We lease space in the office building which houses our principal place of business, located at 3333 Lee Parkway, Suite 1200, Dallas, Texas 75219. The property is in good condition and consists of approximately 40,500 square feet. Our Southeast region leases office space in Miami, Florida of approximately 28,100 square feet and our Southwest region leases office space in Phoenix, Arizona of approximately 1,900 square feet both of which are in good condition. We have no material real estate properties which we own.
The following selected financial data is derived from our audited financial statements for the years ended December 31, 2005, 2004, 2003, 2002, and 2001. You should read selected financial data together with the more detailed information contained in the Financial Statements and associated Notes and Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included elsewhere in this Form 10-K.
Based on 20,225,574 shares of Common Stock outstanding at the end of 2005 and 6,192,148 shares of Common Stock outstanding at the end of 2004, 2003, 2002 and 2001. Outstanding amounts reflect August 2005 rights offering and November 2005 reverse stock split. This assumes redemption occurring on all Series of Preferred Stock. See Note 7 of Notes to Consolidated Financial Statements.
In November, 2005 a one-for-four reverse split of the Company’s common stock, which was approved by shareholders, became effective. See “Capital Transactions - 2005 One-for-Four Reverse Split of Common Stock”.
In August, 2005, GAINSCO, INC. (“the Company”) completed a rights offering which provided capital for additional premium growth. See “Capital Transactions - 2005 Rights Offering”.
In January, 2005 the Company completed a recapitalization transaction that enabled it to pursue a long-term strategic growth plan. See “Capital Transactions - 2005 Recapitalization”.
The Company recorded GAAP combined ratios of 95.2% in 2005, 96.6% in 2004 and 105.1% in 2003. The GAAP expense ratios, included in the GAAP combined ratios, were 27.9%, 27.5% and 30.9%, respectively. The expense and combined ratios do not include the expenses of the holding company.
During its recent transition period, the Company limited its growth by maintaining a ratio of net premiums written to surplus (“leverage”) of approximately 1 to 1, which is below the level at which some competitors operate. The capital restructuring transactions, along with key investments in operations, have permitted management to pursue a more aggressive, geographically diversified expansion plan.
The Company believes it is pursuing a strategy that has the potential to build a substantially larger, competitively distinctive and successful franchise in the nonstandard personal auto business over time and is endeavoring to manage its investments and risks to achieve this result. These risks and other challenges are greater than and different from those to which the Company has previously been subject in writing nonstandard personal auto insurance, however, and we continue to caution that such risks and uncertainties, and our financial results, could potentially alter our business plan in the future.
Gross premiums written in 2005 increased 157% above 2004 which was 27% above 2003. The following table presents gross premiums written by region in thousands of dollars:
The Company recorded net realized capital gains of $73,000, $1,910,000 and $2,050,000 in 2005, 2004 and 2003, respectively. Variability in the timing of net realized capital gains and losses should be expected.
Claims and claims adjustment expenses (“C & CAE”) increased $30,740,000 in 2005 and increased $1,492,000 in 2004. The C & CAE ratio was 67.3% in 2005 versus 69.1% in 2004 and 74.2% in 2003. The decrease in the ratio for 2005 was primarily due to favorable development in estimated ultimate liabilities of approximately $4,600,000 in the runoff lines comprised of a $5,300,000 reduction in commercial auto, an $800,000 reduction in general liability and a $1,500,000 increase in other miscellaneous lines. The decrease in the C & CAE ratio in 2004 was primarily related to favorable development in estimated ultimate liabilities from nonstandard personal auto and the runoff lines. The C & CAE ratio for nonstandard personal auto was 72.6%, 70.1% and 61.9% for 2005, 2004 and 2003, respectively. The increase in this ratio from 2004 to 2005 was primarily due to favorable development in estimated ultimate liabilities in 2004 which recurred at a lower level of magnitude in 2005 than in 2004 and to generally higher ratios on new business. The increase in this ratio from 2003 to 2004 was primarily due to favorable development in estimated ultimate liabilities in 2003 which recurred at a lower level of magnitude in 2004 than in 2003. With regard to environmental and product liability claims, the Company has an immaterial amount of exposure. The Company did not provide environmental impairment coverage and excluded pollution and asbestos related coverages in its policies. A portion of the Company’s remaining claims are related to construction defects. Inflation impacts the Company by causing higher claim settlements than may have originally been estimated. Inflation is implicitly reflected in the reserving process through analysis of cost trends and review of historical reserve results.
Underwriting and operating expenses increased $12,885,000 in 2005 from 2004 and increased $587,000 in 2004 from 2003 primarily due to additional expenses incurred in the infrastructure expansion for increased premium production capability, specifically additional personnel. The increase in 2005 also includes non-cash compensation expense of approximately $1.5 million associated with the grant of restricted shares and restricted share units of Common Stock under the Company’s 2005 Long-Term Incentive Compensation Plan that was approved by shareholders in November, 2005. Underwriting and operating expenses as a percent of Net premiums earned and Other income were 25% for 2005 and 2004 and 27% for 2003.
On January 21, 2005 the Company consummated a recapitalization pursuant to agreements entered into on August 27, 2004 and approved by our shareholders on January 18, 2005. The agreements were with GMSP, then holder of our Series A and Series C Preferred Stock and approximately 5% of our outstanding Common Stock; Robert W. Stallings, the Chairman of the Board and then holder of our Series B Preferred Stock; and First Western Capital, LLC (“First Western”), owned by James R. Reis. The recapitalization substantially reduced, as well as extended, our existing Preferred Stock redemption obligations and resulted in cash proceeds to us of approximately $3.1 million (after approximately $2.2 million in transaction costs and approximately $3.4 million used to redeem the Series C Preferred Stock). The recapitalization was negotiated on our behalf by a Special Committee of the Board comprised of disinterested, independent directors (the “Special Committee”). The events leading up to, and the transactions constituting, the recapitalization are described further in Note (7) to the Company’s Consolidated Financial Statements which appear in Item 8 of this Report. ).
In November, 2005 a one-for-four reverse split of the Company’s Common Stock was approved by shareholders and became effective. Each four shares of the Company’s outstanding Common Stock, par value $0.10 per share were converted into one share of Common Stock, par value $0.10 per share.
At December 31, 2005, the capital base (total assets less total liabilities) of the Company was $73,280,000 and consisted of Shareholders’ Equity of $56,636,000 and Redeemable convertible preferred stock - Series A (“Preferred stock”), which is classified under SEC ASR 268 as mezzanine financing in the aggregate amount of $16,644,000. At December 31, 2005, there was $1,476,000 of unaccreted discount on Preferred stock that remained in Shareholders’ equity. At December 31, 2005, the per common share Shareholders’ equity was approximately $2.80, including unaccreted discount on Preferred stock of $0.07; less such unaccreted discount, the per common share Shareholders’ equity was approximately $2.73 per common share. The aggregate redemption value at December 31, 2005 of the Preferred Stock was $18,120,000 stated value.
In assessing the realization of its deferred tax assets, management considers whether it is more likely than not that a portion or all of the deferred tax assets will be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. In 2001, the Company recorded a valuation allowance against its deferred tax assets. In the first quarter of 2002, the Company announced it was discontinuing the writing of its largest line of business, commercial lines, due to continued adverse claims development and unprofitable results. At that time, the prospects for significant taxable income in personal lines, its only remaining line of business, were unclear. Because the Company had no near-term expectation of taxable income, it was necessary to fully reserve the deferred tax asset due to uncertainty of future taxable income that could utilize this asset.
Currently, on a subjective basis, the Company expects to continue to produce increasing levels of taxable operating income, which provides some positive evidence for potential realization of the deferred tax asset. Positive evidence, such as continued recording of taxable operating income and continued positive expectations for the future could ultimately result in management concluding that it is more likely than not that a portion or all of the deferred tax assets will be realized. Management expects that in the future there will be enough additional positive evidence to conclude that it is more likely than not that a portion or all of the deferred tax assets will be realized. In the fourth quarter of 2005, the company reduced the valuation allowance $3,616,000 as a result of continued increasing levels of taxable operating income and continued positive expectations for the future. As of December 31, 2005, the deferred tax asset was $27,169,000 and the valuation allowance was $23,446,000 and includes 100% of the tax benefits discussed below as of December 31, 2005.
In general, the application of Section 382 is triggered by an increase of more than 50% in the ownership of all of the Company’s currently issued and outstanding stock (determined on the basis of value) by one or more “5% shareholders” during the applicable “testing period” (usually the three year period ending on the date on which a transaction is tested for an ownership change). The determination of whether an ownership change has occurred under Section 382 is made by aggregating the increases in percentage ownership for each 5% shareholder whose percentage ownership (by value) has increased during the testing period. For this purpose, all stock owned by persons who own less than 5% of the Company’s stock is generally treated as stock owned by a single 5% shareholder.
The Company believes that the recapitalization transactions described elsewhere in this Report did not trigger a limitation on the Company’s ability to utilize its loss carryforwards for federal income tax purposes. The recapitalization transactions did, however, result in a substantial ownership shift. Future transactions in Common Stock by the Company or others could affect the Company’s ability to utilize the net operating loss carryforwards.
On September 30, 2005, the Company entered into a credit agreement with a commercial bank providing for term loans of up to $10 million in the aggregate. Proceeds from the term loan advances may be used for working capital. The Company may request advances until September 30, 2007. Interest, payable monthly, will accrue on any outstanding principal balance at a floating rate equal to the 3 month London Interbank Offered Rate plus a margin (initially 2.50%) to be determined by the consolidated net worth of the Company and earnings before interest, taxes, depreciation and amortization for the preceding four calendar quarters. The outstanding principal balance will be payable in equal quarterly installments commencing on October 1, 2007 based on a 60-month amortization schedule, with the balance of the loan payable in full on or before September 30, 2010. The outstanding balance at December 31, 2005 was $500,000.
With regard to liquidity, the average duration of the investment portfolio is approximately 1 year. The fair value of the fixed maturity portfolio at December 31, 2005 was $316,000 below amortized cost, before taxes. Unrealized losses were not material at December 31, 2005 (see Note 2 of Notes to Consolidated Financial Statements). Various insurance departments of states in which the Company operates require the deposit of funds to protect policyholders within those states. At December 31, 2005 and December 31, 2004, the balance on deposit for the benefit of such policyholders totaled $10,386,000 and $10,530,000, respectively.
Net cash provided by operating activities was $13,807,000 for 2005 versus cash used for operating activities of $7,149,000 and $3,051,000 in 2004 and 2003, respectively. The increase of $20,956,000 in cash provided between 2005 and 2004 was primarily attributable to the growth in premium writings in 2005.
Investments and Cash increased in 2005 primarily as a result of positive cash flows from operations and funds raised in the rights offering. At December 31, 2005, 97% of the Company’s investments were rated investment grade with an average duration of approximately 1 year, including approximately 53% that were held in short-term investments. The return on average investments was 3.3%, 2.2% and 2.9% in 2005, 2004 and 2003, respectively. The Company classifies its bond securities as available for sale. The net unrealized loss associated with the investment portfolio was $208,000 (net of tax effects) at December 31, 2005.
Reinsurance balances receivable decreased primarily as a result of a decrease in ceded unpaid C & CAE under the reserve reinsurance cover agreement as a result of settling commercial auto claims in the normal course. An allowance for doubtful accounts of $148,000 has been recorded regarding the collectibility of amounts due, which the Company considers adequate. Balances written off in previous years have been immaterial.
Deferred policy acquisition costs increased primarily as a result of the increase in writings, since these costs vary with the level of premiums writings.
Unearned premiums, Premiums payable and Commissions payable increased primarily as a result of the growth in premium writings, mentioned previously. In 2005 Unearned premiums include the unearned portion of policy fees. Premiums payable are due to a non-affiliated insurance company that the Company uses to write its Texas business. The Company assumes all the premiums, C & CAE, commissions and premium taxes on this book of business from the non-affiliated insurance company and they are paid a fee.
Redeemable preferred stock and Common Stock warrants decreased as a result of the 2005 Recapitalization.
In February, 2006 the Company entered into a Sponsorship Agreement with Stallings Capital Group Consultants, Ltd. dba Blackhawk Motorsports (“Blackhawk”), continuing the Company’s role as the primary sponsor of a Daytona Prototype Series racing team through December 31, 2006. The Sponsorship Agreement provides that, in consideration of the payment by the Company of a sponsorship fee of $1 million, the Company will receive various benefits customary for sponsors of Daytona Prototype Series racing teams, including rights relating to signage on team equipment and access for customers and agents to certain race facilities.
Goodwill represents the excess of purchase price over fair value of net assets acquired. The goodwill recorded is related to the 1998 acquisition of the Lalande Group and reflects a value no more than the estimated fair valuation of combined agency and claims handling operations of this type in the nonstandard personal auto marketplace. Goodwill is subject to an impairment test based on its estimated fair value. Therefore, additional impairment losses could be recorded in future periods.
Currently, on a subjective basis, the Company expects to continue to produce increasing levels of taxable operating income, which provides some positive evidence for potential realization of the deferred tax asset. Positive evidence, such as continued recording of taxable operating income and continued positive expectations for the future could ultimately result in management concluding that it is more likely than not that a portion or all of the deferred tax assets will be realized. Management expects that in the future there will be enough additional positive evidence to conclude that it is more likely than not that a portion or all of the deferred tax assets will be realized. In the fourth quarter of 2005, the company reduced the valuation allowance $3,616,000 as a result of continued increasing levels of taxable operating income and continued positive expectations for the future. As of December 31, 2005, the deferred tax asset was $27,169,000 and the valuation allowance was $23,446,000.
These forward-looking statements reflect our current views, but they are based on assumptions and are subject to risks, uncertainties, and other variables which you should consider in making an investment decision, including, in addition to the terms discussed under “Part I. Item 1A. Risk Factors”, of this document (a) operational risks and other challenges associated with rapid growth into new and unfamiliar markets and states, (b) adverse market conditions, including heightened competition, (c) our ability to adjust and settle the remaining claims associated with our exit from the commercial insurance business on terms consistent with our estimates and reserves, (d) uncertainties in the outcome of pending litigation and adverse trends in litigation and regulation, (e) inherent uncertainty arising from the use of estimates and assumptions in decisions about pricing and reserves, (f) the effects on claims levels resulting from natural disasters and other adverse weather conditions, (g) the availability of reinsurance and our ability to collect reinsurance recoverables, (h) the availability and cost of capital which may be required in order to implement our strategies, and (i) limitations on our ability to use net operating loss carryforwards.
The following Consolidated Financial Statements are on pages 56 through 95:
Consolidated Statements of Operations for the Years Ended December 31, 2005, 2004 and 2003
Consolidated Statements of Shareholders’ Equity and Comprehensive Income (Loss) for the Years Ended December 31, 2005, 2004 and 2003