We believe that the delivery of non-standard personal automobile insurance policies to individual consumers requires the interaction of four basic operations, each with a specialized function:
Premium finance companies, which provide financing alternatives to individual customers of our retail agencies.
Our four operating components often function as a vertically integrated unit, capturing the premium and associated risk and commission income and fees generated from the sale of an insurance policy. There are other instances, however, when each of our operations functions with unaffiliated entities on an unbundled basis, either independently or with one or two of the other operations. For example, our retail stores earn commission income and fees from sales of non-standard automobile insurance policies issued by third-party insurance carriers.
Reserving for unpaid losses and loss adjustment expenses. On a quarterly basis, for each financial reporting period, we record our best estimate of our overall reserve for both current and prior accident years. The amount recorded represents the remaining amount we expect to pay for all covered losses that occurred through the current financial statement date, as well as the amount we expect to expend for all claim settlement expenses. The overall reserve for losses and loss adjustment expenses estimate that we record is the difference between (1) our point estimate of the ultimate loss and ultimate loss adjustment expenses, and (2) the amount of losses and loss adjustment expenses paid through the current financial statement date. Our point estimate of ultimate loss consists of a point estimate for Incurred But Not Reported (IBNR) losses. The IBNR reserve is calculated by reducing the overall reserve for loss by the amount of our case reserves. The point estimate of ultimate loss adjustment expenses consists of a separate point estimate for adjusting and other expenses and for defense and cost containment expenses.
We estimate IBNR losses and ultimate loss adjustment expenses quarterly using detailed statistical analyses and judgment including adjustment for deviations in trends caused by internal and external variables that may affect the resulting reserves. The underlying processes require the use of estimates and informed judgment, and as a result the establishment of loss and loss adjustment expenses reserves is an inherently uncertain process. The following generally accepted actuarial loss and LAE reserving methodologies are used in our analysis:
Frequency and Severity Methods - We use historical claim count development over discrete periods of time to estimate future claim count development. A ratio of ultimate claim counts to earned car years is applied to the ultimate dollars of loss per claim for each accident quarter.
There are numerous factors, both internal and external, that we consider when evaluating the reasonableness of the various methods used to determine the actuarial best estimate of loss and loss adjustment expense reserves. Many of the factors vary for different states, programs, coverage groups, and accident periods. Some examples of internal factors considered are changes in product mix, changes in claims-handling practices, loss cost trends and underwriting standards and rules. External factors considered include frequency, severity, the effect of inflation on medical hospitalization, material repair and replacement costs, as well as general economic and legal trends.
We determined that our historical loss and LAE reserve development does not provide the most reasonable indication of the potential variability associated with our reserves.
The variability surrounding the carried loss reserves diminishes for each accident period as the current accident year contains the greatest proportion of losses that have not been reported or settled, and these elements must be estimated as of the current reporting date. The proportion of losses with these characteristics diminishes in subsequent years. Due to the introduction of new claims practices in late 2009, the payment of claims has been accelerated. The result of this was to increase the upper end of the range of reasonable estimates for both gross and net reserves. If the higher payments were indicative of a higher ultimate level of payments, the additional loss exposure would be between $5 and $35 million on a gross basis and $5 and $30 million on a net basis. These values are reflected in the ranges of gross and net reserves.
We conduct regular reviews to assess whether our investments are impaired and if any impairment is other than temporary. Factors considered by us in assessing whether an impairment is other than temporary include the credit quality of the investment, the duration of the impairment, our ability and intent to hold the investment until recovery or maturity and overall economic conditions. Under Financial Accounting Standards Board (FASB) guidance adopted in the second quarter of 2009, an other-than-temporary impairment is triggered in circumstances where (1) an entity has an intent to sell the security, (2) it is more likely than not that the entity will be required to sell the security before recovery of its amortized cost basis, or (3) the entity does not expect to recover the entire amortized cost basis of the security (that is, a credit loss exists). Other-than-temporary impairments are separated into amounts representing credit losses which are recognized in earnings and amounts related to all other factors which are recognized in other comprehensive income (loss), a component of stockholders’ equity. All impairments on our available-for-sale investment securities were considered temporary in nature as of December 31, 2009 and 2008, respectively. Accordingly, unrealized losses are recorded in other comprehensive income on our consolidated balance sheet.
Valuation of trading investments. Our trading investment securities consist solely of auction-rate tax-exempt investment securities, which are carried at fair value with realized gains and losses reported in current
Based on the valuation model results, management concluded that goodwill was not impaired as the fair value of the Company exceeded its carrying value. Further, the fair value obtained from the discounted cash flow model was subject to a stress test by decreasing forecasted cash flows by 15%, and at the same time increasing the discount rate by 100 basis points to 15.4%. The indicated stress value was sufficient to cover the book value of the Company.
Deferred income taxes. Significant management judgment is required in determining the provision for income taxes, deferred tax assets and liabilities, and the valuation allowance recorded against net deferred tax assets. The process involves summarizing temporary differences resulting from differing treatment of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included within the consolidated balance sheet. In addition, we assess whether valuation allowances should be established against deferred tax assets based on consideration of all available evidence using a “more likely than not” standard. To the extent a valuation allowance is established in a period, an expense must be recorded within the income tax provision in the consolidated statement of operations.
If actual results differ from these estimates or these estimates are adjusted in future periods, the valuation allowance may need to be adjusted, which could materially impact our financial position and results of operations. If sufficient positive evidence arises in the future indicating that all or a portion of the deferred tax assets meet the more likely than not standard, the valuation allowance would be reversed accordingly in the period that such a conclusion is reached.
In the second quarter of 2009, the Company adopted FASB guidance related to the recognition and measurement of other-than-temporary impairments for debt securities which replaced the pre-existing “intent and ability” indicator. These new standards specify that if the fair value of a debt security is less than its amortized cost basis, an other-than-temporary impairment is triggered in circumstances where (1) an entity has an intent to sell the security, (2) it is more likely than not that the entity will be required to sell the security before recovery of its amortized cost basis, or (3) the entity does not expect to recover the entire amortized cost basis of the security (that is, a credit loss exists). Other-than-temporary impairments are separated into amounts representing credit losses which are recognized in earnings and amounts related to all other factors which are recognized in other comprehensive income (loss). Adoption of the new guidance did not have a material effect on our consolidated financial position, results of operations or cash flows.
The Company also adopted in the second quarter of 2009 FASB standards that provide guidance on how to determine the fair value of assets and liabilities when the volume and level of activity for the asset or liability has significantly decreased. These new standards also provide guidance on identifying circumstances that indicate a transaction is not orderly. In addition, the Company is required to disclose in interim as well as annual reporting periods the inputs and valuation techniques used to measure fair value and discussion of changes in valuation techniques. Adoption of these standards did not have a material effect on our consolidated financial position, results of operations or cash flows.
The FASB issued authoritative guidance on measuring the fair value of liabilities and clarifies that the quoted price for an identical liability, when traded as an asset in an active market, is also a Level 1 measurement,
the highest priority in the fair value hierarchy, when no adjustment to the quoted price is required. This guidance was effective for interim and annual periods beginning after August 27, 2009. The Company did not have any revisions in valuation techniques as a result of adopting this guidance in the fourth quarter of 2009.
ASU 2010-06 requires additional disclosures about fair value measurements, including transfers in and out of Levels 1 and 2 and activity in Level 3 on a gross basis, and clarifies certain other existing disclosure requirements including level of disaggregation and disclosures around inputs and valuation techniques. The provisions of the new standards are effective for interim or annual reporting periods beginning after December 15, 2009, except for the additional Level 3 disclosures which will become effective for fiscal years beginnings after December 15, 2010. These standards are disclosure only in nature and do not change accounting requirements. Accordingly, adoption of ASU 2010-06 will not impact the Company’s consolidated financial position, results of operations or cash flows.
We are an insurance holding company engaged in the underwriting, servicing and distributing of non-standard personal automobile insurance policies and related products and services. We distribute our products through three distinct distribution channels: our retail stores, independent agents and unaffiliated underwriting agencies. We generate earned premiums and fees from policyholders through the sale of our insurance products. In addition, through our retail stores, we sell insurance policies of third-party insurers and other products or services of unaffiliated third-party providers and thereby earn commission income from those third-party providers and insurers and fees from the customers.
As part of our corporate strategy, we treat our retail stores as independent agents, encouraging them to sell to their individual customers whatever products are most appropriate for and affordable to those customers. We believe that this offers our retail customers the best combination of service and value, developing stronger customer loyalty and improving customer retention. In practice, this means that in our retail stores, the relative proportion of the sales of our own insurance products as compared to the sales of the third-party policies will vary depending upon the competitiveness of our insurance products in the marketplace during the period. This reflects our intention of maintaining the margins in our insurance company subsidiaries, even at the cost of business lost to third-party carriers.
The market conditions that existed for the past several years continued in 2009 putting downward pressure on industry rate levels. Our insurance company subsidiaries have continued developing and introducing new and better segmented products to serve our target markets during the past twelve months. In the aggregate, our rate level during 2009 modestly increased, as we continued to focus on seeking an appropriate balance between competitive positioning and profitability.
Premiums. One measurement of our performance is the level of gross premiums written and a second measurement is the relative proportion of premiums written through our three distribution channels. The following table displays our gross premiums written by distribution channel for the years ended December 31, 2009, 2008 and 2007 (in thousands):
Total gross premiums written for 2008 decreased $57.6 million, or 13.0%, compared with 2007. The decrease was primarily due to macroeconomic effects. In our retail distribution channel, gross premiums written consist of premiums written for our affiliated insurance carriers’ products only and do not include premiums written for third-party insurance carriers in our retail and franchised stores. We earn commission income and fees in our retail distribution channel for sales of third-party insurance policies. Gross premiums written in our retail distribution channel decreased $13.6 million, or 5.5%, from 2007. In our independent agency distribution channel, gross premiums written for 2008 decreased $35.4 million, or 22.7%, compared with 2007. Gross premiums written by our unaffiliated agencies in 2008 decreased $8.6 million, or 22.1%, compared with 2007.
The largest component of revenue is net premiums earned on insurance policies. Net premiums earned for 2009 increased $8.1 million, or 2.3%, compared with 2008. Since insurance premiums are earned over the service period of the policies, the revenue in the current period includes premiums earned on insurance products written through our three distribution channels in both current and previous periods. Net premiums earned during 2009 on policies sold through our affiliated underwriting agencies increased by $14.4 million, or 4.4%. This increase is primarily due to the increase in retention on the Louisiana and Alabama business with the termination of our quota-share reinsurance agreement, which was partially offset by the macroeconomic environment. Net premiums earned on insurance products sold through the unaffiliated underwriting agencies distribution channel decreased by $6.3 million, or 19.8%, compared with 2008.
Reinsurance. The following table reflects the premiums ceded and assumed under reinsurance agreements in our consolidated financial statements for the years ended December 31, 2009, 2008 and 2007 (in thousands):
In connection with the completion of the acquisition of USAgencies, we reevaluated their reinsurance program in light of the capital structure and risk management programs of the larger combined operations. As a result, terms were renegotiated with the reinsurer and a new quota-share reinsurance agreement was made effective April 1, 2007, under which the net retention increased from 30% to 75% in Louisiana and from 25% to 75% in Alabama on policies issued in those two states. Concurrently, we exercised our option to terminate the prior quota-share contracts on a cut-off basis. In April 2007, we received $31.0 million to settle the unearned premiums less return ceding commissions. Effective January 1, 2009, we terminated our quota-share reinsurance contract on a cut-off basis and received $7.8 million of returned unearned premiums, net of $2.6 million returned ceding commissions.
Our quota-share ceding commission rate structure varies based on loss experience. The estimates of loss experience are continually reviewed and adjusted, and the resulting adjustments to ceding commissions are reflected in current operations.
Policy, installment, premium finance and agency fees are earned for business written or assumed by our insurance companies both through independent agents and our retail agencies. Policy, installment and agency fees are fees charged to the customers in connection with their purchase of coverage from our insurance company subsidiaries. Generally, we can increase or decrease agency and installment fees subject to limited regulatory restrictions, but policy fees and interest rates must be approved by the applicable state’s department of insurance. Premium finance fees are financing fees earned by our premium finance subsidiaries, and consist of interest and origination fees on premiums that customers choose to finance.
Commissions, premium finance and agency fees are earned on sales of third-party companies’ products sold by our retail agencies. As described above, in our owned stores, there can be a shift in the relative proportion of the sales of third-party insurance products as compared to sales of our own carriers’ products due to the relative competitiveness of our insurance products that could result in an increase in our commission income and fees from non-affiliated third-party insurers. We negotiate commission rates with the various third-party carriers whose products we agree to sell in our retail stores. As a result, the level of third-party commission income will also vary depending upon the mix by carrier of third-party products that are sold. In addition, we earn fees from the sales of other products and services such as auto club memberships, bond cards and tax preparation services offered by unaffiliated companies.
Commission income and fees increased $2.9 million, or 3.8%, compared with 2008. Policyholder fees have decreased due to the lower volume of premiums written in states where we collect policyholder fees. While we have experienced a steady increase in premium finance revenue since December 2007 when we began financing third-party premiums, the slight decrease from 2007 to 2008 in premium finance revenue was driven by lower volumes of premiums written and related affiliate premiums financed in Louisiana. Commissions and fees increased as a result of a revised rate structure in 2009, more of our retail customers choosing third-party products due to the market conditions, and a concerted effort to sell more ancillary products.
Net Investment Income and Other Income. Net investment income includes primarily income on our portfolio of debt securities. Also included in net investment income is lease income from our investment in real property. Net investment income for 2009 decreased $4.3 million, or 31.3%, compared with 2008, consisting of a $4.6 million decrease in investment income on debt securities, partially offset by a $0.5 million increase in lease income from investment in real property. The decrease was primarily due to a reduction in yields and a 14.2% decrease in total average invested assets to $266.7 million during 2009 from $310.7 million during 2008. The average investment yield was 3.0% (4.0% on a taxable equivalent basis) in 2009 as compared to 4.1% (5.6% on taxable equivalent basis) in 2008.
Our investment strategy is to conservatively manage our investment portfolio by investing in readily marketable, investment-grade, fixed-income securities. We currently do not invest in common equity securities and we have no exposure to foreign currency risk. The Investment Committee of our Board of Directors has established investment guidelines and periodically reviews portfolio performance for compliance with our guidelines.
As of December 31, 2009, we held $46.4 million, at amortized cost, and $37.4 million fair value of auction-rate tax-exempt securities. Generally, the interest rates for these securities are determined by bidding every 7, 28 or 35 days. When there are more sellers than buyers, an auction fails and bondholders that want to sell are unable to sell the securities. Auctions for these securities began to fail in late January 2008. Issuers remain obligated to pay interest and principal when due when an auction fails. Rates at failed auctions are set at a level established in the terms of the debt. In February 2008, investment banks stopped committing capital to the auctions and there have been widespread auctions failures since that time.
In August 2008, our broker announced settlements in principle with each of the Division Enforcement of the U.S. Securities and Exchange Commission (SEC), the New York Attorney General and other state agencies to purchase all of its clients’ auction-rate securities at par and several other items, including fines. In October 2008, our broker filed a prospectus with the SEC, which published a legally-binding offer to all authorized holders of auction-rate securities in our broker’s accounts (“the settlement”). The majority of our auction-rate securities qualify under the terms of the settlement. The time frames that our broker has set for buybacks have different start dates based upon the individual client’s size, which is determined by each client’s balance of investments held at our broker. For the majority of our auction-rate holdings, the buybacks are expected to occur between July 2010 and two years thereafter. In November 2008, the Company elected to participate in our broker’s offer to purchase our auction-rate securities at par. We classify our portfolio of auction-rate securities as trading and for the year ended December 31, 2009, recorded a realized gain of $2.1 million for the change in fair value. As of
The following table displays the impact of loss and loss development related to prior periods’ business on our loss ratio (losses and loss adjustment expenses divided by net premiums earned) for the years ended December 31, 2009, 2008 and 2007:
The Florida losses were the result of our decision to push the full coverage product in Florida in 2007 in response to the Personal Injury Protection (PIP) sunset in that state on October 1, 2007. Inadequate pricing and product management produced significantly higher losses than anticipated. We have drastically reduced the production of this product by restricting writings by agent, territory and coverage based on where significant loss ratio swings occurred. In February 2010, we notified the Florida Insurance Commissioner of our intent to discontinue writing policies. We plan to begin issuing notices of non-renewal to insureds beginning on May 17, 2010. This decision is directly related to the challenging regulatory environment and the resulting unsatisfactory financial results we have experienced. Although these actions will eventually lead to a complete shutdown of our Florida business, we will continue to evaluate alternate strategies for Florida and will consider re-entering the market when conditions are more conducive to achieving favorable operating results. Excluding Florida in the current accident year, the loss ratio was 74.0%.
Our losses, loss adjustment expense reserves and deposit liabilities of $193.6 million on a gross basis and $161.0 million on a net basis are our best estimates as of December 31, 2009. The analysis provided by our internal valuation methods indicated that the expected range for the ultimate liability for our losses and loss adjustment expense reserves, as of December 31, 2009, was between $155.0 million and $230.0 million on a gross basis and between $135.0 million and $195.0 million on a net basis.
Our historical net liabilities for losses and loss adjustment expenses are impacted by our 100% quota-share reinsurance contract with VFIC. Beginning in 1997, our insurance companies reinsured 100% of the business they wrote to VFIC. During 1999 and 2000, one of our insurance companies retained a small book of business, but continued ceding a majority of its business to VFIC. For the years 2001, 2002 and 2003 we reinsured 100% of business written or assumed by our insurance companies to VFIC. The following table summarizes the development of reserves for unpaid losses and loss adjustment expenses (in thousands).
The following table is a reconciliation of our net liability to our gross liability for losses and loss adjustment expenses (in thousands):
Selling, General and Administrative Expenses. Another measurement of our performance that addresses our overall efficiency is the level of selling, general and administrative expenses. We recognize that our customers are primarily motivated by low prices. As a result, we strive to keep our costs as low as possible to be able to keep our prices affordable and thus to maximize our sales while still maintaining profitability. Our selling, general and administrative expenses include not only the cost of acquiring the insurance policies through our insurance carriers (the amortization of the deferred acquisition costs) and managing our insurance carriers and the retail stores, but also the costs of the holding company. The largest component of selling, general and administrative expenses is personnel costs, including payroll, benefits and accrued bonus expenses.
The following table sets forth the impact that amortization of deferred acquisition costs had on selling, general and administrative expenses and the change in deferred acquisition costs for the years ended December 31, 2009, 2008 and 2007 (in thousands):
We believe that the cumulative effect of all of the actions outlined above, including the sale of the Florida retail operations and the suspension of the 401(k) matching contributions, should produce expense savings of at least $10.0 million annually.
Selling, general and administrative expenses for 2008 decreased $16.4 million, or 10.5%, compared with 2007. The overall decrease in selling, general and administrative expenses was primarily due to a reduction in operating expenses primarily due to the decline in premium volume and management’s efforts to reduce expenses in response to the premium decline.
Net expenses, defined as the sum of selling, general and administrative expenses and depreciation and amortization less commission income and fees, as a percentage of net premiums earned (the net expense ratio) increased to 25.4% in 2009 compared with 20.0% in 2008. The increase was primarily due to a 17.1% increase in selling, general and administrative expenses driven by increasing our retained premiums (reducing reinsurance) and contingent commissions on prior accident year development. Net expenses as a percentage of net premiums earned decreased to 20.0% in 2008 compared with 20.4% in 2007. The decrease was primarily due to a 10.5% decrease in selling, general and administrative expenses. The following table sets forth the components of the net expenses and the computation of the net expense ratios for the years ended December 31, 2009, 2008 and 2007 (in thousands):
During 2006, we developed a comprehensive implementation plan and supporting business case to consolidate and transform our primary business applications onto a new strategic platform. This plan encompasses consolidating and migrating our multiple claims, point-of-sale and policy administration systems onto single strategic platforms, as well as deploying new premium finance, reporting and business analytics capabilities. For all components of this systems transformation plan, we have selected a software package that we will configure and integrate to meet our unique needs. We believe this systems transformation will position us to realize significant strategic benefits including: systemic pricing advantage in our marketplace via consolidated and streamlined systems and operations; faster product time to market; additional retail revenue via premium financing; improved claims and underwriting performance via increased automated application of best practice processing rules; a platform to simplify and hasten post-merger and acquisition integration-reducing integration costs and accelerating synergies realization; and improved customer focus and retention. Through December 31, 2009, we have capitalized $41.5 million of costs related to the transformation. The agency management and premium finance systems were fully implemented in the first quarter of 2008. The insurance systems began to be implemented in June 2008 with the claims system implemented to support all of our operations except for our Louisiana and Alabama operations in the last half of 2008. We converted all remaining open claims from the legacy system to the new system (with the exception of Louisiana and Alabama). Through December 31, 2009, the new point-of-sale and policy administration system was implemented in Illinois, Indiana, Michigan, Missouri, South Carolina and Texas. For the new policy administration system implementation, we plan to operate the legacy systems through the policies’ renewal dates when they will be converted to the new system. This will result in additional operating expense until the legacy systems can be retired.
We recorded a $19.4 million pretax, non-cash gain on extinguishment of debt as a result of this transaction, which is included in a separate line item in the accompanying consolidated statement of income(loss) for the year ended December 31, 2009. The $19.4 million debt extinguishment gain resulted from a $24.2 million discount representing the difference between the carrying value of the original credit agreement and the fair value of the new modified credit agreement, net of $0.7 million of term lender consent fees and the write-off of $4.1 million of deferred debt issuance costs relating to the original credit agreement.
Loss on Interest Rate Swaps. Loss on interest rate swaps for 2009 was $6.4 million. The modification of the senior credit facility effective March 27, 2009 resulted in the interest rate swaps becoming ineffective as cash flow hedges. As a result, the previously hedged interest payments will not occur. Therefore, the amount recorded in accumulated other comprehensive loss through March 27, 2009 was reclassified to earnings as loss on interest rate swaps. Subsequent to March 27, 2009, we record changes in the fair value of the derivative instruments in earnings, as gain or loss on interest rate swaps.
Income Taxes. We recognized an income tax expense from continuing operations of $22.4 million for the year ended December 31, 2009 as compared to income tax benefit from continuing operations of $0.8 million for the year ended December 31, 2008. Our effective tax rate from continuing operations of 152.8% for the year ended December 31, 2009 differed from the federal statutory rate primarily as a result of the recognition of a deferred tax asset valuation allowance and investment income generated by tax-exempt securities.
Our net deferred tax assets prior to recognition of valuation allowance were $20.8 million and $17.5 million at December 31, 2009 and 2008, respectively. In assessing the realizability of our deferred tax assets, we considered whether it was more likely than not that our deferred tax assets will be realized based upon all
available evidence, including scheduled reversal of deferred tax liabilities, historical operating results, projected future operating results, tax carry-back availability, and limitations pursuant to Section 382 of the Internal Revenue Code, among others. Based on this assessment, a valuation allowance was established during the fourth quarter of 2009, resulting in additional tax expense of $31.6 million. Our effective tax rate from continuing operations was (14.4%) for the year ended December 31, 2008 which differed from the statutory rate primarily due to a relatively high proportion of the investment income generated by tax-exempt securities.
There are no restrictions on the payment of dividends by our non-insurance company subsidiaries other than state corporate laws regarding solvency. As a result, our non-insurance company subsidiaries generate revenues, profits and net cash flows that are generally unrestricted as to their availability for the payment of dividends and we have and expect to continue to use those revenues to service our corporate financial obligations, such as debt service and stockholder dividends. Our non-insurance company subsidiaries have paid dividends of $25.0 million in 2009. As of December 31, 2009, we had $1.3 million of cash and equivalents at the holding company level and $28.4 million of cash and cash equivalents at our non-insurance company subsidiaries.
The National Association of Insurance Commissioners’ model law for risk-based capital provides formulas to determine the amount of capital that an insurance company needs to ensure that it has an acceptable expectation of not becoming financially impaired. At December 31, 2009, each of our insurance subsidiaries maintained a risk-based capital level that was in excess of an amount that would require any corrective actions on our part.
liquidity needs other than the capital expenditures related to our strategic systems consolidation and transformation program and the debt service requirements of the senior secured credit facility to fund the acquisition of USAgencies.
The combined ratio covenant has been replaced with a loss ratio covenant.
The fixed charge coverage ratio covenant calculation has been changed to include only interest expense paid in cash. In addition, the annual requirements have been changed for the remaining term of the facility.
The consolidated net worth covenant calculation has been changed to a covenant that excludes goodwill and includes subordinated debt.
At December 31, 2009, we were in compliance with all of our financial and other covenants.
(1) As of December 31, 2009, we leased an aggregate of approximately 461,046 square feet of office space for our agencies, insurance companies and retail stores in various locations throughout the United States. These amounts represent our minimum future operating lease commitments.
(5) The payout pattern for reserves for losses and loss adjustment expenses is based upon historical payment patterns and does not represent actual contractual obligations. The timing and amount ultimately paid can and will vary from these estimates.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Affirmative Insurance Holdings, Inc. and subsidiaries as of December 31, 2009 and 2008, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2009, in conformity with U.S. generally accepted accounting principles.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Affirmative Insurance Holdings, Inc.’s internal control over financial reporting as of December 31, 2009, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 30, 2010 expressed an adverse opinion on the effectiveness of the Company’s internal control over financial reporting.
Affirmative Insurance Holdings, Inc., formerly known as Instant Insurance Holdings, Inc., was incorporated in Delaware in June 1998. The Company is a distributor and producer of non-standard personal automobile insurance policies and related products and services for individual consumers in targeted geographic areas. The Company currently offers insurance directly to individual consumers through retail stores in 9 states (Louisiana, Texas, Illinois, Alabama, Missouri, Indiana, South Carolina, Kansas and Wisconsin) as well as through 9,400 independent agents or brokers in 11 states (Louisiana, Texas, Illinois, Alabama, California, Michigan, Florida, Missouri, Indiana, South Carolina and New Mexico).
Use of Estimates • The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and 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. Actual results could differ materially from those estimates. These estimates and assumptions are particularly important in determining revenue recognition, reserves for losses and loss adjustment expenses, deferred policy acquisition costs, reinsurance receivables, valuation of investments, goodwill and other intangible assets, and deferred income taxes.
Investments • Investment securities consist entirely of debt securities, and are recorded at fair value on the consolidated balance sheet. These investments are classified as either available-for-sale or trading securities, based on management’s intent and ability to hold to maturity. For available-for-sale securities, which comprise approximately 85% of the total investment portfolio, unrealized gains and losses, net of income taxes, are recorded in accumulated other comprehensive income, a separate component of stockholders’ equity. For trading securities, unrealized gains and losses are reported in current period earnings.
In the second quarter of 2009, the Company adopted Financial Accounting Standards Board (FASB) guidance related to the recognition and measurement of other-than-temporary impairments for debt securities, which replaced the pre-existing “intent and ability” indicator. These new standards specify that if the fair value of a debt security is less than its amortized cost basis, an other-than-temporary impairment is triggered in circumstances where (1) an entity has an intent to sell the security, (2) it is more likely than not that the entity will be required to sell the security before recovery of its amortized cost basis, or (3) the entity does not expect to recover the entire amortized cost basis of the security (that is, a credit loss exists). Other-than-temporary impairments are separated into amounts representing credit losses which are recognized in earnings and amounts related to all other factors which are recognized in other comprehensive income. Adoption of the new guidance did not have a material effect on the Company’s consolidated financial position, results of operations or cash flows.
The Company also adopted in the second quarter of 2009 FASB standards which provide guidance on how to determine the fair value of assets and liabilities when the volume and level of activity for the asset or liability has significantly decreased. These new standards also provide guidance on identifying circumstances that indicate a transaction is not orderly. In addition, the Company is required to disclose in interim as well as annual reporting periods the inputs and valuation techniques used to measure fair value and discussion of changes in valuation techniques. Adoption of these standards did not have a material effect on the Company’s consolidated financial position, results of operations or cash flows.
The FASB issued authoritative guidance on measuring the fair value of liabilities and clarifies that the quoted price for an identical liability, when traded as an asset in an active market, is also a Level 1 measurement, the highest priority in the fair value hierarchy, when no adjustment to the quoted price is required. This guidance was effective for interim and annual periods beginning after August 27, 2009. The Company did not have any revisions in valuation techniques as a result of adopting this guidance in the fourth quarter of 2009.
Property and Equipment, Net • Property and equipment is stated at cost, less accumulated depreciation. Depreciation is recognized using the straight-line method over the estimated useful lives of our assets, typically ranging from three to five years. Leasehold improvements are depreciated over the shorter of the estimated useful lives of the assets or the remainder of the lease term.
The results of operations of acquired businesses are included in the Consolidated Financial Statements from the respective dates of acquisition.
Reserves for Losses and Loss Adjustment Expenses • The Company maintains reserves for the estimated ultimate liability for unpaid losses and loss adjustment expenses related to incurred claims and estimates of
Accounting and Reporting for Reinsurance Income and expense on reinsurance contracts are recognized principally over the term of the reinsurance contracts or until the reinsurers maximum liability is exhausted, whichever comes first. Reinsurance contracts do not relieve the Company from its obligations to policyholders. Management continually monitors reinsurers to minimize the exposure to significant losses from reinsurer insolvencies. The Company only cedes risks to reinsurers whom it believes to be financially sound.
Stock-Based Compensation • Compensation cost is measured based on the grant-date fair value of an award utilizing the assumptions discussed in note 17. Compensation cost is recognized for financial reporting purposes
Income Taxes • The Company accounts for income taxes under the asset and liability method. Under this method, deferred income taxes are recognized for temporary differences between the financial statement and tax return bases of assets and liabilities. Recorded amounts are adjusted to reflect changes in income tax rates for the period in which the change is enacted. Any resulting future tax benefits are recognized to the extent that realization of such benefits is more likely than not, and a valuation allowance is established for any portion of a deferred tax asset that management believes will not be realized. While the Company typically does not incur significant interest or penalties on income tax liabilities, the Company’s policy is to classify such amounts as income tax expense on the consolidated statement of income/(loss).
Fair Value of Financial Instruments • During the first quarter of 2009, the Company adopted FASB ASC 820, Fair Value Measurements and Disclosures, which defines fair value, establishes guidelines for measuring fair value and expands disclosures regarding fair value measurements. This new accounting standard did not require any new fair value measurements. The Company applies fair value accounting for all financial assets and liabilities and non-financial assets and liabilities that are recognized or disclosed at fair value in the financial statements on a recurring basis. The Company defines fair value as the price that would be received from selling an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. When determining the fair value measurements for assets and liabilities, which are required to be recorded at fair value, the Company considers the principal or most advantageous market in which the Company would transact and the market-based risk measurements or assumptions that market participants would use in pricing the asset or liability, such as inherent risk, transfer restrictions and credit risk.
SAP requires available-for-sale investments generally be carried at amortized book value while GAAP requires available-for-sale investments be carried at fair value.
On January 1, 2009, new authoritative guidance under ASC 805, Business Combinations, became applicable to the Company’s accounting for business combinations closing on or after January 1, 2009. ASC Topic 805 requires an acquirer, upon initially obtaining control of another entity, to recognize the assets, liabilities and any non-controlling interest in the acquiree at fair value as of the acquisition date. Contingent consideration is required to be recognized and measured at fair value on the date of acquisition rather than at a later date when the amount of that consideration may be determinable beyond a reasonable doubt. This fair-value approach replaces the cost-allocation process required under previous accounting guidance whereby the cost of an acquisition was allocated to the individual assets acquired and liabilities assumed based on their estimated fair value. ASC Topic 805 requires acquirers to expense acquisition-related costs as incurred rather than allocating such costs to the assets acquired and liabilities assumed, as was previously the case under prior accounting guidance. Assets acquired and liabilities assumed in a business combination that arise from contingencies are to be recognized at fair value if fair value can be reasonably estimated. In the event the Company has future business combinations, this new standard could impact future results of operations or financial position.
The Company’s trading investment securities consist solely of auction-rate tax-exempt investment securities, which are carried at fair value with realized gains and losses reported in current period earnings. The Investment Committee of the Board of Directors periodically reviews investment portfolio results and evaluates strategies to maximize yields, to match maturity durations with anticipated needs, and to maintain compliance with investment guidelines.
The Company’s available-for-sale investment securities are carried at fair value with unrealized gains and losses, net of income taxes, reported in accumulated other comprehensive income, a separate component of stockholders’ equity. The Investment Committee periodically reviews investment portfolio results and evaluates strategies to maximize yields, to match maturity durations with anticipated needs, and to maintain compliance with investment guidelines.
Expected maturities may differ from contractual maturities because certain borrowers may have the right to call or prepay obligations with or without penalties. The Company’s amortized cost and estimated fair values of fixed-income securities at December 31, 2009 by contractual maturity were as follows (in thousands):
At December 31, 2009, the Company owned approximately $23.9 million of pre-refunded municipal bonds. These pre-refunded municipal bonds have contractual maturities in excess of ten years. However, due to pre-refunding, these securities will be called by the issuer generally within three years or less. Pre-refunded municipal bonds are created when municipalities issue new debt to refinance debt issued when interest rates were higher. Once the refinancing is completed, the issuer uses the proceeds to purchase U.S. Treasury securities and places these securities in an escrow account. These proceeds are then used to pay interest and principal on the original debt until the bond is called.
The Company’s amortized cost and estimated fair value of pre-refunded municipal bonds at December 31, 2009 by contractual maturity were as follows (in thousands):
Gross realized gains and losses on available-for-sale investments for the years ended December 31 were as follows (in thousands):
The following table summarizes the Company’s available-for-sale securities in an unrealized loss position at December 31, 2009 and 2008 , the fair value and amount of gross unrealized losses, aggregated by investment category and length of time those securities have been continuously in an unrealized loss position (in thousands):
The unrealized losses at December 31, 2009 were attributable to changes in market interest rates since the securities were purchased. Management systematically evaluates investment securities for other-than-temporary declines in fair value on a quarterly basis. This analysis requires management to consider various factors, which include (1) duration and magnitude of the decline in value, (2) the financial condition of the issuer or issuers, (3) structure of the security and (4) the Company’s intent to sell the security or whether its more likely than not that the Company would be required to sell the security before its anticipated recovery in market value. At December 31, 2009, management performed its quarterly analysis of all securities with an unrealized loss and concluded no individual securities were other-than-temporarily impaired.
Under certain of the Company’s reinsurance transactions, the Company has received ceding commissions. The ceding commission rate structure varies based on loss experience. The estimates of loss experience are continually reviewed and adjusted, and the resulting adjustments to ceding commissions are reflected in current operations. The ceding commissions recognized were reflected as a reduction (increase) of the following expenses (in thousands):
The following table summarizes the ceded incurred losses and loss adjustment expenses (consisting of ceded paid losses and loss adjustment expenses and change in reserves for loss and loss adjustment expenses ceded) to various reinsurers for the years ended December 31, 2009, 2008 and 2007 (in thousands):
The Company’s other significant assumed reinsurance agreement is with a Texas county mutual insurance company (the county mutual) whereby the Company has assumed 100% of the policies issued by the county mutual for business produced by the Company’s owned MGAs. The county mutual does not retain any of this business and there are no loss limits other than the underlying policy limits. The county mutual reinsurance agreement may be terminated by either party upon prior written notice of not less than 90 days. In the event of such termination, the MGA agrees that for ten years the MGA shall produce automobile insurance business in the State of Texas solely for the benefit of the county mutual. The county mutual reinsurance agreement automatically terminates on January 1, 2014. AIC has established a trust to secure the Company’s obligation under this reinsurance contract with a balance of $40.2 million as of December 31, 2009.
At December 31, 2009, $12.8 million was included in reserves for losses and loss adjustment expenses that represented the amounts owed by AIC and Insura under reinsurance agreements with the VIG affiliated companies, including Hawaiian Insurance and Guaranty Company, Ltd (Hawaiian). Affirmative established a trust account to collateralize this payable, which currently holds $22.4 million in securities (the AIC Trust). The Special Deputy Receiver in Texas had cumulative withdrawals from the AIC Trust of $0.4 million through December 2009.
Depreciation expense was $8.9 million, $7.3 million, and $5.2 million for the years ended December 31, 2009, 2008 and 2007, respectively.
The Company completed its annual goodwill and indefinite lived intangible asset impairment analysis as of September 30, 2009. The Company reports under a single reporting segment and, as such, the goodwill analysis is measured under one reporting unit. Consistent with prior assessments, the fair value of the Company was determined using an internally developed discounted cash flow methodology and other relevant indicators of value available in the market place such as market transactions and trading values of similar companies. Based upon the results of the assessment, the Company concluded that the carrying values of goodwill and other
Other intangible assets at December 31, 2009 and 2008 were as follows (in thousands):
Amortization expense will be recognized over a weighted-average period of approximately 11.9 years.
The $20.2 million notes payable due 2035 are redeemable by the issuer in whole or in part anytime after March 15, 2010. Prior to March 15, 2010, the notes may only be redeemed in whole or in part subject to certain specific restrictions and prepayment penalties pursuant to the indenture agreement. The notes were issued in March 2005 and bear an initial interest rate of the three-month LIBOR rate plus 3.95 percent not exceeding 12.5 percent through March 2010 with no limit thereafter.
Asset sales are now allowed for transactions with less than 80% of cash proceeds. Financing is limited to $5.0 million per transaction and $10.0 million in the aggregate;
Common stock dividends are permitted only if the leverage ratio is less than or equal to 1.5;
The following table summarizes the Company’s term loan scheduled payments (in thousands):
The Company’s net deferred tax assets before valuation allowance were $20.8 million and $17.5 million at December 31, 2009 and 2008, respectively. In performing its quarterly assessment of the realizability of deferred tax assets, the Company considered whether it was more likely than not that the Company’s deferred tax assets will be realized based upon all available evidence, including scheduled reversal of deferred tax liabilities, historical operating results, projected future operating results, tax carryback availability, and limitations pursuant to Section 382 of the Internal Revenue Code, among others. Based on this assessment, a full valuation allowance was established during the fourth quarter of 2009, resulting in additional tax expense of $31.6 million.
In October 2006, the Company entered into an IT outsourcing contract with a data processing services provider under which the Company outsourced substantially all of its IT operations, including the Company’s data center, field support and application management. The initial term of the agreement was ten years, although it may be terminated for convenience by the Company at any time upon six month’s notice after the first two years, subject to the payment of certain stranded costs and other termination fees. The Company’s IT outsourcing expenses were $12.7 million, $12.7 million and $11.5 million for the years ended December 31, 2009, 2008 and 2007, respectively.
The following table summarizes the Company’s minimum future IT outsourcing and operating lease commitments at December 31, 2009 (in thousands):
The Company and its subsidiaries are named from time to time as parties in various legal actions arising in the ordinary course of the Company’s business and arising out of or related to claims made in connection with the Company’s insurance policies and claims handling. The Company believes that the resolution of these legal actions will not have a material adverse effect on the Company’s consolidated financial position or results of operations. However, the ultimate outcome of these matters is uncertain.
In August 2009, plaintiff Sunrise Business Resources, Inc. (Sunrise) filed suit against Affirmative Insurance Company in the Superior Court for the State of California, County of Los Angeles. Sunrise alleges that it is due approximately $722,000 in deferred compensation arising out of a Claims Administration Agreement between itself and Hawaiian Insurance & Guaranty Company (HIG). AIC, along with other third-party reinsurance companies, were parties to Quota Share Reinsurance Contracts with HIG during 2004 through June 30, 2006. Sunrise claims that it is a third-party beneficiary of the Quota Share Reinsurance Contract, thus rendering AIC liable for the deferred compensation owed under the HIG Claims Administration Agreement. Sunrise also seeks recovery under theories of quantum meruit, negligent misrepresentation and intentional misrepresentation. The Company has removed the action to the U.S. District Court for the Central District of California and is currently seeking a stay of the proceedings pending resolution of the HIG liquidation proceedings pending in Hawaii. The Company believes that this claim lacks merit and intends to defend itself vigorously.
In October 2009, plaintiff Dalton Johnson filed a putative class action in Palm Beach County, Florida against Affirmative Insurance Company. The complaint alleges that Affirmative failed to apply a statutorily-permitted fee schedule for hospital emergency care and services enacted into law in January 2008, thereby exhausting prematurely the PIP benefits available to Affirmative’s insureds. Affirmative has filed a motion to dismiss the complaint in its entirety. The Company believes that this claim lacks merit and intends to defend itself vigorously.
Under the 2004 Plan, the board or committee may fix the term and vesting schedule of each stock option, but no incentive stock option will be exercisable more than ten years after the date of grant. Vested stock options generally remain exercisable for up to three months after a participant’s termination of service or up to 12 months after a participant’s death or disability. Typically, the exercise price of each incentive stock option must not be less than 100% of the fair market value of our common stock on the grant date, and the exercise price of a nonqualified stock option must not be less than 20% of the fair market value of our common stock on the grant date. In the event that an incentive stock option is granted to a 10% stockholder, the term of such stock option may not be more than five years and the exercise price may not be less than 110% of the fair market value on the grant date. The exercise price of each stock option granted under the 2004 Plan may be paid in cash or in other forms of consideration in certain circumstances, including shares of common stock, deferred payment arrangements or pursuant to cashless exercise programs. A stock option award may provide that if shares of the Company’s common stock are used to pay the exercise price, additional stock options will be granted to the participant to purchase that number of shares used to pay the exercise price. Generally, stock options are not
The Company has a 1998 Omnibus Incentive Plan (1998 Plan) under which the Company may grant options to employees, directors and consultants for up to 803,169 shares of common stock. The exercise prices are determined by the board of directors, but shall not be less than 100% of the fair market value on the grant date or, in the case of any employee who is deemed to own more than 10% of the voting power of all classes of our stock, not less than 110% of the fair market value. The terms of the options are also determined by the board of directors, but shall never exceed ten years or, in the case of any employee who is deemed to own more than 10% of the voting power of all classes of our common stock, shall not exceed five years. The Company does not expect to grant any further equity awards under the 1998 Plan, but intends to make all future awards under the 2004 Plan. While all awards previously granted under the 1998 Plan will remain outstanding, 1998 Plan shares will not be available for re-grant if these outstanding awards are forfeited or cancelled.
Stock Options • The Company used the modified Black-Scholes model to estimate the fair value of employee stock options on the date of grant utilizing the assumptions noted below. The risk-free rate is based on the U.S. Treasury bill yield curve in effect at the time of grant for the expected term of the option. The expected term of options granted represents the period of time that the options are expected to be outstanding. Expected volatilities are based on historical volatilities of our common stock. The dividend yield was based on expected dividends at the time of grant.
The Company recognized total compensation expense related to the stock options of $666,000, $727,000 and $863,000 during 2009, 2008 and 2007, respectively. Compensation expense is included in selling, general and administrative expenses in the consolidated statements of income (loss). Total unrecognized compensation expense related to unvested stock options was $0.8 million at December 31, 2009, which will be recognized over a weighted-average period of approximately 2 years.
As part of the terms of the acquisition of AIC and Insura, VIG has indemnified the Company for any losses due to uncollectible reinsurance related to reinsurance agreements entered into with unaffiliated reinsurers prior to December 31, 2003. As of December 31, 2009, all such unaffiliated reinsurers had A.M. Best ratings of “A-” or better with a reinsurance recoverable of $3.3 million.
In January 2007, 227 West Monroe Street, Inc., as landlord (Landlord) executed a Consent to Assignment among the Landlord, KR Callahan & Company, LLC (KRCC), an entity whose sole member and manager is Kevin R. Callahan, the Company’s Chairman and Chief Executive Officer, and Affirmative Property Holdings, Inc. (Affirmative Property), an indirect wholly-owned subsidiary of the Company, and approved the assignment (the Assignment) of the leasehold interest held by KRCC to Affirmative Property with effect from December 2006. Pursuant to the Assignment, KRCC assigned to Affirmative Property all of its right, title and interest in and to the Lease (the Lease), dated May 8, 2006, between KRCC, as tenant, and the Landlord, and Affirmative Property agreed with KRCC to assume all obligations of KRCC, as tenant, under the Lease. The Lease relates to office space in Chicago, Illinois used by the Company’s Claims Staff Counsel. The Lease continues until July 31, 2016 and provides for an average monthly rent of approximately $9,690. In addition, Affirmative Property will be responsible for the payment of taxes, common area maintenance charges and other customary occupancy costs.
In connection with the Lease, KRCC had procured a Letter of Credit in favor of the Landlord in the amount of $293,257 as a security deposit against KRCC’s obligations under the Lease. In connection with the Assignment, Affirmative Property agreed to replace KRCC’s Letter of Credit at a future date with a Letter of Credit of like amount issued in favor of the Landlord on Affirmative Property’s behalf. In May 2007, Affirmative Insurance Holdings, Inc. entered into an irrevocable Letter of Credit in favor of the Landlord in the amount of $293,257 as a replacement for the KRCC Letter of Credit. Effective August 1, 2009, the Letter of Credit was decreased to $150,148.
Any failure by one of the Company’s insurance company subsidiaries to meet the applicable risk-based capital or minimum statutory capital requirements imposed by the laws of Illinois, Louisiana, Michigan, and New York or other states where the Company does business could subject it to further examination or corrective
State insurance laws restrict the ability of the Company’s insurance company subsidiaries to declare stockholder dividends. These subsidiaries may not make an “extraordinary dividend” until 30 days after the applicable commissioner of insurance has received notice of the intended dividend and has not objected in such time or until the commissioner has approved the payment of the extraordinary dividend within the 30-day period. In most states, an extraordinary dividend is defined as any dividend or distribution of cash or other property whose fair market value, together with that of other dividends and distributions made within the preceding 12 months, exceeds the greater of 10.0% of the insurance company’s surplus as of the preceding year-end or the insurance company’s net income for the preceding year, in each case determined in accordance with statutory accounting practices. In addition, dividends may only be paid from unassigned earnings and an insurance company’s remaining surplus must be both reasonable in relation to its outstanding liabilities and adequate to its financial needs. As of December 31, 2009, the Company’s insurance companies could not pay ordinary dividends to the Company without prior regulatory approval due to a negative unassigned surplus position. Dividend payments of $7.3 million were received from the Company’s insurance company subsidiaries in 2008. In February 2009, the Company obtained approval from the New York Department of Insurance for one of its insurance subsidiaries to retire one million shares of its stock for $2.9 million and approved payment of an extraordinary dividend for $100,000.
The following table provides information as of December 31, 2009 about the Company’s financial assets and liabilities measured at fair value on a recurring basis:
The Company’s Level 3 financial assets also include other receivables related to a settlement agreement entered into during November 2008 with the Company’s broker to liquidate certain of the Company’s auction-rate tax-exempt securities. Under the terms of the agreement, the Company’s broker will purchase the Company’s eligible auction-rate tax-exempt securities for full par value on or prior to June 30, 2012. As of December 31, 2009, the Company held $46.4 million, at amortized cost, and $37.4 million fair value of auction-rate tax-exempt securities that are eligible for such settlement. The Company has elected to record the settlement as a financial asset at fair value in accordance with ASC 825-10 Financial Instruments - Overall. The fair value of this agreement was estimated by third-party valuation sources to be $8.8 million and is included in other assets in Level 3 of the fair value hierarchy.
Fair value measurements for assets in category Level 3 for the year ended December 31, 2009 were as follows (in thousands):
Derivative financial instruments are reported at fair value on the consolidated balance sheet. The Company’s current derivative instruments consist of two interest rate swaps entered into in 2007 and 2008, with an aggregate notional amount of $115 million outstanding at December 31, 2009, previously designated as hedges against the variability of cash flows associated with that portion of the senior secured credit facility. The interest rate swap liability is recorded in other liabilities on the consolidated balance sheet.
On March 27, 2009, the Company entered into an amendment to the senior secured credit facility, which was considered an extinguishment of debt. As a result, the previously hedged interest payments will not occur. Therefore, the amount recorded in accumulated other comprehensive loss through March 2009 was reclassified to earnings as loss on interest rate swaps. Subsequent to March 2009, the Company recorded changes in the fair value of the derivative instruments in earnings, as gain or loss on interest rate swaps.
The following is a summary of the Company’s unaudited quarterly consolidated results from continuing operations for the years ended December 31, 2009 and 2008 (in thousands, except per share data):
On June 24, 2009, the Company sold all of its retail stores and its franchise business in Florida effective May 31, 2009. The results of operations of the sold business have been classified as discontinued operations in the consolidated statements of income (loss). Cash flows related to discontinued operations have been combined with cash flows from continuing operations within each category of cash flows.
The aggregate sales price increased by $0.2 million to $4.2 million in the third quarter of 2009 upon the failure by the purchaser to make a scheduled payment of $0.2 million. This also increased the secured 10% note to the principal amount of $2.9 million payable over five years. The sales price also included cash at closing of $0.3 million as well as a deferred payment of $1.0 million, subject to certain adjustments, due within 18 months of closing, which may be converted to a secured note at the purchaser’s option. Due to the uncertainty surrounding the financial viability of the debtor, the note and deferred payment have been recorded with no estimated net realizable value.