We lease approximately 115,000 square feet for our home office at 3760 River Run Drive, Birmingham, Alabama under a long-term operating lease. For our life and health insurance businesses, we lease approximately 25,000 square feet for our life insurance operations in Phoenix, Arizona, and approximately 13,000 square feet in Dallas, Texas under long-term operating leases. In our non standard auto insurance operations, we lease approximately 45,000 square feet in Addison, Texas and approximately 85,000 square feet in Bedford Park, Illinois. In addition, we lease approximately 140 retail locations primarily in the Midwest, Texas and South Carolina.
We believe our office facilities are suitable and adequate for our current and anticipated level of operations.
The following information should be read in conjunction with Vesta’s Consolidated Financial Statements and related notes reported elsewhere in this Form 10-K.
We report financial information according to five business segments: (1) standard property-casualty insurance; (2) nonstandard agency; (3) nonstandard underwriting; (4) life insurance; and (5) corporate and other. Since 1999, we have discontinued a number of business lines. We have segregated the reporting for these discontinued operations in our financial statements.
The financial results of our property-casualty underwriting activities (including our standard property-casualty segment and the nonstandard underwriting segment) primarily depend upon two variables: (1) the amount of premiums we collect, which is dependent upon rates and volume; and (2) the costs we incur to adjust and pay claims submitted by individuals we have insured.
The financial results of our agency activities primarily depend upon the amount of fees and commissions we can collect from the sale of insurance products and the expenses we incur to conduct our day-to-day operations. Although we expect the minimum commissions and policy fees that we earn under a typical agency contract to be relatively stable, we expect to earn a substantial amount of additional “profit sharing” commissions in excess of the contractual minimums. These profit sharing commissions are dependent upon whether the nonstandard auto policies that we produce for other insurers result in a level of losses in relation to written premium (i.e., loss ratios) below the levels stated in our agency contracts. Accordingly, the frequency and severity of claims made on the policies our agencies produce may result in changes to estimated revenue.
The financial results of our life insurance operations primarily depend upon (1) the amount we collect as premium; (2) the amount of investment income earned on invested premium; and (3) the benefits we pay to insureds upon their death. Unlike the standard property-casualty reporting segments, we include the investment income earned on invested premium in the results for our life insurance segment. The greatest variable in our revenue in the life segment is the amount of income we can earn on invested assets, which is dependent upon general interest rates and market conditions. The greatest variable in our expense from period to period is the mortality rate of our insureds, as mortality rates in excess of our actuarially predicted levels will adversely impact financial results in any given period.
• Recoverability of assets, including reinsurance receivables, deferred acquisition costs, deferred tax assets and other intangible assets
We have discussed the application of these critical accounting policies with our Board of Directors and audit committee. In 2002, we initially adopted three accounting standards:
• SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” and
Our financial statements include as assets amounts we either (i) expect to collect from third parties, particularly reinsurance recoverables, or (ii) expect benefit from in future periods, particularly deferred acquisition costs and deferred tax assets. In establishing these amounts, we have made significant judgments and estimates regarding the ultimate realization of each asset. Specifically, we have made critical assumptions and judgments in establishing assets for reinsurance recoverables on paid losses, deferred policy acquisition costs and deferred income taxes. Changes in the assumptions, judgments or estimates we have made with respect to each of these assets would directly impact our financial results and financial condition.
As a matter of practice, we routinely cede risks associated with insurance policies we underwrite to reinsurers pursuant to contractual arrangements. We obtain reinsurance primarily to (1) provide protection for individual loss occurrences, including catastrophic losses; (2) stabilize the results of our underwriting activities; and (3) reduce our net liability for individual risks. Reinsurance recoverable on paid losses represents management’s estimate of the amounts we expect to collect from reinsurers as reimbursement for loss claims we have paid.
In exchange for reinsurance coverage, we pay a portion of the policy premiums we receive to reinsurers who have assumed a specified level of risk pursuant to a reinsurance contract. Although a reinsurer is liable for losses to the extent of coverage to which it assumes, reinsurance arrangements do not legally discharge the principal insurer from primary liability for the full amount of a policy.
When we determine that a claim for loss made under one of our policies is owed, we initially pay the full amount owed to the claimant. Subsequently, we seek to recover any amounts due from reinsurers in accordance with the terms of the applicable reinsurance contract. We record the amounts we expect to receive from reinsurers pursuant to these contracts as assets in our financial statements.
Changes in our assumptions, estimates and judgments with respect to establishing assets for reinsurance recoverables on paid losses would materially impact our financial results and financial condition. For more discussion of reinsurance recoverables and other amounts subject to estimation due to arbitrations with our reinsurers, please refer to Notes G and I to our financial statements on pages 63 and 67, respectively, of this report.
Deferred policy acquisition costs represent costs we incur in connection with acquiring new business or renewing existing business. Deferred policy acquisition costs are primarily comprised of commissions, underwriting and agency expenses and other costs related to issuing insurance policies. In accordance with GAAP, these costs are not expensed in their entirety upon their incurrence (as is the case for statutory accounting purposes); rather, they are initially recorded as assets in our financial statements and are subsequently amortized over the life of the insurance policies to which they relate or at a constant rate based upon the present value of the estimated gross profits to be earned from the underlying policies. This treatment is intended to match the expenses associated with issuing an insurance policy with estimated profits to be earned on the policy over the life of the policy. At December 31, 2002, we had established $71.8 million as assets for deferred acquisition costs in our financial statements.
We account for income taxes in accordance with SFAS No. 109, “Accounting for Income Taxes.” At December 31, 2002, we had established net deferred tax assets of $46.2 million, which reflects the amount of future benefit we expect to realize in the form of income tax refunds or reductions in income taxes paid. Our deferred tax asset is primarily comprised of net operating loss carryforwards that may be used to offset future taxable income and, thereby, reduce income tax payments. The deferred tax assets have been established in accordance with GAAP and based upon the applicable tax rates and tax laws.
In our financial statements, we have recorded $134.9 million of goodwill and other intangible assets, which represents the amount by which the price we paid to acquire net assets exceeds the fair value of tangible assets acquired plus the liabilities assumed. The determination of whether these assets are impaired involves significant judgments based upon management’s short and long-term projections of future performance for each of our business lines. Certain of these forecasts reflect assumptions regarding our ability to sustain or increase activities in our various business lines. Changes in strategy and/or market conditions may result in changes to recorded asset balances.
In the fourth quarter of 2002, we wrote off $9.1 million of goodwill associated with our discontinued health insurance and consulting business lines. With respect to our reporting units in continuing operations, we have concluded that there is no goodwill impairment as of December 31, 2002. With respect to all of our reporting units, our ability to achieve forecasts and projected undiscounted cash flows are based upon a continuation of current financial strength ratings by A.M. Best. Also, because of uncertain market conditions and potential changes in our strategy and business lines, it is possible that forecasts used to support goodwill may change in the future, which could result in additional non-cash charges that would adversely affect our results of operations and financial condition.
Our investments are recorded at fair value based upon quoted prices, if available. If quoted prices are not available, fair value is primarily determined based upon management’s assessment of the market value of comparable investments. Our determination of fair value also considers various factors including time value and volatility issues, credit quality of the counterparty and existing conditions in the overall financial markets. From time-to-time, the carrying values of our investments may be temporarily impaired because of such factors. We do not adjust the carrying value of any investment unless management determines that its value is other than temporarily impaired.
Management conducts regular reviews to assess whether the values of our investments are impaired and if any impairment is other than temporary. If we determine that the value of any investment is other than temporarily impaired, we record a charge against earnings in the amount of the impairment. The determination of whether other than temporary impairment has occurred involves significant assumptions, estimates and judgments by management. Changing economic conditions-global, regional or related to industries of specific issuers-could adversely affect these values
At December 31, 2002, we had recorded liabilities for loss and loss adjustment expenses of $322.3 million. Our loss and loss adjustment expense reserves comprise the largest liability and most significant estimate or compilation of estimates in our financial statements. Furthermore, our loss and loss adjustment expense reserves are subject to significant inherent uncertainties and so there can be no assurance as to whether the actual results will be higher or lower than these estimates. Any adjustments or changes for such differences may be material, especially to our operating results for a period. As our loss and loss adjustment expense reserves are re-estimated, changes to those estimates, if any, are recognized through a charge to income in the most recent period presented.
Generally, we consider commission and policy fees earned by our agency activities to be a relatively stable revenue stream. However, a significant portion of our non-standard agency business utilizes profit sharing, or contingent, commissions that enable us to collect, in certain circumstances, commissions and fees in excess of contractual minimums and we record estimates of these profit sharing commissions when they become probable. The collection of these additional profit sharing commissions is dependent upon whether the non-standard auto policies that we produce for other insurers result in a loss ratio below the levels stated in our agency contracts. Accordingly, the frequency and severity of claims made on the policies our agencies produce may result in changes to estimated revenue.
For a depiction of the various components of revenue, expense and financial results for each of our business segments for the years ending December 31, 2002 please refer to Note L of our financial statements on page 71 included in this report.
Although we expect our net written premium will decrease in 2003 on a net basis, we have implemented rate increases to address emerging loss trends and to protect our net written premium relative to expenses, or underwriting margin. During 2002, we implemented 21 rate increases in our standard automobile business line, which represented an average premium increase of approximately 11.6%. In 2002, we also implemented 23 rate increases in our standard residential property line, which represented an average increase of approximately 13.5%.
For the year ended December 31, 2002, the loss ratio for standard property-casualty segment was 67.5% compared with 64.7% at December 31, 2001. The increase in the loss ratio was primarily attributable to deteriorating results in the first half of 2002 in Pennsylvania, West Virginia and certain other states that deteriorated because of increased severity and frequency. The loss ratio for these states, and the entire segment, returned to more normal levels in the second half of 2002.
increased significantly. In 2002, our non-standard agency segment generated approximately $151 million of commission and fees-based revenue, or approximately 13% of consolidated revenue.
Our non-standard underwriting segment can be separated into two lines of business: (1) underwriting non-standard auto insurance products sold by our affiliated agency operations and (2) underwriting non-standard auto insurance sold by unaffiliated agencies. In each of these business lines, we utilize quota share reinsurance to minimize our exposure to loss. Under a quota share contract, reinsurers share losses and certain allocated expenses in the same percentage as they share in premiums.
Of our total non-standard net written premiums of $181.3 million during 2002, the net premiums written on policies sold by our affiliated agencies was approximately $153.8 million. The largest component of our net premiums written on policies sold by affiliated agencies was approximately $125.2 million net premium written through InsureOne, our affiliated agency operation based in Chicago, Illinois. Until December 1, 2002, we bore 100% of the underwriting risk on these policies. Effective December 1, 2002, we ceded 40% of the premiums and losses on the Insure One business to third party reinsurers pursuant to a quota share reinsurance contract. As a result, we expect our total non-standard underwriting net written premiums will decrease in 2003.
Of our total net written premiums of $181.3 million during 2002, net written premiums produced by unaffiliated agencies was approximately $27.5 million, with approximately $107 million of gross written premium ceded to third party reinsurers. For the year ended December 31, 2002, we also collected “issuing carrier” or “fronting” fees of approximately $5.3 million, up from $4.2 million in 2001. The increase in fronting fees was primarily attributable to an increase in the amount of ceded earned premium fronted for a program in California to $81.1 million in 2002, compared with $74.8 million in 2001.
Although we expect our net written premium will decrease in 2003 on an absolute basis as a result of the quota share reinsurance contract placed on the Insure One business, we have implemented rate increases to address emerging loss trends and to protect our underwriting margin. During 2002, we implemented 25 rate increases in our non-standard underwriting segment, which represented an average premium increase of approximately 17.7%.
Loss and loss adjustment expenses for the non-standard underwriting segment increased by $92.3 million in 2002, to $100.3 million from $8.0 million in 2001. The increase in loss and loss adjustment expenses incurred was primarily attributable to the increase in earned premium produced by affiliated agencies acquired in our agency segment during 2002. The loss ratio for our non-standard underwriting segment at December 31, 2002 was 58.1%, compared with 77.4% at December 31, 2001. The decrease in the loss and loss adjustment expense ratio was primarily attributable to favorable loss ratios on premium produced by affiliated agencies acquired in our agency segment during 2002.
We provided a variety of life insurance products through our holdings in American Founders Financial Corporation, a holding company for two life insurance companies domiciled in Texas. American Founders’ business is driven primarily by the acquisitions of closed blocks of life insurance policies and, to a lesser extent, by marketing and distributing its fixed annuity products. Our life insurance products are sold through marketing firms, financial institutions and 700 independent agents located throughout 41 states and the District of Columbia. At December 31, 2002, American Founders had approximately $2.5 billion (face value) of life and annuity products in force, and approximately $890.0 million in invested assets.
Life insurance premiums and policy fees increased to $14 million from $13.7 million in the prior year as a result of the inclusion of a full year results for acquisitions of Imperial General, Teton National and Washington Life made in 2001 partially offset by normal declines on closed block and increased reinsurance. Investment income decreased from the prior year because of an overall decline in market interest rates during 2002. In addition, investment income declined by approximately $1.5 million in 2002 because we did not accrue interest on approximately $27 million of non-performing loans held as investments in our life insurance segment. As described below, these loans were written off in the fourth quarter of 2002.
During 2002, we actively pursued collection of approximately $27 million in loans held as assets by American Founders, including the filing of civil lawsuits seeking to collect these loans and cooperation with the Mexican Attorney General in a criminal investigation related to the conduct of some of the individuals responsible for these loans. We believed that these collection efforts would yield in a short time period positive indications that the individuals responsible for repaying these loans would acknowledge their obligations and voluntarily perform. As of December 31, 2002, we had seen no indications that these individuals would do so, and we expect to engage in protracted civil litigation regarding this matter. Accordingly, we concluded that these loans were impaired and recorded an estimated loss on these loans equal to their entire balance. This write-off reduced American Founders’ statutory surplus significantly.
During 2002, we experienced an unexpected increase in the severity and volume of reported claims associated with both our discontinued assumed reinsurance and commercial lines and increased payments on claim reserves. Additionally, in the 2nd quarter of 2002, we received an award of $16.4 million from our arbitration with F&G Re related to two loss ratio contracts covering accident years 1996 and 1997. In our financial statements, we recorded a charge of $13.6 million to reflect the difference between our recorded recoverable of $30 million and the award amount. The charge was recorded in our Assumed Reinsurance segment which is included in discontinued operations, consistent with the manner in which premiums and losses were originally recorded. As a result of these items, we recorded a pre-tax charge of $22.9 million in our financial statements for the year ended December 31, 2002.
For the year ended December 31, 2001, we reported a net loss available to common shareholders of $22.4 million ($.84 diluted per share), a decrease of $39.1 million from net income available to shareholders of $16.7 million ($.78 diluted per share) reported for the previous year ended December 31, 2000. The decrease in income available to common shareholders in 2001 was primarily attributable to (1) an additional charge of $17.6 million to after-tax discontinued operations in the current year; and (2) recording an after-tax charge of $16.3 million relating to settlement of a securities class action lawsuit.
For the year ended December 31, 2001, net premiums written in our standard property-casualty lines increased by $58.5 million (up 28.5%), to $264 million from $205.5 million in the prior year. Net premiums earned for standard property-casualty lines increased by $33.3 million in 2001, up 15.6%, to $246.1 million from $212.8 million in 2000. The increase in both net premiums written and net premiums earned was primarily attributable to additional business resulting from our acquisition of Florida Select Insurance Holdings, Inc. on April 1, 2001.
For the year ended December 31, 2001, policy acquisition expenses increased by $2.4 million (up 4.6%) to $54.8 million from $52.4 million for the same period of the prior year. The increase in policy acquisition expenses was primarily related to a corresponding increase in earned premium that was partially offset by a decrease in contingent commissions owed on profitable business. Operating expenses increased by $5.8 million, or 21.8%, to $32.4 million from $26.8 million, primarily as a result of costs incurred by Florida Select, which was acquired on April 1, 2001.
Loss and loss adjustment expense for non-standard lines increased by $7.3 million in 2001, to $8.0 million from $.7 million in 2000. The loss ratio for non-standard lines at December 31, 2001 was 77.4%, compared with 60.2% at December 31, 2000. The increase in loss and loss adjustment expenses incurred was primarily attributable to the increase in earned premium. The increase in the loss ratio was primarily attributable to increased losses from our California program.
For the year ended December 31, 2001, net investment income related to our property-casualty underwriting operations, decreased by $4.4 million to $20.1 million from $24.5 million in 2000. The weighted average yield on invested assets for 2001 (excluding realized and unrealized gains) was 6.25%, compared with 6.7% for the year ended December 31, 2001. The decrease in investment income is primarily attributable to a decline in average yield and a decrease in invested assets. Interest expense decreased by $1.0 million to $8.9 million related to our repurchase of $7.0 million face amount of debt in 2001 and $13.0 million face amount in 2000. Operating expenses increased in 2001 by $2.4 million as compared to 2000. In October 2001, we settled a securities class action litigation for $61.0 million in cash plus expense. In connection with this settlement, we recorded a pre-tax expense of $25 million in our Corporate and other segment for the year ending December 31, 2001.
We exited the reinsurance assumed business and commercial lines business in 2000 and 1999, respectively. We exited these lines through non-renewal of policies, and we remain obligated to settle claims relating to coverages provided prior to the expiration and non-renewal of individual policies. Effective with our decision to exit these lines, we have reported the financial results for these business lines in discontinued operations.
With respect to the discontinued assumed reinsurance line, we increased reserves because of negative trend development relating primarily to certain homeowner coverages. We believe these types of claims should fully develop over a relatively short period of time. With respect to the discontinued commercial lines, the increase in expected losses related to a variety of underlying coverages, including general liability. These types of claims may take many years to fully develop and we must continue to monitor trends in their ultimate developments. Based upon available information, we believed the recorded reserves for discontinued operations at December 31, 2001 was adequate. However, we will continue to monitor these reserves and their related claims activity and experience. Further adjustments to our estimates could be necessary as we continue to run off the remaining outstanding claims.
Vesta is a holding company whose principal asset is its investment in the capital stock of the companies constituting the Vesta Insurance Group. The principal uses of funds at the holding company level are to pay (1) operating expenses; (2) principal and interest on outstanding indebtedness and deferrable capital securities; and (3) dividends to stockholders as declared by the Board of Directors.
Vesta’s principal source of liquidity and capital resources to meet its holding company obligations is dividends paid by our subsidiaries. Many of our subsidiaries are insurance companies that are individually supervised by various state insurance regulators, and other unregulated companies that we own, such as Instant Insurance Holdings, Inc., are owned indirectly through a regulated insurance company. Given our organizational structure, we rely on two subsidiaries to pay dividends to our holding company or otherwise fund the obligations of our holding company on its behalf - Vesta Fire Insurance Corporation, an Illinois domiciled insurer, and J. Gordon Gaines, Inc., a Delaware business corporation.
Transactions between Vesta and its insurance subsidiaries, including the payment of dividends, are subject to certain limitations under the insurance laws of those subsidiaries’ domiciliary states. The insurance laws of the state of Illinois, where Vesta Fire is domiciled, permit the payment of dividends out of unassigned surplus in any year which, together with other dividends or distributions made within the preceding 12 months, do not exceed the greater of 10% of statutory surplus as of the end of the preceding year or the net income for the preceding year, with larger dividends payable only after receipt of prior regulatory approval. The Illinois Insurance Department has indicated that these dividend limitations prohibit the payment of dividends if the insurer has negative or zero “unassigned funds” at the end of the prior year, as reported on its
Effective February 1, 2003, we entered into a new revolving credit arrangement with First Commercial to replace the previous facility. The new facility is a $30 million line secured by a pledge of 358,375 shares of common stock of Instant Insurance Holdings, Inc., representing approximately 70% of Instant’s issued and outstanding shares of capital stock as of December 31, 2002. The new facility bears interest at First Commercial’s prime rate and will mature no earlier than June 30, 2005. As of March 1, 2003, we had drawn the entire $30 million available under this Agreement.
This new credit agreement contains covenants which require us to maintain (i) consolidated GAAP net income (excluding realized gains and losses) of at least $15 million for any calendar year, beginning in 2003, (ii) Consolidated debt to capital ratio of no more than 39%, (iii) an A.M. Best rating of “B” or better, (iv) consolidated GAAP net worth of at least $208 million, (v) an interest coverage ratio of not less than 1.5 to 1 and (vi) risk-based capital of not less than 150% of the NAIC’s authorized control level.
Our subsidiary operations also involve ongoing reinsurance recoverable disputes that could result in an obligation to repay certain amounts to reinsurers from whom we have collected funds. In connection with these disputes, our principal operating subsidiary, Vesta Fire, has obtained letters of credit for the benefit of reinsurers for which it is contingently liable. At December 31, 2002, Vesta Fire was contingently liable for $33.7 million under the terms of letters of credit obtained in connection with these reinsurance disputes.
Additionally, we regularly obtain letters of credit or otherwise pledge securities for the benefit of ceding insurers in our nonstandard underwriting segment pursuant to reinsurance contracts. As of December 31, 2002, we had pledged approximately $7.7 million in securities pursuant to these reinsurance contracts.
(1) As part of the Federal Home Loan Bank program, as more fully described in Note N to our financial statements, we have pledged securities with a market value of approximately $183.6 million to secure our obligation of $176.8 million. We intend to renew all Federal Home Loan Bank advances maturing in the current year, however in the unlikely event we elect not to renew all maturing advances, we could liquidate the pledged investments to satisfy the obligation.
Future payments for our interest and operating lease obligations to third parties at December 31, 2002 are as follows (in thousands):
In addition to the contractual obligations of our holding company to third parties presented in the tables above, our holding company owes contractual obligations to certain of our subsidiaries that are eliminated in consolidation of our financial statements. As of December 31, 2002, our insurance company subsidiaries held $8.7 million face amount of our 8.75% Senior Debentures due 2025 and $44.0 million face amount of our 12.5% Senior Notes due 2005. Our holding company paid these subsidiaries approximately $6.3 million in interest payments in 2002 which was eliminated in consolidation.
The provisions of SFAS No. 142 no longer allow the amortization of goodwill, and certain intangible assets that have indefinite useful lives, and require that potential impairment of goodwill on those assets be tested annually. In 2001 and 2000, we amortized $3.4 million and $1.6 million, respectively, of goodwill and other intangible assets. In addition, SFAS No. 142 requires the following disclosures for goodwill and other intangible assets:
Effective July 1, 2002, Vesta adopted SFAS No. 145, “Rescission of FASB Statement No. 4, 44 and 64, Amendment of FASB Statement No. 13, and Technical Corrections”, which had been issued by the FASB in April 2002. SFAS No. 145 rescinds SFAS No. 4, which required all gains and losses from extinguishments of debt to be aggregated and, if material, classified as an extraordinary item, net of related income tax effect. As a result, the criteria in APB Opinion No. 30, will now be used to classify those gains and losses. SFAS No. 64 amended SFAS No. 4, and is no longer necessary because SFAS No. 4 has been rescinded. SFAS No. 44 and the amended sections of SFAS No. 13 are not applicable to Vesta and, therefore, have no effect on our financial statements. In connection with our adopting SFAS No. 145 on July 1, 2002, we reclassified gains on the extinguishment of debt from extraordinary gain on debt extinguishment to other expense in our third quarter financial statements. These reclassifications decreased other expense by $9.5 million, $1.4 million and $8.1 million for the years ending December 31, 2002, 2001 and 2000, respectively.
In November 2002, the FASB issued FASB Interpretation No. (“FIN”) 45, “Guarantor’s Accounting and Disclosures Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others.” FIN 45 clarifies the requirements of SFAS No. 5, “Accounting for Contingencies,” related to a guarantors accounting for, and disclosures of, the issuance of certain types of guarantees. Vesta is required to adopt the provisions for initial recognition and measurement for all guarantees issued or modified after December 31, 2002 on a prospective basis. Management is currently reviewing the impact related to the initial recognition and measurement guarantees of this Interpretation.
In our opinion, the consolidated financial statements listed in the index appearing under Item 15(a)(1) present fairly, in all material respects, the financial position of Vesta Insurance Group, Inc. and its subsidiaries at December 31, 2002 and 2001, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2002 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedules listed in the index appearing under Item 15(a)(2) present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedules are the responsibility of the Company’s management; our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States of America, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
Gains and losses realized on the disposition of investments are recognized as revenues and are determined on a specific identification basis. Unrealized gains and losses on equity securities and fixed maturities available for sale, net of deferred income taxes, are reflected directly in stockholders’ equity. If an investment becomes other than temporarily impaired, such impairment is treated as a realized loss and the investment is adjusted to net realizable value. An investment in a debt or equity security is impaired if its fair value falls below its book value and the decline is considered other than temporary. Factors considered in determining whether a loss is other than temporary include the length of time and extent to which fair value has been below cost; the financial condition and near term prospects of the issuer; and, the Company’s ability and intent to hold the investment for a period of time sufficient to allow for any anticipated recovery. A debt security is impaired if it is probable that the Company will not be able to collect all amounts due under the security’s contractual terms. Equity investments are impaired when it becomes apparent that the Company will not recover its cost over the expected holding period. Other-than-temporary declines in fair value of investments are included in realized gains and losses. For the year ended December 31, 2002, we recognized other than temporary impairment losses of $8.0 million.
• Earned premiums on property-casualty business are recognized as revenue on a pro rata basis over the policy term. Reinsurance premiums ceded are similarly pro-rated with the prepaid portion recorded as an asset in the Consolidated Balance Sheet.
• Premiums on traditional life contracts are recognized as income when due.
• Policy fees are recorded as revenue on a pro-rata basis over the policy term.
Reinsurance: We report assets and liabilities related to insurance contracts before the effects of reinsurance. Reinsurance receivables and prepaid reinsurance premiums (including amounts related to insurance liabilities) are reported as assets. Estimated reinsurance receivables are recognized in a manner consistent with the liabilities related to the underlying insurance contracts. Reinsurance recoverables represent amounts due from reinsurers for paid losses.
Depreciation expense on property and equipment used in the business was $5.5 million, $3.9 million, and $3.3 million for the years ended December 31, 2002, 2001, and 2000, respectively.
Goodwill and other intangible assets: Goodwill and other intangible assets at December 31, 2002 and 2001 are as follows (in thousands):
Income Per Share: Basic earnings per share (“EPS”) is computed by dividing net income available to common stockholders by the weighted average common shares outstanding for the period. Diluted EPS is calculated by adding to shares outstanding the additional net effect of potentially dilutive securities or contracts that could be exercised or converted into common shares. Reconciliations of net income available to common shareholders and average shares outstanding as follows:
Stock based compensation: During 1995, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standard (“SFAS”) No. 123, “Accounting for Stock-Based Compensation”. The Statement defines a fair value based method of accounting for an employee stock option. It also allows an entity to continue using the intrinsic value based accounting method prescribed by the Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees.” Vesta has continued to use this method to account for its stock options and other forms of stock based compensation. However, SFAS No. 123 requires entities electing to remain with the intrinsic method of accounting to provide pro forma disclosures of net income and earnings per share as if the fair value based method of accounting had been applied as well as other disclosures about Vesta’s stock-based employee compensation plans.
The provisions of SFAS No. 142 no longer allow the amortization of goodwill, and certain intangible assets that have indefinite useful lives, and require that potential impairment of goodwill on those assets be tested annually. In addition, SFAS No. 142 requires the following disclosures for goodwill and other intangible assets:
In November 2002, the FASB issued FASB Interpretation No. (“FIN”) 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others.” FIN 45 clarifies the requirements of SFAS No. 5, “Accounting for Contingencies,” related to a guarantors accounting for, and disclosures of, the issuance of certain types of guarantees. Vesta is required to adopt the provisions for initial recognition and measurement for all guarantees issued or modified after December 31, 2002 on a prospective basis. Management is currently reviewing the impact related to the initial recognition and measurement guarantees of this Interpretation.
In January 2003, the FASB issued FIN 46, “Consolidation of Variable Interest Entities” which clarifies the application of Accounting Research Bulletin No. 51, “Consolidated Financial Statements.” This Interpretation provides guidance on the identification and consolidation of variable interest entities (“VIEs”), whereby control is achieved through means other than through voting rights. Management has completed an analysis of FIN 46 and has determined that Vesta does not have VIEs.
In January 2002, we completed three acquisitions: (1) the acquisition of certain assets of InsureOne Agency and the renewal rights to a book of non-standard automobile business; (2) acquisition of the nonstandard automobile related assets of Harbor Insurance Group; and (3) purchase of the common stock of Old American Investments. The estimated combined purchase prices for these acquisitions was $36.8 million, with $16.6 million due at closing and $20.2 million due upon the occurrence of certain future events. The transactions have been accounted for as purchases. Summarized below is an allocation of assets and liabilities acquired (in thousands and unaudited):
On August 1, 2002, Instant acquired a 100% interest in Driver’s Choice Insurance Services, LLC. The transaction has been accounted for as a purchase. Summarized below is an allocation of assets and liabilities acquired (in thousands and unaudited):
On October 1, 2001, our subsidiary, Instant, acquired a 75% interest in Spacecoast Holdings, Inc. for $3.7 million. On October 31, 2001, Instant acquired A-Affordable Insurance Agency of Texas for approximately $8.5 million. These transactions have been accounted for as purchases. Summarized below is an allocation of assets and liabilities acquired (in thousands and unaudited):
SFAS No. 142 prescribed transitional rules and required that we perform an assessment of whether there was an indication of impairment as of the date of adoption. Companies had up to six months from the date of adoption to determine the fair value of each of their reporting units and compare fair values to each reporting unit’s carrying amount. To the extent a reporting unit’s carrying amount exceeds its fair value, there is an indication that the reporting unit’s goodwill may be impaired and a second test had to be performed pursuant to the transitional rules. The second step required that companies compare the implied fair value of each reporting unit’s goodwill, determined by allocating the reporting unit’s fair value to all of its assets (recognized and unrecognized) and liabilities in a manner similar to a purchase price allocation in accordance with SFAS No. 141, to its carrying amount, both of which would be measured as of the date of adoption.
For the years ended December 31, 2001 and 2000, we recorded $2.2 million and $1.0 million, respectively, in amortization of goodwill. The impact of amortization of goodwill on net income was as follows (in thousands, except per share data):
Amortization expense recorded on the intangible assets for each of the years ended December 31, 2002 and 2001 was $.3 million and $.2 million, respectively. The estimated amortization expense for each of the five succeeding fiscal years is as follows (in thousands):
Vesta’s insurance subsidiaries are required to file statutory financial statements with state insurance regulatory authorities. Accounting principles used to prepare these statutory financial statements differ from accounting principles generally accepted in the United States of America (“GAAP”). The most significant differences between GAAP and statutory accounting principles are as follows: (a) under GAAP acquisition costs of obtaining new business are deferred and amortized over the policy period rather than charged to operations as incurred; (b) under GAAP certain items are reported as assets (property and equipment, agents’ balances, prepaid expenses) rather than being charged directly to surplus as nonadmitted items; (c) statutory accounting disallows reserve credits for reinsurance in certain circumstances; (d) under GAAP bonds classified as available-for-sale are recorded at their market values instead of amortized cost; (e) under GAAP benefit liabilities are computed using a net level method and are based on realistic estimates of expected mortality, interest, and withdrawals as adjusted to provide for possible unfavorable deviation from such assumptions rather than under statutory prescribed assumptions; (f) under GAAP the Asset Valuation Reserve and Interest Maintenance Reserve established for statutory accounting purposes are restored to stockholders’ equity (g) under GAAP other assets such as deferred income taxes and goodwill are not limited to statutory prescribed percentages of equity with any excess charged directly to surplus as nonadmitted items.
Risk-Based Capital Requirements: The NAIC adopted risk-based capital requirements that require insurance companies to calculate and report information under a risk-based formula which attempts to measure statutory capital and surplus needs based on the risks in a company’s mix of products and investment portfolio. The formula is designed to allow state insurance regulators to identify potential weakly capitalized companies. Under the formula, a company determines its “risk-based capital” (“RBC”) by taking into account certain risks related to the insurer’s assets (including risks related to its investment portfolio and ceded reinsurance) and the insurer’s liabilities (including underwriting risks related to the nature and experience of its insurance business). Risk-based capital rules provide for different levels of
with the Mexican Attorney General in a criminal investigation related to the conduct of some of the individuals responsible for these loans. We believed that these collection efforts would yield in a short time period positive indications that the individuals responsible for repaying these loans would acknowledge their obligations and voluntarily perform. As of December 31, 2002, we had seen no indications that these individuals would do so, and we expect protracted civil litigation with them. Accordingly, we concluded that these loans were impaired and recorded an estimated loss on these loans equal to their entire balance.
A summary of fixed maturities and equity securities by amortized cost and estimated fair value at December 31, 2002 and 2001 is as follows (in thousands):
A schedule of fixed maturities by contractual maturity at December 31, 2002 is shown below on an amortized cost basis and on a fair value basis. Actual maturities could differ from contractual maturities due to call or prepayment provisions (in thousands).
Gross gains (losses) realized on the sale of equity securities were $(.6) million, $.4 million and $(.6) million in 2002, 2001 and 2000, respectively. Gross gains realized on the sale of fixed maturities were $10.5 million, $3 million and $1.4 million in 2002, 2001 and 2000, respectively. Gross losses on the sale of fixed maturities were $10.2 million, $.5 million and $1.8 million in 2002, 2001 and 2000, respectively.
to a $30.0 million charge taken on our discontinued lines of business. The main contribution to the adverse development was liability exposures written in the 1980’s.
Also in connection with that settlement, the issuer of our primary directors’ and officers’ insurance policy, which was intended to cover the initial $25 million of settlement costs and related expenses, denied coverage and refused to fund its share of the settlement costs. We sued that insurer in Alabama state court alleging that its action was taken in bad faith. In February 2003, we settled that claim and collected $16 million in cash.
Vesta and two former officers of Vesta are defendants in a lawsuit styled James H. Cashion, Jr. d/b/a American Health Underwriters v. Vesta Insurance Group, Inc., et al. Plaintiff, a former general agent of our subsidiary States General Life Insurance Company, which we purchased in 2001, alleges that the defendants engaged in an actionable civil conspiracy to tortiously interfere with his agency contracts. The civil conspiracy claim is premised, in part, on certain payments made to two former officers of Vesta by another agent who replaced Mr. Cashion. The Plaintiff is seeking actual and punitive damages. Vesta denies tortiously interfering with plaintiff’s agency contract, believes the claims asserted against it have no merit, and is vigorously defending this lawsuit. The case is set for trial on May 12, 2003, but is likely to be rescheduled later in 2003. In the opinion of management, resolution of the lawsuit is not expected to have a material adverse effect on our financial position.
American Founders redeemed its Series A and Series C preferred stock from IFS Holdings, Inc. for less than “reasonably equivalent value,” and, therefore, engaged in a voidable fraudulent transfer. American Founders believes (i) that the redemption transaction was for reasonably equivalent value; (ii) that the allegations brought against it in this lawsuit are without merit. We have vigorously defended this action. In the opinion of management, resolution of the lawsuit is not expected to have a material adverse effect on our financial position. However, depending upon the amount and timing, an unfavorable resolution of this matter could materially affect American Founders’ future operations or cash flows in a particular period.
As discussed in previous SEC filings, in 1998 we corrected our accounting for assumed reinsurance business through restatement of our previously issued financial statements. Similar corrections were made on a statutory accounting basis through recording cumulative adjustments in Vesta Fire’s 1997 statutory financial statements. The impact of this correction has been reflected in amounts ceded under our 20 percent whole account quota share treaty which was terminated on June 30, 1998 on a run-off basis. We believe such treatment is appropriate under the terms of this treaty and have calculated the quarterly reinsurance billings presented to the three treaty participants accordingly. The aggregate amount included herein as recoverable from such reinsurers totaled $33.4 million at December 31, 2002. Additionally, we have previously collected approximately $48.5 million from the drawdown of collateral on hand. Such amount, net of related expenses, has been reflected in the 2002 financial statements.
Vesta, through its subsidiaries, is routinely a party to pending or threatened legal proceedings and arbitration relating to the regular conduct of its insurance business. These proceedings involve alleged breaches of contract, torts, including bad faith and fraud claims and miscellaneous other specified relief. Based upon information presently available, and in light of legal and other defenses available to Vesta and its subsidiaries, management does not consider liability from any threatened or pending litigation regarding routine matters to be material.
We lease office space for our home office and subsidiary offices and other equipment under operating lease arrangements. Rental expense for operating leases was $13.9 million, $6.2 million, and $3.0 million for the years ending December 31, 2002, 2001 and 2000 respectively.
In 2002, we redeemed $.8 million face amount of Deferrable Capital Securities in exchange for approximately 69 thousand shares of common stock. The resulting after-tax gain from this transaction of $.2 million was recorded directly to equity in accordance with EITF 86-32 “Early Extinguishment of a Subsidiary’s Mandatorily Redeemable Preferred Stock.” Also, we redeemed $7.9 million face amount of our Senior Debentures in exchange for approximately 1.1 million shares of common stock, resulting in a pre-tax gain of $2.9 million.
In 2001, we redeemed $10.0 million face amount of Deferrable Capital Securities in exchange for approximately 965 thousand shares of common stock. The resulting after-tax gain from these transactions of $1.9 million was recorded directly to equity in accordance with EITF 86-32. Also, we redeemed $7.0 million face amount of our Senior Debentures in exchange for approximately 568 thousand shares of common stock, resulting in a pre-tax gain of $1.4 million. In December 2001, we issued 1.5 million shares of common stock in exchange for 9.2 million shares of Instant Insurance Holdings, Inc. held by a minority shareholder.
In December 2000, we issued 952 thousand shares of common stock in exchange for 693 shares of non-voting stock of Aegis Financial Corporation. In December 2000, we issued 556 thousand shares of common stock in exchange for 3.0 million shares of Instant Auto Insurance Holdings, Inc. In December 2000, we redeemed $8.0 million face amount of our Deferrable Capital Securities in exchange for approximately 1.2 million shares of common stock. The resulting after-tax gain from this transaction of $1.3 million was recorded directly to equity in accordance with EITF 86-32.
During 2000, we entered into a transaction with NeHi Re, L.P., a special purpose limited syndicate under the INEX Insurance Exchange, to provide $50.0 million of excess-of-loss reinsurance protection to potential losses arising in Hawaii and in the Northeast United States for a period of three years. We paid $3.0 million in annual premiums for this catastrophe reinsurance.
Deferred tax assets are to be reduced by a valuation allowance if it is more likely than not that some portion or all of the deferred tax assets will not be realized. As part of the purchase accounting for our December 2000 acquisition of Instant Auto, we recorded valuation allowance of $7.3 million for net operating losses that were generated prior to the acquisition. The utilization of these net operating losses is subject to a number of acquisition-related limitations and, accordingly, we recorded a valuation allowance as part of purchase accounting. We have determined that the benefits of our remaining deferred tax assets are realizable and accordingly, no valuation allowance has been recorded at December 31, 2002 and 2001 with respect to these assets. Net operating loss carryforwards expire in periods through 2022 with approximately $29.3 million of the total expiring after 2018.
or more of the common stock. The Rights entitle the holder to purchase one one-hundreth of a share of a new series of preferred stock at an exercisable price of $30.00 and will expire on June 15, 2010.
In 2002, we redeemed $.8 million face amount of Deferrable Capital Securities in exchange for approximately 69 thousand shares of common stock. The resulting after-tax gain from these transactions of $.2 million was recorded directly to equity in accordance with EITF 86-32 “Early Extinguishment of a Subsidiary’s Mandatorily Redeemable Preferred Stock.” Also, we redeemed $7.9 million face amount of our Senior Debentures in exchange for approximately 1.1 million shares of common stock, resulting in a pre-tax gain of $2.9 million.
In the fourth quarter of 2000, Vesta redeemed preferred stock of a subsidiary with a stated value of $21 million and a carrying value of $18 million for $7.0 million including a $3.5 million contingent payable. In addition, we redeemed $8 million of Deferrable Capital Securities in exchange for 1.2 million shares of common stock. The resulting after-tax gain from these transactions of $9.2 million was recorded directly to equity in accordance with EITF 86-32 “Early Extinguishment of a Subsidiary’s Mandatorily Redeemable Preferred Stock.”
Unearned stock consists of shares of common stock issued by Vesta that remain subject to certain future restrictions, and therefore are shown as a reduction to stockholders’ equity. Unearned stock compensation is composed of the following at December 31, 2002 and 2001 (in thousands):
The Senior Debentures are unsecured and rank on parity with all other unsecured and unsubordinated indebtedness. The debentures contain certain restrictions on the ability of Vesta to issue, sell, or otherwise dispose of any restricted subsidiary or to pledge the capital stock of any subsidiary.
Vesta’s short-term debt outstanding at December 31, 2002 and 2001 is as follows (in thousands):
In March, 2002, we amended our previous $30 million revolving credit agreements with First Commercial Bank of Birmingham, Alabama (“First Commercial”) to restructure the financial covenants contained therein. These credit agreements, which consisted of a $15 million unsecured line and a $15 million secured line, were due to expire in April 2003. In January 2003, we entered into a new revolving credit arrangement with First Commercial to replace the previous facility. The new facility is a $30 million line secured by our ownership in our non-standard agency operations. The facility bears interest at First Commercial’s prime rate, which was 4.25% at December 31, 2002.
The terms of the capital securities and the underlying debenture permit us to defer interest payments on the debentures, and, therefore, distributions on the capital securities, for up to ten years. We exercised this right of deferral with respect to the semiannual payment originally due July 15, 1999. While we have elected to resume payment on these capital securities effective January 15, 2000, including all accrued amounts due since July 15, 1999, we may elect to defer payments again in the future. In the event we elect to defer such payments again in the future, we will not be permitted to pay any dividends on our common stock or other equity securities.
As of December 31, 2002, our long term debt carried a semiannual distribution obligation of approximately $ 3.4 million.
We are required to maintain a collateral deposit with FHLB. At December 31, 2002 and 2001 respectively, investments having a market value of approximately $183.6 million and $176.8 million were pledged to the FHLB. For the years ended December 31, 2002 and 200l, interest expense was approximately $7.4 million and $8.6 million, respectively.
The following summary sets forth activity under the Plans for the years ended December 31:
Of the 882,311 outstanding options at December 31, 2002, 349,811 were exercisable.
• Mortgage Loans - The fair value of mortgage loans is calculated by discounting scheduled cash flows through the estimated maturity using the current rates at which similar loans would be made to borrowers with similar credit and interest rate risks. Approximately $66,000 of the loans were in the process of foreclosure.
Also in the fourth quarter of 2002, we elected to exit the consulting business. In connection with this decision, we wrote-off goodwill associated with the consulting business of $1.2 million. This business is being actively marketed for sale. Accordingly, in accordance with the requirements of SFAS No. 144, the consulting operations have been segregated from continuing operations herein for all periods presented.
As a result of an unexpected increase in the severity and volume of reported claims associated with both our discontinued commercial and assumed reinsurance lines and an increase in payments on claim reserves during 2001, we increased our expected losses from discontinued operations in the third quarter of 2001 by approximately $19.5 million, net of tax. The increase in our expected losses with respect to our commercial business related to a variety of underlying coverages including general liability. These types of claims may take many years to fully develop and we must continue to monitor trends in their ultimate development. Similarly, we experienced negative development in some of our assumed reinsurance contracts, principally related to certain homeowner coverages. These types of claims should fully develop over a comparatively shorter period of time. During 2002, we incurred an after-tax charge of $9.5 million due to the completion of arbitration with F&G Re related to ceded commercial and assumed reinsurance business (see Note G). While we believe that the recorded reserves for discontinued operations at December 31, 2002 are adequate, further adjustments to our estimates could be necessary as we continue to run off the remaining outstanding claims.
Operating results of reinsurance assumed, commercial, health and consulting lines were as follows (in thousands):
Assets and liabilities of the health and consulting lines are classified as held for sale and are primarily comprised of the following at December 31, 2002:
In June of 2001, the Company settled a contingent liability with three of its executives under the Executive Officer Incentive Compensation Plan by issuing 1.25 million shares of restricted stock and giving the executives total loans of $5.0 million. The restricted stock, which is recorded as Unearned Stock at December 31, 2002, vests over a 10-year period. The loans, which are recorded as Other Assets at December 31, 2002 will be forgiven over a 10-year period. The Company will record the vesting of the restricted stock and the forgiveness of the loans as compensation expense in the appropriate periods.
In December 2002, James E. Tait, the former Chairman, voluntarily resigned. Mr. Tait received a severance payment of $4.2 million. In addition, Mr. Tait returned to Vesta 450 thousand shares of unvested restricted stock and also repaid an outstanding loan in the amount of $1.8 million plus accrued interest under the Executive Officer Incentive Compensation. Also, Mr. Tait returned 145 thousand shares of restricted stock, repaid a $250 thousand loan for a relocation advance, and repaid a Bonus Promissory Note of $550 thousand plus accrued interest.