Implementation of multiple rate increases in most markets to attempt to strengthen pricing adequacy while maintaining desirable business segments;
Upgrade of claims systems, procedures and personnel, including practices intended to accelerate the recognition and resolution of exposure throughout the claims process, from initial recording of claims to their ultimate resolution;
The Company reported a net loss of $3.5 million for the year ended December 31, 2008, compared with net loss of $18.6 million for the year ended December 31, 2007. In 2008, the Company recorded net realized losses of approximately $6.3 million, approximately $5.7 million related to write downs for other-than-temporary declines in fair value of various investments including $4.0 million from auction preferred securities backed by preferred stock of the Federal National Mortgage Association (“Fannie Mae”) and the Federal Home Loan Mortgage Corp. (“Freddie Mac”). Net premiums earned were $176.6 million and $192.8 million in 2008 and 2007, respectively, and gross premiums written were $181.8 million and $184.9 million in 2008 and 2007, respectively.
(2) The Expense and Combined ratios do not reflect expenses of the holding company which include interest expense on the note payable and subordinated debentures.
The Company believes it is pursuing a strategy that has the potential to build a 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, occurring in rapidly changing economic, financial, competitive, regulatory and claims environments, are greater than and in some cases different from those to which the Company previously was subject in writing nonstandard personal auto insurance. The Company’s operating and financial results vary from period to period as a result of numerous factors inherent in the insurance business, many of which are affected by such changes.
On February 7, 2002, the Company announced its decision to cease writing commercial insurance due to continued adverse claims development and unprofitable results. The discontinuance of writing commercial lines resulted in the Company ceasing to be approved to write insurance in several states; however, this state action has not materially restricted the geographic expansion of the Company’s nonstandard personal auto lines thus far.
The Company continues to settle and reduce its inventory of commercial lines claims. At December 31, 2008, there were 30 claims associated with the Company’s runoff book outstanding, compared to 47 as of December 31, 2007. As of December 31, 2008, in respect of its runoff lines, the Company had $7.1 million in net unpaid claims and claim adjustment expenses (“C & CAE”) compared to $10.3 million as of December 31, 2007. For the periods presented, the Company has recorded favorable development in unpaid C & CAE from the runoff lines with the settlement and reduction in the inventory of commercial lines claims. See “Results of Operations - Claims and claim adjustment expenses.” Due to the long tail and litigious nature of these claims, the Company anticipates it will take a substantial number of years to complete the adjustment and settlement process with regard to existing claims and the additional claims it expects to receive in the future from its past business writings. Most of the remaining claims are in suit and the Company’s future results may or may not be impacted either negatively or positively based on its ability to settle the remaining claims and new anticipated claims within its established reserve levels.
Each of the regions, except for Southeast, recorded premium declines in 2008 from 2007. The percent of premium (decrease) increase by region for 2008 from 2007 is as follows: Southeast 8%, South Central (9)%, Southwest (16)% and West (41)%. In the Southeast region, we believe product enhancements, rate adjustments and expanded marketing efforts accounts for the increase in gross premiums written. Net premiums earned decreased 8% in 2008 from 2007 primarily as a result of gross premiums written in the first six months of 2008 being 9% below the comparable period in 2007.
Agency revenues decreased $334,000 (3)% in 2008 primarily as a result of the decrease in writings in 2008. Agency revenues are primarily fees charged on insureds’ premiums due, as discussed previously.
Claims and claim adjustment expenses decreased $27,962,000 (18%) in 2008 and the C & CAE ratio was 73.3% in 2008 versus 81.7% in 2007. The runoff lines recorded favorable development for prior accident years of approximately $1,421,000 and $2,315,000 during 2008 and 2007, respectively. The C & CAE ratio for nonstandard personal auto was 74.2% and 82.9% for 2008 and 2007, respectively. The decrease in the C & CAE ratio was primarily due to less unfavorable development for claims occurring in prior accident years of approximately $4,385,000 in 2008 versus $16,043,000 in 2007. Also contributing to the lower C & CAE ratio was improvement in 2008 accident year as compared the 2007 accident year. The following presents the unfavorable development for claims occurring in prior accident years for each of the three major regions during 2008:
GAN provides administrative and financial services for its wholly owned subsidiaries. GAN needs cash during 2009 primarily for administrative expenses and interest on the Subordinated debentures and the Note payable. GAN has approximately $3.4 million in cash and marketable securities that can be used for general corporate purposes. Another source of cash to meet obligations is statutorily permitted dividend payments from its insurance subsidiary, which requires approval from the Texas Department of Insurance (see note 11 to Consolidated Financial Statements which appears in Item 8 of this Annual Report. For 2008, cash dividends of $5.0 million were paid to GAN. GAN believes the cash available from its short-term investments and dividends from its insurance subsidiary, if permitted, should be sufficient to meet its expected obligations for 2009.
Deferred tax assets are evaluated and a valuation allowance is established if it is more likely than not that all or a portion of the deferred tax asset will not be realized. See note 1(j) “Federal Income Taxes” in Notes to Consolidated Financial Statement appearing under Part 1. Financial Information - Item 1. “Financial Statements” of this Annual Report for further discussion.
As a result of losses in prior years, as of December 31, 2008 the Company had net operating loss carryforwards for tax purposes aggregating $71,953,000. These net operating loss carryforwards of $10,782,000, $33,950,000, $13,687,000, $633,000 and $12,901,000, if not utilized, will expire in 2020, 2021, 2022, 2023 and 2027, respectively. As of December 31, 2008, the tax benefit of the net operating loss carryforwards was $24,464,000, which is calculated by applying the Federal statutory income tax rate of 34% against the net operating loss carryforwards of $71,953,000.
Investments and Cash increased in 2008 primarily as a result of cash from operations offset by the decline in fair value of the investment securities. At December 31, 2008, 66% of the Company’s investments were rated investment grade. The average duration was approximately 2.0 years, including approximately 38% of the Investments that were held in Short-term investments. The Company classifies its bond securities as available for sale. The net unrealized loss associated with the investment portfolio was $4,839,000 (net of tax effects) at December 31, 2008 (see note 2 of Notes to Consolidated Financial Statements which appear in Item 8 of this Annual Report).
Premiums receivable increased primarily due to the increase in premium writings for the six months ended December 31, 2008 over the six months ended December 31, 2007. This balance is comprised primarily of premiums due from insureds. Most of the policies are written with a down payment and monthly payment terms of up to four months on six month policies. The Company recorded an allowance for doubtful accounts of $1,029,000 and $569,000 as of December 31, 2008 and 2007, respectively, which it considers adequate. The increase in the allowance for doubtful accounts was due primarily to an increase in over thirty day receivables.
Deferred policy acquisition costs are principally commissions, premium taxes, marketing expenses and some underwriting expenses which are deferred. The increase of $674,000 in 2008 from 2007 was primarily due to the amortization in 2008 of a $623,000 premium deficiency that was previously recorded in 2007 for expected underwriting losses on the South Central business. The premium deficiency amortized to zero as a result of significant improvement in the expected C & CAE ratio in the South Central region.
Deferred Federal income taxes include temporary differences and the tax asset from net operating loss carryforwards less a valuation allowance that fully reserves these two items, see “Liquidity and Capital Resources - Net Operating Loss Carryforwards.” The increase is primarily due to the increase in unrealized losses on investments, excluding common stocks.
Index to Financial Statements Funds held under reinsurance agreements decreased primarily due to the release of amounts held in trust by the New York Insurance Department for the benefit of policyholders of General Agents. Under the terms of the sale, General Agents returned these amounts to the Company when they were released by the insurance department.
Unpaid C & CAE increased primarily as a result of unfavorable development recorded for the nonstandard personal automobile lines, which were offset with favorable development from the runoff lines. As of December 31, 2008, the Company had $73,077,000 in net unpaid C & CAE (Unpaid C & CAE of $75,482,000 less Ceded unpaid C & CAE of $2,405,000). This amount represents management’s best estimate of the ultimate liabilities. The significant operational changes we have recently made in the nonstandard personal auto claims adjustment process and changing claims trends increase the uncertainties which exist in the estimation process and could lead to inaccurate estimates of claim and claim adjustment expense.
As of December 31, 2008 and 2007, in respect of its runoff lines, the Company had $7,118,000 and $10,275,000, respectively, in net unpaid C & CAE. Historically, the Company has experienced significant volatility in its reserve projections for its commercial lines. This volatility has been primarily attributable to its commercial automobile and general liability product lines. On February 7, 2002, the Company announced it had decided to discontinue writing commercial lines insurance due to continued adverse claims development and unprofitable results. The Company has been settling and reducing its remaining inventory of commercial claims. See “Business Operations-“Discontinuance of Commercial Lines.” As of December 31, 2008, 30 runoff claims remained versus 47 at December 31, 2007. The average runoff claim reserve was approximately $237,000 per claim and $219,000 per claim at December 31, 2008 and December 31, 2007, respectively.
Unearned premiums increased primarily as a result of the increase in premium writings for the six months ended December 31, 2008 over the six months ended December 31, 2007, mentioned previously.
Premiums payable, Commissions payable and Reinsurance balances payable all decreased due to a fronting reinsurance arrangement that was reducing throughout 2008.
Other liabilities increased primarily due to unearned interest income on an investment security purchased in the first quarter of 2008. Under the terms of this security the Company has received all of the interest income and will recognize it over the life of the security.
Index to Financial Statements Accumulated deficit increased due to the net loss which occurred as a result of the net realized losses recorded in 2008.
Accumulated other comprehensive loss increased as a result of an increase in the unrealized losses on investments, which is a result of the activity in the credit markets discussed previously.
The Company’s statutory capital exceeds the benchmark capital level under the Risk Based Capital formula for its insurance company. Risk Based Capital is a method for establishing the minimum amount of capital appropriate for an insurance company to support its overall business operations in consideration of its size and risk profile.
Investments are stated at fair value and are based on prices quoted in the most active market for each security, the fair value of comparable securities, discounted cash flow models or similar methods with changes in fair value recorded as a component of comprehensive income. The “specific identification” method is used to determine costs of investments sold. Provisions for possible losses are recorded only when the values have experienced impairment considered “other than temporary” by a charge to realized losses resulting in a new cost basis of the investment. Our securities are issued by domestic entities and are backed either by collateral or the credit of the underlying issuer. Factors such as an economic downturn, disruptions in the credit markets, a regulatory change pertaining to the issuer’s industry, deterioration in the cash flows or the quality of assets of the issuer, or a change in the issuer’s marketplace may adversely affect our ability to collect principal and interest from the issuer. Both equity and fixed income securities have been affected over the past several years, and may be affected in the future, by significant external events. Credit rating downgrades, defaults, and impairments may result in write-downs in the value of the investment securities held by the Company. The Company regularly monitors its portfolio for pricing changes, which might indicate potential other than temporary impairments, and performs reviews of securities with unrealized losses. In such cases, changes in fair value are evaluated to determine the extent to which such changes are attributable to (i) fundamental factors specific to the issuer, such as financial conditions, business prospects or other factors, or (ii) market-related factors, such as interest rates. See Item 7A, “Quantitative and Qualitative Disclosures about Market Risk” for a discussion of variability of estimates.
The Company’s estimates of fair value for financial assets and financial liabilities are based on the framework established in SFAS No. 157. The framework is based on the inputs used in valuation, gives the highest priority to quoted prices in active markets and requires that observable inputs be used in the valuations when available. The disclosure of fair value estimates in the SFAS No. 157 hierarchy is based on whether the significant inputs into the valuation are observable. In determining the level of the hierarchy in which the estimate is disclosed, the highest priority is given to unadjusted quoted prices in active markets and the lowest priority to unobservable inputs that reflect the Company’s significant market assumptions. The three levels of the hierarchy are as follows:
Level 2 - Quoted prices for similar assets or liabilities in active markets; quoted prices for identical or similar assets or liabilities in inactive markets; or valuations based on models where the significant inputs are observable (e.g., interest rates, yield curves, prepayment speeds, default rates, loss severities, etc.) or can be corroborated by observable market data.
For U. S. Treasury, U. S. government and corporate bonds, the independent pricing services obtain information on actual transactions from a large network of broker-dealers and determine a representative market price based on trading volume levels. For asset backed and mortgage backed instruments, the independent pricing services obtain information on actual transactions from a large network of broker-dealers and sorts the information into various components, such as asset type, rating, maturity, and spread to a benchmark such as the U.S. Treasury yield curve. These components are used to create a pricing matrix for similar instruments.
Premiums and policy fees are recognized as earned on a pro rata basis over the period the Company is at risk under the related policy. Agency revenues are primarily fees charged on insureds’ premiums due. These fees are earned over the terms of the underlying policies. Unearned premiums represent the portion of premiums written and policy fees which are applicable to the unexpired terms of policies in force. Premiums receivable consist of balances owed for coverages written with the Company. The Company’s allowance for doubtful accounts consists of premiums receivables over thirty days past due.
Costs associated with software developed or purchased for internal use are capitalized based on SOP 98-1, “Accounting for the Costs of Computer Software Developed or Obtained for Internal Use” and other related guidance. Capitalized costs include external direct costs of materials and services consumed in developing or obtaining internal-use software and payroll for employees directly associated with, and who devote time to, the development of the internal-use software. Costs incurred in development and enhancement of software that do not meet the capitalization criteria, such as costs of activities performed during the preliminary and post-implementation stages, are expensed as incurred. Costs incurred in development and enhancements that do not meet the criteria to capitalize are activities performed during the application development stage such as designing, coding, installing and testing. The critical estimate related to this process is the determination of the amount of time devoted by employees to specific stages of internal-use software development projects. We review any impairment of the capitalized costs on a periodic basis.
Our growth strategy has entailed increased financial and operational risks and other challenges that are greater than and different from those to which we have previously been subject as the nature of our business has changed and grown. Generally, new business produces higher claim ratios than more seasoned in-force business, and this factor is likely to be magnified to the extent that we enter new states and market areas. Furthermore, it amplifies the importance of our ability to assess any new trends timely and accurately and respond effectively.
Pricing decisions based on assumed loss ratio in new states and markets, involving different claims environments, distribution sources and customer demographics, must necessarily be made without the same level of experience and data that is available in existing markets.
Ultimate liability may be greater or less than current reserves. The Company monitors reserves using new information on reported claims and a variety of statistical techniques which are discussed below. The Company does not discount to present value that portion of its claims reserves expected to be paid in future periods.
Index to Financial Statements When we reviewed claims data to make estimates for 2008, some of the same variances were found. Based on the analysis of these variances, we made the following adjustments:
As the trend first observed in 2006 continued, the credibility associated with each accident quarter gradually increased over time. Changes in credibility over time affect development patterns in that past development patterns are less stable than future patterns based on more credible data. However, the fact that the Company has continued to enter new markets results in limits on credibility for the foreseeable future. We attempted to take this into consideration in our estimates by selection of loss development factors, including extending tail factors to older accident periods and use of actuarial judgment.
During 2008 we realized that the historical recovery pattern established by our Southeast claims operation was not applicable to recoveries in states other than Florida. We attempted to take this into consideration in our estimates by modifying our subrogation and salvage loss development factors and use of actuarial judgment.
In both personal lines and commercial runoff business, we utilize the same procedures for estimating reserves on a quarterly basis as we do annually. Historically, the independent actuarial consulting firm that we retain had the responsibility for making the reserve estimate used in our financial statements. However, we changed our procedures beginning with the financial statements for the third quarter of 2007 and subsequent quarterly and annual periods. In our revised procedures, the reserve estimates are made for each period by our in-house actuarial staff, and we do not rely upon the review by the independent actuarial firm to estimate the amount of our GAAP reserves. However, that firm provides analysis as requested.
However, as noted above, in recent reporting periods the estimates for all runoff claims have been based primarily on case-by-case evaluations of individual claim files as the number of claims has fallen to the point that conventional actuarial methods have become less useful.
We employ various statistical processes to estimate our unpaid claims and CAE. Our actuarial staff performs quarterly analyses on multiple unique, homogenous data subsets to produce estimates of the aggregate unpaid claims and CAE. We analyze the data separately (1) for each of the states in which we write business, (2) for each type of coverage group written, and (3) by accident quarter. We apply the actuarial methodologies outlined below with respect to each of these data subsets to establish separate point estimates for IBNR claims. We then aggregate all of the separate point estimates to develop our best estimate of our overall unpaid claims and CAE.
In addition, ultimate claim counts are estimated using closed and reported claim count data. Ultimate claims and CAE estimates are divided by ultimate claim count estimates to determine an ultimate claim severity, which provides a reasonability check for our ultimate C & CAE amounts. If severities are in line with expectations, we have an additional degree of confidence in our estimates.
The methods listed above assume that the influences that affect the development patterns for each accident quarter will remain constant over time. Because of this, selection of development patterns that will apply to current open claims and claims incurred but not reported must consider several factors. These include, but are not limited to, the impact of inflation on claim costs and changes in the rate of inflation, the rate and level at which our claims adjusters make payments and settle claims and any changes in this rate or level, changes in the adequacy or method used to establish case reserves, changes in the cost of medical care, changes in judicial decisions, legislation changes, and other factors. Changes in any of these factors imply that development patterns are not remaining constant over time - one key assumption in the methods used to estimate ultimate liability. When the rate at which adjusters make payments and settle claims has accelerated over time, ultimate loss estimates developed using the methods employed above may overstate true projected ultimate liabilities, thus adjustments that take these changes in to consideration are utilized. Various methods are used to adjust for these changes including, but not limited to, adjustments that take into consideration changes in exposure recognition, the rate of claims closure and changes in case reserve adequacy as well as tail factor analysis and actuarial judgment.
We believe it is reasonably likely that our loss costs could increase or decrease by 2% from current estimates, as remaining claims are recorded and resolved. Loss costs reflect the incurred loss per unit of exposure and are the product of frequency and severity. A 2% increase or decrease in our loss costs would result in unfavorable or favorable development of $7.5 million (assuming the size of the Company remains constant). This estimate of sensitivity is informational only, is not a projection of future results and does not take into account possible effects of extraordinary litigation events (such as class action claims).
The Company and its subsidiaries file a consolidated Federal income tax return. Deferred income tax items are accounted for under the “asset and liability” method which provides for temporary differences between the reporting of earnings for financial statement purposes and for tax purposes, primarily deferred policy acquisition costs, the discount on unpaid claims and claim adjustment expenses, net operating loss carry forwards and the nondeductible portion of the change in unearned premiums. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment dates.
In 2007, the Company increased the amount of the valuation allowance by $13,183,000, resulting in an allowance on the gross deferred tax asset of $28,699,000. In making this determination, the Company considered all available evidence, including the fact that the Company incurred a taxable loss in 2007 and had incurred, as of December 31, 2007, a cumulative taxable loss for the three years then ended.
Effective January 1, 2008, the Company adopted SFAS No. 157, “Fair Value Measurements,” which defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements, for all of its financial assets and liabilities. The statement does not require new fair value measurements, but emphasizes that fair value is a market-based measurement that should be determined based on the assumptions that market participants would use in pricing an asset or liability and provides guidance on how to measure fair value by providing a fair value hierarchy for classification of financial assets or liabilities based upon measurement inputs. SFAS No. 157 applies to other accounting pronouncements that require or permit fair value measurements. In February 2008, the FASB issued Staff Position 157-1, “Applications of FASB Statement No. 157 to FASB Statement No. 13 and Other Accounting Pronouncements That Address Fair Value Measurements for Purpose of Lease Classification or Measurement under Statement 13” (“FSP 157-1”) which removes leasing transactions from the scope of SFAS No. 157. FSP 157-1 is effective upon adoption of SFAS No. 157. In February 2008, the FASB issued FASB Staff Position No. FAS 157-2 “Effective Date of FASB Statement No. 157” (“FSP 157-2”), which delays the effective date of SFAS No. 157 for non-financial assets and non-financial liabilities, except for items that are recognized or disclosed at fair value in the financial statements on a recurring bases, at least annually, to fiscal years beginning after November 15, 2008. Any amounts recognized upon adoption as a cumulative effect will be recorded to the opening balance of accumulated deficit in the year of adoption. As a result of the issuance of FSP 157-2, we did not apply the provisions of SFAS No. 157 to the non-financial assets and non-financial liabilities and reporting units within the scope of FSP FAS 157-2. Our adoption of SFAS No. 157 had an immaterial impact on the Company’s results of operations or financial position. See note 3 of Notes to Consolidated Financial Statements which appears in Item 8 of this Annual Report for the application of SFAS No. 157 and further details regarding fair value measurement of the Company’s financial assets and liabilities as of December 31, 2008.
In October 2008, the FASB issued FSP 157-3, “Determining the Fair Value of a Financial Asset When the Market for That Asset is Not Active” (FSP FAS 157-3). FSP FAS 157-3 clarifies the application of SFAS No. 157 in a market that is not active and provides an example to illustrate key considerations in determining the fair value of a financial instrument when the market for that financial asset is not active. The FSP was effective upon issuance, including prior periods for which financial statements have not been issued. Our adoption of FSP FAS 157-3 had an immaterial impact on the Company’s results of operations or financial position.
In February 2006, the FASB issued Statement No. 155, “Accounting for Certain Hybrid Financial Instruments-an amendment of Statements No. 133 and 140.” Statement No. 155 (i) permits fair value remeasurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation, (ii) clarifies which interest-only strips and principal-only strips are not subject to the requirements of Statement No. 133, (iii) establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation, (iv) clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives, and (v) amends Statement No. 140 to eliminate the exemption from applying the requirements of Statement No. 133 on a qualifying special-purpose entity from holding a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument. Statement No. 155 is effective for all financial instruments acquired or issued after the beginning of an entity’s first fiscal year that begins after September 15, 2006 (the fiscal year beginning January 1, 2007 for the Company). The Company adopted SFAS No. 155 as of January 1, 2007 and has determined there has been no impact on our consolidated financial position, results of operations or financial condition.
Consolidated Statements of Shareholders’ Equity and Comprehensive Loss for the Years Ended December 31, 2008 and 2007
Consolidated Statements of Cash Flows for the Years Ended December 31, 2008 and 2007