss ratio was 97.4% compared with 81.8% in 2013. The use of quota-share reinsurance overstates the net loss ratio. Loss adjustment expenses include all of the business subject to the quota-share treaties with ceding commission income booked as an offset to selling, general and administrative expenses. Excluding the impact of the quota-share, the loss ratio for the 2014 accident year was 75.2% and 74.6% for the 2013 accident year. The increase in the current year was primarily due to the increase of 2014 losses based on the prior period development.
In 2013, the percentage of net losses and loss adjustment expense to net premiums earned (the net loss ratio) was 89.2% compared with 77.8% in 2012. The current year included $7.0 million of unfavorable prior period development primarily related to the 2011 accident year for our Louisiana business, $3.6 million related to the 2011 and 2012 Texas business, and $1.3 million for the accident year 2012 California business. Excluding the prior year development, the current accident year net loss ratio was 81.8% compared with 74.0% in 2012. The use of quota-share reinsurance overstates the net loss ratio. Loss adjustment expenses include all of the business subject to the quota-share treaties with ceding commission income booked as an offset to selling, general and administrative expenses. Excluding the impact of the quota-share, the loss ratio for the 2013 accident year was 74.6% and 69.4% for the 2012 accident year. The increase in the current year was primarily due to a significant increase in new business, which tends to
have a higher loss ratio than renewal business. Also reflected in the above numbers is the effect of catastrophes. In the current accident year we have incurred catastrophes, net of reinsurance, equal to 2.0% for 2013 and 2012. Both of these numbers are higher than our long term average expectation of 0.5%.
The $30.9 million notes payable due 2035 are redeemable in whole or in part by the Company. The notes adjust quarterly to the three-month LIBOR rate plus 3.60%. The interest rate as of December 31, 2014 was 3.84%.
The $25.8 million notes payable due 2035 are redeemable in whole or in part by the Company. The notes adjust quarterly to the three-month LIBOR rate plus 3.55%. The interest rate as of December 31, 2014 was 3.79%.
On February 28, 2012, the Company exercised its right to defer interest payments on the two notes payable mentioned above beginning with the scheduled interest payment due in March 2012 and continuing for a period of up to five years. The affected notes are associated with obligations to the Company’s unconsolidated trusts. The outstanding balance of the affected notes was $56.7 million as of December 31, 2014. The Company will continue to accrue interest on the principal during the interest deferral period and the unpaid deferred interest will also accrue interest. Deferred interest will be due and payable at the expiration of the interest deferral period and totaled $6.9 million as of December 31, 2014.
The pricing under the senior secured credit facility was amended effective September 30, 2014 to an adjusted LIBOR rate floor of 1.25%, plus 9.25%. The interest rate as of December 31, 2014 was 10.50%. The Company made principal payments of $6.5 million and $5.0 million in 2014 and 2013, respectively. As of December 31, 2014, the principal balance of the senior secured credit facility was $28.5 million. The senior secured credit facility was issued at a discount of $2.0 million that is amortized as interest expense over the expected term of the loan using the effective interest method. Repayment of the facility is due quarterly with $2.0 million payable for each quarter through September 30, 2014, $3.5 million payable each quarter through September 30, 2015, $4.5 million payable on December 31, 2015 and the remaining balance of $13.5 million due in full on March 30, 2016. Prepayments under this agreement are applied to the earliest payments due. Effective December 31, 2014, the senior secured credit facility was amended to postpone the principal payment of $3.5 million due March 31, 2015. The next payment due is $7.0 million on June 30, 2015.
In November 2014, the Company entered into an amendment to the senior secured and subordinated credit facilities. The amendment included the following significant items:
A waiver under both the senior secured and subordinated credit facility of all defaults or events of default arising out of the breach of the Company’s risk-based capital ratio for the quarter ended September 30, 2014.
A fee of 1% is due to the senior secured facility lenders upon approving the amendment. The Company paid a 0.50% fee to the senior secured facility lenders in November 2014 and will pay an additional 0.50% fee to the senior secured facility lenders on March 31, 2015.
The following table summarizes the Company’s credit facilities scheduled principal payments (in thousands):
In March 2013, the Company, through one of its indirect, wholly-owned subsidiaries, entered into a $4.8 million loan secured by commercial real estate to provide liquidity to AIC. The loan is evidenced by a promissory note secured by a mortgage security agreement and assignment of leases and rents on real estate located in Baton Rouge, Louisiana, which is held as investment in real property on the consolidated balance sheet. The mortgage bears interest at a per annum fixed rate of 4.95%. The mortgage requires monthly payments of principal and interest with the final payment due on the maturity date of December 15, 2015. As security for payments, the Company assigned rents due under the lease to a trustee. Pursuant to an escrow and servicing agreement, the trustee will receive rent due under the lease, make required payments due under the mortgage and maintain certain escrow accounts to pay for the necessary expenses of the property until the mortgage is paid in full.
In December 2013, the Company entered into a capital lease obligation related to certain computer software, software licenses and hardware used in the Company’s insurance operations. A receivable for settlement of this transaction was included in other assets as of December 31, 2013. In January 2014, the Company received cash proceeds from the financing in the amount of $4.9 million. The transaction proceeds are pledged as collateral against all the Company’s obligations under the lease. The dollar amount of collateral pledged is set to decline over the term of the lease as the Company makes the scheduled lease payments. At the end of the initial term, the Company will have the right to purchase the software for a nominal fee, after which all rights, title and interest would transfer to the Company.
In October 2012, one of the Lessors terminated their capital lease agreement with the Company. In December 2012, the Lessor conveyed all rights and interest in the leased property to the Company.
The remaining lease term for both capital leases is 6 months with monthly rental payments totaling approximately $0.6 million. Cash and securities pledged as collateral and held as available-for-sale securities were $4.9 million and $5.9 million as of December 31, 2014 and 2013, respectively.
Tax effects of temporary differences that give rise to significant portions of the Company’s deferred tax assets and deferred tax liabilities at December 31, 2014 and 2013 were as follows (in thousands):
At December 31, 2014, the Company’s 2007 and prior tax years were closed by the IRS.
On October 21, 2014, Affirmative Insurance Company (AIC) filed a complaint for breach of contract and declaratory judgment in the U.S. District Court for the District of South Carolina, styled Affirmative Insurance Company v. Travis K. Williams, et al., Case No. 5:14-CV-4087-JMC. The lawsuit arises out of AIC’s defense of its insured who was involved in a fatal automobile accident in November 2007. Plaintiffs in the underlying lawsuits have threatened bad faith litigation against AIC based on their belief that they will obtain an excess judgment against AIC’s insured in the future. AIC believes the allegation of bad faith lacks merit and intends to defend itself vigorously should an excess verdict be obtained and a bad faith action pursued. Further, AIC asserts that its insured breached the insurance policy by, among other things, failing to cooperate in the defense of the underlying lawsuit and entering into competing settlement negotiations with plaintiffs in the underlying lawsuit. AIC seeks a finding that defendants breached the insurance policy, a declaration that AIC has no duty to defend or indemnify the insured in the underlying lawsuits, and a declaration that AIC has not acted in bad faith under South Carolina law. On December 2, 2014, defendants filed a motion to dismiss, which is fully briefed and awaiting decision. No accurate estimate of the range of potential loss nor an assessment of the likelihood of unfavorable outcome can be made at this time.
Net income (loss) per common share is based on the weighted average number of shares outstanding. Diluted weighted average shares is calculated by adjusting basic weighted average shares outstanding by all potentially dilutive stock options and restricted stock. Restricted stock awards outstanding of 472,000 for the year ended December 31, 2014 (Nil for 2013 and 2012), were not included in the computation of diluted earnings per share because there was a loss from continuing operations during the period. Stock options outstanding of 1,263,000, 323,000 and 2,407,000 for the years ended December 31, 2014, 2013 and 2012, respectively, were not included in the computation of diluted earnings per share because the exercise price of the options was greater than the average market price of the common stock or there was a loss from continuing operations in the respective periods.
Stock options outstanding and exercisable at December 31, 2014 were as follows (shares in thousands):
The stock options outstanding and exercisable at December 31, 2014 had aggregate intrinsic values of zero as the aggregate exercise price was greater than the aggregate market value. Stock options exercised during 2014 had an aggregate intrinsic value of $481,000. No stock options were exercised in 2013 or 2012. The Company received $207,000 from the exercise of 274,999 share options during 2014.
Disclosures for Items Reclassified Out of Accumulated Other Comprehensive Income (Loss)
The Company is subject to comprehensive regulation and supervision by government agencies in Illinois, Louisiana, Michigan and New York, the states in which the Company’s insurance company subsidiaries are domiciled, as well as in the states where its subsidiaries sell insurance products, issue policies, handle claims and finance premiums. Certain states impose restrictions or require prior regulatory approval of certain corporate actions, which may adversely affect the Company’s ability to operate, innovate, obtain necessary rate adjustments in a timely manner or grow its business profitably. These regulations provide safeguards for policy owners and are not intended to protect the interests of stockholders. The Company’s ability to comply with these laws and regulations, and to obtain necessary regulatory action in a timely manner, is and will continue to be critical to its success.
The Company’s insurance company subsidiaries are subject to risk-based capital standards and other minimum capital and surplus requirements imposed under applicable state laws, including the laws of their state of domicile. The risk-based capital standards, based upon the Risk-Based Capital Model Act, adopted by the National Association of Insurance Commissioners (NAIC), require the Company’s insurance company subsidiaries to report their results of risk-based capital calculations to state departments of insurance and the NAIC. Failure to meet applicable risk-based capital requirements or minimum statutory capital requirements could subject the Company to further examination or corrective action imposed by state regulators, including limitations on the Company’s writing of additional business, state supervision or liquidation. Any changes in existing risk-based capital requirements or minimum statutory capital requirements may require the Company to increase its statutory capital levels. These risk-based capital standards provide for different levels of regulatory attention depending upon the ratio of an insurance company’s total adjusted capital, as calculated in accordance with NAIC guidelines, to its authorized control level risk-based capital and trend test. Authorized control level risk-based capital is the number determined by applying the NAIC’s risk-based capital formula, which measures the minimum amount of capital that an insurance company needs to support its overall business operations. At December 31, 2014, three of the Company’s insurance subsidiaries maintained a risk-based capital level that was in excess of an amount that would require any corrective actions. The risk-based capital level of Affirmative Insurance Company (AIC) triggered a regulatory action level event under the NAIC standard. As a result, AIC is required to submit a plan to the Illinois Department of Insurance (IDOI) in April 2015 detailing corrective actions it will take to return its risk-based capital ratio to an acceptable level. Upon receipt of the plan, the IDOI may accept the plan, require further amendments to the plan or take additional regulatory action including, but not limited, to placing
AIC in receivership. The following is a comparison of AIC’s total statutory capital to risk-based capital as at December 31, 2014 (in thousands):
The Company evaluates the various types of financial assets and liabilities to determine the appropriate fair value hierarchy based upon trading activity and the observation of market inputs. The Company employs control processes to validate the reasonableness of the fair value estimates of its assets and liabilities, including those estimates based on prices and quotes obtained from independent third-party sources. The Company’s procedures generally include, but are not limited to, initial and ongoing evaluation of methodologies used by independent third-parties and additional pricing services are used as a comparison to determine the reasonableness of fair values used in pricing the investment portfolio.
The Company recognizes transfers between levels at the actual date of the event or change in circumstances that caused the transfer.
The following table provides information as of December 31, 2014 about the Company’s financial assets measured at fair value on a recurring basis (in thousands):
Financial assets classified as Level 1 in the fair value hierarchy include U.S. Treasury and government agencies securities. These securities are actively traded and the Company estimates the fair value of these securities using unadjusted quoted market prices.
Financial assets classified as Level 2 in the fair value hierarchy include mortgage-backed securities, tax-exempt securities, corporate bonds and certificates of deposit. The fair value of these securities is determined based on observable market inputs provided by independent third-party pricing services. To date, the Company has not experienced a circumstance where it has determined that an adjustment is required to a quote or price received from independent third-party pricing sources. To the extent the Company determines that a price or quote is inconsistent with actual trading activity observed in that investment or similar investments, the Company would determine a fair value using this observable market information and disclose the occurrence of this circumstance. All of the fair values of securities disclosed in Level 2 are estimated based on independent third-party pricing services.
The following table presents the carrying value and estimated fair value of the Company’s financial assets and liabilities disclosed, but not carried, at fair value at December 31, 2014 and the level within the fair value hierarchy (in thousands):
The amount of statutory capital and surplus necessary for AIC to satisfy regulatory requirements as of December 31, 2014 was $37.4 million. Except for AIC not achieving the minimum capital and surplus requirement as at December 31, 2014, the statutory capital and surplus of each of the Company’s insurance subsidiaries exceeded the highest level of minimum regulatory required capital as of December 31, 2014, 2013 and 2012.
The following is a summary of the Company’s unaudited quarterly consolidated results from continuing operations for the years ended December 31, 2014 and 2013 (in thousands, except per share data):