Gross premiums written is the sum of direct premiums written and assumed premiums written. Direct premiums written is the sum of the total policy premium, net of cancellations, associated with policies underwritten and issued by our insurance subsidiaries. Assumed premiums written is the sum of total premiums associated with the insurance risk transferred to us by other insurance companies pursuant to reinsurance contracts. See Note 7 to our audited consolidated financial statements included in this report.
We seek to attract customers by developing strong brand name recognition in our markets through our television advertising campaigns that emphasize our low down payment, flexible payment plans, convenient neighborhood locations and customer service. Our neighborhood offices serve as a network for both product
selling, general and administrative, or SGA costs, including salaries, advertising, commissions and other expenses of our employee-agent distribution channel reduced by ceding commissions received under our reinsurance agreements; and
We evaluate our operations by monitoring key measures of growth and profitability. We measure our growth by examining our gross revenues, which are comprised of gross premiums written and revenues from all other sources produced through our distribution system. We generally measure our operating results by examining our net income, return on equity, and our loss, expense and combined ratios. In addition, we evaluate our performance by comparing the level of our ancillary income to premiums earned and to operating expenses. The following provides further explanation of the key measures that we use to evaluate our results:
Combined Ratio. Combined ratio is the sum of the loss ratio and the expense ratio and measures a company’s overall underwriting profit. If the combined ratio is at or above 100, an insurance company cannot be profitable without investment income (and may not be profitable if investment income is insufficient). We use the GAAP combined ratio in evaluating our overall underwriting profitability and as a measure for comparison of our profitability relative to the profitability of our competitors.
Insurance Losses and Loss Adjustment Expense Reserves. Insurance loss and loss adjustment expense reserves represent the estimated ultimate net cost of all unpaid reported and unreported losses incurred as of the date of our balance sheet. Estimating our loss and LAE reserves is complex and requires us to make significant judgments and use many assumptions. Months and sometimes years may elapse between the occurrence of an automobile accident covered by one of our policies, reporting of the accident to us and our payment of the claim. We record a liability for estimates of losses that will be paid for accidents that have been reported to us, which we refer to in this report as case reserves. In addition, since accidents are not always reported when they occur, we estimate liabilities for accidents that have occurred but have not been reported to us, which we refer to in this report as incurred but not reported, or IBNR reserves. Our methodology for estimating our insurance losses and loss adjustment expense reserves is essentially the same for each interim reporting period and year-end.
The following table presents the components of our insurance losses and loss adjustment expense reserves by product at December 31:
Case reserves. We use an automated reserving process to establish our case basis reserves for our private passenger automobile insurance business. We developed this program internally to allow our adjusters to focus on processing claims and to standardize the process for setting case reserves. Our actuaries have established a table of standard case reserves based on historical average paid data by state, coverage type, and age of individual claims. These standard case reserves are periodically adjusted to reflect changing trends. At each month end, this program categorizes all open claims by age and coverage in order to generate the appropriate standard case reserve. Claims supervisors have the ability to override the formula reserve and establish a manual reserve for an individually large claim when the exposure has the potential to exceed statutory minimum limits. Case reserves for loss adjustment expenses are not calculated by the automatic reserve program. These reserves are established by our claims adjusters, based on the specific details of each claim.
The actuarial selections of ultimate incurred losses are reviewed by management who gain an understanding of the underlying assumptions and evaluate the overall reasonableness of the loss and LAE ratios by accident year, by state, and by coverage. Our estimate of IBNR reserves is then determined by deducting paid losses to date and case reserves from the projection of ultimate incurred losses.
Our estimation of loss and LAE reserves is subject to variation as a result of factors such as inflation, claims settlement patterns, legislative activity and litigation trends. We make key assumptions regarding future claims emergence, the number of claims to be closed in the future, the future impact of inflation, amounts that may be collected from subrogation or salvage and the number of claims that will be closed with or without payment. Changes in the assumptions we employ, or our estimates associated with such assumptions, could result in materially different amounts being reported as reserves. If necessary, we will increase or decrease the level of our reserves, as our experience develops or new information becomes known, in the period in which we determine changes to our estimates are necessary. Accordingly, our actual losses and loss adjustment expenses may differ materially from the estimates we have recorded. See “Business - Loss and Loss Adjustment Expense Reserves” for additional information.
In selecting the ultimate incurred losses for each coverage within a state, our actuarial staff estimates the ultimate average severity and frequency of claims. As discussed above, these amounts are subject to variation based upon a number of different factors. Historically, we have experienced the most variability in our selections for the personal injury protection coverage in Florida, where there have been a number of changes in the market, regulatory environment, and our claims processing. We typically have the least variability in our selections for the physical damage coverage because these claims are reported and settled quickly. The table below provides a summary, by coverage, of the potential variability in our selections of ultimate average frequency and severity and the potential impact on our loss reserves and pre-tax losses and LAE incurred, gross of reinsurance, as of December 31, 2006:
Premiums include non-standard personal automobile insurance premiums and term life insurance premiums underwritten by our insurance subsidiaries (which we refer to in this report as direct premiums) and a percentage of non-standard personal automobile insurance premiums assumed from other insurers generally in states where we do not currently have a licensed insurance subsidiary (which we refer to in this report as assumed premiums). We refer to direct and assumed premiums together as gross premiums. We manage virtually every aspect of the assumed
business, including pricing and underwriting, claims settlement and customer service. We currently assume a significant portion of non-standard personal automobile insurance premiums for business produced in North Carolina and Texas.
Year Ended December 31, 2006 Compared to Year Ended December 31, 2005. During 2006, gross premiums written increased $2.9 million or 0.6% to $455.9 million from $453.0 million in 2005. Over this same period, gross premiums earned, a function of gross premiums written over the current and prior periods, decreased to $446.5 million from $461.6 million. In 2006, we experienced declines in Florida and Tennessee, two of our core states, and increases in most of our other states. Decreases in gross premium written in Florida and Tennessee totaled $20.2 million, which was offset by increases in our expansion states of $14.3 million and net increases of $8.8 million in the other core states. While competition in the non-standard market has been intense, we believe that we remain very competitive in the market for our core customer as evidenced by our consistent hit ratio (the ratio of policies to quotes). However, we have experienced declines in quote volumes that we largely attribute to increased advertising by the large national carriers.
During 2005, we continued our expansion into Texas with the acquisition of the assets of three independent agencies in January 2005 that provided us with 82 sales offices. We also developed an additional 18 sales offices in Texas. Beginning in March 2005, we started to convert our book of monthly policies in Texas to annual policies and, as of December 31, 2005, approximately 63.5% of the Texas business had been converted. Our broader distribution network, together with our increase in advertising and the conversion to annual policies resulted in a 32.1% increase in Texas premiums during 2005.
Year Ended December 31, 2006 Compared to Year Ended December 31, 2005. Net premiums written increased 14.4% to $458.5 million in 2005 from $400.6 million in 2005. The ratio of net premiums written to gross premiums written increased to 100.6% in 2006 from 88.4% in 2005 as a result of the higher gross premiums written and the elimination of quota share reinsurance in 2006. Net premiums earned, a function of net premiums written over the current and prior periods, increased to $424.8 million in 2006 from $404.1 million in 2005.
The decrease in commission and service fee income can be attributed to a $1.7 million reduction in fees earned for the administration of our assumed business in Texas due to the Company’s decision to write more of its Texas business through one of its own insurance subsidiaries as opposed to a third party insurer. This change caused a corresponding reduction in operating expenses as assumed reinsurance commissions also decreased by $1.7 million. The decrease was offset by a $0.6 million increase in revenues from our consumer products, including our Direct prepaid Visa program and Direct Cash Advance.
For the year ended December 31, 2006 and 2005, the ratio of ancillary income to gross premiums earned was 20.0% and 19.8%, respectively, and the ratio of ancillary income to operating expenses was 53.5% and 64.3%, respectively.
Year Ended December 31, 2006 Compared to Year Ended December 31, 2005. Gross gains on debt securities for the year ended December 31, 2006 were $0.5 million, which were more than offset by gross losses of $0.9 million. The sale of certain debt securities during the year were primarily driven by adjustments to the portfolio as we repositioned our bond portfolio based on our investment guidelines for changes in market conditions, interest rate environment and other factors. Comparatively, in 2005, we realized gross gains on debt securities of $0.2 million, which were more than offset by gross losses of $1.2 million,
Insurance losses and loss adjustment expenses represent our largest expense item and include payments made to settle claims, estimates for future claim payments and changes in those estimates for current and prior periods, as well as loss adjustment expenses incurred in connection with settling claims. Insurance losses and loss adjustment expenses are influenced by many factors, such as claims frequency and severity trends, the impact of changes in estimates for prior accident years, and increases in the cost of medical treatment and automobile repairs among other factors. The anticipated impact of inflation is considered when we establish our premium rates and set loss reserves. We perform an actuarial analysis each quarter and establish or adjust (for prior accident quarters) reserves, based upon our estimate of the ultimate incurred losses and loss adjustment expenses to reflect loss development information and trends that have been updated for the most recent quarter’s activity. Each quarter our estimate of ultimate loss and loss adjustment expenses is evaluated by accident quarter, by state and by major coverage grouping (e.g., bodily injury, personal injury protection, property damage, and physical damage) and changes in estimates are reflected in the period the additional information becomes known.
During 2006, we decreased our estimate of incurred losses for prior accident years by approximately $0.3 million. This nominal amount of favorable development was primarily comprised of favorable development for PIP in Florida and, to a lesser extent, bodily injury in both Tennessee and Texas that were largely offset by approximately $1.2 million in adverse development in Louisiana and approximately $0.5 million of adverse development in Mississippi. The favorable development in Florida PIP was generally related to the 2005 accident
year and was driven by a 3.1% reduction in ultimate expected frequency and a 2.7% reduction in average severity. Much of this improvement is attributable to our improved claims settlement processes and the elimination of new business in the Miami market. The adverse development in Louisiana included increases in expected frequency and severity for all coverages largely related to the 2005 accident year while the development in Mississippi was primarily related to the bodily injury and property damage coverages. Comparatively, we increased our estimate of incurred losses for prior accident years by approximately $6.8 million in 2005, which resulted in a 1.7 point increase in our 2005 loss ratio.
Reserve Analysis. We perform an actuarial analysis of our loss reserves each quarter, which encompasses an analysis of expected ultimate frequency and severity by accident quarter for all coverages and states in which we operate. Our estimate of ultimate expected losses for the 2005 accident year included an 11.9% decrease in the expected ultimate frequency of PIP claims as compared to the 2004 accident year, which we believe is supported by the new loss trends that exclude the impact of claims from Miami market where we ceased issuing new business policies in October 2004. Our estimate of expected ultimate severity for PIP remained fairly constant with the prior year. We also continued to experience a slight decline in the frequency for bodily injury and property damage claims, which is generally consistent with the trends in the non-standard insurance market.
We have taken a number of actions to improve our overall loss trends in Florida and address the sources of adverse loss reserve development. In October 2004, we ceased writing new business policies in the Miami market due to the high levels of fraudulent activity, which has improved our Florida loss experience and reduced some of the volatility in our underlying claims data. During 2005, we replaced a third party bill review system that we had been using in our personal injury protection unit to identify duplicate medical bills and charges for medical procedures that did not correspond with the diagnosis, with an internally developed program that essentially performs the same review. By eliminating the outside vendor, we have been able to expedite the settlement process while saving the cost of the service and reducing interest costs. We also reinforced our claims closure guidelines to reduce the number and amount of post-closing payments on property damage claims by keeping those files, which have been specifically identified as having the potential for subrogation payments, open for a longer period of time. Finally, we continued to refine our actuarial reserving methodology for personal injury protection claims that started as part of our fourth quarter 2004 review. We believe that these changes have enabled us to expedite the settlement process, reduce certain loss adjustment expenses, and provide a more refined set of data to be used in our loss reserve analysis.
our largely fixed cost neighborhood sales offices staffed by company employees, which results in only marginal increases in operating expenses as we increase our premiums and other revenues.
Year Ended December 31, 2006 Compared to Year Ended December 31, 2005. Operating expenses increased 17.8% to $167.1 million for the year ended December 31, 2006 from $141.9 million in 2005. In an effort to generate additional revenues, we increased our advertising expenses by $9.8 million, with approximately one-half of this increase attributable to our expansion states. Non-advertising expenses in our expansion states of Texas, Missouri, and Virginia increased $2.4 million due to the additional number of offices being in operation, on average throughout the year. In an effort to rein in these costs, we closed 13 underperforming offices in Texas during the fourth quarter of 2006.
We file a consolidated federal income tax return that includes all of our subsidiaries other than our two life insurance subsidiaries, which file separate federal income tax returns. The statutory rate used in calculating our tax provision was 35% and our effective tax rates for the years ended December 31, 2006, 2005 and 2004 were 37.8%, 37.5%, and 36.6%, respectively.
Income tax expense differed from the amounts computed at the statutory rate as demonstrated in the following table:
Our operating subsidiaries’ primary sources of funds are premiums received, finance income, commission and service fee income, investment income, borrowings under credit facilities and proceeds from the sale and redemption of investments. Funds are used to pay claims and operating expenses, to pay interest and principal repayments under the terms of our indebtedness for borrowed money, to purchase investments and to pay dividends to Direct General Corporation. We had positive cash flow from operations of approximately $58.4 million in 2006, $61.1 million in 2005 and $67.0 million in 2004. We expect our cash flows to be positive in both the short-term and reasonably foreseeable future.
Capital Raising - Trust Preferred Securities. In September 2005, Direct General Statutory Trust I (“DGST I”), a wholly owned unconsolidated subsidiary trust of the Company, issued 40,000 shares of preferred securities at $1,000 per share to outside investors and 1,238 shares of common securities to the Company, also at $1,000 per share. The sole assets of DGST I are $41.2 million of junior subordinated debentures issued by the Company. The debentures will mature on September 15, 2035 and are redeemable by the Company in whole or in part beginning on September 15, 2010, at which time the preferred securities are callable. The debentures pay a fixed rate of 7.915% until September 15, 2010, after which the rate becomes variable.
Approximately $20.0 million of the proceeds from the issuance of the trust preferred securities were used for the stock repurchase program. The remainder, which was used to temporarily reduce the amount outstanding under the premium finance revolving credit facility, will ultimately be used for general corporate purposes including, but not limited to, pursuit of the Company’s growth and operating strategy, stock repurchases and/or other general corporate purposes.
Premium Finance Revolving Credit Facility. Our premium finance operations are supported by a revolving credit agreement with a group of banks. The size of the facility was $180.0 million, of which $143.0 million was outstanding at December 31, 2006, and it has a maturity of June 30, 2009. We would expect to continue the practice of periodically increasing the size of the facility to support the growth in premiums, however, there is the risk that our attempt to increase this revolving credit line facility would not be successful, in which case we would be forced to seek alternative methods of financing premiums. The loan is principally secured by the premium finance receivables.
Our premium finance subsidiaries utilize the revolving credit facility by drawing on the facility at the end of every month to settle amounts due to the insurance companies. As payments from our customers are received, the revolving credit facility is reduced over the course of the month. This cycle repeats itself monthly, with historically, some seasonal fluctuation on total amounts drawn at the end of each month.
In an effort to manage our interest rate risk related to our premium finance revolving credit agreement, effective November 1, 2001, we purchased a derivative instrument known as a zero-cost collar from JP Morgan Chase Bank, NA. This derivative instrument requires monthly settlements whereby we pay the difference to the extent the then current 30-day LIBOR rate is below the floor of 5.05% on $25 million and receive the excess of the 30-day LIBOR rate over the cap of 5.05% on $50 million. This derivative instrument was designed to reduce our exposure to changes in LIBOR under our bank loan facilities. Payments associated with the floor were $0.4 million and $0.9 million for the years ended December 31, 2005 and 2004, respectively, and were reported in the income statement as interest expense. This derivative instrument terminated on November 1, 2005.
For the year ended December 31, 2006, there were no repurchases of common stock, and the Company received $0.6 million from the exercise of employee stock options. During 2006, we had net payments under our premium finance revolving credit facility of $7.0 million and net proceeds of $1.4 million of principal associated with other notes and capital lease obligations. Interest paid on outstanding indebtedness totaled $8.5 million and dividends paid on common stock were $3.4 million for the year.
The obligations under the premium finance revolving credit facility, other notes payable, and debentures payable include both principle and related interest. The estimated loss and loss adjustment expense payments under policies of insurance represents the estimated payout of our loss and loss adjustment expense reserve liabilities.
These amounts are presented gross of reinsurance ceded because we remain contractually obligated to our policyholders in the event that our reinsurers do not meet their obligations. The timing and amount of these estimated payments may vary significantly from the above estimates.
We cede premiums and losses to unaffiliated insurance companies under quota share, excess of loss and catastrophe reinsurance agreements. We evaluate the financial condition of our reinsurers and monitor various credit risks to minimize our exposure to losses from reinsurer insolvencies. However, we remain obligated for amounts ceded in the event that the reinsurers do not meet their obligations. The failure of one of our reinsurers to pay could have an adverse effect on our capital and our financial condition and results of operations. In order to mitigate this risk, our reinsurance program is designed to reduce our exposures to unsecured reinsurance recoverables by settling reinsurance premiums on an earned basis versus a written basis, requiring our reinsurers to fund a trust account in the event of a rating downgrade by A.M. Best, and limiting the maximum participation by any one reinsurer.
Investment Strategy. We believe that our investment portfolio is highly liquid and consists substantially of readily marketable, investment-grade debt securities. We currently do not invest in equity securities or securities with exposure to foreign currency risk. Bank One Investment Advisors and U.S. Bancorp Asset Management provide our investment portfolio management advisory services. These advisors operate under investment guidelines approved by our investment committee. These guidelines emphasize:
Debt Securities. Our investment portfolio consists primarily of debt securities, all of which are classified as available for sale and are carried at fair value with unrealized gains and losses reported in our financial statements as a separate component of shareholders’ equity on an after-tax basis. As of December 31, 2006, the net unrealized loss on the fixed maturity portfolio was $5.5 million, comprised of gross unrealized gains of $1.6 million and gross unrealized losses of $7.1 million. At December 31, 2005, the net unrealized loss on the fixed maturity portfolio was $7.2 million, comprised of gross unrealized gains of $0.7 million and gross unrealized losses of $7.9 million. The decrease in net unrealized losses during 2006 was generally attributable to changes in the interest rate environment and not due to deterioration of the credit quality of the portfolio.
The Securities Valuation Office of the NAIC evaluates the bond investments of insurers for regulatory reporting purposes and assigns securities to one of six investment categories called “NAIC designations”. The NAIC designations generally parallel the credit ratings of the nationally recognized statistical rating organizations for marketable bonds. NAIC designations 1 and 2 include bonds considered to be investment grade, which are those rated “BBB-” or higher by Standard & Poor’s (“S&P”), a division of The McGraw-Hill Companies, Inc. NAIC designations 3 through 6 include bonds considered to be below investment grade, rated “BB+” or lower by S&P.
Based upon our analysis, we believe that we will recover all contractual principal and interest payments related to those securities that currently reflect unrealized losses and that we have the ability and intent to hold these securities until they mature or recover in value. Should either of these beliefs change with regard to a particular
security, a charge for impairment would likely be required. While it is not possible to accurately predict if or when a specific security will become impaired, charges for other than temporary impairment could be material to our results of operations in a future period. Management believes it is not likely that future impairment charges will have a significant effect on our liquidity.
As of December 31, 2006, cash and investments carried at fair value totaling approximately $16.0 million were on deposit with state insurance regulatory authorities. Additionally, investments carried at fair value totaling approximately $3.5 million had been pledged to an unaffiliated insurer to secure our assumed reinsurance obligations.
Cash and Cash Equivalents. Our balance in cash and cash equivalents was $74.8 million and $64.5 million as of December 31, 2006 and 2005, respectively. At December 31, 2006, cash and cash equivalents totaling approximately $9.0 million were held in reinsurance security trust accounts for the benefit of certain unaffiliated insurers in order to secure our assumed reinsurance obligations.
Some of the statements under the captions “Risk Factors”, “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, “Business” and elsewhere in this report constitute forward-looking statements. You can identify these statements from our use of the words “may”, “should”, “could”, “potential”, “continue”, “plan”, “forecast”, “estimate”, “project”, “believe”, “intend”, “anticipate”, “expect”, “target”, “is likely”, “will”, or the negative of these terms, and similar expressions. These statements are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. These forward-looking statements may include, among other things:
The Company’s management carried out an evaluation, with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of its internal control over financial reporting as of December 31, 2006. The framework on which such evaluation was based is contained in the report entitled “Internal Control-Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission (the “COSO Report”). Based upon the evaluation described above under the framework contained in the “COSO Report”, the Company’s management concluded that the Company’s internal control over financial reporting was effective as of December 31, 2006.
Ernst & Young LLP, the Company’s independent registered public accounting firm has audited the financial statements presented in this Form 10-K. Ernst & Young LLP has also audited the effectiveness of the Company’s internal control over financial reporting and management’s assessment of that effectiveness as of December 31, 2006, as stated on their report included on the following page of this Form 10-K.
In our opinion, management’s assessment that Direct General Corporation and Subsidiaries maintained effective internal control over financial reporting as of December 31, 2006, is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, Direct General Corporation and Subsidiaries maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on the COSO criteria.
As discussed in Note 1 to the consolidated financial statements, the accompanying consolidated balance sheet as of December 31, 2005 and statement of shareholders’ equity as of December 31, 2005 and 2004 have been restated for an adjustment for unearned policy fees.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Direct General Corporation and Subsidiaries’ internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 14, 2007 expressed an unqualified opinion thereon.
Direct General Corporation, headquartered in Nashville, Tennessee, is a financial services holding company whose principal operating subsidiaries provide non-standard personal automobile insurance, term life insurance, premium finance and other consumer products and services primarily on a direct basis and primarily in the southeastern United States. Direct General Corporation owns five property/casualty insurance companies, two life/health insurance companies, two premium finance companies, twelve insurance agencies, two administrative service companies and one company that provides non-insurance consumer products and services. Direct General Corporation and its subsidiaries are sometimes collectively referred to herein as the “Company.”
The accompanying consolidated financial statements include the accounts of Direct General Corporation and subsidiaries (collectively referred to as the Company or Direct General). These financial statements have been prepared in accordance with accounting principles generally accepted in the United States (GAAP). All intercompany accounts and transactions have been eliminated.
Short-term investments, which are carried at cost, include investments in commercial paper, certificates of deposit, and other interest-bearing time deposits with original maturities of more than three months to one year. In addition, short-term investments include a trading portfolio, which consists primarily of futures contracts, swaps, and other derivative instruments. The trading portfolio represents a speculative investment and does not represent a hedge; accordingly, all contracts are marked to market with the change in market values reported as net realized gains (losses) on securities and other in the Company’s consolidated statements of operations.
Goodwill represents the amount by which the cost of acquired net assets exceeds their related fair value. Other intangible assets includes the costs of specifically identifiable intangible assets, primarily licenses. In accordance with Financial Accounting Standards No. 142, the carrying value of goodwill and other intangible assets is reviewed annually or whenever events or changes in circumstances indicate that the carrying amount might not be recoverable. If the fair value of the operations to which goodwill relates is less than the carrying amount of those operations, including unamortized goodwill, the carrying amount of goodwill is reduced accordingly with a charge to expense. Based on its most recent analysis, the Company believes that no impairment of goodwill and other intangible assets exists at December 31, 2006.
During 2006, the Company corrected its accounting for unearned policy fees as of January 1, 2004 and restated the relevant December 31, 2005 balance sheet amounts. In prior years, the impact of the unearned policy fee calculation difference was not material. However, this difference became material in 2006 because of the decline in operations. The impact of the adjustment on the statement of operations for any of the years presented was not material.
The following is a summary of the line items impacted by the restatement of the December 31, 2005 balance sheet:
The amortized cost and fair value of debt securities available-for-sale at December 31, 2006, by contractual maturity, is shown below:
Depreciation expense was approximately $6,948,000, $6,602,000 and $5,601,000 in 2006, 2005 and 2004, respectively.
During April 1998, the Company entered into a sale and leaseback transaction of its building located in Baton Rouge, Louisiana. The gain of $1,068,000 is being amortized over the term of the lease. At December 31, 2006 and 2005, the unamortized portion of the deferred gain was $136,000 and $242,800, respectively, and is included as a component of other liabilities. The building under capital lease was capitalized using the Company’s average borrowing rate at inception of the lease. Depreciation expense on the capitalized building lease was $769,000 during 2006 and $636,000 during 2005 and 2004, and related accumulated depreciation on the building under capital lease was approximately $5,542,000 and $4,773,000 at December 31, 2006 and 2005, respectively.
The following table provides a reconciliation of insurance loss and loss adjustment expense (LAE) reserves, net of reinsurance recoverables:
The Company’s net loss and LAE reserve development was primarily attributable to revisions to the Company’s estimate of ultimate frequency and severity trends. While development in 2006 was negligible, in 2005, approximately $5,800,000 of the unfavorable development was related to our Florida business, generally attributable to higher than expected severity trends on personal injury protection and property damage coverages. In 2004, approximately $4,500,000 of the unfavorable development was related to our Florida business and approximately $1,100,000 was related to Tennessee. The Florida development was largely attributable to increases in expected frequency and severity trends related to the personal injury protection and property damage coverages while the Tennessee development was generally evenly split between increases to expected bodily injury frequency trends and increases to the expected average severity of property damage claims.
The Company is exposed to natural catastrophes such as hurricanes, earthquakes, and hailstorms. While the Company’s results from operations would be negatively impacted by a major catastrophe, the Company maintains catastrophe insurance that limits its exposure to such events. The Company is generally not exposed to asbestos and environmental claims since it writes only personal automobile and life insurance.
In December 2004, the Company entered into a $30,000,000 revolving credit facility with a consortium of banks. Under the terms of the credit facility the Company may periodically obtain advances until June 30, 2007. Interest is payable quarterly at a rate elected by the Company of either the base commercial rate of First Tennessee Bank, N.A., as “Agent”, or at 2.5% above LIBOR. Principal payments begin 18 months after advances under the credit facility reach $10,000,000 and will be determined based upon a five-year amortization schedule. The credit facility matures on June 30, 2007, with all remaining principal and interest payments being due at that time. There were no amounts outstanding under this facility as of December 31, 2006 or 2005.
Aggregate principal payments due on debt outstanding at December 31, 2006 is as follows:
The Company assumed, under quota-share reinsurance agreements, a percentage of personal automobile insurance produced for other insurers (see Note 8). As of December 31, 2006, the Company provided an unsecured letter of credit in the amount of $4,000,000, pledged investments totaling $3,485,000, and provided reinsurance security trust accounts totaling $6,465,000 for the benefit of certain unaffiliated insurers with respect to its obligations under the assumed reinsurance agreements.
On April 29, 1996, the shareholders of Direct General Corporation approved the 1996 Employee Stock Incentive Plan (the “1996 Plan”). Under the 1996 Plan, incentive stock options and nonqualified stock options were granted. Exercise provisions varied, but most options are exercisable, in whole or in part, beginning six months after grant and ending ten years after grant. In April 2003, upon approval of the 2003 Plan, no further awards could be granted under the 1996 Plan.
As of December 31, 2006, the weighted average remaining contractual life of options outstanding under both plans is approximately seven years.
A summary of the status of the Company’s stock option plans as of December 31, 2006, 2005 and 2004, and changes during the years ending on these dates is as follows:
The Company has historically used and plans to continue to use stock options as a component of its overall compensation to employees. The Company may grant incentive stock options that qualify for certain favorable tax treatment under Section 422 of the Internal Revenue Code of 1986. It may also grant stock options that do not qualify for such favorable tax treatment. The Company grants employee incentive stock options at an exercise price equal to the market price at the date of grant.
Prior to the adoption of the provisions of this statement, the Company followed the provisions of Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees,” to account for its employee stock option activity in the financial statements.
If the accounting for compensation expense based on the fair value of stock options at the grant date as prescribed by SFAS No. 123 would have been in effect for prior periods, net income available to common shareholders and basic and diluted earnings per share would have been reported as presented in the following table.
The Company uses the Black-Scholes pricing model to calculate the fair value of the options awarded as of the date of grant based on the following factors:
As of December 31, 2006, shares of common stock have been reserved for the following:
The Company has designated both of these derivative instruments as cash flow hedges in accordance with Statement of Financial Accounting Standards (SFAS) No. 133, “Accounting for Derivative Instruments and Hedging Activities” as subsequently amended by SFAS No. 138, “Accounting for Certain Derivative Instruments and Certain Hedging Activities - an amendment of SFAS No. 133”. The credit risk associated with these contracts is limited to the uncollected interest payments and the fair market value of the derivative to the extent it has become favorable to the Company.
The Company leases various office space and equipment. Total rent expense was approximately $13,561,000, $11,594,000 and $7,786,000 in 2006, 2005 and 2004, respectively. Approximate future minimum lease commitments for leases having an initial or remaining term of more than one year are as follows at December 31, 2006:
Baton Rouge Facility. The Company currently leases a facility in Baton Rouge, Louisiana for its administrative and customer service center. This lease is scheduled to mature in April 2008. The Company plans to expand its administrative and customer service operations to support its future growth and, in conjunction with these plans, the Louisiana Local Government Environmental and Community Development Authority (“Authority”) will construct a new facility (“Facility”) and the Company will, in turn, lease the Facility from the Authority. On October 29, 2004, the Company and certain of its subsidiaries invested $10,000,000 in Louisiana Taxable Lease Revenue Bonds (“Bonds”) in order to provide the Authority with funds to finance the acquisition of land and the construction of the Facility. Under the terms of the agreements, the ownership of the Facility will transfer to the Company and the lease will expire upon the full repayment of all principal and interest related to the Bonds, which
have a scheduled maturity of June 1, 2024. Construction of the Facility began in the summer of 2006 and is expected to be completed by the end of 2007.
The following methods and assumptions are used by the Company in estimating the fair value disclosures for financial instruments:
Quarterly results of operations for 2006 and 2005 are summarized as follows:
In September, 2005, the AICPA has issued Statement of Position (“SOP”) 05-1, Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection with Modifications or Exchanges of Insurance Contracts. This SOP provides guidance on accounting by insurance enterprises for deferred acquisition costs on internal replacements of insurance and investment contracts other than those specifically described in FASB Statement No. 97, Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments. The provisions in SOP 05-1 are effective for internal replacements occurring in fiscal years beginning after December 15, 2006. The Company does not expect that the adoption of SOP 05-1 will have a material impact on the financial statements of the Company.
On March 6, 2007, we and the other defendants in the consolidated federal shareholder derivative action entered into a Memorandum of Understanding (“March 6th MOU”) with the Plaintiffs in that action. Pursuant to the terms of the March 6th MOU, the defendants will pay an award of attorney’s fees and expenses of $675,000, and the federal derivative action, and related state derivative and state class actions, claims will either be voluntarily dismissed with prejudice, or the parties in the federal derivative litigation will take such action as is necessary to have such claims dismissed with prejudice. Neither we nor any other defendant in these actions has admitted any liability or fault. The parties also are negotiating terms that would provide the plaintiffs with certain benefits if Elara sells or divests Direct General Corporation within a certain time after the Elara Merger closes. The settlement is subject to several conditions, including approval by the court in which the federal litigation is pending.