The following tables present our historical financial and operating data as of the dates or for the periods indicated. We derived the data as of and for each of the five years ended December 31, 2004 from our consolidated financial statements audited by Deloitte & Touche LLP. The results of operations for past accounting periods are not necessarily indicative of the results to be expected for any future accounting periods. You should read this summary in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the financial statements and related notes appearing elsewhere in this annual report.
Loss ratio is the ratio, expressed as a percentage, of (i) losses and loss adjustment expenses incurred, divided by (ii) the sum of (A) net premiums earned, (B) policy service fee revenues, (C) outsourcing servicing fees and (D) other income.
Combined ratio is the sum of the loss ratio and the expense ratio. This ratio is used by our management to evaluate our operating profitability.
The following discussion and analysis of the results of operations for the three years ended December 31, 2004 has been derived from and should be read in conjunction with the consolidated financial statements included elsewhere in this document.
We offer insurance coverage exclusively through independent agents and brokers, which number in excess of 6,300. Because some of our agents and brokers operate from multiple locations, our products are offered at more than 8,300 locations. We are licensed to provide insurance in 37 states and the District of Columbia, although we focus our operations in 21 states that we believe provide significant opportunity for profitable growth. Our markets include California, Florida and Texas, the three largest non-standard automobile insurance markets in the United States. These three states were our first, second, and fifth largest states by premium volume and accounted for 73% of our gross premiums written for the year ended December 31, 2004. In addition to the premiums we charge for our insurance policies, we receive fees for policy issuance, installment payment processing and other items that, in total, aggregate approximately 11% of premiums.
net premiums earned, which comprises the premiums we earn from sales of non-standard automobile insurance policies minus those premiums that we cede to our reinsurers;
In February 2004, we completed an initial public offering of 17,250,000 shares of the Company’s common stock. The Company sold 6,250,000 shares providing net proceeds to the Company, after deducting issuance costs, of approximately $113.4 million. The Company contributed $110.0 million of the proceeds to its principal insurance subsidiary, which increased its statutory surplus.
We believe that market conditions in the states in which we operate are becoming generally more competitive but to varying degrees, depending upon the state. We are seeing few rate filings where companies are raising rates, and in several states, companies with which we compete have filed rate decreases. In addition, primarily in California, some companies with which we compete have relaxed underwriting standards thereby reducing the premium they charge to consumers and increasing the attractiveness of their product relative to ours.
The table below shows our gross written premium by state. In the aggregate, our gross written premium grew by 16.2% in 2004 compared to 2003. Included in these figures is a change in the provision for expected policy cancellations that increased gross written premiums by 6.6% for the year ended December 31, 2004 and decreased gross written premiums by less than 1% for the year ended 2003. The purpose of the provision is to reduce the balance of installment premiums due from policyholders as reflected in the Company’s balance sheet to the amount the Company expects to ultimately earn. Likewise, the Company’s liability for unearned premiums related to the installment premiums is reduced to reflect expected policy cancellations related to such non-payments. The provision was reduced (which increases both premiums receivable and unearned premiums) to reflect an underlying improvement in the Company’s cancellation experience throughout 2004, as well as a more precise measurement of the expected dollar amount of future cancellations. The change in estimate added $46.3 million to gross written premium during 2004 and a similar amount to reported unearned premiums and premiums receivable. The Company believes the reduction in policy cancellations emanates from several factors: point of sale underwriting resulting in fewer up-rates and therefore less cancellations, increased use of electronic funds transfer by our policyholders, the ability to receive telephone and web payments from our policyholders and generally less shopping by consumers.
Exclusive of the change in the provision for cancellations, gross written premiums increased by 8.3% and 23.1% for the years ended December 31, 2004 and December 31, 2003, respectively, to $706.5 million compared to $652.5 million for the comparable period of 2003, and $530.0 million for the comparable period of 2002. Most of our growth, in the aggregate, results from an increase in the number of policies in force. Policies in force increased 8% to approximately 481,000 as of December 31, 2004 from 445,000 as of December 31, 2003.
One aspect of our growth strategy is to increase the number of producers with which we do business. We attempt to target producers in geographic areas where we are under-represented and where we believe we can write profitable business. During 2004, we increased our total number of producers to more than 6,300 and our total number of producer locations to more than 8,300.
We have increased the number of producers in California to 917 with 1,602 locations at December 31, 2004 from 515 producers with 1,002 locations at December 31, 2003, an increase of producer locations of 60%. Our strategy remains to increase the number of producers, without over-saturating the market. We closely monitor the behavior of our new producers to ensure adherence to our underwriting standards.
We have experienced very strong growth in Michigan where our premium volume for the year ended December 31, 2004 increased 48.2% as compared to 2003. Our strategy in Michigan and elsewhere is to grow by increasing the number of producers in profitable geographic areas where we are under-represented. At December 31, 2004, we had 571 producers that had 695 locations up from 455 producers with 576 locations at December 31, 2003.
The Company’s premiums decreased by 45.2% in Georgia to $11.4 million for the year ended December 31, 2004 as compared to $20.8 million for the comparable period of 2003. The Georgia legislature approved the use of credit score as a rating variable in July 2003. The Company made a rate filing using credit score as a rating variable in June 2003. The Georgia Department of Insurance has not approved the filing. Consequently, we have curtailed our writings in Georgia to those risks we believe we can write profitably without employing credit as a rating variable.
We have modified rates 32 times this year. Only one such modification was a decrease. This was in Wisconsin, a state we entered in mid-2003, where we were too conservative in setting rates initially. We plan to continue to seek rate increases in states where necessary to stay ahead of loss cost trends. In addition, we believe we can continue to improve our product structure by filing class plan changes that, through segmentation, are designed to attract certain risks that we have found to be superior versus the overall market in a given state.
The preparation of financial statements in conformity with generally accepted accounting principles in the United States of America, or GAAP, requires us to make estimates and assumptions that affect amounts reported in our financial statements. As additional information becomes available, these estimates and assumptions are subject to change and thus impact amounts reported in the future. We have identified three accounting policies that we consider to be critical due to the amount of judgment and uncertainty inherent in the application of these policies.
In calendar years 2002, 2003 and 2004, we experienced adverse development on loss and loss adjustment expense reserves for years prior to each of those calendar years in the amount of $28.2 million, $9.3 million and $2.5 million, respectively. The most significant factors influencing this development have been the adverse impact of the reorganization of our claims department in 2000 and the pricing and product design assumptions we utilized from 1998 through 2000. In addition, our 2002 loss and loss adjustment expense reserve increases related to 2000 were adversely impacted as a result of previously exhausting our excess of loss reinsurance coverage. Essentially, we were required to reflect 100% of our continuing 2000 adverse development in our 2002 income statement due to the exhaustion of that coverage.
Since mid-2001, our management team focused on restoring our claims practices, procedures and workflow to historical standards of quickly settling claims. These improvements continued into 2002, during which time we were continuing to revise our estimates of the impact on loss and loss adjustment expense reserves. In the fourth quarter of 2002, we recruited a new senior vice president of our claims department to continue that process. In addition, in the course of 2002 and 2003, we made numerous improvements to increase the sophistication of our analyses. These improvements included the following:
Accruals for Litigation. We continually evaluate potential liabilities and reserves for litigation using the criteria established by Statement of Financial Accounting Standards, or SFAS, No. 5, "Accounting for Contingencies." We believe the current assumptions and other considerations we use to estimate our potential liability for litigation are appropriate. While it is not possible to know with certainty the ultimate outcome of these claims or lawsuits, we believe our existing known litigation is adequately reserved and will not have a material effect on our future financial condition or results of operations.
Accounting and Reporting for Reinsurance. Pursuant to SFAS No. 113, "Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts," we are required to review the contractual terms of all our reinsurance purchases to ensure compliance with that statement. The statement establishes the conditions required for a contract with a reinsurer to be accounted for as reinsurance and prescribes accounting and reporting standards for those contracts. The accounting standards depend on whether the contract is long duration or short duration and, if short duration, on whether the contract is prospective or retroactive. For all reinsurance transactions, immediate recognition of gains is precluded unless our liability to our policyholders is extinguished. Contracts that do not result in the reasonable possibility that the reinsurer may realize a significant loss from the insurance risk assumed generally do not meet the conditions for reinsurance accounting and must be accounted for as deposits.
Commissions and Other Underwriting Expenses. Commissions and other underwriting expenses increased to $58.4 million for the twelve months ended December 31, 2004, compared to $51.8 million for the twelve months ended December 31, 2003, an increase of $6.6 million or 12.7%. The growth was less than the growth in net earned premiums, fees and other income, which increased by 16.6%. This category of expenses comprises items such as producers’ commissions, premium taxes and company expenses that relate to the production of and vary with gross earned premium, reduced by ceding commission income. In the aggregate, these expenses represented 14.5% of net earned premiums, fees and other income in 2004 down by 0.5 points from 15.0% in 2003. On a line by line basis: direct commission expense was 15.3% of direct premiums compared to 15.2% in 2003; ceding commission income was 30.4% of ceded premiums compared to 28.7% in 2003; and other underwriting expenses, including premium taxes, were 9.2% of gross premiums earned compared to 9.1% in 2003.
Litigation Expense. For the year ended December 31, 2003, our consolidated statement of operations included a charge in the amount of $13.8 million before tax related to two coordinated class actions that alleged, among other things, improper cancellations of our insurance. See “Item 3. Legal Proceedings.” Our 2003 consolidated statement of operations also included a charge in the amount of $3.6 million before tax, which increased the overall charge to $17.9 million for a class action lawsuit, which alleged, among other things, improper classification of our claims adjusters. As of December 8, 2003, all claimants in that suit had settled.
Our combined ratio is significantly affected by our reinsurance treaties. We ceded 50% and 60% of our gross written premiums in 2004 and 2003, respectively. The following table provides information about our combined ratio before and after reinsurance for 2004 and 2003.
We are organized as a holding company with all of our operations being conducted by our insurance subsidiaries, which underwrite the risks associated with our insurance policies, and our non-insurance subsidiaries, which provide our policyholders and our insurance subsidiaries a variety of services related to the insurance policies we provide. We have continuing cash needs for the payment of principal and interest on borrowings, dividends on common stock, taxes and administrative expenses. These ongoing obligations are funded with dividends from our non-insurance subsidiaries and taxes are paid by each subsidiary through an inter- company tax allocation agreement.
In February 2004, the Company completed a refinancing of its secured credit facility, which had an outstanding balance of $71.5 million at the time of the refinancing. The new bank agreement ("Bank Agreement") consists of: (1) a $50 million Secured Revolving Credit Facility, which includes up to $15 million for letters of credit and matures in 2009, (2) a $35 million Term A Loan, which matures in 2010, and (3) a $40 million Term B Loan, which matures in 2011. The Company's interest rate on borrowings under the Bank Agreement is London Interbank Offered Rate (LIBOR) plus a margin (1.0% to 2.25%), which is determined based on the Company's consolidated total debt to consolidated total capitalization ratio, as defined in the Bank Agreement. The Company also pays certain commitment fees. The Bank Agreement is secured by a pledge of stock of certain of the Company’s subsidiaries. The refinancing extended the maturity of the Company’s debt coming due in 2005 through 2007. The Bank Agreement requires compliance with certain financial loan covenants related to leverage and debt service coverage. As of, and for the twelve-month period ended December 31, 2004, the Company was in compliance with all such covenants.
There are no restrictions on the payment of dividends by our non-insurance subsidiaries other than customary state corporation laws regarding solvency. Dividends from our insurance subsidiaries are subject to limitations based upon statutory surplus and earnings. See "Item 1. Business-Regulatory Matters." As of December 31, 2004, our insurance subsidiaries could pay dividends of $21.9 million without seeking regulatory approval. Our insurance subsidiaries have not paid any dividends since 1999, which has not impacted our ability to meet our obligations. Because our non-insurance subsidiaries generate revenues, profits and net cash flows that are generally unrestricted as to their availability for the payment of dividends, we expect to use those revenues to service all of our corporate financial obligations, such as debt service and stockholder dividends.
Net cash provided by (used in) financing activities was $114.0 million, $0.3 million, and $(15.1) million for the years ended December 31, 2004, 2003 and 2002, respectively. The increase in cash provided by financing activities from 2003 to 2004 was due to the Company’s initial public offering proceeds of $113.4 million as noted above with regard to the increase in investment purchases.
On March 16, 2005, the Company announced that its Board of Directors has authorized the repurchase of up to $30 million of the Company’s outstanding common stock. Under this program, share purchases may be made from time to time in the open market depending on share price, market conditions, and other factors. We plan to utilize internally generated funds as the funding source for the common stock repurchase program.
In December 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 123, Share-Based Payments (revised 2004), (“SFAS No. 123R”). This statement eliminates the option to apply the intrinsic value measurement provisions of APB No. 25 to stock compensation awards issued to employees. Rather, SFAS No. 123R requires companies to measure the cost of employee services received in exchange for an award of equity instruments based on the grant date fair value of the award. That cost will be recognized over the period during which an employee is required to provide services in exchange for the award - the requisite service period (usually the vesting period). SFAS No. 123R will also require companies to measure the cost of employee services received in exchange for employee stock purchase plan awards. SFAS No. 123R will be effective for the Company’s fiscal quarter beginning July 1, 2005. Based on the number of stock options outstanding of December 31, 2004, the effect of the adoption of SFAS No. 123R would be to decrease net income by approximately $85,000 and $84,000 in 2005 and 2006, respectively.
The payment of loss and loss adjustment expense reserves by year included in the above table are estimated based upon historical loss payment patterns. Since there are not definitive due dates for the payments, payments by year and in the aggregate are subject to uncertainties. See "Item 1. Business - Loss and Loss Adjustment Expense Reserves."
We do not believe that inflation has had a material effect on our results of operations, except insofar as inflation may affect interest rates and claim costs. The effects of inflation are also considered in pricing and in estimating reserves for unpaid claims and claim expenses. The actual effects of inflation on our results cannot be accurately known until claims are ultimately settled. In addition to general price inflation, we are exposed to a persisting long-term upward trend in the cost of judicial awards for damages. We make every effort to take this into account in our pricing and establishing loss and loss adjustment expense reserves.