As of December 31, 2010, we leased an aggregate of approximately 466,041 square feet of office space in various locations throughout the United States. The office space includes a lease for approximately 56,875 aggregate square feet of office space in a common building in Burr Ridge, Illinois, and our Burr Ridge lease term expires in November 2016. We lease approximately 56,888 square feet of office space in Addison, Texas, and our Addison lease term expires in March 2015. We also have two leases of approximately 71,909 aggregate square feet of office space in Baton Rouge, Louisiana. One Baton Rouge lease is for approximately 20,117 square feet of office space with a term that expires in September 2012. The second Baton Rouge lease is for approximately 51,792 square feet of office space with a term that expires in December 2019. We also presently have space in Melbourne, Florida with approximately 3,225 square feet which will expire in October 2012. We also have offices in Chicago, Baton Rouge and Dallas, which have 4,003, 3,394, and 2,619 square feet, respectively. In addition, we have 202 owned retail stores that presently lease space on an individual basis at various locations in the states in which we do business. None of these individual retail store leases are material to our operations.
In Baton Rouge, Louisiana, we own a building of approximately 177,469 square feet for investment purposes. The building is under a lease agreement with a federal agency. The lease expires on November 16, 2020. However, the federal agency may terminate the lease, in whole or in part, upon one hundred twenty days’ written notice on or after December 17, 2015.
As of December 31, 2010, our subsidiaries included insurance companies licensed to write insurance policies in 40 states, underwriting agencies, and retail agencies with 202 owned stores and relationships with two unaffiliated underwriting agencies. We are currently active in offering insurance directly to individual consumers through retail stores in 9 states (Louisiana, Texas, Illinois, Alabama, Missouri, Indiana, South Carolina, Kansas, and Wisconsin) and distributing our own insurance policies through 9,200 independent agents or brokers in 9 states (Louisiana, Texas, Illinois, Alabama, California, Michigan, Missouri, Indiana and South Carolina). In May 2010, we discontinued writing new and renewal policies in the state of Florida. In July 2010, we discontinued writing new and renewal policies in New Mexico.
Insurance companies, which possess the regulatory authority and capital necessary to issue insurance policies;
The preparation of our consolidated financial statements in conformity with U. S. generally accepted accounting principles (GAAP) requires us to make estimates and assumptions when applying our accounting policies. Critical accounting policies are defined as those that are reflective of significant judgments and uncertainties, and potentially result in materially different results under different assumptions and conditions. Our critical accounting policies are described below. For a detailed discussion on the application of these and other accounting policies, see note 2 of Notes to Consolidated Financial Statements which appears in Item 8 of this Annual Report.
Incurred Bornhuetter/Ferguson - We use a combination of incurred development methods and expected loss adjustment expense methods. Expected loss ratio methods are based on the assumption that ultimate losses vary proportionately with premiums. Expected loss and loss adjustment expense
We track monthly the actual emergence of loss and loss adjustment expense data by accident period and compare it to the expected emergence. We review any deviations and determine if it is appropriate to revise any assumptions that will be used to develop loss and loss adjustment expense reserve estimates.
The range of potential ultimate values for any accident year diminishes with the age of the accident year. A recent accident year will tend to have a wider range of potential values as the claims may have only recently been reported or details as to the injuries are still unknown. As the accident year ages, the number of open claims diminishes and the specifics of the injury become clearer. Due to the introduction of new claims practices in late 2009, the closure of claims has been accelerated. This acceleration has increased the severity of claims paid to date as claims that would have been paid at later dates have been settled earlier than in the past. As it takes a number of quarters for normal reserving patterns to reflect the impact of these types of claims practice changes, additional uncertainty has been introduced into the reserve review process. If the additional severity were to persist into future payments, the additional loss exposure would be approximately between $15 and $20 million on a gross basis and between $13 and $18 million on a net basis. These values are reflected in the ranges of gross and net reserves.
We routinely monitor the collectibility of the reinsurance recoverables of our insurance companies to determine if an amount is potentially uncollectible. Our evaluation is based on periodic reviews of our aged recoverables, as well as our assessment of recoverables due from reinsurers known to be in financial difficulty.
At December 31, 2010, our receivables from reinsurers included $13.2 million net recoverable (net of $2.9 million payable) from VFIC. At December 31, 2010, the VFIC Trust held $16.7 million to collateralize the $13.2 million net recoverable from VFIC. We have, with the approval of the VFIC Special Deputy Receiver and the District Court, Austin, Texas, withdrawn $8.7 million through December 31, 2010 from the trust securing our reinsurance recoverables from VFIC, which represented 100% of the amount we paid in losses as of the date of the withdrawal covered by the VFIC reinsurance. We have made arrangements with the VFIC Special Deputy Receiver to submit quarterly statements for approval to withdraw additional funds from the trust based upon losses paid.
As of December 31, 2010 and 2009, we had no reserve for uncollectible reinsurance recoverables. We assessed the collectibility of our year-end receivables and believe all amounts are collectible based on currently available information.
Valuation of goodwill and other intangible assets. We evaluate goodwill for impairment annually as of September 30, or more frequently if events or circumstances indicate that the carrying value may not be recoverable. We report under a single reporting segment and, as such, the goodwill analysis is measured at the consolidated company level. Consistent with prior assessments, the fair value of the Company was determined using an internally developed discounted cash flow methodology and other relevant indicators of value available in the market place such as market transactions and trading values of similar companies. Management considered its market capitalization in relation to its book value and believes that our market capitalization is not representative of the long-term value of the Company. In arriving at this conclusion, management considered the limited daily trading volume of the Company’s stock, the global economic factors impacting the financial markets in general and the specific performance of the Company as indicated by written premium volumes as compared to plan during the recent months of economic decline.
Key inputs in our valuation model are projected cash flows, future inflationary trends, future tax rates, and the risk-adjusted discount rates. The risk-adjusted discount rates were developed using a capital asset pricing model to estimate our weighted-average cost of capital and ranged between 12.5% and 14.0%. The relative mix of capital between debt and equity was estimated at approximately 34 percent based on observed industry averages.
Management applies significant judgment when determining the estimated fair value of the Company and when assessing the relationship of its market capitalization to its estimated fair value and book value. The valuation methodologies utilized are subject to key judgments and assumptions that are sensitive to change. Estimates of fair value are inherently uncertain and represent management’s reasonable expectation regarding future developments. These estimates and the judgments and assumptions upon which the estimates are based will, in all likelihood, differ in some respects from actual future results. Declines in estimated fair value could result in goodwill impairments in future periods which could materially adversely affect the Company’s results of operations or financial position.
operations. If sufficient positive evidence arises in the future indicating that all or a portion of the deferred tax assets meet the more likely than not standard, the valuation allowance would be reversed accordingly in the period that such a conclusion is reached.
In the second quarter of 2009, we adopted FASB guidance related to the recognition and measurement of other-than-temporary impairments for debt securities which replaced the pre-existing “intent and ability” indicator. These new standards specify that if the fair value of a debt security is less than its amortized cost basis, an other-than-temporary impairment is triggered in circumstances where (1) an entity has an intent to sell the security, (2) it is more likely than not that the entity will be required to sell the security before recovery of its amortized cost basis, or (3) the entity does not expect to recover the entire amortized cost basis of the security (that is, a credit loss exists). Other-than-temporary impairments are separated into amounts representing credit losses which are recognized in earnings and amounts related to all other factors which are recognized in other comprehensive income (loss). Adoption of the new guidance did not have a material effect on our consolidated financial position, results of operations or cash flows.
The FASB issued authoritative guidance on measuring the fair value of liabilities and clarifies that the quoted price for an identical liability, when traded as an asset in an active market, is also a Level 1 measurement, the highest priority in the fair value hierarchy, when no adjustment to the quoted price is required. This guidance was effective for interim and annual periods beginning after August 27, 2009. We did not have any revisions in valuation techniques as a result of adopting this guidance in the fourth quarter of 2009.
ASU 2010-26 modifies the types of costs incurred by insurance entities that can be capitalized in the acquisition of new and renewal insurance contracts. The new standard requires costs to be incremental or directly related to the successful acquisition of new or renewal contracts to be capitalized as a deferred acquisition cost. The provisions of the new standard are effective for interim and annual periods beginning after December 15, 2011 and may be adopted early as of the beginning of an annual reporting period using either the prospective or retrospective method. Adoption of the new standard could have a material impact on our consolidated financial position or results of operations. Management is evaluating the impact.
ASU 2010-20 amended guidance for disclosures about the credit quality of financing receivables and the allowance for credit losses. The new standard amends existing guidance by requiring more robust and disaggregated disclosures by an entity about the credit quality of its financing receivables and its allowance for credit losses. These disclosures will provide additional information about the nature of credit risks inherent in a company’s financing receivables, how a company analyzes and assesses credit risk in determining its allowance for credit losses, and the reasons for any changes a company may make in its allowance for credit losses. The provisions of the new standard are generally effective for interim and annual reporting periods ending on or after December 15, 2010; however, certain aspects of the update pertaining to activity that occurs during a reporting period are effective for interim and annual reporting periods beginning on or after December 15, 2010. The adoption of the new guidance had no significant impact on the Company’s consolidated financial position, results of operations or cash flows.
ASU 2009-16 eliminated the concept of a qualifying special-purpose entity, creates more stringent conditions for reporting a transfer of a portion of a financial asset as a sale, clarifies other sale-accounting criteria, and changes the initial measurement of a transferor’s interest in transferred financial assets. The provisions of the new standards are effective for fiscal years beginning after November 15, 2009. The adoption of the new standard effective January 1, 2010 did not impact our consolidated financial position, results of operations or cash flows.
Total gross premiums written for 2010 decreased $13.9 million, or 3.8%, compared with 2009 primarily due to a decline in production from our retail distribution channel. In our retail distribution channel, gross premiums written consist of premiums written for our affiliated insurance carriers’ products only and do not include premiums written for third-party insurance carriers in our retail stores. We earn commission income and fees in our retail distribution channel for sales of third-party insurance policies. Gross premiums written in our retail distribution channel for 2010 decreased $21.7 million, or 10.5%, when compared with 2009. This decrease was due to more of our retail customers choosing third-party products. The overall net reduction in premium volume produced by our retail agencies is primarily due to the shift in policies sold to shorter periods of coverage. The following represents gross premiums written produced by our retail agencies (in thousands):
Gross premiums written by our unaffiliated underwriting agencies in 2010 decreased $4.9 million, or 19.3%, compared with 2009. This decline was due to a decision to reduce the writings of one of the agencies.
During 2010 and into 2011, a number of actions have been taken to increase prices and strengthen underwriting standards to improve the profitability of the gross premiums written. As a result, base rates on an overall basis have increased by 15% from September 30, 2010 to the first quarter of 2011. Improved controls and monitoring of pricing activity have been put in place. We have suspended or constrained new business production for unprofitable independent agent relationships. We expect that these actions will have a negative effect on premium production levels in 2011, but should improve the profitability of the business.
Total gross premiums written for 2009 decreased $17.2 million, or 4.5%, compared with 2008 primarily due to macroeconomic factors. Gross premiums written in our retail distribution channel for 2009 decreased $27.8 million, or 11.9%, when compared with 2008. These declines were primarily due to the negative macroeconomic environment. In our independent agency distribution channel, gross premiums written for 2009 increased $15.5 million, or 12.8%, compared with 2008. This increase was primarily due to the expansion of independent agency
relationships. Gross premiums written by our unaffiliated underwriting agencies for 2009 decreased $4.9 million, or 16.1%, compared with 2008.
The following table displays our gross premiums written and assumed by state (in thousands):
The largest component of revenue is net premiums earned on insurance policies. Net premiums earned for 2010 decreased $32.1 million, or 8.8%, compared with 2009. This decrease was primarily due to the overall reduction in gross premium volumes and the effect of a quota share reinsurance agreement put in place during the fourth quarter of 2010.
Net premiums earned for 2009 increased $8.1 million, or 2.3%, compared with 2008. Net premiums earned during 2009 on policies sold through our affiliated underwriting agencies increased by $14.4 million, or 4.4%. This increase is primarily due to the increase in retention on the Louisiana and Alabama business with the termination of a quota-share reinsurance agreement, which was partially offset by the macroeconomic environment. Net premiums earned on insurance products sold through the unaffiliated underwriting agencies distribution channel decreased by $6.3 million, or 19.8%, compared with 2008.
Reinsurance. The following table reflects the premiums ceded and assumed under reinsurance agreements in our consolidated financial statements (in thousands):
For 2008, we ceded 25% of our Louisiana and Alabama business under a quota-share reinsurance agreement. Effective January 1, 2009, we terminated this quota-share reinsurance contract for Louisiana and Alabama business on a cut-off basis and received $7.8 million of returned unearned premiums, net of $2.6 million returned ceding commissions.
The Michigan Catastrophic Claims Association (MCCA) is the mandatory reinsurance facility that covers no-fault medical losses above a specific retention amount in Michigan. For policies effective in 2010 the required retention is $0.5 million. As a writer of personal automobile policies in the state of Michigan, we cede premiums and claims to the MCCA. Funding for MCCA comes from assessments against automobile insurers based upon their proportionate market share of the state’s automobile liability insurance market. Insurers are allowed to pass along this cost to Michigan automobile policyholders. Our ceded premiums written to the MCCA were $3.3 million, $2.4 million and $1.9 million in 2010, 2009 and 2008, respectively. Our ceded losses to the MCCA were $50.7 million, $4.3 million and $4.5 million in 2010, 2009 and 2008, respectively. The increase was primarily due to an increase in ceded case reserves due to revised estimates of ultimate losses.
We entered into an excess of loss reinsurance contract effective August 1, 2010 that provides coverage for individual losses in excess of $100,000 up to $1 million primarily to reduce our exposure to no-fault medical losses in Michigan and other exposures. In addition, we entered into a reinsurance agreement effective June 1, 2010 to provide coverage for catastrophic events that may involve multiple insured losses.
Commission income and fees increased $4.1 million, or 5.2%, compared with 2009. Premium finance revenue has increased due to the continued emphasis on providing premium financing solutions for our customers. Commissions and fees have increased due to the increase in third-party policies sold and the expansion of ancillary product offerings in all of our retail stores.
Net Investment Income and Other Income. Net investment income includes income on our portfolio of debt securities and lease income from our investment in real property. Net investment income for 2010 decreased $4.5 million, or 47.8%, compared with 2009. The decrease was primarily due to a reduction in yields and a 12.9% decrease in total average invested assets to $232.3 million during 2010 from $266.7 million during 2009. The average investment yield was 2.3% (2.6% on a taxable equivalent basis) in 2010, compared with 3.0% (4.0% on taxable equivalent basis) in 2009. In addition, investment income for our investment in real estate declined $1.9 million for 2010 compared with 2009. This decrease was due to the vacancy of the property while we made improvements for a new long-term lease, which commenced in the fourth quarter of 2010.
Generally, the interest rates for auction-rate tax-exempt securities are determined by bidding every 7, 28 or 35 days. When there are more sellers than buyers, an auction fails and bondholders that want to sell are unable to sell the securities. Auctions for these securities began to fail in late January 2008. Issuers remain obligated to pay interest and principal when due when an auction fails. Rates at failed auctions are set at a level established in the terms of the debt.
In October 2008, our broker filed a prospectus with the SEC, which published a legally-binding offer to all authorized holders of auction-rate securities to purchase all eligible securities at par (“the settlement”). The time frames set by our broker for buybacks had different start dates based upon the individual client’s size, which is determined by each client’s balance of investments held at our broker. In November 2008, we elected to participate in our broker’s offer to purchase our auction-rate securities at par and classified our portfolio of auction-rate securities as trading. The settlement agreement requires our broker to purchase eligible securities at par, at any time during a two-year period beginning June 30, 2010. At December 31, 2010, there were no auction-rate securities in our investment portfolio. At December 31, 2009, the fair value of the settlement was $8.8 million which is recorded in other assets in the consolidated balance sheets with changes in fair value recorded in other income (loss) in the consolidated statement of income (loss). We had redemptions of auction- rate securities, at par, of $46.4 million and realized gains of $9.0 million during 2010 offset by a corresponding reduction in fair value of the settlement recorded in other income (loss).
Losses and Loss Adjustment Expenses. Losses and loss adjustment expenses for 2010 increased $24.5 million, or 8.5%, compared with 2009. Losses and loss adjustment expenses for 2009 increased $13.8 million, or 5.0%, compared with 2008.
In 2010, the increase in the current accident year loss ratio was due to increased losses on the Texas and Michigan businesses as well as significantly increased severity, which was primarily due to the claims transformation project that began in the third quarter of 2009. Significant pricing and underwriting actions were taken to address Texas and Michigan profitability in 2010. Also, additional controls were established in the handling of claims to mitigate the significant increases in severity that occurred.
In 2010, the adverse development on reserve estimates from prior accident years was $28.0 million. This primarily related to the 2009 accident year and was a result of the Texas and Michigan businesses and the increase in severity starting in the third quarter of the year due to the claims transformation project. In 2009, adverse development on reserve estimates for prior accident years was $14.8 million. This was primarily due to the Florida business due to a decision in late 2007 to promote our full coverage product, which had inadequate pricing and product management. We ceased writing business in Florida in May 2010.
Our losses and loss adjustment expenses are a blend of the specific estimated and actual costs of providing the coverage contracted by the purchasers of our insurance policies. We maintain reserves to cover our estimated ultimate liability for losses and related loss adjustment expenses for both reported and unreported claims on the insurance policies issued by our insurance companies. The establishment of appropriate reserves is an inherently uncertain process, involving actuarial and statistical projections of what we expect to be the cost of the ultimate settlement and administration of claims based on historical claims information, estimates of future trends in claims severity and other variable factors such as inflation. The change in claims practices that began in the third quarter of 2009 have added additional uncertainty to the reserving process. Due to the inherent uncertainty of estimating reserves, reserve estimates can be expected to vary from period to period. To the extent that our reserves prove to be inadequate in the future, we would be required to increase our reserves for losses and loss adjustment expenses and incur a charge to earnings in the period during which such reserves are increased. The historic development of our reserves for losses and loss adjustment expenses is not necessarily indicative of future trends in the development of these amounts.
The following table presents the development of reserves for unpaid losses and loss adjustment expenses from 2000 through 2010 for our insurance company subsidiaries, net of reinsurance recoveries or recoverables. The first line of the table presents the reserves at December 31 for each indicated year. This represents the estimated amounts of losses and loss adjustment expenses for claims arising in that year and all prior years that are unpaid at the balance sheet date, including losses incurred but not reported to us. The upper portion of the table presents the cumulative amounts subsequently paid as of successive years with respect to those claims. The lower portion of the table presents an update of the estimated amount of the previously recorded reserves based upon the experience as of the end of each succeeding year. The estimates are revised as more information becomes known about the payments, frequency and severity of claims for individual years. A redundancy (deficiency) exists when the reestimated reserves at each December 31 is less (greater) than the prior reserve estimate. The cumulative redundancy (deficiency) depicted in the table, for any particular calendar year, represents the aggregate change in the initial estimates over all subsequent calendar years.
Our historical net liabilities for losses and loss adjustment expenses are impacted by our 100% quota-share reinsurance contract with VFIC. During 2000, one of our insurance companies retained a small book of business, but ceded a majority of its business to VFIC. For the years 2001, 2002 and 2003 we reinsured 100% of business written or assumed by our insurance companies to VFIC. The following table summarizes the development of reserves for unpaid losses and loss adjustment expenses (in thousands):
Selling, General and Administrative Expenses. Another measurement of our performance that addresses our overall efficiency is the level of selling, general and administrative (SG&A) expenses. We recognize that our customers are primarily motivated by low prices. As a result, we strive to keep our costs as low as possible to be able to keep our prices affordable and thus to maximize our sales while still maintaining profitability. Our SG&A expenses include not only the cost of acquiring the insurance policies through our insurance carriers (the amortization of the deferred acquisition costs) and managing our insurance carriers and the retail stores, but also the costs of the holding company. The largest component of SG&A expenses is personnel costs, including payroll, benefits and accrued bonus expenses. SG&A expenses increased $4.2 million, or 2.6%, compared with 2009 primarily related to a $5.6 million increase in employee compensation and benefits, including $2.6 million increase in base employee costs, $1.3 million in severance, and $1.1 million increase in temporary and contract labor costs, a $6.2 million increase in amortization of policy acquisition costs due to increased commissions resulting from independent agent sales volumes, which were partially offset by ceding commissions on the quota-share reinsurance agreement of $9.7 million.
In 2009, selling, general and administrative expenses increased $23.8 million, or 17.1%, compared with 2008. This increase was primarily related to a reduction in ceding commission of $13.1 million due to the termination of the Louisiana and Alabama quota-share agreement, a $6.3 million reallocation of expenses from unallocated loss adjustment expenses to more accurately reflect claim handling costs in unallocated loss adjustment expense and contingent commissions related to prior period development of $4.4 million.
Gain on Extinguishment of Debt. On March 27, 2009, we entered into an amendment of the senior secured credit facility. See the Liquidity and Capital Resources section for a complete discussion of the amendment. We evaluated the present value of the cash flows under the terms of the amended credit agreement to determine if they were at least 10 percent different from the present value of the remaining cash flows under the terms of the original credit agreement. It was determined that the terms were substantially different and, therefore, should be accounted for as a debt extinguishment. The amended debt agreement was recorded at fair value, which was determined to be $112.5 million, with the discount to be amortized as interest expense over the remaining life of the note using the effective interest method. In addition, $1.8 million of new debt issuance costs were incurred, which were capitalized and are being amortized to interest expense over the term of the amended credit agreement.
We recorded a $19.4 million pretax, non-cash gain on extinguishment of debt as a result of this transaction, which is included in a separate line item in the accompanying consolidated statement of income (loss) for the year ended December 31, 2009. The $19.4 million debt extinguishment gain resulted from a $24.2 million discount representing the difference between the carrying value of the original credit agreement and the fair value of the new modified credit agreement, net of $0.7 million of term lender consent fees and the write-off of $4.1 million of deferred debt issuance costs relating to the original credit agreement.
Loss on Interest Rate Swaps. Loss on interest rate swaps for 2010 decreased $5.5 million, or 85.0%, compared with 2009. The loss relates to the impact on the determination of fair value associated with the decline in short-term interest rates implied in the forward yield curve. All of the interest rate swap agreements expire during the first half of 2011.
Interest Expense. Interest expense for 2010 decreased $0.8 million, or 3.2%, compared with 2009. This decrease was due to a decrease in the average debt outstanding, which was partially offset by higher interest rates on the senior secured credit facility and the amortization of debt discount of $6.1 million in 2010. The average principal balance of our senior secured credit facility was $119.0 million during 2010, a decrease of $14.3 million, or 10.7%, from the average principal balance during 2009. In 2010, we repaid $21.6 million of the senior secured facility.
Interest expense for 2009 increased $5.1 million, or 27.9%, compared with 2008. This increase reflects the amortization of loan discount of $5.7 million resulting from the modification of the senior credit facility as well as the increased interest rate, which was partially offset by a lower loan balance due to principal reductions. The average principal balance of our senior secured credit facility was $133.3 million during 2009, a decrease of $19.5 million, or 12.8%, from the average principal balance during 2008. In 2009, we repaid $6.7 million of the senior secured facility.
Our net deferred tax assets prior to recognition of valuation allowance were $53.4 million and $20.8 million at December 31, 2010 and December 31, 2009, respectively. In assessing the realizability of our deferred tax assets, we considered whether it was more likely than not that our deferred tax assets will be realized based upon all available evidence, including scheduled reversal of deferred tax liabilities, historical operating results, projected future operating results, tax carry-back availability, and limitations pursuant to Section 382 of the Internal Revenue Code, among others. Based on this assessment, we began recording a valuation allowance against deferred taxes in December 2009. The valuation allowance was $65.6 million and $31.6 million at December 31, 2010 and 2009, respectively.
We recognized an income tax expense from continuing operations of $22.4 million for the year ended December 31, 2009 as compared to income tax benefit from continuing operations of $0.8 million for the year ended December 31, 2008. Our effective tax rate from continuing operations of 152.8% for the year ended December 31, 2009 differed from the federal statutory rate primarily as a result of the recognition of a deferred tax asset valuation allowance and investment income generated by tax-exempt securities.
There are no restrictions on the payment of dividends by our non-insurance company subsidiaries other than state corporate laws regarding solvency. As a result, our non-insurance company subsidiaries generate revenues, profits and net cash flows that are generally unrestricted as to their availability for the payment of dividends and we have and expect to continue to use those revenues to service our corporate financial obligations, such as debt service and stockholder dividends. As of December 31, 2010, we had $1.6 million of cash and cash equivalents at the holding company level and $11.8 million of cash and cash equivalents at our non-insurance company subsidiaries.
commissioner of insurance has received notice of the intended dividend and has not objected in such time or until the commissioner has approved the payment of the extraordinary dividend within the 30-day period. In most states, an extraordinary dividend is defined as any dividend or distribution of cash or other property whose fair market value, together with that of other dividends and distributions made within the preceding 12 months, exceeds the greater of 10.0% of the insurance company’s surplus as of the preceding year-end or the insurance company’s net income for the preceding year, in each case determined in accordance with statutory accounting practices. In addition, dividends may only be paid from unassigned earnings and an insurance company’s remaining surplus must be both reasonable in relation to its outstanding liabilities and adequate to its financial needs. As of December 31, 2010, our insurance companies could not pay ordinary dividends to us without prior regulatory approval due to a negative unassigned surplus position of Affirmative Insurance Company. However, as mentioned previously, our non-insurance company subsidiaries provide adequate cash flow to fund their own operations. Dividend payments of $7.3 million were received from our insurance company subsidiaries in 2008. In February 2009, we obtained approval from the New York Department of Insurance for one of our insurance subsidiaries to retire one million shares of its stock for $2.9 million and approved payment of an extraordinary dividend for $0.1 million.
The National Association of Insurance Commissioners’ model law for risk-based capital provides formulas to determine the amount of capital that an insurance company needs to ensure that it has an acceptable expectation of not becoming financially impaired. At December 31, 2010, each of our insurance subsidiaries maintained a risk-based capital level that was in excess of an amount that would require any corrective actions.
Senior secured credit facility. In 2007, we entered into a $220.0 million senior secured credit facility (the facility) provided by a syndicate of lenders, that provide for a $200.0 million senior term loan facility and a revolving facility of up to $20.0 million, depending on our borrowing capacity. The principal amount of the term loan is payable in quarterly installments, with the remaining balance due January 31, 2014. Beginning in 2008, we were also required to make additional annual principal payments that are calculated based upon our financial
performance during the preceding fiscal year. In addition, certain events, such as the sale of material assets or the issuance of significant new equity, necessitate additional required principal repayments. During 2010, we made $21.6 million in principal payments. The revolving portion of the facility expired in January 2010.
Our obligations under the facility are guaranteed by our material operating subsidiaries (other than our insurance companies) and are secured by a first lien security interest on all of our assets and the assets of our material operating subsidiaries (other than our insurance companies), including a pledge of 100% of the stock of AIC.
The permitted dividend leverage ratio was changed from 1.5 to 1.0.
Effective April 1, 2011, the pricing under the agreement is changing to if the leverage ratio is greater than 2.3, the pricing is LIBOR plus 9.00%. If the leverage ratio is greater than 2.0 and less than or equal to 2.3, the pricing is LIBOR plus 7.50%. If the leverage ratio is greater than 1.8 and less than or equal to 2.0, the pricing is LIBOR plus 6.25%. The pricing for leverage ratios less than or equal to 1.8 was unchanged.
We have the option to capitalize interest that is in excess of the prior payment terms to the loan balance.
In addition, we paid a 0.25% fee to all lenders that approved the amendment. The amendment is expected to increase our interest costs in 2011.
In March 2009, we entered into an amendment to the facility. The amendment included the following changes:
The following table summarizes our contractual obligations at December 31, 2010 (in thousands):
(5) Our current derivative instruments consist of two interest rate swaps with an aggregate notional amount of $90 million outstanding at December 31, 2010, previously designated as hedges against the variability of cash flows associated with that portion of the senior secured credit facility. The interest rate swap liability is recorded in other liabilities on the consolidated balance sheet.
(6) In October 2006, we entered into an IT outsourcing contract with a data processing services provider under which we outsourced substantially all of our IT operations, including our data center, field support and application management. The initial term of the agreement is ten years, although it may be terminated for convenience by us at any time upon six month’s notice after the first two years, subject to the payment of certain stranded costs and other termination fees. These amounts represent our minimum future IT outsourcing commitments.
(7) The payout pattern for reserves for losses and loss adjustment expenses is based upon historical payment patterns and does not represent actual contractual obligations. The timing and amount ultimately paid can and will vary from these estimates.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Affirmative Insurance Holdings, Inc.’s internal control over financial reporting as of December 31, 2010, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 31, 2011 expressed an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Affirmative Insurance Holdings, Inc and subsidiaries as of December 31, 2010 and 2009, and the related consolidated statements of income (loss), stockholders’ equity, comprehensive income (loss), and cash flows for each of the years in the three-year period ended December 31, 2010, and our report dated March 31, 2011 expressed an unqualified opinion on those consolidated financial statements.
Certain prior year amounts have been reclassified to conform to the current presentation, including discontinued operations for the Florida retail operations sold in June 2009.
Use of Estimates • The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ materially from those estimates. These estimates and assumptions are particularly important in determining reserves for losses and loss adjustment expenses, deferred policy acquisition costs, reinsurance receivables, valuation of investments, goodwill and other intangible assets, and deferred income taxes.
Other invested assets is comprised of an investment in a hedge fund, which primarily invests in mortgage-backed securities with the strategy of seeking attractive yields on commercial as well as residential mortgage-backed securities. The fair value of this investment is estimated using the net asset value of the fund as reported by the fund manager. The financial statements of the hedge fund are subject to annual audits evaluating the net asset positions of the underlying investments. The Company’s hedge fund is presented seaparately as other invested assets on the consolidated balance sheet and the fair value is included in the Level 3 fair value hierarchy. The Company records changes in the value of its other invested assets as a component of net investment income.
Premium Finance Receivable • The Company recognizes interest and origination fees from finance receivables over the term of the finance contract. Late fee revenue is recognized when received.
Goodwill and Other Intangible Assets, Net • Goodwill and other intangible assets with indefinite useful lives are tested for impairment annually as of September 30 or more frequently if events or changes in circumstances indicate that the assets might be impaired.
Identifiable intangible assets consist of brand names, agency relationships and non-competition agreements. The Company amortizes intangible assets with finite lives over their estimated useful lives, ranging from two to twenty years, and reviews them for impairment whenever an impairment indicator exists. Management continually monitors events and changes in circumstances that could indicate carrying amounts of long-lived assets, including intangible assets, may not be recoverable. When such events or changes in circumstances occur, management assesses recoverability by determining whether the carrying value of such assets will be recovered through the undiscounted expected future cash flows. If the future undiscounted cash flows are less than the carrying amount of these assets, an impairment loss is recognized based on the excess of the carrying amount over the fair value of the assets.
In May 2005, the Company formed Affirmative Insurance Holdings Statutory Trust II (“Trust II”), an unconsolidated trust subsidiary, for the sole purpose of issuing $25.0 million in trust preferred securities. Trust II used the proceeds from the sale of these securities and the Company’s initial capital contribution to purchase $25.8 million of subordinated debt securities from the Company. The debt securities are the sole assets of Trust II, and the payments under the debt securities are the sole revenues of Trust II.
Fee Income - Policy origination fees, agency fees and installment fees compensate the Company for the costs of providing installment payment plans, as well as late payment, policy cancellation, policy rewrite and reinstatement fees. Policy origination fees are recognized over the underlying policy terms. Other fees are recognized when services are provided. Premium finance and origination fees are recognized over the term of the finance contracts.
Accounting and Reporting for Reinsurance • Income and expense on reinsurance contracts are recognized principally over the term of the reinsurance contracts or until the reinsurers maximum liability is exhausted, whichever comes first. Reinsurance contracts do not relieve the Company from its obligations to policyholders. Management continually monitors reinsurers to minimize the exposure to significant losses from reinsurer insolvencies. The Company only cedes risks to reinsurers whom it believes to be financially sound.
Stock-Based Compensation • Compensation cost is measured based on the grant-date fair value of an award utilizing the assumptions discussed in note 18. Compensation cost is recognized for financial reporting purposes on a straight-line basis over the period in which the employee is required to provide service in exchange for the award.
Net Income Per Common Share • Basic net income per common share is computed by dividing net income available to common stockholders by the weighted average number of common shares outstanding during the year. Diluted net income per share is computed by giving effect to the potential dilution that could occur if securities or other contracts to issue common shares were exercised and converted into common shares during the year. Shares issued under restricted stock awards are included in basic shares upon issuance of the awards even though the vesting of shares will occur over time.
Fair Value of Financial Instruments • During the first quarter of 2009, the Company adopted FASB ASC 820, Fair Value Measurements and Disclosures, which defines fair value, establishes guidelines for measuring fair value and expands disclosures regarding fair value measurements. This new accounting standard did not require any new fair value measurements. The Company applies fair value accounting for all financial assets and
liabilities and non-financial assets and liabilities that are recognized or disclosed at fair value in the financial statements on a recurring basis. The Company defines fair value as the price that would be received from selling an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. When determining the fair value measurements for assets and liabilities, which are required to be recorded at fair value, the Company considers the principal or most advantageous market in which the Company would transact and the market-based risk measurements or assumptions that market participants would use in pricing the asset or liability, such as inherent risk, transfer restrictions and credit risk.
Statutory accounting practices • The Company’s insurance subsidiaries are required to report results of operations and financial position to insurance regulatory authorities based upon statutory accounting practices (SAP). The more significant differences between SAP and GAAP are as follows:
period using either the prospective or retrospective method. Adoption of the new standard could have a material impact on the Company’s consolidated financial position or results of operations. Management is evaluating the impact.
As of December 31, 2010, the Company no longer holds any trading investment securities as all remaining auction-rate securities were redeemed in the fourth quarter of 2010. As of December 31, 2009, the Company’s trading investment securities consisted solely of auction-rate tax-exempt investment securities, which were carried at fair value with realized gains and losses reported in current period earnings. The Company had redemptions of $46.4 million and $4.9 million, at par, for the years ended December 31, 2010 and 2009, respectively.
The Company’s available-for-sale investment securities are carried at fair value with unrealized gains and losses, net of income taxes, reported in accumulated other comprehensive income, a separate component of stockholders’ equity. Gains and losses realized on the disposition of investment securities are determined on the specific-identification basis and credited or charged to income.
Expected maturities may differ from contractual maturities because certain borrowers may have the right to call or prepay obligations with or without penalties. The Company’s amortized cost and estimated fair values of fixed-income securities at December 31, 2010 by contractual maturity were as follows (in thousands):
The following table summarizes the Company’s available-for-sale securities in an unrealized loss position at December 31, 2010 and 2009, the fair value and amount of gross unrealized losses, aggregated by investment category and length of time those securities have been continuously in an unrealized loss position (in thousands):
The Company’s portfolio contains approximately 64 and 22 individual investment securities that were in an unrealized loss position as of December 31, 2010 and 2009, respectively.
At December 31, 2010 and 2009, investments in fixed-maturity securities with an approximate carrying value of $9.7 million and $9.4 million, respectively, were on deposit with regulatory authorities as required by insurance regulations.
On August 1, 2010, the Company entered into an excess of loss reinsurance contract with third-party reinsurers which provides coverage for individual losses in excess of $100,000 up to $1 million.
The table below presents the total amount of receivables due from reinsurers as of December 31, 2010 and 2009 (in thousands):
At December 31, 2010, $8.8 million was included in reserves for losses and loss adjustment expenses that represented the amounts owed by AIC and Insura under reinsurance agreements with the VIG affiliated companies, including Hawaiian Insurance and Guaranty Company, Ltd (Hawaiian). Affirmative established a trust account to collateralize this payable, which currently holds $20.7 million in securities (the AIC Trust). The Special Deputy Receiver in Texas had cumulative withdrawals from the AIC Trust of $0.4 million through December 2010, and the Special Deputy Receiver in Hawaii had cumulative withdrawals from the AIC Trust of $1.7 million through December 2010.
Premium finance receivables are secured by the underlying unearned insurance premiums for which the Company obtains assignment from the policyholder in the event of non-payment. When a payment becomes past due, the Company cancels the underlying policy with the insurance carrier and receives the unearned premium thereof to clear unpaid principal and interest. The loan is closed by writing off any uncollected amounts or refunding any overpayment to the customer. Therefore, no finance receivables are considered past due in excess of thirty days. Losses due to non-realization of premium finance receivables were $0.7 million and 0.4% of total premiums financed for 2010, and $0.8 million and 0.5% of total premiums financed for 2009.
Property and equipment, net, consisted of the following as of December 31, 2010 and 2009 (in thousands):
The effect of these assumptions was incorporated into our forecasts for 2011 and later years. A discount rate of 16.5% was used at December 31, 2010, which management believes represents an appropriate risk-adjusted discount rate based on the Company’s overall cost of capital. Based on its updated analysis, the Company concluded that there was no impairment of goodwill as of December 31, 2010, as the fair value of the Company continued to exceed its carrying value.
Changes in the carrying value of goodwill for the year ended December 31, 2010 and 2009 were as follows (in thousands):
Other intangible assets at December 31, 2010 and 2009 were as follows (in thousands):
Estimated future amortization expense will be recognized over a weighted-average period of approximately 11.5 years as of December 31, 2010.
In 2010, the increase in the current accident year loss ratio was due to increased losses on the Texas and Michigan businesses as well as significantly increased severity, which was primarily due to the claims transformation project that began in the third quarter of 2009. Significant pricing and underwriting actions were taken to address Texas and Michigan profitability in 2010.
The Company’s long-term debt instruments and balances outstanding at December 31, 2010 and 2009 were as follows (in thousands):
The $25.8 million notes payable due 2035 are redeemable in whole or in part by the issuer after five years. The notes were issued in June 2005 and bore an initial interest rate of 7.792% until June 15, 2010. Since June 15, 2010, the securities adjust quarterly to the three-month LIBOR rate plus 3.55%. The interest rate as of December 31, 2010 was 3.85%.
At every quarter end, the Company will pay to the lenders a payment equal to the excess of cash at the non-regulated entities of $12 million at December 31 and March 31 and $10 million at June 30 and September 30.
In addition, the Company paid a 0.25% fee to all lenders that approved the amendment. The amendment is expected to increase interest costs in 2011.
In accordance with ASC 470-50 Debt-Modifications and Extinguishments, the Company evaluated the present value of the cash flows under the terms of the amended credit agreement to determine if they were at least 10 percent different from the present value of the remaining cash flows under the terms of the original credit agreement. It was determined that the terms were substantially different and therefore should be accounted for as a debt extinguishment. The amended debt agreement was recorded at fair value, which was determined to be $112.5 million, with the discount to be amortized as interest expense over the remaining life of the note using the effective interest method. In addition, $1.8 million of new debt issuance costs were incurred, which were capitalized and will be amortized to interest expense over the term of the amended credit agreement.
In 2007 and 2008, the Company entered into two interest rate swap arrangements to hedge its exposure to variable cash flows related to interest payments on its senior secured credit facility. One swap, entered into in April 2007, has a notional amount of $50.0 million that requires quarterly settlements whereby the Company pays a fixed rate of 4.993% and receives a three-month LIBOR rate. This swap expires in April 2011. The second swap, entered into in January 2008 had an original notional amount of $95.0 million scheduled to gradually decline to $40.0 million prior to its expiration in February 2011, and was $40.0 million as of December 31, 2010. For this swap, the Company pays a fixed rate of 3.031% and receives a three-month LIBOR rate.
The March 2009 amendment to the senior secured credit facility, discussed above, changed the pricing to include a LIBOR floor of 3.0%, thus creating a basis difference in the hedging relationship since the hedged debt has a floor and the swap does not. With this amendment, the Company could no longer assume that the interest swap agreements would be highly effective in hedging the variability of interest payments on the Company’s senior secured credit facility. As a result, as of March 27, 2009, the qualifying criteria to elect hedge accounting were no longer met. Accordingly, the Company reclassified the accumulated other comprehensive loss associated with the interest rate swaps to earnings and going forward, recognizes any changes to the fair value of the interest rate swaps in current period earnings.
Property under capital lease at December 31, 2010 was as follows (in thousands):
The Company’s effective tax rate differed from the statutory rate of 35% for the years ended December 31 as follows:
Tax effects of temporary differences that give rise to significant portions of the Company’s deferred tax assets and deferred tax liabilities at December 31, 2010 and 2009 were as follows (in thousands):
The change in valuation allowance attributable to continuing operations and other comprehensive income is presented below (in thousands):
If actual results differ from these estimates or these estimates are adjusted in future periods, the valuation allowance may need to be adjusted, which could materially impact the Company’s financial position and results of operations. If sufficient positive evidence arises in the future indicating that all or a portion of the deferred tax assets meet the more likely than not standard, the valuation allowance would be reversed accordingly in the period that such a conclusion is reached.
As of December 31, 2010, the Company has available for income tax purposes federal net operating loss carryforwards (NOL’s), which may be used to offset future taxable income. The Company’s NOL’s expire as follows (in thousands):
As of December 31, 2010, the Company leased office space for its agencies, insurance companies and retail stores in various locations throughout the United States. The Company’s operating lease rental expenses were $9.1 million, $8.8 million and $9.6 million for the years ended December 31, 2010, 2009 and 2008, respectively.
On October 26, 2010, the Chapter 7 Trustee for Brooke Corporation, Brooke Capital Corporation and Brooke Investments, Inc., along with Brooke Agency Services Company, LLC (“BASC”), filed an adversary proceeding in the U.S. Bankruptcy Court for the District of Kansas against Affirmative Insurance Holdings, Inc., Affirmative Insurance Services, Inc., Affirmative Insurance Services of Illinois, Inc., and Affirmative Insurance Company. The Plaintiffs assert claims for an accounting, constructive fraudulent transfer and preferential transfer under Section 547 of the Bankruptcy Code, seeking to recover premium funds transferred to the Defendants by BASC pursuant to producer agreements pursuant to which BASC’s franchisee’s sold Defendants’ insurance policies. Plaintiffs also assert a claim for breach of contract for alleged unpaid profit sharing commissions. The Company believes that these claims lack merit and intends to defend itself vigorously.
On August 17, 2009, plaintiff Toni Hollinger filed a putative class action in the U.S. District Court for the Eastern District of Texas against several county mutual insurance companies and reinsurance companies, including Affirmative Insurance Company. The complaint alleges that defendants engaged in unfair discrimination and violated the Texas Insurance Code by charging different policy fees for the same class and hazard of insurance written through county mutual insurance companies. On August 5, 2010, the Court issued an order dismissing plaintiff’s claims for lack of subject matter jurisdiction. Plaintiff filed a notice of appeal of the dismissal on August 25, 2010. The appeal is pending. The Company believes that this claim lacks merit and intends to defend itself vigorously.
On January 12, 2010, the Circuit Court of Cook County, Illinois granted plaintiff Valerie Thomas leave to amend her complaint to assert a putative class action against Affirmative Insurance Company. The complaint alleged that Affirmative failed to provide a statutory 5% premium discount to insureds who had anti-theft devices installed as standard equipment on their vehicles even when the insureds did not disclose the existence of such devices to Affirmative. The case was consolidated with several identical class actions against other defendant insurance companies. On March 24, 2011, pursuant to the parties’ Stipulation of Dismissal, the Court issued an order dismissing the plaintiff’s complaint.
Affirmative Insurance Company is a party to a 100% quota-share reinsurance agreement with Hawaiian Insurance and Guaranty Company, Ltd (Hawaiian). In November 2004, Hawaiian was named in a complaint filed in the Superior Court of the State of California for the County of Los Angeles alleging various causes of action relating to the alleged bad faith denial of coverage and defense for Hawaiian’s former insured resulting in a default judgment against the insured in the amount of $35 million. In January 2006, Hawaiian obtained summary judgment on all claims in its favor. Plaintiff appealed, but in October 2006, Hawaiian obtained a stay of the appellate proceedings by virtue of the Order of Liquidation for Hawaiian entered in August 2006. The Supreme Court of California denied plaintiff’s attempt to lift the stay in July 2007, and the matter has been inactive since that time.
The following table sets forth the reconciliation of numerators and denominators for the basic and diluted earnings per share computation for each of the years ended December 31, 2010, 2009 and 2008 (in thousands, except per share amounts):
In May 2004, the Company’s board of directors adopted and its stockholders approved the 2004 Stock Incentive Plan (2004 Plan) to enable the Company to attract, retain and motivate eligible employees, directors
Stock Options • The Company used the modified Black-Scholes model to estimate the fair value of employee stock options on the date of grant utilizing the assumptions noted below. The risk-free rate is based on the U.S. Treasury bill yield curve in effect at the time of grant for the expected term of the option. The expected term of options granted represents the period of time that the options are expected to be outstanding. Expected volatilities are based on historical volatilities of the Company’s common stock. The dividend yield was based on expected dividends at the time of grant.
The Company recognized total compensation expense related to the stock options of $0.5 million, $0.7 million and $0.7 million during 2010, 2009 and 2008, respectively. Compensation expense is included in selling, general and administrative expenses in the consolidated statements of income (loss). Total unrecognized compensation expense related to unvested stock options was $0.3 million at December 31, 2010, which will be recognized over a weighted-average period of approximately 1.3 years.
Stock options outstanding and exercisable at December 31, 2010 were as follows (shares in thousands):
The stock options outstanding and exercisable at December 31, 2010 had aggregate intrinsic values of zero as the aggregate exercise price was greater than the aggregate market value. No stock options were exercised during 2010, 2009 or 2008.
The Company recognized total compensation expense related to the restricted stock awards of $0.6 million, $0.4 million and $0.4 million during 2010, 2009 and 2008, respectively. Compensation expense is included in selling, general and administrative expenses in the consolidated statement of income. As of December 31, 2010, there was approximately $0.1 million of total unrecognized compensation cost related to unvested restricted stock awards, which will be recognized over a weighted average period of approximately 0.9 years.
The aggregate fair value of restricted stock awards vested during 2010, 2009 and 2008 was $0.1 million at the date of vesting.
In January 2007, 227 West Monroe Street, Inc., as landlord (Landlord) executed a Consent to Assignment among the Landlord, KR Callahan & Company, LLC (KRCC), an entity whose sole member and manager is Kevin R. Callahan, the Company’s former Chairman and Chief Executive Officer, and the Company, and approved the assignment (the Assignment) of the leasehold interest held by KRCC to the Company with effect from December 2006. Pursuant to the Assignment, KRCC assigned to the Company all of its right, title and interest in and to the Lease (the Lease), dated May 8, 2006, between KRCC, as tenant, and the Landlord, and the Company agreed with KRCC to assume all obligations of KRCC, as tenant, under the Lease. The Lease relates to office space in Chicago, Illinois used by the Company’s Claims Staff Counsel. The Lease continues until July 31, 2016 and provides for an average monthly rent of approximately $9,690. In addition, Affirmative Property will be responsible for the payment of taxes, common area maintenance charges and other customary occupancy costs.
In connection with the Lease, KRCC had procured a Letter of Credit in favor of the Landlord in the amount of $293,257 as a security deposit against KRCC’s obligations under the Lease. In connection with the
Any failure by one of the Company’s insurance company subsidiaries to meet the applicable risk-based capital or minimum statutory capital requirements imposed by the laws of Illinois, Louisiana, Michigan, and New York or other states where the Company does business could subject it to further examination or corrective action imposed by state regulators, including limitations on the Company’s writing of additional business, state supervision or liquidation. Any changes in existing risk-based capital requirements or minimum statutory capital requirements may require the Company to increase its statutory capital levels, which the Company may be unable to do. As of December 31, 2010, each of the Company’s insurance company subsidiaries maintained a risk-based capital level in excess of an amount that would require any corrective actions.
State insurance laws restrict the ability of the Company’s insurance company subsidiaries to declare stockholder dividends. These subsidiaries may not make an “extraordinary dividend” until 30 days after the applicable commissioner of insurance has received notice of the intended dividend and has not objected in such time or until the commissioner has approved the payment of the extraordinary dividend within the 30-day period. In most states, an extraordinary dividend is defined as any dividend or distribution of cash or other property whose fair market value, together with that of other dividends and distributions made within the preceding 12 months, exceeds the greater of 10.0% of the insurance company’s surplus as of the preceding year-end or the insurance company’s net income for the preceding year, in each case determined in accordance with statutory accounting practices. In addition, dividends may only be paid from unassigned earnings and an insurance company’s remaining surplus must be both reasonable in relation to its outstanding liabilities and adequate to its financial needs. As of December 31, 2010, the Company’s insurance companies could not pay ordinary dividends to the Company without prior regulatory approval due to a negative unassigned surplus position of Affirmative Insurance Company. Dividend payments of $7.3 million were received from the Company’s insurance company subsidiaries in 2008. In February 2009, the Company obtained approval from the New York Department of Insurance for one of its insurance subsidiaries to retire one million shares of its stock for $2.9 million and approved payment of an extraordinary dividend for $100,000.
The following table identifies the states in which the Company operates and the gross premiums written by state (in thousands):
Where possible, the Company utilizes quoted market prices to measure fair value. For assets and liabilities that have quoted market prices in active markets, the Company uses the quoted market prices as fair value and includes these prices in the amounts disclosed in Level 1 of the hierarchy. When quoted market prices in active markets are unavailable, the Company determines fair values based on independent external valuation information, which utilizes various models and valuation techniques based on a range of inputs including pricing models, quoted market prices of publicly traded securities with similar duration and yield, time value, yield curve, prepayment speeds, default rates and discounted cash flow. In most cases, these estimates are determined based on independent third-party valuation information, and the amounts are disclosed as Level 2 or Level 3 of the fair value hierarchy depending on the level of observable market inputs.
The following table provides information as of December 31, 2009 about the Company’s financial assets and liabilities measured at fair value on a recurring basis (in thousands):
Financial assets classified as Level 1 in the fair value hierarchy include U.S. Government bonds and certain government agencies securities and cash or cash equivalents. These securities are actively traded and the Company estimates the fair value of these securities using unadjusted quoted market prices. Cash and cash equivalents primarily consist of highly liquid money market funds, which are reflected within Level 1 of the fair value hierarchy.
At December 31, 2010, the Company’s Level 3 financial assets include other invested assets related to an investment in a hedge fund and is presented as a separate line item in the consolidated balance sheet. The Company measured the fair value of other invested assets on the basis of the net asset value of the fund as reported by the fund manager.
At December 31, 2009, the Company’s Level 3 financial assets included auction-rate tax-exempt securities. Observable market inputs for certain auction-rate tax-exempt securities that experienced failed auctions as a result of liquidity issues in the global credit and capital market were not readily available. The fair value of these securities was estimated using third-party valuation sources.
Also at December 31, 2009, the Company’s Level 3 financial assets included other receivables related to a settlement agreement with the Company’s broker to liquidate certain of the Company’s auction-rate tax-exempt securities. The settlement agreement required the Company’s broker to purchase eligible securities at par, at any time during a two-year period beginning June 30, 2010. The fair value of this agreement was included in other assets in Level 3 of the fair value hierarchy. As of December 31, 2010, the fair value of the settlement agreement was zero as the Company no longer held any auction-rate tax-exempt securities in its portfolio. All remaining auction-rate securities were redeemed in the fourth quarter of 2010.
Notes payable - The fair values of the notes payable were determined using a third-party valuation source and were estimated to be $24.3 million in the aggregate with a total carrying value of $76.9 million at December 31, 2010.
The Company assigned store operating leases to the purchaser, but remain contingently liable on store leases in the event of default by the assignee. These stores have future lease related payments totaling approximately $0.2 million through August 2012. The Company believes the likelihood of a liability being triggered under these leases is remote, and, therefore, no liability has been accrued for these lease obligations as of December 31, 2010.