Our principal executive offices are located in approximately 44,000 square feet of office space located at 3813 Green Hills Village Drive, Nashville, Tennessee and are occupied by us under a lease agreement expiring December 31, 2011. Our retail locations typically are located in leased storefronts in retail shopping centers, and each location contains less than 1,000 square feet of space. The leases for our retail locations are generally for terms of less than three years.
The following tables provide selected historical consolidated financial and operating data of the Company as of the dates and for the periods indicated. In conjunction with the data provided in the following tables and in order to more fully understand our historical consolidated financial and operating data, you should also read “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and the accompanying notes included in this report. We derived our selected historical consolidated financial data as of June 30, 2004 and 2003 and for the years ended June 30, 2004, 2003, and 2002 from our audited consolidated financial statements included in this report. We derived our selected historical consolidated financial data as of June 30, 2002, 2001 and 2000 and for the years ended June 30, 2001 and 2000 from our audited consolidated financial statements not included in this report. The results for past accounting periods are not necessarily indicative of the results to be expected for any future accounting period.
There was no income tax expense (benefit) recorded for the years presented prior to the year ended June 30, 2004 because we had NOLs available to offset federal taxable income for which a full valuation allowance had been established. For financial reporting purposes, the benefit resulting from the utilization of NOLs directly offsets federal income taxes that would have otherwise been payable.
Insurance operating expenses are reduced by fee income from insureds and ceding commissions received from our reinsurer as compensation for the costs incurred on servicing the business on their behalf.
As of September 1, 2004, we owned and operated 146 retail locations, staffed by employee-agents. Our employee-agents exclusively sell insurance products either underwritten or serviced by us. We currently write non-standard personal automobile insurance in seven states: Georgia, Tennessee, Alabama, Mississippi, Ohio, Missouri and Indiana. We are also licensed as an insurer in 16 additional states.
The acquisition of USAuto was accounted for using the purchase method of accounting. The consideration consisted of $76.0 million in cash, 13,250,000 shares of our common stock issued at closing and up to an additional 750,000 shares that may be issued at a later date if certain financial targets are reached at the end of calendar year 2004. The aggregate purchase price of $160.1 million was allocated to the tangible and intangible assets acquired and the liabilities assumed based upon their respective fair values as of the date of the acquisition. Total goodwill and identifiable intangible assets recorded from the acquisition were $103.3 million, which was net of a $41.3 million reduction in our deferred tax allowance based upon our projections of USAuto’s future taxable income. Of the purchase price, $1.2 million was allocated to an identifiable intangible asset relating to future policy renewals existing as of April 30, 2004. This asset is amortizable and resulted in amortization expense of $0.4 million for the year ended June 30, 2004. Amortization expense for the years ended June 30, 2005 and 2006 will be $0.7 million and a $0.1 million, respectively.
premiums earned from sales of policies issued by the insurance company subsidiaries, net of the portion of those premiums that are ceded to reinsurers;
commission income paid by our reinsurer to us for ceded premiums; and
The following table presents gross premiums earned by state for the insurance operations separately for policies written by the insurance company subsidiaries and for policies issued by the MGA subsidiaries on behalf of other insurance companies, on both an actual and a pro-forma basis for the periods presented. This table is therefore reflective of the total gross premiums serviced by us and under our control.
The following table presents net premiums earned by state for the insurance operations on both an actual and a pro-forma basis for the periods presented. This table is reflective of the net underwriting risk retained by us after considering the effects of reinsurance. Note that Alabama premiums are assumed by us through a quota share reinsurance contract which was increased from 15% to 50% effective February 1, 2004.
The invested assets of the insurance operations are generally highly liquid and consist substantially of readily marketable, investment grade, tax-free, municipal bonds. At June 30, 2004, approximately 69% of our fixed maturities portfolio was tax-exempt. Most securities held are issued by political subdivisions in the states of Georgia and Tennessee, which enables our insurance company subsidiaries to obtain premium tax credits. Investment income is primarily composed of interest earned on these securities, net of related investment expenses. Realized gains and losses on our investment portfolio may occur from time-to-time as changes are made to our holdings based upon changes in interest rates and changes in the credit quality of securities held.
The non-standard personal automobile insurance industry is cyclical in nature. In the past, the industry has been characterized by periods of price competition and excess capacity followed by periods of high premium rates and shortages of underwriting capacity. If new competitors enter this market, existing competitors may attempt to increase market share by lowering rates. Such conditions could lead to reduced prices, which would negatively impact USAuto’s revenues and profitability. However, we believe that during 2002 and 2003, the underwriting results in the personal automobile insurance industry improved as a result of favorable pricing and competitive conditions that allowed for broad increases in rate levels by insurers. Rates and premium levels for non-standard automobile insurance have stabilized during 2004.
Investment income related to cash equivalents decreased to $0.8 million for the year ended June 30, 2004 versus $1.1 million for the same period last year. This decrease is due to lower interest rates and a decrease in the amount of available cash equivalents as a result of the effects of the USAuto acquisition.
Gains on sales of foreclosed real estate for the year ended June 30, 2004 were $4.1 million resulting from the sale of a total of ten parcels, as compared to $0.2 million for the same period last year. Gains on sales of real estate represents proceeds received from the sale of foreclosed real estate in excess of carrying value, less selling costs.
For the two months included in the operating results for the year ended June 30, 2004, the insurance operations recorded income before taxes of $3.2 million. The combined ratio for this period was 74.8% which was comprised of a loss and loss adjustment expense ratio of 61.1% and an expense ratio of 13.7%.
Investment income increased as the increase in invested assets more than offset the reduction in yield. The weighted average investment yield for the portfolio was 3.84% at June 30, 2004 with a duration of 4.55 years. The yield for the comparable Lehman Brothers municipal bond indices at June 30, 2004 was 3.72%.
Insurance operating expenses increased 14% from $36.0 million for the year ended June 30, 2003 to $41.1 million for the year ended June 30, 2004. Such increase is primarily due to the increase in net premiums earned. Insurance operating expenses for the year ended June 30, 2004 did include $1.0 million in costs incurred by USAuto as result of its acquisition by us.
Prior to April 30, 2004, our operations consisted solely of acquisition activities and real estate operations.
Prior to the USAuto acquisition, our historical funding requirements have been operating expenses, including legal, audit, and consulting expenses incurred in connection with evaluation of potential acquisition candidates and other strategic opportunities. Our historical primary sources of funding for operating expenses have been proceeds from the sales of foreclosed real estate, investment income on cash and cash equivalents, and cash on hand.
Operating activities for the year ended June 30, 2004 used $0.5 million of cash compared to $1.1 million used in the same period last year. In each of the periods, cash was used for operating expenses, partially offset by investment income and proceeds from the sales of foreclosed real estate. During the year ended June 30, 2004, cash was also used for the severance costs related to the acquisition of USAuto. However, this period also included the results of insurance company operations since the April 30, 2004 acquisition.
Net cash provided by financing activities for the year ended June 30, 2004 was $49.5 million versus $1.0 million in the same period last year. During the year ended June 30, 2004, we received net proceeds of $49.4 million through the issuance of stock in the rights offering on April 30, 2004.
The acquisition of USAuto, including acquisition expenses, required total cash of $77.7 million, which came from our cash on hand, as well as a portion of the $49.4 million net proceeds received from the rights offering. At closing, we also paid $2.9 million to extinguish a portion of USAuto’s debt. In addition, we used $5.0 million to increase the statutory capital and surplus of the insurance company subsidiaries. At June 30, 2004, we had $20.5 million available in unrestricted cash and cash equivalents outside of the insurance company subsidiaries.
As a result of the additional available liquidity to increase the statutory capital and surplus of the insurance company subsidiaries, effective September 1, 2004, we have elected to not renew our 50% quota share reinsurance treaty. This non-renewal will have the effect of eliminating quota-share reinsurance on all premiums earned after the non-renewal date. This non-renewal will have the effect of recapturing the portion of our net underwriting profit that was ceded to the quota-share reinsurer. In addition, we expect our invested assets to increase which will allow us to earn additional investment income. Likewise, in the future, our consolidated balance sheet will no longer reflect prepaid reinsurance premiums and the reinsurance recoverables and amounts due to reinsurance will decrease significantly. On a pro-forma basis for the year ended June 30, 2004, ceded premiums earned by the reinsurer were $44.4 million.
The following table summarizes all of our contractual obligations by period as of June 30, 2004 (in thousands):
Valuation of deferred tax asset. Income taxes are maintained in accordance with SFAS No. 109, “Accounting for Income Taxes,” whereby deferred income tax assets and liabilities result from temporary differences. Temporary differences are differences between the tax basis of assets and liabilities and operating loss and tax credit carryforwards and their reported amounts in the consolidated financial statements that will result in taxable or deductible amounts in future years. Valuation of the deferred tax asset is considered a critical accounting policy because the determination of our ability to utilize the asset involves a number of management assumptions relating to future operations that could materially affect the determination of the ultimate value and, therefore, the carrying amount of our deferred tax asset.
We are directly liable for loss and loss adjustment expenses under the terms of the insurance policies that the insurance company subsidiaries underwrite. Each of the insurance company subsidiaries establishes a reserve for all of its unpaid losses and loss adjustment expenses, including case and IBNR reserves, and estimates for the cost to settle the claims. We rely primarily on historical loss experience in determining reserve levels, on the assumption that historical loss experience provides a good indication of future loss experience. We also consider various other factors, such as inflation, claims settlement patterns, legislative activity and litigation trends. We continually monitor these estimates and as experience develops or new information becomes known, increase or decrease the level of its reserves in the period in which changes to the estimates are determined. Accordingly, the actual losses and loss adjustment expenses may differ materially from the estimates we have recorded.
Consolidated Statements of Operations for the Years Ended June 30, 2004, 2003 and 2002
Consolidated Statements of Cash Flows for the Years Ended June 30, 2004, 2003 and 2002
We have audited the accompanying consolidated balance sheets of First Acceptance Corporation and subsidiaries, formerly known as Liberté Investors, Inc., as of June 30, 2004 and 2003, and the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the years in the three-year period ended June 30, 2004. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of First Acceptance Corporation and subsidiaries as of June 30, 2004 and 2003, and the results of their operations and their cash flows for each of the years in the three-year period ended June 30, 2004, in conformity with U.S. generally accepted accounting principles.
First Acceptance Corporation, f/k/a Liberté Investors Inc., a Delaware corporation (the “Company”), was organized in April 1996 in order to effect the reorganization of Liberté Investors, a Massachusetts business trust (the “Trust”). At a special meeting of the shareholders of the Trust held on August 15, 1996, the Trust’s shareholders approved a plan of reorganization whereby the Trust contributed its assets to the Company and received all of the Company’s outstanding common stock, par value $.01 per share. The Trust then distributed to its shareholders, in redemption of all outstanding shares of beneficial interest in the Trust, the shares of the Company. The Company assumed all of the Trust’s assets and outstanding liabilities and obligations.
Since August 1996, the Company has been actively pursuing opportunities to acquire one or more operating companies in order to increase value to existing stockholders and provide a new focus and direction for the Company. The Company’s primary objective has been to seek long-term growth through an acquisition of a business rather than short-term earnings. As further discussed in Note 2, to that end, on April 30, 2004, the Company acquired USAuto Holdings, Inc. (“USAuto”) for consideration consisting of $76.0 million in cash, 13,250 shares of the Company’s common stock, and up to an additional 750 shares of common stock that may be issued at a later date if certain financial targets are reached. A portion of the cash consideration was raised in a stock rights offering.
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities. It also requires disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenue and expenses during the period. Actual results could differ from those estimates.
Reinsurance arrangements are short-duration prospective contracts for which prepaid reinsurance premiums are amortized ratably over the related policy terms. Ceding commission income with retrospective adjustment features is calculated based upon the related estimated incurred losses and loss expenses including a provision for unreported losses.
Under purchase accounting, the fair value of loss and loss adjustment expense reserves and related reinsurance recoverables as of the April 30, 2004 acquisition date was estimated based on the present value of the expected underlying cash flows of the loss reserves and reinsurance recoverables, and included a profit and risk margin. In determining the fair value estimate, USAuto’s historical undiscounted net loss reserves were adjusted to present value assuming a 1.5% discount rate, which approximated the two-year U.S. Treasury rate. The discounting pattern was actuarially developed from USAuto’s historical loss data. An estimated profit and risk margin of 4% was then applied to the discounted loss reserves to reflect an estimate of the cost USAuto would incur to reinsure the full amount of the net loss and loss adjustment expense reserves with a third party reinsurer. This margin was based upon management’s assessment of the uncertainty inherent in the net loss reserves and our knowledge of the reinsurance marketplace. For the two months ended June 30, 2004, $214 of the net margin/discount was accreted to income.
Goodwill and other identifiable intangible assets are solely attributable to the Company’s April 30, 2004 acquisition of USAuto. Goodwill and indefinite-life intangible assets are not amortized for financial statement purposes but are instead tested annually for impairment. On a go-forward basis, the Company has chosen June 30 of each year as its annual impairment testing date for goodwill and other intangible assets. Included in other identifiable intangible assets is an amount related to the value of policy renewals at the date of acquisition which is being amortized over a 24-month period in proportion to anticipated policy expirations. As of June 30, 2004, the Company has recorded no impairment in connection with goodwill and other intangible assets. For the two months ended June 30, 2004, $390 relating to the identifiable intangible assets was amortized against income. Amortization expense for the years ended June 30, 2005 and 2006 will be $744 and $66, respectively.
During the year ended June 30, 2004, the Company paid $670 in income taxes and $44 in interest.
Prior to July 1, 2003, the Company applied APB No. 25 in accounting for employee stock options. Under APB No. 25, the difference between the aggregate market value and exercise price of the securities underlying the stock options at grant date, or intrinsic value, is recorded as compensation expense on a straight-line basis over the vesting period. If the employee stock options had been accounted for under SFAS No. 123, the fair value of the stock options would have been recorded as compensation expense on a straight-line basis over the vesting period. The following table, as prescribed by SFAS No. 148, illustrates the effect on net loss and loss per share if the Company had applied the fair value recognition provisions of SFAS No. 123 to all stock-based employee compensation. The fair value of the options awarded was estimated at the grant date using the Black-Scholes option pricing model, which includes the following assumptions: risk-free interest rate based on the ten-year U.S. Treasury Note rate; expected option life of ten years; expected volatility of 36% to 38%; and no expected dividends.
The following table summarizes the estimated fair value of the assets acquired and liabilities assumed at the date of acquisition based on third-party valuations.
The composition of the portfolio at June 30, 2004 was as follows. At June 30, 2004, approximately 69% of the portfolio was tax-exempt.
The Insurance Companies reinsure risks on both a quota-share and excess-of-loss basis (for catastrophic events) with other insurance organizations to provide them with additional underwriting capacity and minimize their risk. Although the reinsurance agreements contractually obligate the reinsurers to reimburse the Insurance Companies for their proportionate share of losses, they do not discharge the primary liability of the Insurance Companies, who remain contingently liable in the event the reinsurers are unable to meet their contractual obligations. The Insurance Companies evaluate the financial condition of their reinsurers and monitor concentrations of credit risk to minimize their exposure to significant losses from reinsurer insolvencies.
Amounts related to ceded unpaid losses are included in reinsurance recoverables while amounts related to ceded unearned premiums are reflected as prepaid reinsurance premiums in the consolidated financial statements.
At June 30, 2004, the Insurance Companies had a net unsecured aggregate recoverable for unpaid losses, including IBNR, and prepaid reinsurance premiums of $12,782 from Transatlantic Reinsurance Company. Reinsurance recoverables at June 30, 2004 consisted entirely of amounts related to unpaid losses.
Ceded premiums earned and reinsurance recoveries on losses and loss adjustment expenses for the year ended June 30, 2004 were as follows:
USAuto also has assumed private-passenger non-standard automobile insurance premiums from other insurance companies produced by the USAuto’s managing general agency subsidiary in Alabama.
An analysis of net premiums written and earned for the year ended June 30, 2004 is summarized as follows:
There was no income tax expense (benefit) recorded for the years ended June 30, 2003 or 2002 as a result of the uncertainty of the utilization of any tax benefit. Income tax expense for the year ended June 30, 2004 consisted of the following:
The tax effects of temporary differences that give rise to the deferred tax assets at June 30, 2004 and 2003 are presented below:
At June 30, 2004, the Company had net operating loss (NOL) carryforwards for federal income tax purposes of $222,103, which are available to offset future federal taxable income. The NOL carryforwards will expire in 2005 through 2024, as shown in the table below.
Statement of Financial Accounting Standard No. 128 “Earnings Per Share” (“EPS”) specifies the computation, presentation and disclosure requirements for earnings per share. Basic EPS excludes all dilution while diluted EPS reflects the potential dilution that could occur if securities or other contracts to issue common shares were exercised or converted into common shares.
Due to the net losses incurred for the years ended June 30, 2004 and 2003, the effects of common stock equivalents have been excluded from diluted EPS. There were no common stock equivalents outstanding at June 30, 2002. Diluted weighted average shares for the years ended June 30, 2004 and 2003 exclude incremental shares from assumed conversion of stock options of 1,101 and 593, respectively, granted to employees of the Company under the Company’s long term incentive plan. The weighted average shares for the year ended June 30, 2003 also excludes 27 available shares under the stock purchase rights granted to an officer of the Company.
In July 2002, the Company and Donald J. Edwards entered into an employment agreement, which was approved by the Company’s Board of Directors (the “Employment Agreement”), that set forth the terms and conditions of Mr. Edwards’ then employment as the Company’s President and Chief Executive Officer. The Employment Agreement provided for a grant of a stock option to Mr. Edwards pursuant to a Nonqualified Stock Option Agreement by and between the Company and Mr. Edwards (the “Option Agreement”). In addition, in July 2002, the Company’s Board of Directors also approved the Company’s 2002 Long Term Incentive Plan (the “Plan”). In July 2002, in accordance with the terms of the Employment Agreement, the Company’s Board of Directors granted to Mr. Edwards an option, under the Plan, to purchase 2,574 shares of common stock of the Company at an exercise price of $3.00 per share pursuant to the terms of the Option Agreement. The option expires on July 9, 2012. The aggregate market value of the securities underlying Mr. Edwards’ options at the grant date was $9,265. On April 30, 2004, as a result of the rights offering and in accordance with the terms of the Employment Agreement, Mr. Edwards was granted an additional 1,152 anti-dilution options on the same terms, and as a result of the termination of his employment, all of Mr. Edwards options were fully vested. The aggregate market value of the securities underlying Mr. Edwards’ anti-dilution options at the grant date was $7,546.
A summary of the status of the Company’s 2002 Long Term Incentive Plan as of June 30, 2004 and 2003 and changes during the years then ended is presented below:
USAuto Insurance Company, Inc. (“USAuto Insurance”) is required by the Tennessee Department of Commerce and Insurance to maintain statutory capital and surplus of $2,000 and at June 30, 2004, its statutory capital and surplus as filed was $17,573. Village Auto Insurance Company, Inc. (“Village”) is required by the Georgia Department of Insurance to maintain statutory capital and surplus of $3,000 and at June 30, 2004, its statutory capital and surplus as filed was $14,516. At June 30, 2004, on a consolidated statutory basis, capital and surplus as calculated was $27,088. For the twelve months ended June 30, 2004, consolidated statutory net income as filed was $3,854.
There are no material accounting methods prescribed or permitted by state insurance departments for either USAuto Insurance or Village that differ from NAIC statutory accounting practices.
The maximum amount of dividends which can be paid by Tennessee and Georgia insurance companies to shareholders, without the prior approval of the respective insurance commissioner, is limited to the greater of 10% of statutory capital and surplus as of December 31 next preceding or net income (not including realized capital gains) for the year. Accordingly, as of December 31, 2003, the maximum dividend payouts which may be made by USAuto Insurance and Village without prior approval within any preceding twelve-month period are $2,800 and $950, respectively (subject to the sufficiency of unassigned surplus). USAuto Insurance paid dividends of $500 and $3,000 in October 2003 and April 2004, respectively. A portion of the April 2004 dividend was considered extraordinary and required prior approval.
A summarized balance sheet, statement of operations and statement of cash flows, as of and for the year ended June 30, 2004, of First Acceptance Corporation (parent company), are presented below:
The term loan contains certain financial covenants and requires USAuto to maintain certain financial ratios. At June 30, 2004, USAuto was in compliance with all provisions of the loan agreement, including the financial covenants and ratios, except for a Risk Based Capital ratio and a Debt Service Coverage ratio for which waivers had been obtained.
The Company is committed under various lease agreements for office space and equipment. Rental expense for 2004, 2003 and 2002 was $528, $87 and $76, respectively. Future minimum lease payments under these agreements are as follows:
Effective with the USAuto acquisition and in accordance with the terms of the severance agreement of Mr. Donald J. Edwards, the Company’s former President and Chief Executive Officer, the Company has assigned and transferred to a new entity controlled by Mr. Edwards, all of the Company’s rights, title and interest in its lease for office space in Chicago, Illinois. Such entity has assumed all obligations under the lease and such obligations will be reimbursed to the entity by the Company during the term of the lease. The total estimated future cost of this obligation is $1,086 and such amount has been accrued in the consolidated financial statements by the Company as part of the cost of Mr. Edward’s severance.
USAuto primarily transacts business either directly with its policyholders or through four independently-owned insurance agencies in Tennessee who exclusively write insurance policies on behalf of USAuto.
Policyholders whose premiums are written through the independent agencies make their payments to these agencies who in turn remit these payments to USAuto. Balances due to USAuto resulting from premium payments made to these agencies are unsecured.
Brandon L. Jones was the Company’s Senior Vice President of Business Development and is the son-in-law of Edward W. Rose, III, a former director of the Company. For the fiscal years ended June 30, 2004 and 2003, Mr. Jones’ total cash compensation was $207 and $260, respectively. Also, on December 1, 2002, pursuant to the 2002 Long Term Incentive Plan, the Company granted Mr. Jones an option to purchase 250 shares of common stock of the Company at an exercise price of $3.00 per share. In addition, upon the termination of his employment, Mr. Jones was granted an option to purchase an additional 122 shares at the same exercise price.
Effective May 1, 2004, the Company entered into an advisory services agreement with an entity controlled by Donald J. Edwards, the former President and Chief Executive Officer and a current director of the Company, as an advisor to the Company to render advisory services (which services will be personally rendered by Mr. Edwards) in connection with financings, mergers and acquisitions and other related matters involving the Company. In consideration for the advisory services to be provided, the Company will pay to the advisor a quarterly fee of $62.5 for a four-year period. The advisory agreement may be terminated by the Company if the advisor fails or refuses to perform its services pursuant to the agreement, does any act, or fails to do any act which results in an indictment for or conviction of a felony or other similarly serious offense or upon the written agreement of the advisor. The advisor may terminate the agreement upon written consent of the Company or if the Company is in material breach of its obligations thereunder.
The fair value of financial instruments has been estimated by the Company using available market information as of June 30, 2004 and 2003, and valuation methodologies considered appropriate to the circumstances:
The fair values of cash equivalents and cash and fiduciary funds-restricted approximate their carrying amounts based upon their short maturities.
The fair values of the note payable to financial institution approximates its carrying amount based upon its variable interest rate and comparability to rates currently being offered for similar notes.
To accrete fair value adjustment to loss and loss adjustment expense reserves.
To eliminate stock-based compensation expense of Company employees terminated pursuant to the terms of the acquisition agreement effective upon closing of the acquisition.
To amortize identifiable intangible assets resulting from the acquisition and also eliminate depreciation on assets disposed of as part of Company employee severance cost as result of the acquisition.
To record the additional income tax expense as result of (1) the change in tax status of certain USAuto subsidiary companies from S corporation to C corporation, (2) expected utilization of available NOL carryforwards and (3) the tax-effect of deductible pro forma adjustments.