Our accounting policies are more fully described in Note 2 of Notes to Consolidated Financial Statements. As disclosed therein, the preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions about future events that affect the amounts reported in the financial statements and accompanying notes. Future events and their effects cannot be determined with absolute certainty. Therefore, the determination of estimates requires the exercise of judgment. Actual results inevitably will differ from those estimates, and such differences may be material to the financial statements.
The most significant accounting estimates inherent in the preparation of our financial statements include estimates associated with management’s evaluation of the determination of liability for unpaid loss and LAE, the amount and recoverability of amortization of deferred policy acquisition costs. In addition, significant estimates form the bases for our reserves with respect to finance contracts, premiums receivable and deferred income taxes. Various assumptions and other factors underlie the determination of these significant estimates. The process of determining significant estimates is fact specific and takes into account factors such as historical experience, current and expected economic conditions, and in the case of unpaid loss and LAE, an actuarial valuation. Management regularly reevaluates these significant factors and makes adjustments where facts and circumstances dictate. In selecting the best estimate, we utilize up to 6 different actuarial methodologies. Each of these methodologies is designed to forecast the number of claims we will be called upon to pay and the amounts we will pay on average to settle those claims. In arriving at our best estimate, our actuaries consider the likely predictive value of the various loss development methodologies employed in light of underwriting practices, premium rate changes and claim settlement practices that may have occurred, and weight the credibility of each methodology. Our actuarial methodologies take into account various factors, including, but not limited to, paid losses, liability estimates for reported losses, paid allocated loss adjustment expenses, salvage and other recoveries received, reported claim counts, open claim counts and counts for claims closed with and without payment of loss.
We are required to review the contractual terms of all our reinsurance purchases to ensure compliance with SFAS No. 113, "Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts. The statement establishes the conditions required for a contract with a reinsurer to be accounted for as reinsurance and prescribes accounting and reporting standards for those contracts. Contracts that do not result in the reasonable possibility that the reinsurer may realize a significant loss from the insurance risk assumed generally do not meet the conditions for reinsurance accounting and must be accounted for as deposits. SFAS No. 113 also requires us to disclose the nature, purpose and effect of reinsurance transactions, including the premium amounts associated with reinsurance assumed and ceded. It also requires disclosure of concentrations of credit risk associated with reinsurance receivables and prepaid reinsurance premiums.
In September 2005, the AICPA issued Statement of Position 05-1, "Accounting by Insurance Enterprises for Deferred Acquisition Costs in connection with Modifications or Exchanges of Insurance Contracts" (“SOP 05-1”). This statement provides guidance to insurance entities that incur deferred acquisition costs on internal replacements of insurance and investment contracts other than those specifically described in SFAS No. 97, Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments. SOP 05-1 defines internal replacements as modifications in product benefits, features, rights, or coverages that occur by the exchange of a contract for a new contract, or by amendment, endorsement, or rider to a contract, or by the election of a feature or coverage with a contract. The accounting treatment for such replacements depends on whether, under the provisions of the SOP, the replacement contract is considered substantially changed from the replaced contract. A substantial change would be treated as the extinguishment of the replaced contract, and all unamortized deferred acquisition costs, unearned revenue liabilities, and deferred sales inducement assets from the replaced contract would no longer be deferred in connection with the replacement contract. A replacement contract that is substantially unchanged should be accounted for as a continuation of the original contract. SOP 05-1 will be effective for internal replacements occurring in fiscal years beginning after December 15, 2006, with earlier adoption encouraged. The Company plans to adopt this statement beginning with the fiscal quarter beginning January 1, 2006. We do not expect that adoption of this SOP will have a material impact on the Company’s net income in 2006.
In May 2005, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 154, “Accounting Changes and Error Corrections-a replacement of APB Opinion No. 20 and FASB Statement No. 3” (“SFAS 154”). This Statement replaces APB Opinion No. 20, Accounting Changes, and FASB Statement No. 3, Reporting Accounting Changes in Interim Financial Statements, and changes the requirements for the accounting for and reporting of a change in accounting principle. This Statement applies to all voluntary changes in accounting principle. It also applies to changes required by an accounting pronouncement in the unusual instance that the pronouncement does not include specific transition provisions. When a pronouncement includes specific transition provisions, those provisions should be followed.
In May 2003, the FASB issued SFAS, No 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity. This Statement establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity and it requires that an issuer classify a financial instrument that is within its scope as a liability because the financial instrument embodies an obligation of the issuer. This Statement is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective in the first interim period beginning after June 15, 2003. In July 2003 and September 2004, we completed private placements of our 6% Senior Subordinated Notes. These notes fall within the definition of financial instruments as described in Financial Accounting Standard Number 150 and were originally presented as a liability in conformity with Statement of Financial Accounting Standard Number 150. As such, the adoption of this Statement did not have any impact on our Consolidated Financial Statements.
As of December 31, 2005 as Compared to December 31, 2004
Below is a summary of unrecognized impairment loss at December 31, 2005 and 2004 by category.
Finance contracts receivable, net of allowance for credit losses, decreased $1.0 million, or 11.8%, to $7.3 million as of December 31, 2005, as compared to $8.3 million as of December 31, 2004. The decrease is primarily due to our sale in December 2004 of our assets related to our non-standard automobile insurance agency business in Florida and the associated financed contracts.
The largest component of the increase relates to our expanding commercial general liability insurance business for which premiums receivable increased $2.1 million, or 968%, to $2.3 million as of December 31, 2005, as compared to $0.2 million as of December 31, 2004.
Additional components of the premium receivable include amounts in connection with our homeowners’ business which increased $1.0 million, or 100.2%, to $1.9 million as of December 31, 2005, compared to $1.0 million as of December 31, 2004. The increase in the homeowner’s receivable is due to the Company’s success in expanding homeowner’s written premium.
Premiums receivable in connection with our automobile line of business decreased by $1.7 million, or 2.8%, to $4.2 million as of December 31, 2005 compared to $5.8 million as of December 31, 2004. The decrease in automobile related premiums receivable is associated with the sale of our distribution channels in connection with the sale of our agencies, effective December 31, 2004.
Income taxes recoverable decreased to nothing, as of December 31, 2005, as compared to $7.9 million as of December 31, 2004. The decline is due to the collection of previously paid income taxes, which were available through net operating loss carry-backs to years ended December 31, 2003 and 2002.
Unpaid losses and LAE increased $107.5 million, or 230.8%, to $154.0 million as of December 31, 2005, as compared to $46.6 million as of December 31, 2004. The increase in unpaid losses and LAE relates to our payment patterns relative to the settling of hurricane related claims. Case reserves totaled $93.7 million and $31.2 million, and IBNR reserves totaled $60.3 million and $15.4 million as of December 31, 2005 and December 31, 2004, respectively. Federated National’s reserves increased by $101.9 million as of the year ended December 31, 2005 as compared to the year end December 31, 2004. American Vehicle’s reserves increased by $5.6 million for the year ended December 31, 2005 as compared to the year ended December 31, 2004.
Unearned premiums increased $11.7 million, or 23.3%, to $61.8 million, as of December 31, 2005, as compared to $50.1 million, as of December 31, 2004. The increase was due to an $11.5 million increase in unearned homeowner’s insurance premiums, a $4.4 million increase in unearned commercial liability premiums, a $3.7 million decrease in unearned automobile premiums, and a $0.5 million decrease in unearned mobile home insurance premiums. These changes reflect our continued emphasis in 2005 on property and commercial general liability insurance products.
Funds held under reinsurance treaties increased to $1.5 million as of December 31, 2005, as compared to nothing as of December 31, 2004. During its regularly scheduled meeting on August 17, 2005, the Board of Governors of Citizens Property Insurance Corporation “Citizens” determined a 2004 plan year deficit existed in the High Risk Account. The Board decided that a $515 million Regular Assessment is in the best interest of Citizens and consistent with Florida Statutes. On this basis, the Board certified for a Regular Assessment. Federated National’s participation in this assessment totaled $2.0 million. Provisions contained in our excess of loss reinsurance policies provide for their participation totaling $1.5 million. Pursuant to Section 627.3512, Florida Statutes, insurers are permitted to recoup the assessment by adding a surcharge to policies in an amount not to exceed the amount paid by the insurer to Citizens. Federated National is currently underwriting the recoupment in connection with this assessment and it is scheduled to begin in March 2006. As noted above, Federated National is entitled to recoup this assessment, and will subrogate $1.5 million to our reinsurers.
Income taxes payable increased to $3.0 million as of December 31, 2005, as compared to nothing as of December 31, 2004. The increase is due to our return to profitable operations.
Subordinated Debt decreased $6.7 million, or 40.0%, to $10.2 million, as of December 31, 2005, as compared to $16.9 million, as of December 31, 2004. The decrease is in connection with the quarterly principle payments as scheduled. Please see Note 22 to our Consolidated Financial Statements included under item 8 of this Report on Form 10-K, for further discussion.
Deferred income from sale of agency operations decreased to nothing, as of December 31, 2005, as compared to $2.5 million as of December 31, 2004. This reflects the contractual provisions associated with the December 31, 2004 sale of our non-standard automobile insurance agency business in Florida that provided for a post-closing payment of up to $2.5 million provided that certain performance criteria are met. We have reflected in current year operations, in other income, a $0.41 million receivable, net of a $0.70 million allowance in connection with this transaction. Please see Note 24 to our Consolidated Financial Statements included under Item 8 of this Report on Form 10-K, for further discussion.
Accounts payable and accrued expenses increased $0.6 million, or 17.8%, to $4.2 million, as of December 31, 2005, as compared to $3.5 million, as of December 31, 2004. The increase is due to our cash management efforts and timing of payments with our trade vendors.
Gross premiums written increased $18.8 million, or 18.7%, to $119.4 million for the year ended December 31, 2005, as compared to $100.7 million for the comparable period in 2004. The following table denotes gross premiums written by major product line.
The increase in prepaid reinsurance premiums was $6.6 million for the year ended December 31, 2005, as compared to the decrease in prepaid reinsurance premiums of $2.9 million for the year ended December 31, 2004. The increased credit toward written premium is primarily associated with the timing of our reinsurance payments measured against the term of the underlying reinsurance policies.
Net realized investment gains decreased by $.2 million, or 33.5%, to $0.5 million for the year ended December 31, 2005, as compared $0.7 million for the year ended December 31, 2004. The table below reflects the gains and losses by investment category.
Other income increased by $0.7 million, or 86.3%, to $1.4 million for the year ended December 31, 2005, as compared to $0.8 million for the year ended December 31, 2004. During the year ended December 31, 2005, the Company recognized other income totaling $0.4 million (net of $0.7 million valuation allowance) in connection with the recognition of deferred gain stemming from the sale of certain assets and liabilities relative to the agency operations. Additional components contained in other income include $0.3 million in building rents for both years ended December 31, 2005 and 2004, and commission based fee income from various arrangements totaling $0.7 million and $0.5 million for the years ended December 31, 2005 and 2004, respectively.
For further discussion, see the Note 7 to the Consolidated Financial Statements included under Part I, Item 1, of this Report.
Interest expense increased by $0.3 million, or 28.5%, to $1.4 million for the year ended December 31, 2005, as compared to $1.1 million as of December 31, 2004. The increase in interest expense is attributed to approximately $0.4 million associated with the July 2003 and September 2004 Notes, mitigated by a decrease totaling approximately $0.1 million in interest expense in connection with our reliance upon outside sources for financing our contracts receivable.
Policy acquisition costs, net of amortization, increased $6.1 million, or 72.9%, to $14.6 million for year ended December 31, 2005, as compared to $8.4 million for the year ended December 31, 2004. Policy acquisition costs, net of amortization, consists of the actual policy acquisition costs, including commissions, payroll and premium taxes, less commissions earned on reinsurance ceded and policy fees earned.
Gross premiums written increased $27.7 million, or 37.9%, to $100.7 million for the year ended December 31, 2004, as compared to $73.0 million for the comparable period in 2003. The following table denotes gross premiums written by major product line.
Gross premiums ceded decreased $6.6 million, or 29.9%, to $15.5 million for the year ended December 31, 2004, from $22.1 million for the year ended December 31, 2003. The decrease due to the decline in our ceded quota-share reinsurance associated with our automobile insurance which totaled $20.5 million and was offset by a $13.9 million increase in ceded premiums associated with our property lines of business.
The increase in unearned premiums rose by $10.8 million, or 209.0%, to ($16.0) million as of December 31, 2004, as compared to ($5.2) million as of December 31, 2003. The unearned premium liability increase of $16.0 million during 2004 is net of homeowner and commercial liability unearned premiums increases of $18.9 million and $2.7 million, respectively, and is offset by automobile unearned premiums decreases of $5.5 million. These changes reflect our continued emphasis in 2004 on property and commercial general liability insurance products.
Losses and LAE increased by $47.5 million, or 172.6%, to $75.0 million for the year ended December 31, 2004, as compared to $27.5 million as of December 31, 2003. The increase is due to the impact of the 2004 hurricane season wherein August and September of 2004, the State of Florida experienced four hurricanes, Charley, Frances, Ivan and Jeanne. One of our subsidiaries, Federated National, incurred significant losses relative to its homeowners’ insurance line of business. The Company's loss ratio, as determined in accordance with GAAP, for the year ended December 31, was 113.21% compared with 61.30% for the same period in 2003. The table below reflects the loss ratios by product line.
Approximately 8,500 policyholders have filed hurricane-related claims totaling an estimated $105.4 million, of which we estimate that our share of the costs associated with these hurricanes will be approximately $39.1 million and $4.4 million for homeowners’ and mobile homeowners’, respectively, net of reinsurance recoveries. As of September 30, 2004 approximately 7,500 policyholders had filed hurricane-related claims totaling an estimated $62.0 million, of which we estimated that our share of the costs associated with these hurricanes will be approximately $33.0 million, net of reinsurance recoveries.
The All Products Lines loss ratio of 113.21% as of December 31, 2004 would have been 47.42% without the impact of the four hurricanes in August and September of 2004. The four hurricanes in August and September of 2004 increased our homeowners’ and mobile homeowners’ loss ratio for the year ended December 31, 2004 by approximately 129.14 percentage points and 205.67 percentage points, respectively.
Losses and LAE, the Company's most significant expense, represent actual payments made and changes in estimated future payments to be made to or on behalf of its policyholders, including expenses required to settle claims and losses. Management revises its estimates based on the results of its analysis of estimated future payments to be made. This process assumes that past experience, adjusted for the effects of current developments and anticipated trends, is an appropriate basis for predicting future events.
The Company attributes the overall increase in the loss ratio to be clearly related to the four hurricanes in August and September of 2004. If we were to segregate the affects of the four hurricanes in August and September of 2004 we estimate that our All Products Lines loss ratio would have been approximately 47.42% as of December 31, 2004 as compared to 61.30% as of December 31, 2003 and attribute that decrease to the increasingly significant operational contributions made by our lines of business other than automobile.
Interest expense increased by $0.5 million, or 79.2%, to $1.1 million for the year ended December 31, 2004, as compared to $0.6 million as of December 31, 2003. The increase in interest expense is attributable to our July 2003 and September Notes. For further discussion relative to the Notes see footnote 22 titled Subordinated Debt.
During the year ended December 31, 2004, the difference between the ceded commissions earned of $1.5 million and amortized costs of $9.9 million resulted in a charge to earnings of $8.4 million. The $9.3 million increase in policy acquisition costs, net of amortization, in the 2004 period as compared to the 2003 period is attributable to the decrease in ceded commissions earned during the year ended December 31, 2004 totaling $5.2 million, netted against amortized costs of $4.1 million during the same period.
Subject to catastrophic occurrences, net operating cash flow is currently expected to be positive in both the short-term and the reasonably foreseeable future.
Federated National’s and American Vehicle’s statutory capital surplus levels as of December 31, 2005 were approximately $11.2 million and $18.0 million, respectively, and their statutory net income(loss) for the year ended December 31, 2005 were ($2.2) million and $2.9 million, respectively.
As of December 31, 2005, 2004, and 2003, we did not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as “structured finance” or “special purpose” entities, which were established for the purpose of facilitating off-balance-sheet arrangements or other contractually narrow or limited purposes. As such, management believes that we currently are not exposed to any financing, liquidity, market or credit risks that could arise if we had engaged in transactions of that type requiring disclosure herein.
The Warrants issued to the purchasers of the September 2004 Notes and to the placement agent in the offering, J. Giordano, each entitle the holder to purchase one share of our Common Stock at an exercise price of $12.75 per share and will be exercisable until September 30, 2007. The number of shares issuable upon exercise of the 2004 Warrants issued to purchasers equaled $12.5 million divided by the exercise price of the warrants, and totaled 980,392. The number of shares issuable upon exercise of the 2004 Warrants issued to J. Giordano equaled $500,000 divided by the exercise price of the warrants, and totaled 39,216. GAAP requires that detachable warrants be valued separately from debt and included in paid-in capital. Based on the terms of the purchase agreement with the investors in the private placement, management believes that the September 2004 Warrants had zero value at the date of issuance.
For the years ended December 31, 2005 and 2004, there were no off balance sheet transactions.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY AND COMPREHENSIVE INCOME (LOSS)
Federated National is authorized to underwrite personal automobile insurance, homeowners’ property and casualty insurance and mobile home property and casualty insurance in Florida as an admitted carrier. American Vehicle is authorized to underwrite personal and commercial automobile insurance and commercial general liability insurance in Florida as an admitted carrier. In addition, American Vehicle is authorized to underwrite commercial general liability insurance in Georgia, Kentucky, South Carolina and Virginia as a surplus lines carrier and in Texas, Louisiana and Alabama as an admitted carrier. American Vehicle operations in Florida, Georgia and Louisiana are on-going. American Vehicle operations in Texas, Alabama, Kentucky, South Carolina and Virginia are expected to begin this year. American Vehicle has pending applications, in various stages of approval, to be authorized as a surplus lines carrier in the states of Connecticut, Illinois, Missouri, Nevada, New Mexico, West Virginia, California and Arkansas.
Assurance MGA, a wholly owned subsidiary, acts as Federated National's and American Vehicle's exclusive managing general agent. Assurance MGA currently provides all underwriting policy administration, marketing, accounting and financial services to Federated National, American Vehicle and our agencies, and participates in the negotiation of reinsurance contracts. Assurance MGA generates revenue through policy fee income, affiliated commission income and other administrative fees from the marketing of companies' products through the Company's distribution network. Assurance MGA plans to establish relationships with additional carriers and add additional insurance products in the future.
Deferred acquisition costs represent primarily commissions paid to outside agents at the time of policy issuance (to the extent they are recoverable from future premium income) net of ceded premium commission earned from reinsurers, salaries and premium taxes net of policy fees, and are amortized over the life of the related policy in relation to the amount of premiums earned. The method followed in computing deferred acquisition costs limits the amount of such deferred costs to their estimated realizable value, which gives effect to the premium to be earned, related investment income, unpaid loss and LAE and certain other costs expected to be incurred as the premium is earned. There is no indication that these costs will not be fully recoverable in the near term.
The activity in the allowance for credit losses for premiums receivable was as follows:
See Note 4 for the activity in the allowance for credit losses for finance contracts.
If substantially all the costs associated with the MGA contracts which do not involve affiliated insurers are incurred during the underwriting process, then the MGA fees and the related acquisition costs are recognized at the time the policy is underwritten, net of estimated cancellations. If the MGA contract requires significant involvement subsequent to the completion of the underwriting process, then the MGA fees and related acquisition costs are deferred and recognized over the life of the policy. Included in Managing General Agent Fees are policy fees, charged by the insurance companies and passed through to Assurance MGA. Policy fees are discussed further below.
In May 2003, the FASB issued Statement of Financial Accounting Standard Number 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity." This Statement establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity and it requires that an issuer classify a financial instrument that is within its scope as a liability because the financial instrument embodies an obligation of the issuer. This Statement is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective in the first interim period beginning after June 15, 2003. On July 31, 2003, we completed a private placement of our 6% Senior Subordinated Notes (the “July 2003 Notes”), and on September 30, 2004 , we completed another private placement of our 6% Senior Subordinated Notes (the “September 2004 Notes”), both of which were offered and sold to accredited investors as units consisting of one Note with a principal amount of $1,000 and warrants (the “Warrants”) to purchase shares of our Common Stock. These Notes which fall within the definition of financial instruments as described in Financial Accounting Standard Number 150 are presented as a liability in conformity with Statement of Financial Accounting Standard Number 150. As such, the adoption of this Statement did not have any impact on our Consolidated Financial Statements.
Similar to other property and casualty insurers, our liability for unpaid losses and LAE, although supported by actuarial projections and other data, is ultimately based on management's reasoned expectations of future events. Although considerable variability is inherent in these estimates, we believe that this liability is adequate. Estimates are reviewed regularly and adjusted as necessary. Such adjustments are reflected in current operations. In addition, the realization of our deferred income tax assets is dependent on generating sufficient future taxable income. It is reasonably possible that the expectations associated with these accounts could change in the near term and that the effect of such changes could be material to the Consolidated Financial Statements.
LEGAL/REGULATORY RISKS--the risk that changes in the regulatory environment in which an insurer operates will create additional expenses not anticipated by the insurer in pricing its products. That is, regulatory initiatives designed to reduce insurer profits, restrict underwriting practices and risk classifications, mandate rate reductions and refunds, and new legal theories or insurance company insolvencies through guaranty fund assessments may create costs for the insurer beyond those recorded in the financial statements. We attempt to mitigate this risk by monitoring proposed regulatory legislation and by assessing the impact of new laws. As we write business only in the states of Florida, Louisiana and Georgia and in the near future in Texas and Alabama, we are more exposed to this risk than some of our more geographically balanced competitors.
As of December 31, 2005, both Federated National and American Vehicle were in compliance with all regulatory requirements. However, as a result of the hurricanes striking Florida in August and September 2004, we were technically not in compliance with certain regulatory requirements. To retain our certificates of authority, Florida insurance laws and regulations require that our insurance company subsidiaries, Federated National and American Vehicle, maintain capital surplus equal to the greater of 10% of its liabilities or the 2004 statutory minimum capital and surplus requirement of $4.00 million as defined in the Florida Insurance Code. As of December 31, 2004, Federated National was not in compliance with its requirement to maintain minimum capital surplus primarily based on the incurred losses associated with the four hurricanes that occurred in August and September 2004. Under the provisions afforded Federated National according to Statement of Statutory Accounting Principles No 72 titled “Surplus and Quasi-reorganizations”, compliance with this provision was restored by way of a surplus infusion from 21st Century. American Vehicle remains in compliance with statutory minimum capital and surplus requirement. The insurance companies are also required to adhere to prescribed premium-to-capital surplus ratios. As of December 31, 2004, Federated National did not comply with the prescribed premium-to-capital surplus ratio, primarily based on the incurred losses associated with the four hurricanes that occurred in August and September 2004. Under the provisions afforded Federated National according to Statement of Statutory Accounting Principles No 72, compliance with this provision was also restored. American Vehicle remains in compliance with statutory premium-to-capital surplus ratios.
CREDIT RISK--the risk that issuers of securities owned by us will default or that other parties, including reinsurers to whom business is ceded, which owe us money, will not pay. We attempt to minimize this risk by adhering to a conservative investment strategy, maintaining reinsurance agreements with financially sound reinsurers, and by providing for any amounts deemed uncollectible.
For a more in depth discussion of our risks please refer to ITEM 1 and the section titled RISK FACTORS
The fair value of our investments is estimated based on prices published by financial services or quotations received from securities dealers and is reflective of the interest rate environment that existed as of the close of business on December 31, 2005 and 2004. Changes in interest rates subsequent to December 31, 2005 may affect the fair value of our investments. Refer to Note 3(a) of the Notes to Consolidated Financial Statements for details.
In July 2001, the FASB issued SFAS 141 "Business Combinations," effective for all business combinations initiated after June 30, 2001, and SFAS 142 "Accounting for Goodwill and Other Intangible Assets," effective for fiscal years beginning after December 15, 2001. SFAS 141 requires the purchase method of accounting be used for all business combinations. Goodwill and indefinite-lived intangible assets will remain on the balance sheet and not be amortized. Intangible assets with a definite life will continue to be amortized over their estimated useful lives. SFAS 142 establishes a new method of testing goodwill for impairment. On an annual basis, and when there is reason to suspect that their values may have been diminished or impaired, these assets must be tested for impairment. The amount of goodwill determined to be impaired will be expensed to current operations. Prior to the adoption of SFAS 141 and 142, goodwill was amortized on a straight-line basis for financial statement purposes over periods ranging from 10 to 20 years. Effective December 31, 2004 we sold our interest in the assets associated with approximately $1,586,000 of goodwill. The remaining goodwill as of December 31, 2004 was sold on January 1, 2005. According to these transactions it was determined that goodwill was not impaired as of December 31, 2004. There was no amortization of goodwill recorded in 2004 and 2003.
We account for stock-based compensation using the intrinsic value method prescribed in Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees”. Compensation cost for stock options, if any, is measured as the excess of the quoted market price of our stock at the date of grant over the amount an employee must pay to acquire the stock.
We continue to account for stock-based compensation using the intrinsic value method prescribed by Accounting Principles Board Opinion No. 25, under which no compensation cost for stock options is recognized for stock option awards granted to employees at or above fair market value. Had compensation expense for our stock compensation plan been determined based upon fair values at the grant dates for awards under the plan in accordance with SFAS No. 123, our net income (loss) and net income (loss) per share would have been reduced (increased) to the pro forma amounts indicated below. Additional stock option awards are not anticipated in future years.
Property, plant and equipment is stated at cost less accumulated depreciation. Depreciation on property, plant and equipment is calculated on a straight-line basis over the following estimated useful lives: building and improvements - 30 years and furniture and fixtures - 7 years. We capitalize betterments and any other expenditure in excess of $500 if the asset is expected to have a useful life greater than one year. The carrying value of property, plant and equipment is periodically reviewed based on the expected future undiscounted operating cash flows of the related item. Based upon our most recent analysis, we believe that no impairment of property, plant and equipment exists at December 31, 2005.
The following table shows the realized gains (losses) for fixed and equity securities for the years ended December 31, 2005 and 2004.
The investments held at the end of the year were comprised mainly of United States government and agency bonds as well as municipal bonds which are viewed by the Company as conservative and less risky holdings however, sensitive to interest rate changes. There is a smaller concentration of corporate bonds predominantly held in the financial, automotive, and conglomerate industries. Approximately half of the equity holdings are in income funds while the other half is invested in equities related to the mortgage investment industry and business service industry.
The unrealized loss positions relative to the federal and state holdings are directly attributed to the fluctuations in the current interest rates. The impairments relative to the corporate bonds are the result of holdings in the financial and United States automotive industry. The financial industry is also affected by the fluctuations in current interest rates. The United States automotive industry has been significantly affected by a rise in gas, oil prices and foreign competition. As was widely publicized during the end of 2005, labor and benefit reductions were made in an effort to bolster long-term profitability. Finally, the unrealized losses relative to our equity holdings is attributable to the volatility of such holdings which are affected by rising interest rates.
Below is a summary of fixed maturities at December 31, 2005 and 2004 by contractual or expected maturity periods. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
United States Treasury Notes with a book value of $1,000,000, each, and maturing in 2012 were on deposit with the Florida OIR as of December 31, 2005, as required by law for both Federated National and American Vehicle.
The activity in the allowance for credit losses was as follows:
As of December 31, 2005, approximately $2.5 million, or 31.4%, of the gross premium finance receivables (before the allowances for credit losses and unearned premium finance charges) represented policies from an unrelated insurance company. This unrelated insurance company currently is rated “B-“ (Fair) by A.M. Best.
At December 31, 2005 and 2004, the Company had an unsecured aggregate recoverable for paid and unpaid losses and LAE and unearned premiums with the following reinsurers:
As a result of our review of our liability for losses and LAE, which includes a re-evaluation of the adequacy of reserve levels for prior year’s claims, we increased the liability for loss and LAE for claims occurring in prior years by $6,094,843 for the year ended December 31, 2005 and increased (decreased) the liability for losses and LAE for claims occurring in prior years by ($1,430,278) and $1,234,047 for the years ended December 31, 2004 and 2003, respectively. The adjustments in the liability were primarily attributable to loss development in connection with the four hurricanes of 2004 There can be no assurance concerning future adjustments of reserves, positive or negative, for claims through December 31, 2005.
Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of our net deferred tax asset are as follows:
As of December 31, 2005, to meet regulatory requirements, we had bonds with a carrying value of approximately $2.0 million pledged to the Insurance Commissioner of the State of Florida.
Based upon the 2004 statutory financial statements for American Vehicle, statutory surplus exceeded all regulatory action levels established by the NAIC. Based upon the 2004 statutory financial statements for Federated National, statutory surplus did not exceed regulatory action levels established by the NAIC. Federated National’s results required us to submit a plan containing corrective actions. Federated National has submitted its plan for corrective action and is currently in discussions with the Florida OIR regarding the merits of the action plan points. The regulatory action level permits the insurance regulators to perform an examination or other analyses and issue a corrective order.
The NAIC has also developed IRIS ratios to assist state insurance regulators in identifying companies which may be developing performance or solvency problems, as signaled by significant changes in the companies’ operations. Such changes may not necessarily result from any problems with an insurance company, but may merely indicate changes in certain ratios outside the ranges defined as normal by the NAIC. When an insurance company has four or more ratios falling outside “usual ranges,” state regulators may investigate to determine the reasons for the variance and whether corrective action is warranted.
As of December 31, 2005, Federated National was outside NAIC’s usual ranges with respect to its IRIS tests on six out of thirteen ratios. With the exception of one of these test results, all of test results can be attributed to the significant degradation of policyholders’ surplus stemming from the losses incurred in its homeowners’ line of business as a result of the five hurricanes in 2005 and the four hurricanes in 2004. Although there was only modest improvement with respect to our 2005 IRIS test results as compared to 2004 results, management’s attention to risk retention techniques in connection with the five Florida hurricanes during 2005 was the major reason for improvement in an otherwise adverse year for property insurers.
As of December 31, 2004, Federated National was outside NAIC’s usual ranges with respect to its IRIS tests on seven out of twelve ratios. With the exception of one of these test results, all of test results can be attributed to the significant degradation of policyholders’ surplus stemming from the losses incurred relative to its homeowner s’ line of business as a result of the four hurricanes that affected Florida in August and September of 2004. Change in Net Writings was the result of test ratios that do not employ Policyholders’ Surplus and was out of range primarily due to parent company surplus infusions into Federated National.
As of December 31, 2004, American Vehicle was outside NAIC’s usual ranges for three out of twelve ratios. The first ratio relates to a larger than anticipated change in net writings, the second ratio relates to higher surplus growth that stemmed from the Parent company’s capital contributions totaling $4.3 million during the year and the third ratio relates to an investment yield that was slightly less than expected.
We do not currently believe that the Florida OIR will take any significant action with respect to Federated National or American Vehicle regarding the IRIS ratios, though there can be no assurance that will be the case.
American Vehicle’s statutory capital and surplus was $18.0 million and $17.1 million as of December 31, 2005 and 2004, respectively. American Vehicle’s statutory net income was approximately $2.9 million, $2.03 million and $0.85 million for the years ended December 31, 2005, 2004 and 2003 respectively. American Vehicle’s statutory non-admitted assets were approximately $2.9 million and $0.17 million as of December 31, 2005 and 2004, respectively.
In and 2001 respectively, two class action lawsuits were filed against an unaffiliated insurance company for which our subsidiary, Assurance MGA, was the managing general agent. These lawsuits were seeking compensatory damages in an undisclosed amount based on allegations of unfair practices involving the computation of interest due the policyholder in connection with automobile premium refunds. The unaffiliated company has contested these lawsuits over the last several years. Negotiations relative to this matter have been ongoing and in July 2005 the parties reached an agreement wherein we have paid $240,000 to resolve the underlying actions in these suits subject to our contractual duties with respect to the unaffiliated company. We believe that we will be successful in our efforts to enjoin others to participate in this settlement; however we are unable to quantify the participation of others at this time. Accordingly, we charged against second quarter 2005 earnings $240,000 for this action.
Specifically, the plaintiffs alleged that we recognized ceded commission income on a written basis, rather than amortized on a pro rata basis. The plaintiffs allege that this was contrary to the Statement of Financial Accounting Concepts Nos. 1, and 5. We believe, however, that the lawsuit is without merit and we have vigorously defended the action, because we reasonably relied upon outside subject matter experts to make these determinations at the time. We have also since accounted for ceded commission on a pro rata basis and have done so since these matters were brought to our attention in 1998. Nevertheless, we have also continued to actively participate in settlement negotiations with the plaintiffs and have agreed to settle the case. The parties have negotiated the final terms of a Memorandum of Understanding, which was executed by the parties and then approved by the court in late February 2005. We reserved and charged against forth quarter 2003 earnings $600,000 for the potential settlement and associated costs. Our active involvement in this case has been concluded.
As a direct premium writer in the State of Florida, we are required to participate in certain insurer solvency association under Florida Statutes 631.57(3)(a). Participation in these pools is based on our written premium by line of business to total premiums written statewide by all insurers. Participation may result in assessments against us. There was no assessment made for the years ended December 31, 2005, 2004 or 2003.
During its regularly scheduled meeting on August 17, 2005, the Board of Governors of Citizens determined a 2004 plan year deficit existed in the High Risk Account. The Board decided that a $515 million Regular Assessment is in the best interest of Citizens and consistent with Florida Statutes. On this basis, the Board certified for a Regular Assessment. Federated National’s participation in this assessment totaled $2.0 million. Provisions contained in our excess of loss reinsurance policies provide for their participation totaling $1.5 million. Pursuant to Section 627.3512, Florida Statutes, insurers are permitted to recoup the assessment by adding a surcharge to policies in an amount not to exceed the amount paid by the insurer to Citizens. Federated National is currently underwriting the recoupment in connection with this assessment are scheduled to begin in March 2006. As noted above, Federated National is entitled to recoup this assessment, and will subrogate $1.5 million to our reinsurers.
Federated National and American Vehicle are also required to participate in an insurance apportionment plan under Florida Statutes Section 627.351, which is referred to as a JUA Plan. The JUA Plan provides for the equitable apportionment of any profits realized, or losses and expenses incurred, among participating motor vehicle insurers. In the event of an underwriting deficit incurred by the JUA Plan which is not recovered through the policyholders in the JUA Plan, such deficit shall be recovered from the companies participating in the JUA Plan in the proportion that the net direct written premiums of each such member during the preceding calendar year bear to the aggregate net direct premiums written in this state by all members of the JUA Plan. Federated National and American Vehicle were assessed $44,350 and $1,615, respectively by the JUA Plan based on its July 2005 Cash Activity Report. During the year ended December 31, 2004 Federated National and American Vehicle were assessed $362,121 and $120,009, respectively. These charges are contained in Operating and Underwriting Expenses in the Statement of Operations. Future assessments by this association are undeterminable at this time.
Effective December 31, 2004 we sold our interest in our agency operations which relieved us from our lease obligations, Until then we leased office space under various lease agreements with expiration dates through September 2007. Rental expense associated with operating leases was charged to expense in the period incurred. Rental expenses for 2005, 2004 and 2003 were approximately $-0-, $840,000 and $733,000, respectively, and are included in discontinued operations in the accompanying consolidated statements of operations.
One of our directors is a partner at a law firm that handles some of the Company’s claims litigation. Fees paid to this law firm amounted to approximately $192,000, $327,000 and $219,000 for the years ended December 31, 2005, 2004 and 2003, respectively.
Net income (loss) per share is computed by dividing net income (loss) by the weighted average number of shares of common stock and common stock equivalents outstanding during the periods presented. Options granted in accordance with the stock option plan were anti-dilutive for the years ended December 31, 2004 and were not taken into account in the computation.
A summary of the numerator and denominator of the basic and fully diluted (2005 and 2003 only) net income (loss) per share is presented below:
Supplemental segment information as of and for the year ended December 31, 2005, 2004 and 2003 follows:
We have established a profit sharing plan under Section 401(k) of the Internal Revenue Code. This plan allows eligible employees, except key and highly compensated employees, to contribute up to 100 percent of their compensation on a pre-tax basis, not to exceed statutory limits. For the years ended December 31, 2005, 2004 and 2003, we did not contribute to the plan. Our contributions, if any, are vested incrementally over five years.
Reclassification adjustments related to the investment securities sold and previously included in comprehensive income (loss) for the years ended December 31, 2005, 2004 and are as follows:
Our Amended and Restated Articles of Incorporation authorize the issuance of one million shares of preferred stock with designations, rights and preferences determined from time to time by our board of directors. Accordingly, our board of directors is empowered, without shareholder approval, to issue preferred stock with dividends, liquidation, conversion, voting or other rights that could adversely affect the voting power or other rights of the holders of common stock. We have not issued preferred shares as of December 31, 2005.
The July 2003 Notes pay interest at the annual rate of 6%, are subordinated to senior debt of the Company, and mature on July 31, 2006. Quarterly payments of principal and interest due on the July 2003 Notes may be made in cash or, at our option, in shares of our Common Stock. If paid in shares of Common Stock, the number of shares to be issued shall be determined by dividing the payment due by 95% of the weighted-average volume price for the Common Stock on NASDAQ as reported by Bloomberg for the 20 consecutive trading days preceding the payment date.
On September 30, 2004, we completed a private placement of 6% Senior Subordinated Notes due September 30, 2007 (the “September 2004 Notes”). These notes were offered and sold to accredited investors as units consisting of one September 2004 Note with a principal amount of $1,000 and warrants to purchase shares of our Common Stock (the “2004 Warrants”), the terms of which are similar to our July 2003 Notes and 2003 Warrants, except as described below. We sold an aggregate of $12.5 million units in this placement, which resulted in proceeds (net of placement agent fees of $700,000 and offering expenses of $32,500) to us of $11,767,500.
For the July 2003 Notes, the first quarterly principal and interest payments totaling approximately $0.7 million per payment were due on October 31, 2003 and quarterly thereafter for three years with the last installment due on July 31, 2006. The scheduled loan payments are as follows:
As indicated on the table below, we paid, pursuant to the terms of the September 2004 Notes, the quarterly payments of principal and interest due in shares of our Common Stock and in accordance with the contractual computations issued common stock as follows:
Currently, both parties are in discussions relative to the comparison of actual results to the established performance criteria. We have been tentatively delayed in reaching an agreement as to certain provisions that are specific to the performance criteria. The delay is primarily due to scheduling conflicts among the parties. We have reflected in current year operations, in other income, a $0.41 million receivable, net of a $0.70 million allowance in connection with this transaction.
Effective on or about March 1, 2006, the Company sold its interest in the property located at 3661 West Oakland Park Boulevard, Lauderdale Lakes, Florida to an unrelated party for approximately $5.0 million cash and a $0.9 million six year 5% note. The transaction will result in an estimated $2.5 million pre-tax gain and will be included in the first quarter of 2006 operations. As part of the transaction, we have agreed to lease the same facilities for a six year term. The Company is expected to realize an approximate gain of $2.4 million and will recognize the gain in accordance with the FASB 13.
Pursuant to a Written Consent of the Board of Directors dated December 5, 2005, 696,849 shares of common stock previously reflected as Treasury stock in Shareholders’ Equity were cancelled and returned to authorized, but not outstanding effective February 2006.