Management’s Discussion and Analysis of Financial Condition and Results of Operations addresses the financial condition of Alfa Corporation and its subsidiaries (the Company) as of December 31, 2007, compared with December 31, 2006 and the results of operations for each of the three years ended December 31, 2007. The following discussion should be read in conjunction with Item 8. Financial Statements and Supplementary Data.
Alfa Corporation is a financial services holding company headquartered in Alabama that offers primarily personal lines of property casualty insurance, life insurance and financial services products through its wholly-owned subsidiaries:
On July 17, 2007, the Company received an offer from Alfa Mutual Insurance Company (Mutual), Alfa Mutual Fire Insurance Company (Fire) and Alfa Mutual General Insurance Company (General) (collectively, the Mutual
Group), which collectively own a majority of its common stock, for a transaction that would result in the privatization of the Company. The Mutual Group proposed to acquire all of the outstanding shares of the Company’s common stock that are not currently owned by them. The Company’s Board of Directors appointed a special committee of its four independent directors to review, evaluate and negotiate the proposal. On November 4, 2007, the Company, Mutual and Fire entered into a definitive merger agreement pursuant to which Mutual and Fire will acquire all of the outstanding shares of the Company’s common stock they do not currently own for $22.00 per share. Concurrent with the agreement, Mutual and Fire will acquire General’s (0.8%) ownership at the same price offered to the Company’s stockholders. For additional details refer to Note 21 - Privatization of the Company and Note 22 - Subsequent Events in the Notes to Consolidated Financial Statements and Item 1A. Risk Factors.
On January 1, 2007, the Company adopted Statement of Position (SOP) 05-1, Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection With Modifications or Exchanges of Insurance Contracts. This statement provides guidance on accounting for deferred acquisition costs on an internal replacement. Transactions are accounted for as an internal replacement, as defined by this statement, when a policyholder requests a change not within the terms of the original contract and the change is deemed by the Company to be significant and integrated. For internal replacements of insurance products, the unamortized balance of acquisition costs previously deferred under the original contract is extinguished and charged to income. The new acquisition costs associated with the replacement are deferred and amortized to income.
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America (GAAP) requires the Company’s management to make significant estimates and assumptions based on information available at the time the financial statements are prepared. In addition, management must ascertain the appropriateness and timing of any changes in these estimates and assumptions. Certain accounting estimates are particularly sensitive because of their significance to the Company’s financial statements and because of the possibility that subsequent events and available information may differ markedly from management’s judgments at the time financial statements are prepared. For the Company, the areas most subject to significant management judgments include reserves for property casualty losses and loss adjustment expenses, reserves for future policy benefits, deferred policy acquisition costs, valuation of investments, and reserves for pending litigation. The application of these critical accounting estimates impacts the values at which 62% of the Company’s assets and 63% of the Company’s liabilities are reported at December 31, 2007 and, therefore, have a direct effect on net earnings and stockholders’ equity. For additional information, refer to Note 1-Summary of Significant Accounting Policies in the Notes to Consolidated Financial Statements.
Losses and loss adjustment expenses payable are management’s best estimates at a given point in time of what the Company expects to pay claimants, based on known facts, circumstances, historical trends, emergence patterns and settlement patterns. Reserves for reported losses are established on a case-by-case basis with the amounts determined by claims adjusters based on the Company’s reserving practices, which take into account the type of risk, the circumstances surrounding each claim and policy provisions relating to types of loss. Loss and loss adjustment expense reserves for incurred claims that have not yet been reported (IBNR) are estimated based primarily on historical emergence patterns with consideration given to many variables including statistical information, inflation, legal developments, storm loss estimates and economic conditions.
data, actuarial projections, accounting projections, exposure growth, current business conditions, catastrophe developments and late reported claims. In addition, reasonableness is established in the context of claim severity, loss ratio and trend factors, all of which are implicit in the liability estimates. On an interim basis, the Company’s internal actuarial staff reviews the direct emergence for each line of business compared to the expected emergence implied by the most recent annual review. If the emergence is not within acceptable bounds, the opinion on reserve adequacy is revised and reserve amounts are adjusted. Otherwise, IBNR reserves are adjusted as changes in exposure indicate that additional reserves are needed until the next annual review is completed. The following methodologies are used to develop a range of probable outcomes for estimated loss and loss adjustment expense reserves during the annual review, with the Catastrophes methods used during both annual and interim reviews:
The annual actuarial reviews are presented to management with a point estimate established within the range of probable outcomes for evaluating the adequacy of reserves and determination of the appropriate reserve value to be included in the financial statements. Management establishes reserves slightly above mid-point to include an estimated provision for uncertainty and to minimize the necessity for changing historical estimates. Although management uses many internal and external resources, as well as multiple established methodologies to calculate reserves, there is no method for determining the exact ultimate liability.
An important assumption underlying the reserve estimation methods for the property casualty lines is that the loss cost trends implicitly built into the loss and LAE patterns will continue into the future. Some of the factors that could influence assumptions arise from a variety of sources including tort law changes, development of new
Benefit reserves for universal life type products and annuity products are determined according to the provisions of SFAS No. 97, Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments. This standard directs that, for policies with an explicit account balance, the benefit reserve is the account balance without reduction for any applicable surrender charge.
include provision for all actuarial reserves and related items that ought to be established.
portfolio and conducts quarterly reviews of investments that have experienced a decline in fair value below cost to evaluate whether the decline is other than temporary. Such evaluations involve judgment and consider the magnitude and reasons for a decline and the prospects for the fair value to recover in the near term. Declines resulting from broad market conditions or industry-related events, and for which the Company has the intent to hold the investment for a period of time believed to be sufficient to allow a market recovery or to maturity, are considered to be temporary. Future adverse investment market conditions, or poor operating results of underlying investments, could result in an impairment charge in the future. Where a decline in fair value of an investment below its cost is deemed to be other than temporary, a charge is reflected in income for the difference between the cost or amortized cost and the estimated net realizable value. As a result, writedowns of $15.0 million and $10.3 million were recorded in 2007 on equity securities and fixed maturities, respectively. During 2006, writedowns of $2.9 million and $20 thousand were recorded on equity securities and fixed maturities, respectively.
Effective January 1, 2007, the property casualty insurance Pooling Agreement (refer to Note 2 - Pooling Agreement in the Notes to Consolidated Financial Statements) was modified as follows:
On January 1, 2007, the Company adopted SOP 05-1, Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection With Modifications or Exchanges of Insurance Contracts.
Total premiums and policy charges increased $27.8 million, or 4.0%, in 2007 and $54.0 million, or 8.5%, in 2006.
The 4.3%, or $15.7 million, earned premium growth in the automobile line is mainly attributable to the addition of Alliance. Alliance contributed $10.3 million and AVIC contributed $2.5 million of the earned premiums increase. AIC’s and AGI’s growth for the automobile line was $2.9 million. Written premiums in the automobile line declined $526 thousand, or 0.1%. AVIC declined $9.6 million due to lower production and the Company’s anticipated exit from the Florida market during 2007. AIC’s and AGI’s written premiums increased slightly by $168 thousand with rate increases in the Georgia preferred and standard automobile lines in the first quarter of 2007. Offsetting these rate increases, were rate decreases in the Alabama preferred automobile line during the first quarter of 2006 and in the Alabama standard automobile line during the second quarter of 2007. Alliance contributed written premiums for the automobile line of $8.9 million.
AIC, AGI and Alliance have a broader line of insurance products. AIC’s and AGI’s homeowner line earned premium growth of $10.0 million and written premium growth of $6.0 million was impacted by three rate increases across both preferred and standard lines during 2006 as well as a manufactured home increase in the second quarter of 2007. The farmowner earned and written premium growth of $1.2 million and $399 thousand, respectively, was impacted by a rate increase in the last quarter of 2005. AIC and AGI other personal lines earned premiums increased $421 thousand and commercial lines earned premiums increased slightly at $51 thousand. Alliance contributed earned premiums for the homeowner line of $6.5 million, other personal lines of $1.8 million and commercial lines of $7.9 million and contributed written premiums for the homeowner lines of $5.7 million, other personal lines of $1.7 million and commercial lines of $6.5 million.
Reinsurance ceded earned premiums increased 19.1%, or $909 thousand, mainly due to increases in the Company’s catastrophe reinsurance premiums, increases in the working cover program and the addition of Alliance’s programs. Reinsurance assumed earned premiums decreased 85.5%, or $21.0 million, due to the commutation of the Virginia Mutual quota share reinsurance treaty and a $324 thousand decrease in the assumed premiums from the state of Texas through AVIC. These decreases are offset by a $604 thousand increase in involuntary markets assumed premium. The decreases in reinsurance ceded and assumed written premiums are primarily related to the commutation of the Virginia Mutual quota share reinsurance treaty.
2006 Earned and Written Premium Growth: The growth in the automobile line is attributable to the addition of AVIC to the pool. AVIC writes nonstandard auto business and contributed $29.0 million of the earned premium increase and $23.8 million of the written premium increase. AIC and AGI, which have a broader line of insurance products, contributed $18.5 million of the personal and commercial lines net increase in earned premiums and $19.8 million of the personal and commercial lines net increase in written premiums. AIC’s and AGI’s growth for the automobile line was $5.5 million for earned premiums and $6.4 million for written premiums with a slight rate decrease in the first quarter of 2006. The homeowner line earned premium growth of $10.5 million and written premium growth of $10.7 million was impacted by three rate increases across both preferred and standard lines during 2006 and 2005. The farmowner earned and written premium growth of $1.6 million and $1.8 million, respectively, was impacted by a rate increase in the last quarter of 2005. Other personal lines earned premium growth was $467 thousand and commercial lines earned premium growth was $427 thousand.
casualty subsidiaries along with other members of the Mutual Group cede their direct property casualty business, which includes premiums, losses and underwriting expenses to Mutual. Mutual retrocedes to each participant a specified portion of premiums, losses and underwriting expenses based on each participant’s pooling percentage. The Company’s share of the pool was 65% during 2007, 2006 and 2005; therefore, pooling did not impact premium growth. Because premiums are allocated according to the Pooling Agreement, policy count data is not applicable to the Company. Refer to Note 2 - Pooling Agreement in the Notes to Consolidated Financial Statements for additional detail of the Pooling Agreement.
Life insurance premiums and policy charges, net of eliminations, increased $6.1 million, or 7.3%, in 2007 and $6.2 million, or 8.1%, in 2006.
Life insurance premiums, net of eliminations, increased $4.7 million, or 10.3%, in 2007 and $4.9 million, or 11.9%, in 2006. The 2007 increase is primarily the result of an increase in term life premiums of $4.8 million and an increase of 6.4% in term life policies inforce year to date. The 2006 increase is primarily the result of an increase in term life premiums of $4.7 million and an increase of 7.8% in term life policies inforce year to date. The majority of the increase for 2007 and 2006 is attributable to the return of premium level term life product introduced during 2006.
Life insurance policy charges increased $1.3 million, or 3.6%, in 2007 and $1.3 million, or 3.7%, in 2006. The 2007 increase is primarily due to an increase in universal life policy charges resulting from increases in fund balances that the charges are assessed against along with a slight increase of 0.3% in the number of universal life policies inforce. The 2006 increase of $1.3 million is primarily due to an increase in universal life policy charges resulting from increases in fund balances that the charges are assessed against along with a slight increase of 0.3% in the number of universal life policies inforce. The persistency ratio for life business was 90.7% at December 31, 2007 and 2006. Persistency, a non-GAAP financial measure, represents the ratio of the annualized premiums of policies inforce at December 31, 2007 and 2006 as a percentage of the annualized premiums paid at December 31, 2007 and 2006, respectively. There is no comparable GAAP measure for annualized premium. The following table shows the growth in policies inforce and inforce annualized premium, on a statutory accounting basis, for 2007 and 2006:
2006 Policies Inforce Growth and Inforce Annualized Premium Growth: Policies inforce grew for all lines in 2006. The slight increase in traditional life was the result of increases in new product offerings offset by a decline
Net investment income increased $1.5 million, or 1.7%, for 2007 due to increases in interest income on fixed maturities, short-term investments and partnership income. Offsetting these increases was a decrease of $8.7 million in equity in net earnings (after internal capital charge) of MidCountry for 2007 as well as a decrease in dividend income on equity securities. In addition, Alliance contributed $2.1 million of the 2007 increase. Net investment income decreased $1.7 million, or 1.8%, during 2006 due to the $3.5 million increase in net loan losses as a result of collateral loans written off, increased interest costs on commercial paper and notes payable, declines in partnership income offset by increases in interest income on fixed maturities, dividend income on equity securities and interest income on collateral loans and short-term investments. Positive cash flows resulted in an increase in total invested assets, including investments in affiliates, of 4.0% and 6.2% in 2007 and 2006, respectively.
Other income decreased $701 thousand, or 2.5%, in 2007 mainly due to decreases in Vision’s commission income and AVIC’s policy fee income. Offsetting these decreases is a $1.1 million gain recognized from the purchase of Alliance. The Company considers the amount to not be material to income; therefore, the gain was recorded as other income in the first quarter of 2007. Other income increased $5.5 million, or 24.2%, in 2006 due to increases in fee income from AVIC and commission income from Vision.
during the first quarter. Under the new guidance, for internal replacements of insurance products deemed by the Company to be significant and integrated, as defined by the statement, the unamortized balance of acquisition costs previously deferred under the original contract is charged to income. The new acquisition costs associated with the replacement are deferred and amortized to income. During 2007, $2.2 million of acquisition costs previously deferred were charged to income.
Net income declined 12.2% on a per share diluted basis in 2007 compared to 2006 and improved 6.3% on a similar basis in 2006 compared to 2005.
Results of operations for this segment have been impacted by the following events in 2007:
The quota share agreement between Fire and Virginia Mutual was terminated and applicable references were removed from the Pooling Agreement.
Property casualty insurance earned premiums increased $21.7 million, or 3.6%, during 2007 with AVIC contributing $2.1 million and AIC and AGI contributing $14.8 million of the increase. Alliance earned premiums also increased in 2007 to $25.7 million compared to the Virginia Mutual quota share amount of $20.8 million in 2006.
AVIC earned premiums are reported in the table above as $51.7 million of personal lines, $143 thousand of reinsurance ceded and $2.8 million of reinsurance assumed premiums for 2007 and $49.3 million of personal lines, $80 thousand of reinsurance ceded and $3.1 million of reinsurance assumed premiums for 2006.
Alliance earned premiums are reported as $18.6 million of personal lines, $7.9 million of commercial lines, $1.1 million of reinsurance ceded and $244 thousand of reinsurance assumed premiums in the table above for 2007. The Virginia Mutual quota share earned premiums are reported as $401 thousand of reinsurance ceded and $21.2 million of reinsurance assumed premiums for 2006.
The overall loss ratio increased 0.4% from 58.0% in 2006 to 58.4% in 2007 with a decline of 0.1% in catastrophe losses. The loss ratio for AIC and AGI increased from 57.3% as of December 31, 2006 to 57.6% as of December 31, 2007. The loss ratio for 2007 related to AVIC business was 73.1% and Alliance was 46.5%, which represents 8.3% of the overall loss ratio of 58.4%. For 2006, the loss ratio for AVIC was 64.6% and Virginia Mutual was 57.9%, which represents 7.6% of the overall loss ratio of 58.0%.
The 0.1% decrease in the overall LAE ratio for 2007 is mainly attributable to an AIC and AGI decrease of 0.3% offset by increases in both AVIC’s and Alliance’s LAE ratios. AVIC impacted the LAE ratio by 1.1% in 2007 compared to 1.0% in 2006, and Alliance impacted the current year ratio by 0.2%. Technology costs impacted the LAE ratio by 0.1% in 2007 and 2006.
Net investment income increased $6.0 million, or 15.2%, for 2007, as a result of increases in interest income on fixed maturities, short-term investment income and partnership income. In addition, the Company’s newly capitalized subsidiary, Alliance, contributed $2.1 million of the increase.
Other income and fees increased $890 thousand, or 6.5%, for 2007 mainly due to a gain of $1.1 million recognized in the first quarter of 2007 from the purchase of Alliance. The Company considers the amount to not be material to income; therefore, the gain was recorded as other income in the first quarter of 2007.
Net income increased $3.7 million, or 4.5%, during 2007 compared to an increase in net income of $1.6 million, or 2.0%, in 2006.
Results of operations for this segment have been impacted by the following events in 2006:
AVIC’s increase is a result of all nine states being active during 2006 and overall production increases. AVIC and Virginia Mutual premiums are reported as $49.3 million of personal lines earned premiums, $481 thousand of reinsurance ceded earned premiums and $24.3 million of reinsurance assumed earned premiums in the table above for 2006 and $20.0 million of personal lines, $389 thousand of reinsurance ceded and $22.6 million of reinsurance assumed premiums for 2005.
The loss ratio for AIC and AGI declined from 60.6% as of December 31, 2005 to 57.3% as of December 31, 2006. The overall loss ratio declined 2.1% from 60.1% in 2005 to 58.0% in 2006.
Other income and fees increased $4.0 million in 2006 due to an increase in fee income from AVIC.
The following table sets forth summarized financial information for the Company’s life insurance subsidiary, Life, for the years ended December 31, 2007, 2006 and 2005:
On a statutory accounting basis, issued annualized new business premiums decreased by 6.2% to $16.7 million with a total volume of $3.7 billion of insurance being issued in 2007. The new product offerings in 2006 contributed as follows in 2007: return of premium level term - 5,152 policies issued, $3.7 million of issued annualized new business premiums and volume of $928.1 million of insurance issued; annuities - 29 policies issued and $778 thousand of issued annualized new business premium.
Total life insurance inforce as of December 31, 2007 increased $1.8 billion, with term insurance increasing $1.4 billion, or 11.6%, compared to 2006. Annualized premiums for inforce business increased 3.6%, or $4.8 million, with term insurance increasing 12.5%, or $4.8 million. Policies inforce increased 3.3% in 2007 compared to 2006. The persistency ratio for life business was 90.7% at December 31, 2007 and 2006.
Invested assets, including investments in affiliates, increased 3.4% since December 31, 2006, while net investment income increased $3.1 million, or 5.5%. Interest on short-term investments increased $2.5 million, or 142.9%, during 2007. Net realized investment gains (losses), net of tax, decreased $6.1 million, or 113.7%, in 2007 as a result of increased writedowns on fixed maturities and equity securities offset by increased net gains on fixed maturities and equity securities. On a pretax basis, writedowns increased from $2.1 million in 2006 to $22.2 million in 2007. Pretax net gains on fixed maturities and equity securities increased $1.6 million and $8.9 million, respectively, in 2007.
At December 31, 2007, the life subsidiary’s Adjusted Capital calculation in accordance with NAIC RBC guidelines was $222.2 million compared to the Authorized Control Level (Required) RBC amount of $15.1 million.
Operating income, net of tax, increased 10.1% during 2006 and net income increased 14.6%, or $3.7 million. With an increase in realized investment gains in 2006, net income increased 14.6% compared to a decrease in net income of 4.0% in 2005, which was the result of a 51.3% decrease in realized investment gains in 2005.
Noninsurance operating income decreased $1.7 million to an operating loss of $1.3 million in 2007 compared to an operating profit of $328 thousand for 2006. Noninsurance produced a net loss of $1.4 million for 2007 compared to net income of $277 thousand in 2006. Included in operating expenses for this segment is $175 thousand of SFAS No. 123(R) expense for 2007 compared to $142 thousand for 2006.
Commercial lease operations in Financial produced a net loss of $1.9 million for 2006 as a result of servicing fee expense, legal expenses and reduced lease income compared to a net loss in 2005 of $2.2 million.
The composition of the Company’s investment portfolio is as follows at December 31, 2007 and 2006:
The rating of the Company’s portfolio of fixed maturities using the Standard & Poor’s rating categories is as follows at December 31, 2007 and 2006:
At December 31, 2007, 40.5% of fixed maturities were mortgage-backed securities. Such securities are comprised of Collateral Mortgage Obligations (CMOs) and pass through securities. Based on reviews of the Company’s portfolio of mortgage-backed securities, the impact of prepayment risk on the Company’s financial position and results from operations is not believed to be significant. These risks are discussed in more detail in
To the Board of Directors and Stockholders of Alfa Corporation (the “Company”):
Alfa Corporation is affiliated with Alfa Mutual Insurance Company, Alfa Mutual Fire Insurance Company and Alfa Mutual General Insurance Company (collectively, the Mutual Group). The Mutual Group owns 55.0% of Alfa Corporation’s common stock, their largest single investment. Alfa Specialty Insurance Corporation (Specialty) is a wholly-owned subsidiary of Alfa Mutual Insurance Company (Mutual). The Company together with the Mutual Group and Specialty comprise the Alfa Group (Alfa). Prior to January 1, 2007, Virginia Mutual Insurance Company (Virginia Mutual) ceded 80% of its direct business to Alfa Mutual Fire Insurance Company (Fire) under a Strategic Affiliation Agreement signed in August 2001. On January 1, 2007, Virginia Mutual demutualized and Alfa Alliance Insurance Corporation (Alliance), a new subsidiary of the Company, was formed.
Alfa Corporation operates predominantly in the insurance industry. During 2007, its insurance subsidiaries wrote life insurance in Alabama, Georgia and Mississippi and property casualty insurance in Arkansas, Florida, Georgia, Indiana, Kentucky, Mississippi, Missouri, North Carolina, Ohio, Tennessee and Virginia. In addition, AVIC assumed business in Texas.
As more fully discussed in Note 2 - Pooling Agreement, the Company’s property casualty insurance business is pooled with that of the Mutual Group, which writes property casualty business in Alabama, and
Traditional Life Insurance Products: Traditional life insurance products include those products with fixed and guaranteed premiums and benefits and consist principally of whole life insurance policies, term life insurance policies and certain annuities with life contingencies. Premiums are recognized as revenue over the premium-paying period of the policy when due. The liability for future policy benefits is computed using a net level method including assumptions as to investment yields, mortality, withdrawals and other assumptions based on the Company’s experience, modified as necessary, to reflect anticipated trends and to include provisions for possible unfavorable deviations. Policy benefit claims are charged to expense in the period that the claims are incurred.
The Company recognizes expense for its share-based compensation based on the fair value of the awards that are granted. The fair value of stock options is estimated at the date of grant using the Black-Scholes-Merton option valuation model. Option valuation methods require the input of assumptions, including the expected stock price volatility, expected option term, risk-free interest rate and expected dividend yield. The fair value of nonvested restricted shares is measured at the date of grant using the closing price of the Company’s common stock on the date of grant.
The Company’s policy is to recognize interest and penalties related to uncertain tax positions in income tax expense. At the date of adoption, the amount of interest and penalties included in the consolidated balance sheet was $285 thousand.
On January 1, 2007, the Company adopted Emerging Issues Task Force (EITF) Issue No. 06-3, How Taxes Collected from Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement (That Is, Gross versus Net Presentation). This consensus requires disclosure of the accounting policy employed by the Company for any tax assessed by a governmental authority that is directly related to a revenue-producing transaction between a seller and a customer. EITF 06-3 requires that taxes be presented in the income statement either on a gross basis (included in revenues and costs) or a net basis (excluded from revenues), and that this accounting policy decision be disclosed. The Company has not changed its accounting policy for reporting taxes collected from customers. Two subsidiaries of the Company collect taxes that are remitted to governmental authorities. AVIC, in the property casualty segment, collects taxes from policyholders and reports the premiums collected on a net basis. Financial, in the noninsurance segment, collects taxes on lease payments from customers and reports the lease revenue on a gross basis. The amount of tax collected is not significant to the amount of revenue reported.
Fixed Maturities: Fixed maturities held for investment include investments that the Company has both the ability and positive intent to hold until maturity; such securities are reported at amortized cost. Securities available for sale include bonds and redeemable preferred stocks that the Company may elect to sell prior to maturity and are reported at their current fair value. The unrealized gains or losses on these securities are reflected in accumulated other comprehensive income within stockholders’ equity, net of taxes. Furthermore, deferred policy acquisition costs for universal and other interest-sensitive life insurance products are adjusted to reflect the effect that would have been recognized had the unrealized holding gains and losses been realized. This adjustment to deferred acquisition costs results in a corresponding adjustment to comprehensive income. The amount of this adjustment before taxes was $1.7 million and $2.0 million in 2007 and 2006, respectively. Amortization of premium or discount is calculated using the scientific (constant yield) interest method and is recorded as an adjustment to investment income. The interest method results in a constant effective yield equal to the prevailing rate at the time of purchase or at the time of subsequent adjustments to book value. Fixed maturities containing call provisions (where the issue can be called away from the Company at the issuer’s discretion) are amortized to the call or maturity value/date that produces the lowest asset value (yield to worst). For mortgage-backed and asset-backed securities, the amortization period reflects estimates of the period over which repayment of principal is expected to occur, not the stated maturity period.
Declines in fair values of fixed maturities and equity securities deemed to be other than temporary are recognized in the determination of net income. Generally, realized gains and losses on sales of investments are recognized in net income using the first-in, first-out methodology. In some instances, the Company may use the specific identification method if so directed by the investment portfolio manager. Realized investment gains and losses are reported on a pretax basis as a component of revenues. Income taxes applicable to net realized investment gains and losses are included in the provision for income tax.
Collateral Loans and Commercial Leases: Collateral loans and lease financings, included in other long-term investments, are reported in the balance sheet at outstanding principal balance adjusted for charge-offs and the allowance for losses in accordance with Statement of Position (SOP) 01-6, Accounting by Certain Entities That Lend to or Finance the Activities of Others. The allowance for losses on collateral loans and commercial leases represents the Company’s best estimate of probable losses inherent in the portfolios based on relevant observable data that include, but are not limited to, historical experience, collateral type, account balance and delinquency. Credit losses are deducted from the allowance and charged off in the period in which the loans or leases are deemed uncollectible. Recoveries previously charged off are recorded when received. The Company considers an account to be delinquent if it is thirty or more days late in its scheduled payments. If the account is over 90 days late, the Company considers repossession of the collateral. If collateral is repossessed, the loan or lease is written down against the allowance for losses and the asset is transferred to other assets and carried at the lower of cost or estimated fair value less the cost to dispose. Loans are placed on a nonaccrual status when a bankruptcy is reported or the collateralized assets are repossessed. The Company uses the effective interest method to recognize income on loans and leases. Deferred fees are amortized over the term of the commercial lease.
Other Long-term Investments: Partnerships, joint ventures and unconsolidated investee companies are a component of other long-term investments and other long-term investments in affiliates. With the exception of two partnerships carried at cost, investments in partnerships, joint ventures and unconsolidated investee companies are stated at the underlying audited equity value based on accounting principles generally accepted in the United States of America. Investments are reviewed annually for impairments and adjusted accordingly. It is the Company’s policy to review investments for applicability of Financial Accounting Standards Board Interpretation (FIN) 46(R), Consolidation of Variable Interest Entities. At December 31, 2007, the Company determined that no investment required consolidation based on FIN 46(R) criteria.
Short-term Investments: Short-term investments with maturities of three months or less are considered to be investments and are not considered to be cash or cash equivalents. The Company’s short-term investments include money market funds, bonds and certificates of deposit. Money market mutual funds seek to maintain a stable net asset value of $1.00 per share. There is no assurance that funds will be able to maintain a stable asset value of $1.00 per share. However, the Company’s policy is to invest in money market funds that are rated AAAm and/or Aaa by Standard & Poor’s and/or Moody’s Investor Service,
Internal replacements, as defined by Statement of Position (SOP) 05-1, Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection With Modifications or Exchanges of Insurance Contracts, are reviewed by the Company to determine whether changes made are considered to be significant and integrated. If changes are significant and integrated, the unamortized balance of deferred policy acquisition costs related to the original contract is extinguished and charged to income. Acquisition costs associated with the replacement policy are deferred and amortized to income. At the date of adoption of SOP 05-1, no adjustments were made to retained earnings in the life segment.
Property Casualty Products: Acquisition costs for property casualty insurance are amortized over the period in which the related premiums are earned. Internal replacements, as defined by SOP 05-1,
A premium deficiency reserve is recognized by recording an additional liability for the deficiency, with a corresponding charge to operations when anticipated losses, loss adjustment expenses, commissions, other acquisition costs and maintenance costs exceed the recorded unearned premium reserve, and any future installment premiums on existing policies. The Company had no liability related to premium deficiency reserves at December 31, 2007 or 2006. The Company utilizes anticipated investment income as a factor in the premium deficiency calculation.
Included in other assets, furniture, equipment, capital leases, software and leasehold improvements are stated at cost less accumulated depreciation or amortization. Depreciation is computed principally using the straight-line method over the estimated useful lives of the related assets. Software amortization for significant business software projects is computed using the 200% double declining basis (half year convention) over five years. Costs to develop internal use software in accordance with SOP 98-1, Accounting for the Costs of Computer Software Developed or Obtained for Internal Use, is capitalized and depreciated on a straight-line basis over the estimated useful life of the software, not to exceed five years. Leasehold improvements are amortized on a straight-line basis over the lesser of the lease terms or the estimated useful lives of the improvements, not to exceed seven years. Accumulated depreciation and amortization at December 31, 2007 and 2006 was $8.4 million and $7.1 million, respectively. Depreciation and amortization expense for 2007, 2006 and 2005 was $5.0 million, $3.4 million and $1.6 million, respectively.
As part of its funding efforts, the Company issued a $70 million long-term obligation maturing on June 1, 2017 in the second quarter of 2002 that is included in total borrowings. Management believed it was prudent to limit the variability of a portion of its interest payments. It was the Company’s objective to hedge 100 percent of its variable-rate long-term interest payments over the first five years of the life of the debt obligation.
To meet this objective, management entered into an interest rate swap to manage fluctuations in cash flows resulting from interest rate risk. The interest rate swap changed the variable-rate cash flow exposure of the variable-rate long-term debt obligation to fixed-rate cash flows by entering into a receive-variable, pay-fixed interest rate swap. Under the interest rate swap, the Company received variable interest payments and made fixed interest rate payments, thereby creating long-term debt with a fixed rate of 4.945%. During 2007, interest received ranged from 5.32% to 5.32113%. The interest rate swap expired April 30, 2007.
Changes in fair value of the interest rate swap designated as a hedging instrument of the variability of cash flows associated with floating-rate, long-term debt obligation were reported in accumulated other comprehensive income, net of taxes. The Company accounted for the hedging instrument using the short-cut method and has not reclassified any of the gains or losses to interest expense in the subsequent periods. The fair value of the interest rate swap contract at December 31, 2006 was $162 thousand prior to tax expense of $57 thousand.
On January 1, 2007, Virginia Mutual restructured to form Alliance, a subsidiary of the Company. Prior to June 30, 2001, Virginia Mutual sponsored a defined benefit pension plan covering substantially all of its employees. It also sponsored a non-qualified benefit pension parity plan (the parity plan) covering
At January 1, 2007, these plans were subject to remeasurement under SFAS No. 141, Business Combinations, in accordance with SFAS No. 87, Employers’ Accounting for Pensions and SFAS No. 106, Accounting for Postretirement Benefits Other Than Pensions. As a result, the unfunded balance of the parity plan and the postretirement life and medical insurance benefit plan were recorded as liabilities which eliminated any previously unrecognized gain or loss, prior service cost and transition asset or obligation related to the plans. The defined benefit pension plan liability was remeasured to reflect the anticipated liability for terminating the plan. The Company filed to terminate the pension plan with the Internal Revenue Service during July 2007 and received a favorable determination on January 25, 2008.
At January 1, 2007, the Company adopted SFAS No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106 and 132(R). With the plans remeasured as a result of SFAS No. 141, there was no impact on the Company’s financial position or results of operations at the date of adoption.
Certain amounts in prior periods have been reclassified to conform to the presentation adopted in the current year. Such reclassifications had no impact on previously reported net income or stockholders’ equity.
Effective January 1, 2006, the Pooling Agreement was amended to reallocate Specialty’s coinsurance allocation of catastrophes to Mutual.
The Mutual Group is a direct writer primarily of personal lines property casualty insurance in Alabama. Specialty is a direct writer in Alabama, Georgia, Mississippi and Virginia. During 2007, the Company’s subsidiaries were direct writers in: Arkansas, Florida, Georgia, Indiana, Kentucky, Mississippi, Missouri, North Carolina, Ohio, Tennessee and Virginia; and assumed business from Texas. No direct business is being written in Florida in 2008 as the Company is exiting this market.
Under the Pooling Agreement, each participant cedes premiums, losses and underwriting expenses on all of their direct property casualty business to Mutual, and Mutual in turn retrocedes to each participant a specified portion of premiums, losses and underwriting expenses based on each participant’s pooling percentage. The Mutual Group’s and Specialty’s direct property casualty business (together with the property casualty business ceded by the Company) is included in the pool.
The pooling participants and their percentage participation in the pool since inception are as follows:
The Company incurred catastrophe losses of $13.9 million, $13.8 million and $11.6 million in 2007, 2006, and 2005, respectively. These losses resulted in reductions to the Company’s net income of $0.11, $0.11 and $0.09 per diluted share, after reinsurance and taxes in the respective years.
Should any member of the affiliated group be unable to meet its obligation on a claim for a policy written by the Company’s property casualty subsidiaries, the obligation to pay the claim would remain with the Company’s subsidiaries. The participation of the Company in the Pooling Agreement may be changed or terminated without the consent or approval of the stockholders and the Pooling Agreement may be terminated only by mutual agreement of the parties in writing. Any such termination, or a change in the Company’s allocated share of the pooled business, inclusion of riskier business or certain types of reinsurance assumed in the pool, or other changes to the Pooling Agreement, could have a material adverse impact on the Company’s earnings. Participants’ respective abilities to share in the pooled business are subject to regulatory capital requirements.
Under a Management and Operating Agreement, Mutual provides substantially all facilities, management and other operational services to the Company and its subsidiaries and to other companies associated with Mutual. Most of the personnel providing management services to the Company are full-time employees of, and are directly compensated by, Mutual. The Company’s business is substantially integrated with that of Mutual, Fire and General. Mutual periodically conducts expense allocation studies. Mutual charges the Company for its allocable and directly attributable expenses, including facilities. The amounts paid by the Company to Mutual under the Management and Operating Agreement were $70.7 million in 2007, $65.9 million in 2006 and $61.8 million in 2005. The Company reimburses Mutual for the full amount of all its agents’ commissions paid by Mutual for the sale of the Company’s insurance products.
During 1999, the Company formed a subsidiary, ABC, to administer nonqualified employee and director benefit plans on behalf of Mutual. As a result, the accrued benefit liabilities held by the various Alfa property casualty entities and their related assets were transferred to ABC at that time. The amounts of net transfers from ABC to Mutual in 2007 and 2006 for payments of benefits totaled $2.2 million and $1.0 million, respectively.
Financial leases equipment, automobiles, furniture and other property to the Mutual Group and its affiliates. The Mutual Group and its affiliates paid $5.2 million in 2007, $4.0 million in 2006 and $3.4 million in 2005 under these leases. Periodically, the Mutual Group invests in automobile and other installment loans issued and serviced by Financial. The amount invested by the Mutual Group in such loans was $6.3 million and $8.3 million at December 31, 2007 and 2006, respectively. Interest paid by Financial to the Mutual Group on these loans was $425 thousand in 2007, $334 thousand in 2006 and $200 thousand in 2005. Federation and Alfa Services, Inc. (Services), a Federation subsidiary, invest in short-term lines of credit with the Company and Financial. The balance outstanding on these lines of credit included in notes payable to affiliates was $25.1 million and $19.3 million at December 31, 2007 and 2006, respectively. Interest paid by the Company and Financial to the Federation and its subsidiary was $1.1 million in 2007, $1.0 million in 2006 and $502 thousand in 2005.
On December 31, 2005, the Company completed the sale of Financial’s leasing division, OFC Capital, to OFC Servicing Corporation, a subsidiary of MidCountry that continues to service the Company’s retained commercial lease portfolio. Service fees incurred by the Company in 2007 were $457 thousand and $908 thousand in 2006. Included in other long-term investments in affiliates at December 31, 2007 and 2006, respectively, is a note receivable of $13.5 million and $33.0 million related to the sale transaction. Interest received from OFC Servicing Corporation was $864 thousand and $1.8 million in 2007 and 2006, respectively.
Applicable deferred income tax benefit on net unrealized losses for equity securities aggregated $969 thousand at December 31, 2007. Applicable deferred income taxes on net unrealized gains for equity securities aggregated $3.6 million at December 31, 2006.
Applicable deferred income tax benefit on net unrealized losses for fixed maturities available for sale aggregated $281 thousand at December 31, 2007. Applicable deferred income taxes on net unrealized gains for fixed maturities available for sale aggregated $3.7 million at December 31, 2006.
Of the 180 fixed maturities in an unrealized loss position at December 31, 2007, the majority are mortgage-backed securities. Of the $18.9 million in unrealized losses on mortgage-backed securities, the majority was issued by governmental agencies. Therefore, return of principal is not currently an issue. The market value of these securities has been adversely affected by the illiquidity in the current market. The interest rate environment has been the primary cause of the other fixed maturity loss positions in the portfolio. While unrealized gains and losses will fluctuate with interest rate changes, receipt of principal is highly probable if these securities are held to maturity. The Company reviews securities for impairment each quarter and considers its intent and ability to hold any debt securities in a loss position until the fair value recovers. During quarterly reviews in 2007, the Company evaluated its exposure to subprime mortgage-related risks. The Company does not own direct investments in subprime mortgage loans, or have investments in subsidiary, controlled and affiliated entities with subprime-related risk. Exposure to
Proceeds from sales of fixed maturities available for sale were $176.3 million in 2007, $101.7 million in 2006 and $108.4 million in 2005. Gross gains of $8.1 million in 2007, $1.2 million in 2006 and $427 thousand in 2005 and gross losses of $3.4 million in 2007, $1.3 million in 2006 and $2.2 million in 2005 were realized on those sales. In addition, the Company recorded a loss of $10.3 million in 2007, $20 thousand in 2006 and $1.0 million in 2005 for fixed maturities available for sale whose decline in fair value was deemed to be other than temporary. In 2007, $6.5 million of the total writedowns were due to the subprime mortgage market. At December 31, 2007, the Company’s mortgage-backed securities were comprised of CMOs and pass through securities. The valuation of such securities is subject to significant fluctuations due to changes in interest rates. The Company has a history of positive cash flow and has the ability to hold such investments to maturity. Management performs periodic assessments of the portfolio to monitor interest rate fluctuations. At December 31, 2007, the Company had $5.2 million in fixed maturities available for sale on deposit with regulatory agencies in order to meet statutory requirements.
Partnerships, Joint Ventures and Unconsolidated Investee Companies: The majority of the investments in partnerships, joint ventures and unconsolidated investee companies are stated at the underlying audited equity value based on accounting principles generally accepted in the United States of America. Ownership in equity-method partnership interests range from 1% to 34%. Equity-method partnership interests represent 77.1%, or $66.3 million, of other long-term investments at December 31, 2007 and 73.9%, or $64.2 million, at December 31, 2006. Similarly, partnership interests and joint ventures represent 19.6%, or $24.9 million, of other long-term investments in affiliates at December 31, 2007 and 19.9%, or approximately $24.0 million, at December 31, 2006.
The table below shows an aggregate summary of affiliated equity-method investees’ financial information derived from the investees’ financial statements, along with the Company’s total equity investment:
Commercial Leases: The Company’s commercial lease portfolio totaled $685 thousand and $1.7 million at December 31, 2007 and 2006, respectively. The majority of the commercial lease portfolio was sold in the fourth quarter of 2005 to OFC Servicing Corporation, a wholly-owned subsidiary of MidCountry. During 2007, 2006 and 2005, the Company charged off leases totaling $342 thousand, $328 thousand and $1.4 million, respectively. At December 31, 2007, the Company had an allowance for losses of $1.0 million. At December 31, 2006, the allowance for losses on the lease portfolio was $1.2 million. The Company has estimated the fair value of the commercial lease portfolio to be $685 thousand and $1.7 million at December 31, 2007 and 2006, respectively. The estimated fair value of the lease portfolio at December 31, 2007 and 2006 approximates carrying value after allowing for estimated lease losses. Assets leased to affiliated companies are expected to be held until the lease terminates and, therefore, fair value is assumed to equal net cost. The Company had impaired leases and repossessed assets, net of allowances for losses on disposal, included in other assets of $0 and $551 thousand subject to individual valuation at December 31, 2007 and 2006, respectively. Leases that are more than 90 days late are placed in a nonaccrual status and totaled $61 thousand and $459 thousand at December 31, 2007 and 2006, respectively.
Other Investments: Included in the Company’s other long-term investments are its leased asset portfolio (refer to Note 15 - Leases), notes receivable from affiliates and an investment in MidCountry preferred stock (refer to Note 3 - Related Party Transactions). The leased asset portfolio and notes receivable are carried at net book value and the preferred stock is carried at cost which approximates fair value.
Includes elimination of intercompany profits within the corporate and elimination segment
At the date of adoption, no adjustments were made to retained earnings in the life segment or the property casualty segment. For 2007, there were not any significant impacts in the property casualty segment for internal replacements. In the life segment, internal replacements resulted in the extinguishment of acquisition costs previously deferred and a charge to income through amortization expense of $2.2 million for 2007. During the first quarter of 2007, Life provided an opportunity for policyholders to convert existing policies to the new return of premium product.
“Agent Relationships” intangible asset represents ongoing contractual relationships between existing agents at acquisition date and the managing general agent.
For the year ended December 31, 2007, premiums under individual ordinary life insurance participating policies were $5.3 million, or 4% of total premiums collected. The Company accounts for its policyholder dividends based upon dividends apportioned for payment for the next year plus any adjustments for dividends paid differently from those apportioned in the prior year. Total policyholder dividends incurred for 2007 were $4.2 million. The Company paid dividends in the amount of $4.2 million during 2007 to policyholders and did not allocate any additional income to such policyholders. The Company did not issue any participating policies during 2007. The amount of insurance inforce on participating policies represents 1% of ordinary life insurance inforce or $226 million at December 31, 2007.
Deferred tax assets (liabilities) include the following as of December 31:
A reconciliation of the change in the UTB balance from January 1, 2007 to December 31, 2007 is as follows:
The Company’s policy is to recognize interest and penalties related to uncertain tax positions in income tax expense. The Company had approximately $383 thousand and $285 thousand for the payment of interest and penalties accrued at December 31, 2007 and 2006, respectively.
The Company uses variable-rate debt to partially fund its consumer loan and commercial lease portfolios. In particular, it has issued variable-rate long-term debt and commercial paper. These debt obligations expose the Company to variability in interest payments due to changes in interest rates. If interest rates increase, interest expense increases. Conversely, if interest rates decrease, interest expense also decreases. Short-term debt was $228.8 million and $234.4 million at December 31, 2007 and 2006, respectively, and long-term debt was $70 million at both December 31, 2007 and 2006.
The Company had $197.4 million in commercial paper outstanding at a weighted average rate of 5.07% at December 31, 2007. Rates ranged from 4.75% to 5.27% with maturities from January 2, 2008 to January 30, 2008. At December 31, 2006, the Company had $206.9 million in commercial paper outstanding at a weighted average rate of 5.30%. Rates ranged from 5.28% to 5.35% with maturities from January 8, 2007 to January 31, 2007. The Company intends to continue to use the commercial paper program to fund its short-term needs. However, backup lines of credit are in place up to $300 million to cover up to $230 million in commercial paper and the $70 million variable-rate demand note described below. Commitment fees related to the backup lines were $228 thousand in 2007 and $257 thousand in 2006. The backup lines agreements contain usual and customary covenants requiring the Company to meet certain operating levels. Included in the financial covenants are requirements that the Company maintain minimum levels of stockholders’ equity and perform at a level that produces acceptable ratios of earnings before income taxes to interest expense and indebtedness to capitalization. The Company has maintained full compliance with all such covenants. The Company has A-1+ and P-1 commercial paper ratings from Standard & Poor’s and Moody’s Investors Service, respectively. The commercial paper is guaranteed by two affiliates, Mutual and Fire. Due to the short-term nature of the Company’s commercial paper borrowings, the fair value approximates the carrying value.
In addition, the Company had $31.4 million and $27.5 million in short-term debt outstanding to affiliates at December 31, 2007 and 2006, respectively, with interest payable monthly at rates established using the existing commercial paper rate and renewable for multiples of 30-day periods at the commercial paper rate then applicable. Due to the short-term nature of the Company’s outstanding debt to affiliates, the fair value approximates the carrying value.
Certain legal proceedings are in process at December 31, 2007. Costs for these and similar legal proceedings, including accruals for outstanding cases, totaled $6.6 million in 2007, $219 thousand in 2006 and $2.2 million in 2005. These proceedings involve alleged breaches of contract, torts, including bad faith and fraud claims, and miscellaneous other causes of action. These lawsuits involve claims for unspecified amounts of compensatory damages, mental anguish damages and punitive damages.
Subsequent to the end of the second quarter, nine purported class action lawsuits, seven in the Delaware Chancery Court and two in the Circuit Court of Montgomery County, Alabama, have been brought against the Company, the Mutual Group and directors and/or officers on behalf of the public shareholders of the Company, to enjoin the defendants from causing the Company to enter into an agreement to be acquired by the Mutual Group, among other allegations. Refer to Note 21 - Privatization of the Company for more information. On August 16, 2007 and on August 29, 2007, orders were entered that consolidated the actions filed in Delaware into In Re Alfa Corporation Shareholders Litigation, in the Court of Chancery of the State of Delaware in and for New Castle County, C.A. No. 3104-VCP. On October 29, 2007, an order was entered that consolidated the actions filed in Alabama into In Re Alfa Corporation Shareholder Litigation, in the Circuit Court of Montgomery County, Alabama, CV-07-900485. The Company believes the actions are without merit.
On December 20, 2007, the counsel to the parties in the above referenced Delaware consolidated action entered into a Memorandum of Understanding (Delaware MOU) to settle such action, subject to approval of the court. Under the terms of the Delaware MOU, counsel to the Delaware consolidated action will be provided an opportunity to review and comment on the preliminary proxy statement. The parties to the Delaware litigation subsequently intervened in In Re Alfa Corporation Shareholder Action in the Circuit Court of Montgomery County, Alabama, for the purposes of participating in confirmatory discovery and for participating in the settlement of the action.
On or about January 23, 2008, the defendants’ motion to sever and transfer in the Macon County litigation was denied by the trial court. Defendants then filed a petition for writ of mandamus to the Alabama Supreme Court seeking to have the trial court’s denial of defendants’ motion reversed.
On or about February 7, 2008, a preliminary hearing was held in consolidated In Re Alfa Corp. Shareholder Litigation, in the Circuit Court of Montgomery County, Alabama, where the parties filed a Stipulation of Settlement and the court entered a Scheduling Order that, among other things, set a final hearing to determine approval of the class action settlement for April 14, 2007. The court also authorized the form of a Notice of Pendency and Proposed Settlement of Class Action to be sent to all members of the class, as defined in the Notice.
On or about February 8, 2008, plaintiffs in the Macon County litigation voluntarily dismissed the policyholder class action allegation against defendants.
On February 23, 2008, counsel for the parties in the above-described Walker County action entered into a Memorandum of Understanding to settle such action, subject to approval of the court. On March 4, 2008, the Walker County court conditionally approved the settlement and set a final approval hearing for May 28, 2008.
Guarantees: The Company’s property casualty subsidiaries entered into an agreement with Fire in 2000 with respect to a loan guarantee on Fire’s part, on behalf of EastChase Land Company, LLC to Whitney Bank. Fire’s guarantee amount to Whitney Bank is $1 million. In the unlikely event of a guarantee call, the Company’s property casualty subsidiaries would be liable to reimburse Fire a maximum of $200 thousand. Similarly, in 2003, the Company’s property casualty subsidiaries entered into a second agreement with Fire guaranteeing, on behalf of Alfa Ventures II, LLC, the lesser of $25 million or 50% of the total obligations of The Shoppes at EastChase, LLC and EastChase Plaza, LLC with Columbus Bank & Trust Company (CB&T). This second guarantee is known as the “bucket” guarantee and supercedes all previous CB&T guarantees for each of these EastChase entities. In the unlikely event of a guarantee call, the Company’s property casualty subsidiaries would be liable to reimburse Fire a maximum of $1.4 million. During the third quarter of 2007, the Company’s property casualty subsidiaries entered into an agreement with Fire guaranteeing, on behalf of Alfa Ventures II, LLC, the lesser of $13 million or 50% of the total obligations of EastChase Market Center, LLC with CB&T. In the unlikely event of a guarantee call, the Company’s property casualty subsidiaries would be liable to reimburse Fire a maximum of $2.6 million.
The Company maintains a variety of funding agreements in the form of lines of credit with affiliated entities. The table below depicts, at December 31, 2007, the cash outlay by the Company representing the potential amounts the Company would have to supply to other affiliated entities if they made full use of their existing lines of credit during 2008 with the Company’s finance subsidiary. Other commercial commitments of the Company shown below include partnership commitments, potential performance payouts related to Vision, recourse on commercial leases sold and various fees and expenses, including financial advisory and legal, related to the privatization of the Company (refer to Note 21 - Privatization of the Company and Note 22 - Subsequent Events).
Guaranty Fund and Other Insurance-related Assessments: In all states, insurers licensed to transact certain lines of insurance are required to become members of a guaranty fund. In most states, in the event of the
Statutory Practices: Generally accepted accounting principles differ in certain respects from the statutory accounting practices prescribed or permitted by insurance regulatory authorities. Prescribed statutory accounting practices include state laws, regulations and general administrative rules, as well as a variety of publications of the NAIC. Permitted statutory accounting practices encompass all accounting practices that are not prescribed. Such practices differ from state-to-state, may differ from company-to-company within a state and may change in the future. Currently, the Company’s statutory net income and surplus is the same under NAIC accounting practices and the State of Alabama for Alfa Life Insurance Corporation, Alfa Insurance Corporation, Alfa General Insurance Corporation and Alfa Vision Insurance Corporation and the Commonwealth of Virginia for Alfa Alliance Insurance Corporation. The amounts of statutory net income and stockholders’ equity for the Company’s life and property casualty insurance subsidiaries are as follows:
Dividend Restrictions: Alfa Corporation is a holding company with no operations and, accordingly, any cash available for dividends or other distributions must be obtained by it from borrowings or in the form of distributions from its operating subsidiaries. Distributions to the Company from its insurance subsidiaries are subject to regulatory restrictions. Under applicable regulatory requirements, the Company’s insurance subsidiaries can distribute to the Company an aggregate of $107.0 million without prior regulatory approval.
Regulatory Requirements: At December 31, 2007, the life subsidiary’s Adjusted Capital calculated in accordance with NAIC Risk-Based Capital guidelines was $222.2 million, compared to the Authorized Control Level amount of $15.1 million, and the property casualty subsidiaries’ Adjusted Capital was $508.9 million, compared to the Authorized Control Level amount of $33.5 million. The Risk-Based Capital analysis serves as the benchmark for the regulation of insurance enterprises’ solvency by state insurance regulators.
These transactions increased the total number of shares outstanding to 80,761,779 shares at December 31, 2007.
The following table summarizes the effects of reinsurance on premiums and losses for the years ended December 31, 2007, 2006 and 2005:
The Company’s life insurance subsidiary reinsures portions of its risks with other insurers under yearly renewable term agreements and coinsurance agreements. Generally, Life will not retain more than $500 thousand of individual life insurance on a single risk with the exception of COLI and group policies where the retention is limited to $100 thousand per individual. The amount retained on an individual life will vary depending upon age and mortality prospects of the risk. At December 31, 2007, Life had total insurance inforce of $24.4 billion of which $2.6 billion was ceded to other insurers. In addition, reserve credits of $10.6 million have been taken as a result of the ceding of these inforce amounts to other insurers.
Effective July 1, 2006, Life entered into a new Accidental Death Catastrophic Reinsurance Agreement. The new agreement covers accidental death exposure in the portfolio by providing attritional and catastrophic protection with Life retaining the first $7.5 million of claims through June 30, 2007. Effective July 1, 2007, Life’s retention increased to the first $8.25 million of claims. Coverage includes acts of terrorism, but excludes war, armed forces active duty, professional sports teams, credit card business and liability from any pool.
The cost of reinsurance related to long-duration contracts is accounted for over the life of the underlying reinsured policies using assumptions consistent with those used to account for the underlying policies. Amounts paid or deemed to have been paid for Life’s reinsured contracts are recorded as reinsurance receivables.
The Company’s subsidiaries participate in a small number of involuntary pools and underwriting associations on a direct basis and receive a proportional share through the Pooling Agreement. In addition, the Company received a proportional share of Fire’s quota share reinsurance treaty with Virginia Mutual through the Pooling Agreement during 2005 and 2006. On January 1, 2007, the Pooling Agreement was amended and the quota share agreement between Fire and Virginia Mutual was terminated. AVIC directly participates in a reinsurance program in the state of Texas assuming non-standard automobile business which is retroceded to the pool.
On October 25, 1993, the Company established a Stock Incentive Plan (the 1993 Plan). The 1993 Plan was subsequently amended on April 26, 2001. On April 28, 2005, the Company’s stockholders approved the 2005 Amended and Restated Stock Incentive Plan (the 2005 Plan). This Plan amends and restates the 1993 Plan. The 2005 Plan permits the grant of a variety of equity-based incentives based upon the Company’s common stock. These include stock options, which may be either “incentive stock options” as that term is defined in Section 422 of the Internal Revenue Code of 1986, as amended or “nonqualified options”. The 2005 Plan also permits awards of Stock Appreciation Rights, Restricted Shares, Restricted Share Units and Performance Shares. A maximum of 3,800,000 shares of stock may be issued under the 2005 Plan. During 2007, the Company granted 78,134 awards of restricted stock to certain officers and issued 468,000 nonqualified options under the 2005 Plan. At December 31, 2007, 2,648,964 shares were available for grant.
It is the Company’s policy to issue treasury shares upon exercise of options or release of awards. The Company currently has a stock repurchase program to repurchase its outstanding common stock in the open market or in negotiated transactions in such quantities and at such times and prices as management may decide. The Company suspended its stock repurchase program following the proposal for privatization (refer to Note 21 - Privatization of the Company). At December 31, 2007, 3,021,245 treasury shares were available for issuance.
Under the 1993 and 2005 Plans, options ratably become exercisable annually over three years and expire ten years from the date of the award. Compensation cost for options with graded vesting is recognized using the straight-line method over the three year vesting period for non-retirement eligible employees. Compensation cost for options is recognized immediately for grants to retirement eligible employees or over the period from the grant date to the date retirement eligibility is achieved.
At December 31, 2007, there was $1.4 million of unrecognized compensation expense related to nonvested stock options granted that are expected to be charged to expense over a weighted average period of 1.33 years. This expense will be allocated according to Alfa’s Management and Operating Agreement.
Expected life or term of the stock options granted is derived from historical analysis and represents the period of time that share options are expected to be outstanding.
Expected volatility is based on historical volatility of the Company’s shares over a period equal to the expected life of each option grant.
are awards of restricted stock to certain officers based on specified target levels of ownership of Company common stock by those officers. These shares vest on the third anniversary after the date of grant, but are not negotiable by the recipients until the recipients terminate employment with the Company. The Company will vote these shares until they are issued to the recipients and dividends paid will be credited as additional shares of restricted stock and held by the Company until such shares are issued.
The total fair value of shares vested during 2007, 2006 and 2005, was $0, $199 thousand and $0, respectively. A total of 12,271.44 shares have been released with all whole shares being issued from treasury shares and fractional shares paid in cash.
OFC Capital (OFC), a division of Financial, originated various leases to commercial businesses during its affiliation with the Company. OFC was sold on December 31, 2005 to OFC Servicing Corporation. Financial retained a portion of the lease portfolio in run-off.
The Company leases certain equipment under agreements that are classified as capital leases. The cost of equipment included in other assets was $185 thousand at both December 31, 2007 and 2006. Accumulated amortization of the equipment at December 31, 2007 and 2006 was $185 thousand and $172 thousand, respectively. Amortization of assets under capital leases is included in depreciation expense. At December 31, 2007, there were no future minimum lease payments required.
Segment profit or loss for the property casualty segment is measured by underwriting profits and losses as well as by operating income. Segment profit or loss for the life insurance segment, the noninsurance segment and the corporate segment is measured by operating income. Management believes operating income serves as a meaningful tool for assessing the profitability of the Company’s ongoing operations. Operating income, a non-GAAP financial measure, is defined by the Company as net income excluding net realized investment gains and losses, net of applicable taxes. Realized investment gains and losses are somewhat controllable by the Company through the timing of decisions to sell securities. Therefore, realized investment gains and losses are not indicative of future operating performance.
Summarized financial performance data for each of the Company’s reportable segments are as follows:
The following computations set forth the calculation of basic and diluted net income per common share and common share equivalents for the years ended December 31, 2007, 2006 and 2005:
At December 31, 2007, weighted average shares of 395,527 were not included in the computation of diluted earnings per share since the exercise prices exceeded the average market price of the Company’s common shares and the inclusion would have an anti-dilutive effect. These shares could potentially have a dilutive effect in subsequent periods.
The following table presents the Company’s noncash investing and financing activities and required supplemental disclosures to the Statements of Cash Flows for the years ended December 31, 2007, 2006 and 2005:
The Company’s decline in income before income tax expense and net income for the quarter ended December 31, 2007 was primarily due to net realized investment losses, legal and other expenses related to the privatization of the Company and losses on equity-method investments.
On November 4, 2007, the Company entered into an Agreement and Plan of Merger (the “Merger Agreement”) with Alfa Mutual Insurance Company (Mutual), Alfa Mutual Fire Insurance Company (Fire) and Alfa Delaware Merger Sub, Inc. (Merger Sub), a Delaware corporation and wholly-owned subsidiary of Mutual and Fire. Under the terms of the Merger Agreement, Merger Sub will be merged with and into the Company, and as a result of the merger, the separate corporate existence of Merger Sub will cease with the Company continuing as the surviving corporation. Mutual and Fire collectively own approximately 54.2% of the Company’s common stock. At the effective time of the merger, each share of the Company’s common stock outstanding (other than shares owned by Mutual, Fire, Merger Sub, the Company and its wholly-owned subsidiaries, holders of shares subject to certain company awards, and holders who have perfected and not withdrawn a demand for appraisal rights) will be cancelled and converted into the right to receive $22.00 in cash, without interest. As a result of the merger, the Company will be wholly-owned by Mutual and Fire.
Concurrent with the Merger Agreement, Mutual and Fire will acquire Alfa Mutual General Insurance Company’s (General) (0.8%) ownership at the same price offered to the Company’s stockholders.
The merger is subject to a number of customary conditions, including, but not limited to obtaining the requisite regulatory approvals and obtaining approval of the holders of at least a majority of the outstanding shares of the Company’s common stock. Mutual and Fire have agreed to vote all of its shares of the Company’s common stock in favor of the merger, making the requisite stockholder approval assured. The merger is expected to be completed in the first half of 2008.
Although no assurances can be given that the transaction will occur, provisions in stock-based compensation plans will be triggered by the transaction resulting in immediate vesting of options and awards that will accelerate the recognition of expense and impact the Company’s future results of operations. As of December 31, 2007, there was $1.4 million of unrecognized compensation expense related to nonvested stock options granted and $624 thousand of unrecognized compensation expense related to restricted share awards that will continue to be recognized as required under SFAS No. 123(R) until the transaction is probable. These expenses are allocated to the Company based on the Management and Operating Agreement with Mutual (refer to Note 3 - Related Party Transactions for additional information).
The Company will likely incur future costs for the merger and/or litigation stemming from the merger.
Following the July 17, 2007 announcement of the proposal by the Mutual Group to acquire the outstanding common stock not owned by the Mutual Group at the price of $17.60 per share, certain putative class actions were filed on behalf of the Company’s public stockholders in the Delaware Court of Chancery and in the Circuit Court of Montgomery County, Alabama, naming the Company and its board of directors, Mutual, Fire and General as defendants, collectively. On August 16, 2007 and on August 29, 2007, orders were entered that consolidated the actions filed in Delaware. On October 31, 2007, an order was entered that consolidated the actions filed in Alabama. The plaintiffs in the Delaware action moved to intervene in the actions filed in Alabama for the limited purpose of seeking to dismiss, abate or stay such actions.
On November 7, 2007, the counsel to the parties in the above referenced Alabama consolidated action entered into a Memorandum of Understanding to settle such action, subject to approval of the court. Under the terms of the Memorandum of Understanding, Mutual and Fire agreed to pay $22.00 per share to acquire the outstanding shares of common stock of the Company that it does not own. As further consideration, lead counsel to the Alabama consolidated action was provided an opportunity to review and comment on the preliminary proxy statement. The Memorandum of Understanding also provided for confirmatory discovery, which has been completed.
On February 7, 2008, the Circuit Court of Montgomery County held a preliminary approval hearing in the above referenced Alabama consolidated action at which time the court conditionally certified the action as a non-opt-out class action and preliminarily approved the class action settlement. Notice to the class was mailed beginning on February 12, 2008. A fairness hearing on the settlement is scheduled for April 14, 2008.
In addition to the above referenced actions in Alabama and Delaware that were brought on behalf of the Company’s public stockholders, on November 9, 2007, a policyholder of Mutual filed a purported class action against Mutual in the Circuit Court of Macon County, Alabama. In that action, Preston M. Wright v. Alfa Mutual Insurance Co., No. CV-07-900070, the policyholder contended that the merger was not in the best interest of the policyholders of Mutual and Fire and asserted claims for the alleged impairment of Mutual’s assets. The policyholder subsequently elected to dismiss the class action claims.
Also, on November 21, 2007, certain policyholders of the Mutual Group filed a purported class action and derivative action against the Company, the Mutual Group and certain of their officers and directors, in the Circuit Court of Walker County, Alabama. In that action, Mr. and Mrs. Prince Hagler et. al. v. Alfa Mutual Insurance Co., et. al., No. CV-07-408, the policyholders contended that the merger was not in the best interest of the policyholders of the Mutual Group and would unjustly enrich the defendants. Plaintiffs sought to enjoin the merger, other injunctive relief, and unspecified damages, costs and attorneys’ fees. The Company believes that the claims were without merit. On December 21, 2007, the Mutual Group filed a motion to transfer the action to the Circuit Court in Montgomery County, Alabama, where the
For additional information, refer to Note 11 - Commitments and Contingencies.