The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States requires the Company to make estimates and assumptions that affect the reported amounts of assets and liabilities and the 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. These estimates and assumptions are based on historical experience and various other factors that are believed to be reasonable under the circumstances. Actual results could differ from these estimates under different assumptions or conditions.
The Company believes the following accounting policies are the most critical since these policies require significant judgment or involve complex estimations that are important to the portrayal of the Company's financial position and operating results:
The Company records valuation allowances to reduce the deferred tax assets to the amount that is more likely than not to be realized. While the Company considers taxable income in assessing the need for a valuation allowance, in the event the Company determines it would be able to realize its deferred income tax assets in the future in excess of the net recorded amount, an adjustment would be made and income increased in the period of such determination. Likewise, in the event the Company determines it would not be able to realize all or part of its deferred income tax assets in the future, an adjustment would be made and charged against income in the period of such determination.
Statement of Financial Accounting Standard No. 133, Accounting for Derivative Instruments and Hedging Activities ("SFAS No.133") is effective for all fiscal years beginning after June 15, 2000. SFAS No. 133, as amended, establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. Under SFAS No. 133, certain contracts that were not formerly considered derivatives may now meet the definition of a derivative. The Company adopted SFAS No. 133 effective January 1, 2001. The Company identified one product that meets the definition of a derivative instrument as defined in SFAS No. 133. The identified derivative was formerly accounted for as an insurance contract within the policy liabilities for loss and loss adjustment expenses account in the consolidated balance sheet. At December 31, 2002 the fair value of the derivative instrument has been determined by using a financial model that incorporates market data and other assumptions. Due to the volatility in the marketplace, the Company has suspended marketing of this product effective September 2001.
Investments ----------- During the years ended December 31, 2002 and 2001, net investment income earned was $486,138 and $604,463, respectively. The decrease in investment income is primarily attributed to redemption of bonds to meet the demand of claim payments. Net realized gains for the years ended December 31, 2002 and 2001 were $66,239 and $305,461, respectively. Net realized gains during 2002 and 2001 are a result of gains on bond disposals of $66,239 and $329,360. The gains for 2001 are offset by losses of $23,899 on stock disposals.
Income from Investment in Affiliate ----------------------------------- The earnings of $59,252 and $61,457 for the years ending December 31, 2002 and 2001 represent a 30% equity position the Company holds on a California agency.
Loss and Loss Adjustment Expenses --------------------------------- Loss and loss adjustment reserves have been prepared by consulting actuaries in accordance with accepted actuarial standards for the periods ended December 31, 2002 and 2001. Loss and loss adjustment expenses incurred represent the impact of the large influx of claims CCS experienced during 2002. Losses incurred for the year ended December 31, 2002 was $6,055,043 and represents an increase of $2,811,944 or 86.7% over 2001 losses incurred. The following table reflects the variance in losses incurred:
The increase in direct losses when compared to prior year losses is comprised of primarily contract claims on contractors defaulting under performance and payment bond requirements. CCS encountered unexpected losses on an assumed block of business during 2002 creating incurred losses on that block of business of approximately $1,169,325.
In analyzing the development of large claims, CCS's management has redirected its underwriters to concentrate and focus on new business writings with small contractors and commercial surety business. Effective July 2002, CCS elected to not renew its assumption reinsurance treaties.
Derivative Instruments ---------------------- Upon adoption of SFAS No. 133 Accounting for Derivative Instruments and Hedging Activities effective January 1, 2001, it was determined that CCS has one policy, referred to as the Registered Investment Advisors (RIA) program, deemed a derivative instrument. The RIA program provides specific liability coverage for professional services rendered by registered investment advisors. The insured liability risk arises from written warranties which address minimum performance standards associated with the delivery of risk management program services. The structure of the RIA is based on market value fluctuations and is sold as an insurance policy, with a five-year maturity schedule, guaranteeing a return of the principal amount invested, subject to meeting policy criteria. The Company distributes the policy to "market timer's and has no contract with the individual client. Prior to January 1, 2001, the RIA program was included in the category of loss and loss adjustment expenses on the Consolidated Balance Sheet and Consolidated Statement of Operations. Due to the volatility in the marketplace, the Company suspended marketing of this product effective September 10, 2001.
In prior years, the Company reserved for the derivative at a percentage of the earned premium. In valuing the reserves on the derivative, the Company had no history other than relying on market fluctuation projections which had a history of supporting the actuarial formulas developed when the policy was initially approved by Consulting Actuaries and Florida regulators. At December 31, 2002 and 2001, respectively, the derivative was valued using a growth factor, lapse factor and loss projections before applying a present value factor to ultimately determine the liability to the Company. At December 31, 2002 and 2001, the derivative instrument liability for this policy was set at $4,346,285 and $3,597,782, respectively. The policies began maturing in June of 2002. Claims paid in 2002, net of reinsurance was $184,075. Derivative expense for the periods ended December 31, 2002 and 2001 was $505,816 and $1,060,799, respectively.
Interest Expense ---------------- Interest expense on non-affiliated debt is interest paid to the former owners of The Surety Group and Surety Associates on notes due to agencies the Company purchased in 1995. Interest on affiliated debt represents interest on a note payable to TransCor, a division of KC.
Income Taxes ------------ The Company incurred income tax (benefits) during 2002 and 2001 of $(912,031) and $(75,932), respectively. The company's effective tax rate for 2002 is 36.7% and 26.7% for 2001.
During the years ended December 31, 2001 and 2000, net investment income earned was $604,463 and $576,406, respectively. The return on average invested assets was 6.01% for the year 2001 as compared to 6.28% for the year 2000. The slight decrease in the return is attributed to the decrease in overall interest rates. Net realized gains for the years ended December 31, 2001 and 2000 were $305,461 and $38,381, respectively. Net realized gains during 2001 are a result of gains on bond disposals of $329,360 which is offset by losses of $23,899 on stock disposals. Realized gains in year 2000 are attributed to stock disposals.
Other Income ------------ Other income is earned through an affiliate offering claims consulting services to insurance carriers. Primarily, their services include management, administration and completion of jobs defaulted under surety bonds. Other income for 2001 increased by $200,223 or 15% when compared to the same period in the prior year.
The amount that would be attributed to derivative instruments for the year ended December 31, 2000 is $310,005 and is included in liability for loss and loss adjustment expense reserves.
Derivative Instruments ---------------------- Prior to 2001, the Company reserved for the RIA policy at a percentage of the earned premium. The change in valuation became significant when SFAS No. 133 Accounting for Derivative Instruments and Hedging Activities became effective January 1, 2001.
Income Taxes ------------ The Company incurred income tax (benefit) expense during 2001 and 2000 of $(75,932) and $764,390, respectively. The Company's effective tax rate for the 2001 is 26.7% and 42% for 2000.
Asset Impairment ---------------- In accordance with Statement of Financial Accounting Standard 121 ("SFAS 121"), goodwill and other long-lived assets that were capitalized in conjunction with the purchase of Associates Acquisition Corp., d/b/a Surety Associates, were deemed impaired as of December 31, 2001, and an asset impairment charge of $437,418 was recorded.
The capacity of a surety company to underwrite insurance and reinsurance is based on maintaining liquidity and capital resources sufficient to pay claims and expenses as they become due. Based on standards established by the National Association of Insurance Commissioners (NAIC) and promulgated by the Florida Department of Financial Services, the Company is permitted to write net premiums up to an amount equal to three times its statutory surplus, or approximately $14,204,000 at December 31, 2002. Statutory guidelines impose an additional limitation on increasing net written premiums to no more than 33% of prior year's net written premiums. Under these guidelines, the Company could increase net written premiums by approximately $1,800,000.
Net cash provided by (used in) investing activities was $1,787,211, $(572,432) and $(1,293,487) for the years ended December 31, 2002, 2001 and 2000, respectively. Investing activities consist primarily of purchases, sales and maturities of investments.
Net cash used in financing activities was $(124,322), $(220,570) and $(204,262) for the years ended December 31, 2002, 2001 and 2000, respectively. Financing activities consist primarily of repayments on borrowings and advances to (from) affiliates during 2002, 2001 and 2000.
The following summarizes the Company's contractual cash obligations at December 31, 2002 and the effect such obligations are expected to have on its liquidity and cash flow in future periods.
Payments Due by Period (in thousands) ------------------------------------------ Less than 1-3 4-5 After 5 Total 1 Year Years Years Years ------------------------------------------ Contractual cash obligations: Operating leases .................. $1,345 $ 262 $ 654 $ 365 $ 64 Debt instruments .................. 1,059 676 144 144 95 ------ ------ ------ ------ ------ Total contractual cash obligations $2,404 $ 938 $ 798 $ 509 $ 159 ====== ====== ====== ====== ======
The differences between the December 31, 2002 liability for losses and LAE reported in the accompanying consolidated financial statements in accordance with accounting principles generally accepted in the United States of America ("GAAP") and that reported in the annual statement filed with the state insurance departments in accordance with insurance accounting practices prescribed or permitted by the Florida Department of Financial Services as follows:
Statutory reserves for losses and LAE's (which is net of reinsurance recoverables on unpaid losses and LAE) .......... $ 4,638,870 Reinsurance recoverables on losses and LAE's ................... 4,999,661 Subrogation recoverables on losses and LAE's ................... 1,304,649 Statutory reserve for derivative instrument .................... (2,047,710) ----------- Liability for losses and LAE, as reported in the accompanying GAAP basis consolidated financial statements ................ $ 8,895,470 ===========