We lease approximately 23,000 square feet of office space in an office project at 1301 Capital of Texas Hwy., Suite C-300, Austin, Texas as our principal executive offices.
We also lease approximately 290 square feet of office space for our Financial Services business at 1750 Tysons Blvd., 4th Floor, McLean, Virginia.
The following table sets forth selected historical financial and operating data for the Company and is derived from our consolidated financial statements which management believes incorporate all of the adjustments necessary for the fair presentation of the financial condition and results of operations for such periods in accordance with GAAP. The data should be read in conjunction with the consolidated financial statements, related notes and other financial information included elsewhere in this report, but may not be comparable as data for periods 2006 and later was impacted by the implementation of SFAS No. 123(R). Actual financial results through December 31, 2007 may not be indicative of future financial performance. Equity compensation expense of approximately $1,200,000 related to our acquisition of API is included in the 2007 results from operations.
There have been significant changes in the type of information reported and the presentation format as a result of the acquisition of API effective April 1, 2007 since we effectively became an insurance company as a result of the transaction. With the acquisition of API, our consolidated revenue and earnings are predominately derived from medical professional liability insurance provided through our Insurance Services segment. Prior to April 1, 2007, the historical results of operations of our Insurance Services segment were determined by the management fees we received from API pursuant to a management agreement and the expenses incurred in managing API’s operations such as personnel expenses, rent, office expenses and technology costs. The management agreement obligated API to pay management fees to us based on API’s earned premiums before payment of reinsurance premiums. The management fee percentage was 13.5% of API’s earned premiums. In addition, any pre-tax profits of API were shared equally with us (profit sharing) so long as the total amount of profit sharing did not exceed 3% of earned premiums. When we acquired API, our management agreement with API was terminated and our consolidated results of operations are no longer affected by management fees from API; but, rather our results of operations are now directly affected by premiums API earns from the sale of medical professional liability insurance, investment income earned on assets held by API, insurance losses and loss adjustment expenses relating to the insurance policies API writes as well as commissions and other insurance underwriting and policy acquisition expenses API incurs.
The following discussion should be read in conjunction with the consolidated financial statements and notes thereto accompanying this report. Except for historical information contained here, the discussions in the MD&A contain forward-looking information that involves risks and uncertainties. As discussed under “Cautionary Statement Regarding Forward-Looking Statements,” our actual financial condition and operating results could differ significantly from these forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those discussed under Item 1A. Risk Factors.
Through our subsidiaries, APS Financial Corporation, or APS Financial, APS Capital Corporation, or APS Capital, and APS Asset Management, Inc., or Asset Management, we provide investment and investment advisory services to institutions and individuals.
APS Financial is a licensed broker/dealer that provides brokerage and investment services primarily to institutional and high net worth individual clients. APS Financial also provides portfolio accounting, analysis, and other services to insurance companies and banks. We recognize commission revenue, and the related compensation expense, on a trade date basis.
Asset Management manages fixed income and equity assets for institutional and individual clients on a fee basis. We recognize fee revenue monthly based on the amount of funds under management.
As of December 31, 2007, we own 385,000 shares of Financial Industries Corporation (“FIC”), representing approximately 4% of their outstanding common stock. Our policy is to account for investments as available-for-sale securities which requires that we assess fluctuations in fair value and determine whether these fluctuations are temporary or “other than temporary” as defined in Statements of Financial Accounting Standards (SFAS) No. 115, Accounting for Certain Investments in Debt and Equity Securities. Temporary changes in fair value are recognized as unrealized gains or losses excluded from earnings and reported in equity as a component of accumulated other comprehensive income, net of income taxes. Should a decline in an investment be deemed other than temporary, as was the case with our investment with FIC since 2004, pre-tax charges to earnings were taken in the period in which the impairment is considered to be other than temporary. For the year ended December 31, 2007, 2006 and 2005 there were $693,000, $19,000 and $136,000, respectively in impairment charges resulting from our investment in FIC having previously resolved that declines in FIC’s stock price will be considered to be “other than temporary.” As a consequence of these write-downs, our basis in this stock has declined to $5.80 per share which is slightly above the fair market value of FIC common stock of $5.70 per share at December 31, 2007.
On January 15, 2008, FIC announced that it has entered into an agreement and plan of merger pursuant to which Americo Life, Inc. will acquire FIC. Under the terms of the agreement, FIC shareholders will receive $7.25 per share in cash. The total transaction is valued at $74.7 million. The merger is subject to customary closing conditions, including shareholder and regulatory approvals, and is currently scheduled to close in the second quarter of 2008. However, there can be no assurance that the transaction will be consummated on these or any other terms. For additional discussion regarding our FIC investment, please see Item 7A, Quantitative and Qualitative Disclosures About Market Risk and, Item 15, Notes 4 and 24 to the Consolidated Financial Statements.
Revenue Recognition. Historically, our Insurance Services segment recognized revenues in accordance with Staff Accounting Bulletin (“SAB”) No. 101, Revenue Recognition in the Financial Statements. Prior to April 1, 2007, our Insurance Services revenues were historically related to management fees based on the earned premiums of API and included a profit sharing component related to API’s annual earnings. Management fees equaled 13.5% of API’s earned premiums before payment of reinsurance premiums plus profit sharing equal to 50% of API’s pre-tax earnings up to a maximum of 3% of earned premiums before payment of reinsurance premiums. Management fees were recorded, based upon the terms of the management agreement, in the period the related premiums are earned by API. API recognizes premiums as earned ratably over the terms of the related policy. The profit sharing component was historically recognized in the fourth quarter when it was certain API would have an annual profit. In 2007, however, since the management contract ended March 31, 2007, we recognized the quarter’s profit in March, based on our ability to fully determine the profit sharing base.
Fair values for fixed income and equity securities are based on quoted market prices, where available. For fixed income and equity securities not actively traded, fair values are estimated using values obtained from independent pricing services.
The financial condition and near-term prospects of the security’s issuer, taking into consideration the economic prospects of the issuer’s industry and geographical region, to the extent that information is publicly available; and
Investment income includes amortization of premium and accrual of discount on the yield-to-maturity method for our available-for-sale investments acquired at other than par value. Amortization for loan-backed, or mortgage-backed, securities is adjusted prospectively for changes in pre-payment speed assumptions.
In November 2005, the Financial Accounting Standards Board (“FASB”) issued Staff Position No. FSP 115-1 and 124-1, The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments (“FSP 115-1 and 124-1”). FSP 115-1 and 124-1 supersedes Emerging issues Task Force Issue No. 03-1, The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments and amends SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities, SFAS No. 124, Accounting for Certain Investments Held by Not-for-Profit Organizations and Accounting Principles Board No. 18, The Equity Method of Accounting for Investments in Common Stock. FSP 115-1 and 124-1 address the determination as to when an investment is considered impaired, whether that impairment is other-than-temporary and the measurement of an impairment loss. FSP 115-1 and 124-1 also includes provision for accounting considerations subsequent to the recognition of an other-than temporary impairment and requires certain disclosures about unrealized losses that have not been recognized as other-than-temporary impairments. FSP 115-1 and 124-1 is effective for periods beginning after December 15, 2005, with earlier adoption permitted. The Company adopted FSP 115-1 and 124-1 during the fiscal quarter ended December 31, 2005. The adoption of FSP 115-1 and 124-1 did not have a material effect on our financial position, results of operations or cash flows.
Reserve for Loss and Loss Adjustment Expense. Loss and loss adjustment expense reserves represent management’s estimate of the ultimate costs of all reported and unreported losses incurred. API writes substantially all of its policies on a claims-made basis, and the reserve for unpaid loss and loss adjustment expense are estimated using actuarial analysis. These estimates include expectations of what the ultimate settlement and administration of claims will cost based on the company’s assessments of facts and circumstances then known, review of historical settlement patterns, estimates in trends in loss severity, frequency, legal theories of liability and other factors. Other factors include the nature of the injury, the judicial climate where the insured event occurred and trends in healthcare costs. In addition, variables in reserve estimation can be affected by both internal and external events, such as economic inflation, legal trends and legislative changes. The estimation of medical professional liability insurance loss and loss adjustment expense is inherently difficult. Injuries may not be discovered until years after an incident, or a claimant may delay pursuing recovery for damages. Medical liability claims are typically resolved over an extended period of time, often five years of more.
Each technique has inherent benefits and shortcomings (i.e., biases), particularly when applied to company-specific characteristics and trends. For example, certain methods (e.g., the Bornhuetter-Ferguson and pure premium methods) are more relevant to immature accident years, and other methods (e.g., the loss development methods) provide more meaningful information for years with a greater level of maturity. Because each method has its own set of attributes, API does not rely exclusively upon a single method. Rather, we evaluate each of the methods for the different perspectives that they provide. Each method is applied in a consistent manner from period to period and the methods encompass a review of selected claims data, including claim and incident counts, average indemnity payments and loss adjustment expenses.
Loss and loss adjustment expenses represent the largest component of API’s expenses. In considering the potential sensitivity of the factors and assumptions underlying management’s best estimate of loss and loss adjustment reserves, it is also important to understand that the medical professional liability sector of the property and casualty insurance industry is characterized by a relatively small number of claims with a large average cost per claim. For example, at December 31, 2007, we had 4,930 policyholders, and since the date of acquisition (April 1, 2007) API paid a total of $9,926,000 in paid damages on 72 claims. Even a relatively small change in the number of claims expected to be paid (i.e. frequency) or a relatively small percentage change in the average cost per claim (i.e. severity) could have a significant impact on reserves and correspondingly, our financial position and results of operations. This is also the case for other key assumptions as well, such as the frequency of reported claims that will ultimately close with paid damages versus those that will close without paid damages. Historically, API has closed over 80% of claims with no paid damages. In addition, due to the relatively small number of claims ultimately resulting in paid damages and the average cost per claim, any change in the trends of key assumptions used in estimating the ultimate values such as legislative changes resulting in tort reform, claims handling procedures, economic inflation and other factors could result in a significant change in the reserve estimate.
API attempts to consider all significant facts and circumstances known at the time loss reserves are established. Due to the inherently uncertain process involving loss and loss adjustment expense reserve estimates, the final resolution of the ultimate liability may be different from that anticipated at the reporting date. Therefore, actual paid damages in the future may yield a materially different amount than currently reserved-favorable or unfavorable. While API believes that the estimates for loss and loss adjustment expense reserves are adequate as of December 31, 2007, there can be no assurance that its estimates will not change in the future given the many variables inherent in such estimates and the extended period of time that it can take for claim patterns to emerge.
The following summarizes reserve development since our acquisition of API on April 1, 2007; (Since API was acquired on April 1, 2007, prior year development data is not applicable)
The table does not present accident year or policy year development data. Conditions and trends that have affected the development of liabilities in the past may not necessarily occur in the future. Accordingly, it may not be appropriate to extrapolate future redundancies or deficiencies based on this table.
Under API’s primary medical professional liability reinsurance contract or excess of loss treaty, certain premiums are ceded to other insurance companies under the terms of the reinsurance agreement. The excess of loss treaty provides coverage for losses in excess of API’s retention of $250,000 on individual claims and beginning in 2002, $350,000 on multiple insured claims related to a single occurrence. The 2006 reinsurance contract provides for these same terms with API retaining 10% of the risk above the aforementioned $250,000 and $350,000 retention levels. The 2007 reinsurance contract provides for the same terms with API retaining 20% of the risk above the $250,000 and $350,000 retention levels. The reinsurance contracts for 2002 through 2007 contain variable premium ceding rates based on loss experience and thus, a portion of policyholder premium ceded to the reinsurers is calculated on a retrospective basis. The variable premium contracts are subject to a minimum and a maximum premium range to be paid to the reinsurers, depending on the extent of losses actually paid by the reinsurers. A provisional premium is paid during the initial policy year. The actual percentage rate ultimately ceded under these contracts will depend upon the development of ultimate losses ceded to the reinsurers under their retrospective treaties.
In addition to an adjustment to premiums ceded, estimates of ultimate reinsurance ceded premium amounts compared to the amounts paid on a provisional basis give rise to a balance sheet asset classified as “Other amounts receivable under reinsurance contracts” or a balance sheet liability classified as “Funds held under reinsurance treaties.” Furthermore, each retrospective treaty requires a 24- or 36-month holding period before any premium adjustments or cash can be returned or paid. The ultimate settlement amount will not be determined until all losses have been settled under the respective treaties. As of December 31, 2007, we had recorded a balance sheet asset, “Other amounts receivable under reinsurance contracts” of $4,535,000 and a balance sheet liability, “Funds held under reinsurance treaties” of $4,651,000, which represent the differences between the estimates of ultimate reinsurance premiums ceded amounts for the 2002 through 2006 treaty years as compared to the amounts paid on a provisional basis.
Similar to the estimate for reserves, due to the long-tailed nature of the medical professional liability line of insurance, relatively small changes in the actuarial assumptions for trends, inflation, severity, frequency for projected ultimate loss and loss adjustment expense reserves can have a greater impact on the recorded balance for reinsurance recoverables than with most other property and casualty insurance lines. While API believes that its estimate for ultimate projected losses related to loss and loss adjustment expense is adequate based on reported and open claim counts, there can be no assurance that additional significant reserve enhancements will not be necessary in the future given the many variables inherent in such estimates and the extended period of time that it can take for claim patterns to emerge.
Death, Disability and Retirement Reserves. API has established a death, disability and retirement reserve for policyholders, which is intended to set aside a portion of the policy premium to account for the coverage provided for the extended reporting period or tail coverage offered by API upon the death and/or disability and/or retirement of a policyholder which is provided at no additional cost to the policyholder. The death, disability and retirement reserve is included in unearned premiums.
Income Taxes. We compute income taxes utilizing the asset and liability method. We recognize current and deferred income tax expense, which is comprised of estimated provisions for federal income taxes. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis and operating loss and tax credit carry forwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. A valuation allowance against deferred tax assets is recorded if it is more likely than not that all or some portion of the benefits related to the deferred tax assets will not be realized. We have not established a valuation allowance because we believe it is more likely than not our deferred tax assets will be fully recovered. In July 2006, the Financial Accounting Standards Board ("FASB") issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes-an interpretation of FASB Statement No. 109 ("FIN 48"), which we adopted on January 1, 2007. FIN 48 clarifies the accounting for income tax uncertainties. We have developed and implemented a process based on the guidelines of FIN 48 to ensure that uncertain tax positions are identified, analyzed and properly reported in the company’s financial statements in accordance with SFAS 109. Based on all known facts and circumstances and current tax law, we believe that the total amount of unrecognized tax benefits as of January 1, and December 31, 2007, is not material to our results of operations, financial condition or cash flows. We also believe that the total amount of unrecognized tax benefits as of January 1, and December 31, 2007, if recognized, would not have a material effect on our effective tax rate. We further believe that there are no tax positions for which it is reasonably possible that the unrecognized tax benefits will significantly increase or decrease over the next 12 months producing, individually or in the aggregate, a material effect on our results of operations, financial condition or cash flows.
We are providing the following unaudited pro forma condensed consolidated financial statements to present a picture of the results of operations of the combined company after giving effect to our acquisition of API, absent any operational or other changes, had API’s and our businesses been combined for the periods and at the dates indicated. The pro forma condensed consolidated statements of operations for the years ended December 31, 2007 and 2006 are presented as if the API acquisition occurred on January 1, 2006. The unaudited pro forma condensed consolidated financial statements were prepared using the purchase method of accounting.
The pro forma adjustments are based upon available information and assumptions that each company’s management believes are reasonable. The unaudited pro forma condensed consolidated financial statements are presented for illustrative purposes only and are based on the estimates and assumptions set forth in the notes accompanying these statements, which should be read in conjunction with these unaudited pro forma condensed consolidated financial statements. The companies may have performed differently had they always been combined. You should not rely on this information as being indicative of the historical results that would have been achieved had the companies always been combined or the future results that the combined company will experience. The unaudited pro forma condensed consolidated financial information is not comparable to our historical financial information due to the inclusion of the effects of the API acquisition. The unaudited pro forma condensed consolidated financial statements and the related notes thereto should be read in conjunction with the audited consolidated financial statements of the Company for the years ended December 31, 2007 and 2006, and the related notes thereto and other information in the “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the unaudited financial statements of API for the quarter ended March 31, 2007 filed in the Form S-1 of the Company dated, June 19, 2007.
The accompanying unaudited pro forma statements of operations present the pro forma effects of our acquisition of API through the issuance of common and preferred shares of our stock. The statements of operations for the years ended December 31, 2007 and 2006 are presented as though the acquisition occurred on January 1, 2006.
We accounted for the acquisition using the purchase method of accounting for business combinations. We were deemed to be the acquirer for accounting purposes based on a number of factors determined in accordance with GAAP. The purchase method of accounting requires that API’s assets acquired and liabilities assumed by us be recorded at their estimated fair values.
For comparative purposes, we have also included on a pro forma basis the results of operations for the year ended December 31, 2007 and 2006 of the Company and API as if the acquisition had occurred on January 1, 2006. Any reference in the MD&A Section below to “on a pro forma basis” is as if the Company acquired API on January 1, 2006.
Pro forma revenues increased $3,592,000 (4%) to $98,721,000 from $95,129,000 for the year ended December 31, 2007 compared to 2006. Our income from operations increased $8,388,000 (30%) to $36,558,000 from $28,170,000 for year ended December 31, 2007 compared to 2006. Our net income increased $5,162,000 (28%) to $23,436,000 from $18,274,000 for the year ended December 31, 2007 compared 2006. Diluted net income per share increased $0.40 (11 %) to $4.12 from $3.72 for the year ended December 31, 2007 compared to 2006.
On a pro forma basis, gross premiums and maintenance fees written decreased $9,247,000 (12%) to $65,586,000, from $74,833,000 for the year ended December 31, 2007 compared to the same period in 2006. While API increased in the number of policyholders to 4,930 at December 31, 2007 from 4,712 at December 31, 2006, gross premiums and maintenance fees written decreased due to rate decreases which averaged 14% for the year ended December 31, 2007. As a result of increased marketing efforts, we continue to experience growth in the number of policyholders; however, this growth has slowed in 2007 as compared to 2006 as a result of pricing and competitive pressures.
Premiums ceded increased to $4,813,000 from $0 for the year ended December 31, 2007 as compared 2006 as a result of the acquisition of API on April 1, 2007.
On a pro forma basis, premiums ceded expenses decreased $7,115,000 to $2,406,000 from ($4,709,000) for the year ending December 31, 2007 as compared to the same period in 2006. The reinsurance contracts beginning in 2002 through 2007 are variable premium treaties that have various minimum and maximum rates. The actual premium rate will depend upon the ultimate losses ceded to the reinsurer under the related treaty. We, supported periodically by outside consulting actuarial reviews, continually monitor the development of claims subject to reinsurance and adjusts premiums ceded for estimated profit sharing provisions based on claims development in the reinsurance layers. The pro forma decrease in premiums ceded of $7,115,000 is primarily the result of lower estimated ceding rates due to lower estimated loss and loss adjustment expenses for prior treaty years 2002 through 2006. This prior year favorable development in the reinsurance layer resulted in us recognizing $10,888,000 primarily as a reduction to ceded premiums for the twelve months ended December 31, 2007. During 2006 we lowered the estimated ceding rates for prior treaty years 2002 through 2005, which caused us to recognize $7,743,000 in positive development as a reduction in ceded premium. Additionally, ceded premiums decreased year over year due to the Company retaining 20% of any claim in excess of $250,000 on individual claims and $350,000 on multiple insured claims for the 2007 reinsurance treaty. We retained 10% of any excess on the 2006 treaty. We are retaining this additional risk in the reinsurance layer based on decreases in claims since the passage of tort reform legislation in 2003. In addition, ceded premiums are lower for the current period due to lower earned premiums in 2007 as compared to 2006.
Net premiums and maintenance fees earned increased to $56,039,000 from $0 for year ended December 31, 2007 as compared to 2006 as a result of the acquisition of API on April 1, 2007.
Investment income, net of investment expenses increased by $7,778,000 (850%) to $8,693,000 from $915,000 for the year ended December 31, 2007 as compared to 2006 as a result of a substantial increase in invested assets resulting from the acquisition of API on April 1, 2007 and from capital received from our common stock offering in June 2007.
On a pro forma basis, investment income, net of investment expenses, increased by $2,900,000 (38%) to $10,505,000 from $7,605,000 for the year ended December 31, 2007 as compared to the same period for 2006. On a pro forma basis, cash and invested assets increased by $52,858,000 (31%) to $223,193,000 at December 31, 2007 from $170,335,000 at December 31, 2006 resulting in the increase in investment income. In addition, the increase in invested assets resulted primarily from the use of proceeds of our common stock offering as well as from positive net cash flow from operating activities.
Of our entire invested assets, including unrestricted cash, agency-backed mortgage obligations, with underlying collateral consisting of GNMA, FHLMC, or FNMA loans comprise 42% of our portfolio; non-agency collateralized mortgage obligations comprise 17% of our portfolio; 27% is comprised of U.S. Treasury, government agency bonds and notes, municipal tax exempt bonds and corporate bonds and the remaining 14% is cash, equities and other invested assets. The majority of the non-agency CMO’s in our portfolio have underlying mortgages categorized as “Prime” quality loans, and none of our CMO’s have underlying mortgages classified as “Subprime.” However, within our portfolio at December 31, 2007 there were ten CMO securities classified as “Alternative-A” or “Alt-A.” These Alt-A securities are generally considered to have underlying mortgages with underwriting characteristics that are stronger than “Subprime” mortgages but less stringent than “Prime” mortgages. All of our Alt-A securities are investment grade, currently rated either AAA, AA or A.
On a pro forma basis, realized capital losses were $5,130,000 for the year ended December 31, 2007 versus a gain of $161,000 for the year ended December 31, 2006. The increase in losses for the current year is primarily due to other than temporary impairment charges of $4,566,000 in the last two quarters of 2007, resulting from fair market value declines in our investment in Alt-A collateralized mortgage-backed securities. In addition, we incurred realized losses on our investment in FIC. Both of these realized investment losses are discussed above under actual results.
On a pro forma basis, loss and loss adjustment expenses for the year ended December 31, 2007 decreased by $12,909,000 (34%) to $24,659,000 from $37,568,000 for the year ended December 31, 2006. The decrease of $12,909,000 on a pro forma basis is the result of a lower accident year loss and loss adjustment expense and higher favorable development on prior year losses in 2007 as compared to 2006. For the year ended December 31, 2007, current accident year loss and loss adjustment expenses totaled $40,682,000 based on 402 claims reported and prior year losses developed favorably $16,023,000 as a result of reductions in our estimates of claims severity, principally the 2002 through 2006 report years. For the year ended December 31, 2006, current accident year loss and loss adjustment expenses were $42,344,000 based on 507 claims reported and there was $5,001,000 favorable development on prior years. The positive effects of 2003 tort reform in Texas on average claim severity has resulted in continued favorable development of reserves and improved claim development patterns. API has favorably settled a number of post-tort reform claims from the 2004 and 2005 report years at below the reserved amounts. However, even though reported claims have decreased by 103 claims year over year, we continue to accrue our current accident year losses conservatively based on increases in policyholder count from 4,712 as of December 31, 2006 to 4,930 as of December 31, 2007.
We continually review and update the data underlying the estimation of the loss and loss adjustment expense reserves and make adjustments that we believe the emerging data warrant. Any adjustments to reserves that are considered necessary are reflected in the results of operations in the period the estimates are changed. As of December 31, 2007, we continue to reserve at the upper end of the reserve range.
Other underwriting expenses increased to $8,320,000 from $0 for the year ended December 31, 2007 compared to 2006 as a result of the acquisition of API on April 1, 2007.
Our Financial Services expenses increased $3,873,000 (26%) to $19,030,000 from $15,157,000 for the year ended December 31, 2007 compared to 2006. The primary reason for the current year increase is a $3,007,000 (32%) increase in commission expense in 2007 compared to 2006 resulting from the increase of commissions paid on non-investment grade bond and trade claim transactions mentioned above. In addition, incentive compensation costs increased $257,000 (25%) in 2007 as a result of increased profits in the current year compared to 2006. Legal and professional expenses were higher by $494,000 (126%) for 2007 due to costs incurred for litigation concerning certain transactions and for expenses to further our efforts to become compliant with the Sarbanes-Oxley Act of 2002. Lastly, a claim was settled in 2007 in the amount of $135,000 resulting from a disputed trade claim transaction.
General and administrative expenses increased $3,353,000 (159%) to $5,459,000 from $2,106,000 for the year ended December 31, 2007 compared to 2006. The increase in general and administrative expenses in the current year includes higher salaries of $389,000 or 55% resulting from our hiring a new Chief Operating Officer and new administrative assistant in April of 2007 in addition to adding a new Treasurer position in November; higher incentive compensation of $1,075,000 or 175%, a formula-driven expense that is higher in 2007 due to the large increase in net earnings resulting primarily from the acquisition of API in April 2007 and from record earnings at our Financial Services segment; higher board fees of $416,000 or 198% resulting from deferred compensation awarded as a result of the successful merger as well as due to a greater number of directors and a greater number of board meetings necessitated by the merger with API and the common stock secondary offering; higher legal and professional fees of $401,000 or 214% resulting primarily from internal control expenditures to further our efforts to assess our internal controls consistent with the Sarbanes-Oxley Act of 2002; and higher interest of $429,000 resulting from interest and preferred stock dividends due to our preferred share holders. In addition, there was a decrease in a gain on the sale of assets of $446,000, or 99% in 2007 compared to 2006. These gains were treated as a reduction of rent expense in 2006 and represented the recognition of a deferred gain related to the November 2001 sale and subsequent leaseback of real estate. The monthly recognition of deferred revenue from this sale ended in September 2006 and totaled $422,000 in that year.
Goodwill was originally recorded upon the repurchase of an interest in APS Insurance Services from a minority holder in 2003. Goodwill was determined to exist based on earnings expected to be generated from the management agreement with API. With our purchase of API and termination of the management agreement, we determined that the original circumstances creating the goodwill no longer existed and that the entire $1,247,000 balance was impaired. The goodwill was written off in the quarter ended June 30, 2007.
Investment income, net of investment expenses increased by $328,000 (56%) to $915,000 from $587,000 for the year ended December 31, 2006 as compared to 2005 as a result of a larger balance of interest-bearing fixed income securities earning a higher rate of interest in 2006 compared to 2005. At December 31, 2006 there was a balance in investment securities held of $16.7 million compared to a balance of $13.2 million held at December 31, 2005.
Financial Services revenues decreased $1,475,000 (8%) to $16,850,000 from $18,325,000 in 2006 compared to 2005. This decrease was primarily due to lower revenue derived from commissions earned at our broker-dealer, APS Financial. Commission income, mostly generated from transactions in the investment grade and non-investment grade fixed-income market, was down $5,420,000 (33%) to $10,990,000 from $16,410,000 in 2006 compared to 2005. Going into 2006, the Federal Reserve had raised short-term rates 17 times for a total of 425 basis points since mid 2004, and then held rates steady throughout 2006. The resulting flat to inverted yield curve, in conjunction with lack of volatility throughout the year, resulted in generally less customer activity and trading volumes in investment grade bonds. As a result of these depressed trading conditions, APS Financial shut down its Houston branch office in the third quarter of 2006 and consolidated its trading and sales activities in its Austin office. Regarding its non-investment grade trading, APS Financial has also realized lower trading volumes in the high yield market, due to narrow interest rate spreads. The narrow spreads resulted from a corporate market experiencing historically low default rates and lower volatility. Offsetting somewhat the lower level of securities trading revenues were revenues earned from our investment banking and distressed debt/trade claim trading operations, which contributed an aggregate increase of $3,763,000 (201%) to $5,638,000 from $1,875,000 in 2006 compared to 2005.
Our general and administrative expenses decreased $497,000 (19%) to $2,106,000 from $2,603,000 in 2006 compared to 2005. The current year decrease is primarily due to lower incentive compensation expense. Incentive compensation, a formula driven expense calculated in part on net earnings, decreased $442,000 (42%) to $613,000 from $1,055,000 due to much lower investment gains in 2006 compared to 2005. In addition, salaries expense was $84,000 (11%) lower to $708,000 from $792,000 in 2006 as a result of a severance payment in 2005 to a former employee, Duane Boyd, who has since been retained as a tax consultant. Legal and professional fees declined in 2006 by $128,000 (46%) to $153,000 from $281,000 as costs associated with internal controls disclosures and procedures under SOX 404, compliance was minimal in 2006 compared to 2005 when we were ramping up our compliance efforts. With the uncertainty as to what, if any, relief was to be granted to non-accelerated filers like us, we slowed our expenditures in an attempt to control SOX 404 compliance costs. In particular, we did not retain the outside SOX 404 consultants we employed during 2005 and have concentrated instead on internal compliance efforts. Partially offsetting these decreases was stock option expense of $45,000 in 2006, the first year that such expenses were charged.
Cash Flows. Our total cash and cash equivalents balance at December 31, 2007, was $18,391,000, an increase of $14,149,000 (334%) in the current year as cash provided by operating and financing activities more than offset net cash used in investing activities. Our cash flows provided from operating activities totaled $8,075,000 for the current year on the strength of net income before extraordinary gains of $21,009,000. Our Insurance Services segment generated the bulk of the cash received from operating activities, the result of increased premium and maintenance fee receipts and decreased claims payouts. Cash provided by financing activities contributed $32,417,000 for the year ended December 31, 2007 as a result of cash received from our secondary offering of common stock totaling approximately $30,227,000 as well as cash received from an over-allotment sale of an additional 315,000 shares which contributed another $4,846,000. Partially offsetting this was a dividend paid to our common stock shareholders ($1,416,000) and a partial redemption payment to our preferred stockholders ($1,018,000). Our cash flows used in investing activities totaled $26,343,000 in 2007 primarily as a result of purchases of available-for-sale fixed income securities in excess of proceeds from their sale. Partially offsetting this use of cash from investing activities was cash totaling $9,910,000 received as part of the assets acquired from our acquisition of API. For details of the amounts described above, refer to the Condensed Consolidated Statements of Cash Flows of this Form 10-K.
Escrow Account. In connection with the API acquisition, the Texas Department of Insurance has required us to place $2,500,000 into an escrow account with a bank, to remain in escrow until the aggregate remaining redemption and dividend obligation relating to our Series A redeemable preferred stock is less than the amount of the escrow balance. No withdrawals may be made from this escrow account without prior approval from the Texas Department of Insurance.
At December 31, 2007, API had investments with a fair market value of $1,381,000 on deposit with state insurance departments to satisfy regulatory requirements and these securities are included in fixed maturities, available for sale.
There are no participation agreements or purchase commitments as of December 31, 2007 Our primary liability is the reserves for losses and loss adjustment expenses which are estimates of the ultimate expected payouts on existing reported and estimated unreported claims. These reserves totaled $101,606,000 at December 31, 2007. Our reserves for unpaid losses and loss adjustment expenses are an estimate of future cash flows necessary to fulfill insurance obligations based on insured events that have already occurred, but the amount and timing of the cash flow is uncertain. As a result of the acquisition of API on April 1, 2007, we issued Series A manditorily redeemable preferred stock. The holders of our Series A redeemable preferred stock are entitled to cumulative dividends thereon at the rate of three percent per annum payable on the remaining redemption value per share, in priority to the payments of dividends on our common shares. Holders of Series A redeemable preferred stock have no preemptive rights and have the same voting rights as the holders of our common stock. The preferred shares are non-certificated and mandatorily redeemable. They must be redeemed ratably at not less than $1,000,000 per year, with all remaining outstanding shares being redeemed by December 31, 2016.
The following is a summary of our contractual obligations as of December 31, 2007:
In permitting clients to purchase on margin, we are subject to the risk of a market decline, which could reduce the value of our collateral below the client’s indebtedness. Agreements with margin account clients permit our clearing organization to liquidate our clients’ securities with or without prior notice in the event of an insufficient amount of margin collateral. Despite those agreements, our clearing organization may be unable to liquidate clients’ securities for various reasons including the fact that the pledged securities may not be actively traded, there is an undue concentration of certain securities pledged or a trading halt is issued with regard to pledged securities. If the value of the collateral were insufficient to repay the margin loan, a loss would occur, which we may be required to fund. As of December 31, 2007, the total of all customer securities pledges on balances held in margin accounts was approximately $1.7 million while the total value of the securities within these margin accounts was approximately $7.6 million. We are also exposed to risks should Southwest be unable to fulfill its obligations for securities transactions.
In February 2006, the FASB issued Statement of Financial Accounting Standards, or SFAS, No. 155, Accounting for Certain Hybrid Financial Instruments, an amendment of SFAS No. 133 and 140. SFAS No. 155 becomes effective for all financial instruments acquired or issued after the beginning of an entity’s first fiscal year that begins after September 15, 2006. This Statement permits fair value re-measurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation; clarifies which interest-only strips and principal-only strips are not subject to the requirements of SFAS No. 133; establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation; clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives; and amends SFAS No. 140 to eliminate the prohibition on a qualifying special-purpose entity from holding a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument. Management does not expect the adoption of this standard to have a material effect on the Company’s financial position, results of operations or cash flows. The adoption of SFAS No. 155 did not have a material effect on our financial position, results of operations or cash flows.
In September 2006, the FASB issued Statement of Financial Accounting Standards, or SFAS No. 157, “Accounting for Fair Value Measurements”, effective for fiscal years beginning after November 15, 2007. However, on February 12, 2008, the FASB issued FSP FAS 157-2 which would delay the effective date of SFAS No. 157 for all non-financial assets and non-financial liabilities, except those that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually). This FSP partially defers the effective date of SFAS No. 157 to fiscal years beginning after November 15, 2008, and interim periods within those fiscal years for items within the scope of this FSP. This Statement defines fair value, establishes a framework for measuring fair value in accordance with GAAP and expands disclosures about fair value measurements. Accordingly, this Statement does not require any new fair value measurements. However, for some entities, the application of this Statement will change current practice. We are currently evaluating the impact, if any, the adoption of this standard will have on our financial position, results of operations or cash flows.
In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities. This Statement permits entities to choose to measure certain financial assets and liabilities at fair value which are otherwise measured on a different basis in existing literature. Additional disclosures are required. It is effective for the Company, if elected, as of January 1, 2008. Early adoption is permitted with several constraints. We are currently evaluating the impact, if any, the adoption of this standard would have on our financial position, results of operations or cash flows.
In December 2007, the FASB issued Statement of Financial Accounting Standards, or SFAS No. 141 (Revised December 2007) “Business Combinations” (SFAS 141R). SFAS 141R replaces FASB Statement No. 141, “Business Combinations” but retains the fundamental requirement in SFAS 141 that the acquisition method (referred to as the purchase method in SFAS 141) of accounting be used for all business combinations. SFAS 141R provides new and additional guidance with respect to business combinations including: defining the acquirer in a transaction, the valuation of assets and liabilities when noncontrolling interests exist, the treatment of contingent consideration, the treatment of costs incurred to effect the acquisition, the treatment of reorganization costs, and the valuation of assets and liabilities when the purchase price is below the net fair value of assets acquired. SFAS 141R applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. Earlier adoption is prohibited. We will adopt the Statement on its effective date.