In Baton Rouge, Louisiana, we own a building of approximately 177,469 square feet for investment purposes. The building is under a lease agreement with a federal agency. The lease expires on August 31, 2008. However, the federal agency may terminate the lease at any time upon fifteen days’ written notice.
As of December 31, 2007, our subsidiaries included five insurance companies licensed to write insurance policies in 40 states, four underwriting agencies, six retail agencies with 221 owned stores and 35 operating franchise retail store locations in Florida. We are currently active in offering insurance directly to individual consumers through retail stores in 10 states (Louisiana, Illinois, Texas, Missouri, Indiana, South Carolina, Florida, Kansas, Wisconsin and Alabama) including our franchised stores in Florida and distributing our own insurance policies through 7,900 independent agents in 9 states (Illinois, California, Texas, Missouri, Indiana, South Carolina, Florida, Michigan and New Mexico). The 13 states in which we operate collectively represent approximately 56% of the non-standard personal automobile insurance market. These states accounted for $16.7 billion in direct written premium in 2006, based on information from A. M. Best and our company analysis. We believe the states in which we operate are among the most attractive non-standard personal automobile insurance markets due to a number of factors, including size of market and existing regulatory and competitive environments.
Our three operating components often function as a vertically integrated unit, capturing the premium and associated risk and commission income and fees generated from the sale of an insurance policy. There are other instances, however, when each of our operations functions with unaffiliated entities on an unbundled basis, either independently or with one or both of the other two operations. For example, as of December 31, 2007, our insurance companies had relationships with two unaffiliated underwriting agencies that design, distribute and service our policies through their approximately 4,300 independent agencies, and our underwriting agencies distributed insurance policies through approximately 3,600 independent agencies in addition to our owned and franchised retail stores. In addition, our retail stores earn commission income and fees from sales of third-party policies.
At December 31, 2007, our receivables from reinsurers included $17.1 million gross recoverable from VFIC. At December 31, 2007, the VFIC Trust held $18.4 million to collateralize the $17.1 million gross recoverable from VFIC. We have, with the approval of the VFIC Special Deputy Receiver and the District Court, Austin, Texas, withdrawn $5.8 million from the trust securing our reinsurance recoverables from VFIC, which represented 100% of the amount we paid in losses as of the date of the withdrawal covered by the VFIC reinsurance. We have made arrangements with the VFIC Special Deputy Receiver to submit quarterly statements for approval to withdraw additional funds from the trust based upon losses paid.
Reserving for unpaid losses and loss adjustment expenses. On a quarterly basis, for each financial reporting period, we record our best estimate of our overall reserve for both current and prior accident years. The amount recorded represents the remaining amount we expect to pay for all covered losses that occurred through the current financial statement date, as well as the amount we expect to expend for all claim settlement expenses. The overall reserve for losses and loss adjustment expenses estimate that we record is the difference between (1) our point estimate of the ultimate loss and ultimate loss adjustment expenses, and (2) the amount of losses and loss adjustment expenses paid through the current financial statement. Our point estimate of ultimate loss consists of a point estimate for Incurred But Not Reported (IBNR) losses. The IBNR reserve is calculated by reducing the overall reserve for loss by the amount of our case reserves. The point estimate of ultimate loss adjustment expenses consists of a separate point estimate for adjusting and other expenses and for defense and cost containment expenses.
Incurred Bornhuetter/Ferguson - We use a combination of incurred development methods and expected loss adjustment expense methods. Expected loss ratio methods are based on the assumption that ultimate losses vary proportionately with premiums. Expected loss and loss adjustment expense ratios are typically developed based upon the information used in pricing and are multiplied by the total amount of premiums earned to calculate ultimate loss and loss adjustment expense.
Applying the above potential variation to the December 31, 2007 estimate of ultimate loss reserves would yield an indication of sensitivity to held reserves from $(11.0) million to $8.5 million, generating an impact to after-tax income of $7.2 million to $(5.5) million, respectively (assuming a 35% tax rate). The final outcome may fall below or above these amounts.
Valuation of investments. Our investments are recorded at fair value, which is typically based on publicly available quoted prices. From time to time, the carrying value of our investments may be temporarily impaired because of the inherent volatility of publicly-traded investments. We do not adjust the carrying value of any investment unless management determines that the impairment of an investment’s value is other than temporary.
We evaluate impairment of goodwill and indefinite life intangibles. Goodwill impairment is based upon: (1) the historical financial performance of the unit; (2) the most recent financial performance of the unit; (3) our financial forecast for the unit; (4) information regarding publicly available financial terms of recent transactions in the industry; and (5) other publicly available information.
In December 2007, the FASB issued SFAS No. 141R, Business Combinations, which requires most identifiable assets, liabilities, noncontrolling interests, and goodwill acquired in a business combination to be recorded at full fair value. SFAS No. 141R also requires, among other things, the acquisition costs to be expensed in the periods they are incurred, the contingent considerations resulting from events after the acquisition date to be measured and recognized at the acquisition date fair value with subsequent changes recognized in earnings, and the change in deferred tax benefit that are recognizable because of a business combination to be recognized either in income or directly in contributed capital in the period of business combination. This statement is effective for business combinations occurring after December 15, 2008. If we acquire companies, SFAS No. 141R could have a material impact in the future on our results of operations or financial condition.
The following table sets forth the components of consolidated statements of income as a percentage of total revenues and certain operational information for the periods indicated (in thousands).
We are an insurance holding company engaged in the underwriting, servicing and distributing of non-standard personal automobile insurance policies and related products and services. We distribute our products through three distinct distribution channels: our owned retail stores, independent agents and unaffiliated managing general agencies. We generate earned premiums and fees from policyholders through the sale of our insurance products. In addition, through our owned retail stores, we sell insurance policies of third-party insurers and other products or services of unaffiliated third-party providers and thereby earn commission income from those third-party providers and insurers and fees from the customers.
As part of our corporate strategy, we treat our owned retail stores as independent agents, encouraging them to sell to their individual customers whatever products are most appropriate for and affordable to those customers. We believe that this offers our retail customers the best combination of service and value, developing stronger customer loyalty and improving customer retention. In practice, this means that in our owned retail stores, the relative proportion of the sales of our own insurance products as compared to the sales of the third-party policies will vary depending upon the competitiveness of our insurance products in the marketplace during the period. This reflects our intention of maintaining the margins in our insurance company subsidiaries, even at the cost of business lost to third-party carriers.
better segmented products to serve our target markets during the past twelve months. In the aggregate, our rate level during 2007 modestly increased, as we continued to focus on seeking an appropriate balance between competitive positioning and profitability.
Total revenues for 2007 increased $142.9 million, or 40.0%, to $500.0 million from $357.1 million for 2006. The increase is primarily due to the acquisition of USAgencies.
As of December 31, 2007, we had two active unaffiliated relationships.
The following table displays our gross premiums written by state for the years ended December 31, 2007, 2006, and 2005 (in thousands):
The following table sets forth net premiums earned by distribution channel for 2007, 2006 and 2005 (in thousands):
The largest component of revenues is net premiums earned on our insurance policies. Net premiums earned for 2007 increased $107.9 million, or 37.5%, compared with 2006. Since insurance premiums are earned over the life of the policies, the revenue in the current period includes premiums earned on insurance products written through our three distribution channels in both current and previous periods. Excluding USAgencies, earned premiums declined by $14.2 million, or 5%, in 2007. This decline was due to competitive pressure and a shifting emphasis to third-party products in selected markets. Net premiums earned during 2007 on policies sold through our affiliated underwriting agencies (including retail and independent agencies) increased by $108.2 million, or 43.6%. This increase was due to the acquisition of USAgencies. Net premiums earned on insurance products sold through the unaffiliated underwriting agencies distribution channel decreased by $0.2 million, or 0.5%, compared with 2006.
Reinsurance. The following table reflects the premiums ceded and assumed under reinsurance agreements in our consolidated financial statements for the years ended December 31, 2007, 2006 and 2005 (in thousands):
Our quota share ceding commission rate structure varies based on loss experience. The estimates of loss experience are continually reviewed and adjusted, and the resulting adjustments to ceding commissions are reflected in current operations.
The amount of recoveries pertaining to quota share reinsurance contracts that were deducted from losses incurred during 2007 was approximately $48.2 million. The amount of loss reserves and unearned premium we would remain liable for in the event our reinsurers are unable to meet their obligations is as follows for the years ended December 31, 2007, 2006 and 2005 (in thousands):
On April 1, 2007, as discussed above, we exercised our option to terminate the quota share contracts on a cut-off basis. On April 30, 2007, we received $31.0 million to settle the unearned premiums less return ceding commissions. Taking this recovery into account, our net exposure for reinsurance provided by the reinsurer at December 31, 2007 was $36.8 million.
The following table summarizes the ceded incurred losses and loss adjustment expenses (consisting of ceded paid losses and loss adjustment expenses and change in loss and loss adjustment expense reserves ceded) to various reinsurers for the years ended December 31, 2007, 2006, and 2005 (in thousands):
Effective May 1, 2006, our quota-share reinsurance agreement with a reinsurer under which we ceded 25% of business produced by our Florida underwriting agency was terminated.
Effective August 1, 2005, we entered into novation agreements with several unaffiliated reinsurers who participated in a quota share reinsurance agreement in which we also participated. Pursuant to these agreements, we were substituted in place of these reinsurers assuming all rights, interests, liabilities and obligations related to the original quota share reinsurance agreement. As a result of these novation agreements, our participation in the original reinsurance agreement increased from 5% to 100% effective August 1, 2005. In consideration for our assumption of their liabilities, these reinsurers agreed to pay us an amount equal to their share of the liabilities under the original quota share agreement as of July 31, 2005. The terms of this reinsurance agreement did not meet the risk transfer requirements according to SFAS No. 113; therefore, this contract was accounted for as deposits according to the guidelines of SOP 98-7, Deposit Accounting for Insurance and Reinsurance Contracts that do not Transfer Insurance Risk. If the estimated deposit liabilities are less than the recorded liabilities, we record excess deposit liabilities as income based on a percentage of actual paid losses. We believe that this methodology approximates the effective interest method prescribed in SOP 98-7. Changes in the carrying amount of the deposit liability should be reported as income or expense as appropriate. We received cash in the amount of $14.2 million in relation to this novation. The deferred gain initially totaled $1.8 million, of which we recognized $401,000, $683,000, and $477,000 in income for the years ended December 31, 2007, 2006, and 2005, respectively.
Commission Income and Fees. The following sets forth the components of consolidated commission income and fees earned for the years ended December 31, 2007, 2006 and 2005 (in thousands):
Commission income and fees consists of three principal types, including (a) the commission income and fees earned by our underwriting agencies on insurance business that is not written or retained by us, (b) policy, installment, premium finance, franchise, royalty and agency fees earned for business written or assumed by our insurance companies both through independent agents and our retail agencies and (c) the commission income earned on sales of third-party companies’ insurance polices or other products sold by our retail agencies. These various types of commission income and fees are impacted in different ways by the corporate decisions we make in pursuing our corporate strategy.
Commissions are earned on sales of third-party companies’ products sold by our retail agencies. As described above, in our owned retail stores, there can be a shift in the relative proportion of the sales of third-party insurance products as compared to sales of our own carriers’ products due to the relative competitiveness of our insurance products that could result in an increase in our commission income and fees from non-affiliated third-party insurers. We negotiate commission rates with the various third-party carriers whose products we agree to sell in our retail stores. As a result, the level of third-party commission income will also vary depending upon the mix by carrier of third-party products that are sold. In addition, we earn fees from the sales of other products and services (such as tax preparation services, auto club memberships and bond cards) offered by unaffiliated companies.
Commission income and fees related to sales of third-party insurance policies and products for 2007 decreased 1.0% compared with 2006. In the second quarter of 2006, we reduced or eliminated our agency fees in our retail stores to reduce the cost to the customer of purchasing coverage from us. This increased the overall level of sales and thereby increased our commission income (when the product sold is a third-party carrier’s coverage) and earned premiums (when the product sold is our insurance company subsidiaries’ coverage). In the fourth quarter of 2006, we reinstituted certain agency fees but at a moderate level compared with the first half of 2006.
Net Investment Income. At December 31, 2007, our fixed-income investments were invested in the following: U.S. Treasury and Agencies securities - 1.9%, corporate securities - 1.6%, mortgage backed securities - 2.2%, and tax-exempt securities - 94.3%. As of December 31, 2007, all of our fixed-income securities were rated “A” or better by nationally recognized statistical rating organizations. We attempt to mitigate interest rate risk by managing the duration of our fixed-income portfolio to a target range of less than three years. As of December 31, 2007, the effective duration of our fixed-income investment portfolio was 1.06 years.
Net investment income for 2006 increased $3.1 million, or 54.1%, compared with 2005. The increase was primarily a result of a 33.7% increase in total average invested assets to $228.5 million during 2006 from $170.8 million during 2005. The increase in average invested assets was primarily the result of increased cash flows from insurance operations. The average investment yield was 3.70% (5.33% on a taxable equivalent basis) for 2006 as compared to 3.37% (4.53% on a taxable equivalent basis) for 2005. This increase was primarily the result of the higher interest rates available for new investments in 2006.
Our losses and loss adjustment expenses are a blend of the specific estimated and actual costs of providing the coverage contracted by the purchasers of our insurance policies. We maintain reserves to cover our estimated ultimate liability for losses and related loss adjustment expenses for both reported and unreported claims on the insurance policies issued by our insurance companies. The establishment of appropriate reserves is an inherently uncertain process, involving actuarial and statistical projections of what we expect to be the cost of the ultimate settlement and administration of claims based on historical claims information, estimates of future trends in claims severity and other variable factors such as inflation. Due to the inherent uncertainty of estimating reserves, reserve estimates can be expected to vary from period to period. To the extent that our reserves prove to be inadequate in the future, we would be required to increase our reserves for losses and loss adjustment expenses and incur a charge to earnings in the period during which such reserves are increased. We have a limited history in establishing reserves and the historic development of our reserves for losses and loss adjustment expenses is not necessarily indicative of future trends in the development of these amounts.
If existing estimates of the ultimate liability for losses and related loss adjustment expenses are lowered, then that favorable development is recognized in the subsequent period in which the reserves are reduced. This has the effect of benefiting that subsequent period, when the aggregate losses and loss adjustment expenses (reflecting the favorable development related to previously reported earned premiums) are reduced relative to that period’s earned premium. Although the favorable development must be included in that subsequent period’s financial statements, it is appropriate for measurement purposes to compare only the losses and loss adjustment expenses related to any specific period’s earned premiums in evaluating performance during that particular period. Overall, we are experiencing frequency indications that are flat compared to prior year selections and severity trends of low single digits on an aggregate basis. In a period of stable premium rates, these trends would have resulted in generally stable loss ratios (the ratio of losses and loss adjustment expenses to earned premiums). However, the current competitive environment has led us to selectively reduce rates in certain markets and on certain products. Such rate decreases constrict our insurance margins and increase our loss ratios.
The following table provides a reconciliation of the beginning and ending reserves for unpaid losses and loss adjustment expenses, for the periods indicated (in thousands):
Our historical net liabilities for losses and loss adjustment expenses are impacted by our 100% quota share reinsurance contract with VFIC. Beginning in 1997, our insurance companies reinsured 100% of the business they wrote to VFIC. During 1999 and 2000, one of our insurance companies retained a small book of business, but continued ceding a majority of its business to VFIC. For the years 2001, 2002 and 2003 we reinsured 100% of business written or assumed by our insurance companies to VFIC. The reclassification in 2004 and 2005 discussed above is reflected in the tables below (in thousands).
The cost of policy acquisition (amortization of deferred policy acquisition costs) is the largest component. Policy acquisition costs, primarily commissions, advertising, premium taxes and underwriting expenses related to issuing a policy, are deferred and charged against income ratably over the terms of the policies produced. As a result, the amortization of deferred acquisition costs is correlated with earned premiums. The following table sets forth the impact that amortization of deferred acquisition costs has on selling, general and administrative expenses and the change in deferred acquisition costs for the years ended December 31, 2007, 2006 and 2005 (in thousands):
Also in 2007, we incurred $11.5 million of expenses for our outsourcing contract, which outsourced substantially all of our information technology operations, including our data center, field support and application
management. The combined total of the outsourcing expense (which excludes the transformation costs) and our continuing information technology operating expenses in 2007 exceeded the cost of our information technology operations in 2006 by $2.0 million primarily due to the expenses related to transitioning to the new outsourced environment in 2007.
Salaries and benefits increased primarily due to the acquisition of USAgencies. We employed 1,252 and 942 at December 31, 2007 and 2006, respectively.
During 2005, we recognized expenses in relation to unusual events including $2.7 million in severance for three former executives, $2.4 million for the write-off of a system and $200,000 incurred for a retained search for a replacement executive. Other selling, general and administrative expenses for 2005 were $78.6 million and $73.4 million excluding the significant events in 2005, or 49.3% of earned premium.
The following table summarizes the components of other selling, general and administrative expenses and the impact of significant events that impact comparability for the years ended December 31, 2007, 2006 and 2005 (in thousands):
(2) Write-down of amounts capitalized on the enterprise system development and license agreement.
2004 was fully amortized in the first quarter of 2006, resulting in amortization expense of only $39,000 in 2006 as compared with $233,000 in 2005. Other amortization expense was related to amortization of intangible assets for acquired agency relationships.
Interest expense for 2006 increased $827,000, or 23.5%, compared with 2005. Interest expense was primarily related to our $56.7 million notes payable, which were issued in December 2004 and June 2005.
Income Taxes. Income tax expense for 2007 was $2.1 million, or an effective rate of 17.9%, compared with income tax expense of $2.7 million, or an effective rate of 21.3%, for 2006. The lower effective tax rate for 2007 was primarily due to the relatively high proportion of the investment income generated by the tax-exempt securities in our investment portfolio.
Minority Interest. Minority interest, net of income taxes, for 2006 was $81,000 compared with $672,000 in 2005. The decrease was due to our purchase of the remaining 27.0% interest in our Florida underwriting agency from the minority holders in March 2006.
Sources and uses of funds. We are a holding company with no business operations of our own. Consequently, our ability to pay dividends to stockholders, meet our debt payment obligations and pay our taxes and administrative expenses is largely dependent on dividends or other distributions from our subsidiaries, including our insurance company subsidiaries.
There are no restrictions on the payment of dividends by our non-insurance company subsidiaries other than state corporate laws regarding solvency. As a result, our non-insurance company subsidiaries generate revenues, profits and net cash flows that are generally unrestricted as to their availability for the payment of dividends, and we expect to use those revenues to service our corporate financial obligations, such as debt service and stockholder dividends. As of December 31, 2007, we had $1.3 million of cash and equivalents at the holding company level and $15.9 million of cash and cash equivalents at our non-insurance company subsidiaries.
The National Association of Insurance Commissioners’ model law for risk-based capital provides formulas to determine the amount of capital that an insurance company needs to ensure that it has an acceptable expectation of not becoming financially impaired. At December 31, 2007, the capital ratios of the AIC Group and Direct substantially exceeded the risk-based capital requirements and exceeded the highest level for regulatory action under the risk-based capital guidelines.
As part of our investment holdings, we hold approximately $119 million of auction-rate municipal securities. The interest rates for these securities are determined by bidding every 7, 28 or 35 days. When there are more sellers than buyers, an auction fails and bondholders that want to sell are left holding the securities. Issuers remain obligated to pay interest and principal when due when an auction fails. Rates at failed auctions are set at a level established in the terms of the debt. Auctions for these securities began to fail in late January 2008. In mid-February 2008, the investment banks stopped committing capital to the auctions and there have been widespread auctions failures since that time. We evaluated the creditworthiness of all of the underlying securities in our auction-rate municipal security portfolio excluding the impact of any monoline insurance guarantee. With the exception of one security, all of our securities are rated A- or better. The one exception is rated BBB+. Historically, the default rate on AAA-rated corporate bonds is greater than ten times higher the default rate on A-rated municipal securities.
Our operating subsidiaries’ primary sources of funds are premiums received, commission and fee income, investment income and the proceeds from the sale and maturity of investments. Funds are used to pay claims and operating expenses, to purchase investments and to pay dividends to our holding company.
We believe that existing cash and investment balances, as well as new cash flows generated from operations and available borrowings under our other credit facilities, will be adequate to meet our capital and liquidity needs during the 12-month period following the date of this report at both the holding company and insurance company levels. We do not currently know of any events that could cause a material increase or decrease in our long-term liquidity needs other than the capital expenditures related to our strategic systems consolidation and transformation program and the debt service requirements of the senior secured credit facility completed on January 31, 2007 to fund the acquisition of USAgencies.
The following table summarizes our contractual obligations at December 31, 2007 (in thousands):
(1) As of December 31, 2007, we leased an aggregate of approximately 423,074 square feet of office space for our agencies, insurance companies and retail stores in various locations throughout the United States. These amounts represent our minimum future operating lease commitments.
(2) All of the outstanding notes payable at December 31, 2007 are redeemable in whole or in part after five years of issuance. For this disclosure, it is assumed that none of these notes will be redeemed before their contractual maturities and interest rates on these notes will remain at their current levels. Difference between future cash payments and the carrying value of the notes represents fair value adjustment at the date of acquisition of USAgencies that is being amortized into interest expense over the notes outstanding period.
(3) The principal amount of the Borrowing is payable in quarterly installments of $500,000, with the remaining balance due on the seventh anniversary of the closing of the Facility. Beginning in 2008, we are also required to make additional annual principal payments that are to be calculated based upon our financial performance during the preceding fiscal year. In addition, certain events, such as the sale of material assets or the issuance of significant new equity, necessitate additional required principal repayments. As of the date of this filing, we have not borrowed any funds under the revolving portion of the Facility.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Affirmative Insurance Holdings, Inc. and subsidiaries as of December 31, 2007 and 2006, and the results of their operations and their cash flows for each of the years in the two-year period ended December 31, 2007, in conformity with U.S. generally accepted accounting principles.
In our opinion, the consolidated statements of income, changes in stockholders’ equity and cash flows for the year ended December 31, 2005 present fairly, in all material respects, the results of Affirmative Insurance Holdings, Inc. and its subsidiaries’ (the Company) operations and their cash flows for the year ended December 31, 2005, in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
Affirmative Insurance Holdings, Inc., formerly known as Instant Insurance Holdings, Inc., was incorporated in Delaware in June 1998. We are a distributor and producer of non-standard personal automobile insurance policies and related products and services for individual consumers in targeted geographic areas. We are currently active in offering insurance directly to individual consumers through retail stores in 10 states (Louisiana, Illinois, Texas, Missouri, Indiana, South Carolina, Florida, Kansas, Wisconsin and Alabama) and distributing our own insurance policies through independent agents in nine states (Illinois, California, Texas, Missouri, Indiana, South Carolina, Florida, Michigan and New Mexico).
Use of Estimates • Our preparation of financial statements in conformity with GAAP requires us to make estimates and assumptions that affect our reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of our financial statements and our reported amounts of revenues and expenses during the reporting period. Actual results could differ materially from those estimates. These estimates and assumptions are particularly important in determining revenue recognition, reserves for losses and loss adjustment expenses, deferred policy acquisition costs, reinsurance receivables, impairment of assets and purchase price allocations.
Gains and losses realized on the disposition of bonds are determined on the specific identification basis and credited or charged to income. Premium and discount on bonds are amortized and accreted using the interest method and charged or credited to investment income.
and ability to hold the investment. We also consider potential adverse conditions related to the financial health of the issuer based on rating agency actions. Once a decline in fair value is determined to be other-than-temporary, an impairment charge is recorded and a new cost basis in the investment is established.
Deferred Policy Acquisition Costs • Deferred policy acquisition costs represent the deferral of expenses that we incur acquiring new business or renewing existing business. Policy acquisition costs, consisting of primarily commission, advertising, premium taxes, underwriting and agency expenses, are deferred and charged against income ratably over the terms of the related policies. At December 31, 2007, we had $25.8 million of deferred policy acquisition costs. We regularly review the categories of acquisition costs that are deferred and assess the recoverability of this asset. A premium deficiency, and a corresponding charge to income is recognized, if the sum of the expected losses and loss adjustment expenses, unamortized acquisition costs, and maintenance costs exceeds related unearned premiums and anticipated investment income. At December 31, 2007, we determined that there was no premium deficiency. Amounts received as expense allowances on reinsurance contracts that represent reimbursement of acquisition costs are recorded as reductions of deferred acquisition costs.
Treasury Stock • We record treasury stock purchases under the cost method, whereby the entire cost of the acquired stock is recorded as treasury stock. When reissued, shares of treasury stock will be removed from the treasury stock account at the average purchase price per share of the aggregate treasury shares held.
Losses and Loss Adjustment Expenses • We maintain reserves in the amount of the estimated ultimate liability for unpaid losses and loss adjustment expenses related to incurred claims and our estimate of unreported claims. Our estimation of the ultimate liability for unpaid losses and loss adjustment expenses is based on projections developed by our actuaries using analytical methodology commonly used in the property-casualty insurance industry. Our liabilities stated for unpaid claims and for expenses of investigation and adjustment of unpaid claims are based on: (1) the accumulation of estimates of individual claims for losses reported prior to the close of the accounting period; (2) estimates received from ceding companies, reinsurers and insurance pools and associations; (3) estimates of unreported losses based on past experience; (4) estimates based on past experience of expenses for investigating and adjusting claims; and (5) estimates of subrogation and salvage collections. We
periodically adjust our losses and loss adjustment expense reserves for changes in product mix, underwriting standards, loss cost trends and other factors. Our losses and loss adjustment expense reserves may also be impacted by factors such as the rate of inflation, claims settlement patterns, litigation and legislative activities. Unpaid losses and loss adjustment expenses have not been reduced for reinsurance recoverable. Changes in estimates of our liabilities for unpaid losses and loss adjustment expenses are reflected in our consolidated statement of operations in the period in which determined. Ultimately, our actual losses and loss adjustment expenses may differ materially from the estimates we have recorded.
Accounting and Reporting for Reinsurance • Pursuant to SFAS No. 113, Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts, we are required to review the contractual terms of all our reinsurance purchases to ensure compliance with that statement. The statement establishes the conditions required for a contract with a reinsurer to be accounted for as reinsurance and prescribes accounting and reporting standards for those contracts. For all reinsurance transactions, immediate recognition of gains is precluded unless our liability to our policyholders is extinguished. SFAS No. 113 also requires us to disclose the nature, purpose and effect of reinsurance transactions, including the premium amounts associated with reinsurance assumed and ceded. It also requires disclosure of concentrations of credit risk associated with reinsurance receivables and prepaid reinsurance premiums. Contracts that do not result in the reasonable possibility that the reinsurer may realize a significant loss from the insurance risk assumed generally do not meet the conditions for reinsurance accounting and must be accounted for as deposits according to the guidelines of Statement of Position (SOP) 98-7, Deposit Accounting for Insurance and Reinsurance Contracts that do not Transfer Insurance Risk. Under Deposit Accounting, the amount of the deposit asset or liability is adjusted at subsequent reporting dates by calculating the effective yield on the deposit to reflect actual payments to date and expected future payments, with a corresponding credit or charge to interest income or expense.
Stock-Based Compensation • We adopted SFAS No. 123R, Share-Based Payment, on January 1, 2006 using the modified prospective method and, accordingly, prior periods have not been restated because of the adoption. We recognize stock-based compensation expense using the straight-line method.
Net Income Per Share • Basic net income per share is computed by dividing net income available to common stockholders by the weighted average number of common shares outstanding during the year. Diluted net income per share is computed by giving effect to the potential dilution that could occur if securities or other contracts to issue common shares were exercised and converted into common shares during the year. Shares issued under our restricted stock awards are included in basic shares upon issuance of the awards even though the vesting of shares will occur over time.
Recently Issued Accounting Standards • In September 2006, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 157, Fair Value Measurements. SFAS No. 157 defines fair value to be the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date and emphasizes that fair value is a market-based measurement, not an entity-specific measurement. SFAS No. 157 establishes a fair value hierarchy and expands disclosures about fair value measurements in both interim and annual periods. SFAS No. 157 will be effective for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years. We do not expect SFAS No. 157 to have a material impact on our results of operations or financial condition.
The estimated fair values and useful lives of assets acquired and liabilities assumed are based on management’s valuation. We completed a valuation study to determine the allocation of the total purchase price to the various assets acquired and liabilities assumed. The final purchase price allocations did not result in material differences in allocations for tangible and intangible assets than presented in previously reported consolidated balance sheets.
Included in the purchase price allocation are intangible assets subject to amortization totaling $9.8 million, consisting of $1.0 million for a non-competition agreement, $4.7 million of customer relationships, $3.9 million of trade name and $200,000 of lease interest. As of December 31, 2007, these intangible assets had a carrying value of $4.7 million. Goodwill recorded in connection with the acquisition is not deductible for tax purposes. Other intangible assets related to state licenses of $1.7 million are not subject to amortization.
Other Acquisitions • On July 19, 2005, we acquired 100% of the assets of IPA, LLC (IPA), an underwriting agency with operations in Michigan. IPA generates approximately $20.0 million in premiums annually. We paid $600,000 at closing to the owners of IPA, assumed certain liabilities for processing of claims and providing of customer service from existing business, and may pay up to an additional $1.3 million if certain performance criteria are met. We paid $366,000, $502,000 and $246,000, respectively, of the $1.3 million to the previous owners of IPA for meeting certain performance criteria during the years ended December 31, 2007, 2006 and 2005, respectively.
On March 14, 2006, we completed the acquisition of the 27% minority ownership interest of Space Coast Holdings, Inc. We paid approximately $3.2 million to the minority owners and recorded $3.2 million in goodwill. Consequently, our current ownership interest in Space Coast is 100%.
Gross realized gains and losses on investments for the years ended December 31 are summarized as follows (in thousands):
At December 31, 2007 and 2006, investments in fixed-maturity securities with an approximate carrying value of $59.1 million and $52.7 million, respectively, were on deposit with regulatory authorities as required by insurance regulations.
On April 1, 2007, we exercised our option to terminate certain quota share contracts on a “cut-off” basis. On April 30, 2007, we received $31.0 million to settle the unearned premiums less return ceding commissions. Taking this recovery into account, our net exposure for reinsurance provided by the quota share reinsurer at December 31, 2007 was $36.8 million.
The Michigan Catastrophic Claims Association (MCCA) is a reinsurance facility that covers no-fault medical losses above a specific retention amount. For policies effective July 1, 2007 to June 30, 2008, the required retention is $420,000. As a writer of personal automobile policies in the state of Michigan, we cede premiums and claims to the MCCA. Funding for MCCA comes from assessments against automobile insurers based upon their proportionate market share of the state’s automobile liability insurance market. Insurers are allowed to pass along this cost to Michigan automobile policyholders. Our ceded premiums written to the MCCA was $3.6 million in 2007 and $1.8 million in 2006. We did not issue policies in Michigan prior to 2006.
Our other significant assumed reinsurance agreement is with a Texas county mutual insurance company (the county mutual) whereby we have assumed 100% of the policies issued by the county mutual for business produced by our owned MGAs. The county mutual does not retain any of this business and there are no loss limits other than the underlying policy limits. The county mutual reinsurance agreement may be terminated by either party upon prior written notice of not less than 90 days. In the event of such termination, the MGA agrees that for ten years the MGA shall produce automobile insurance business in the State of Texas solely for the benefit of the county mutual. The county mutual reinsurance agreement automatically terminates on January 1, 2014.
Assumed written premiums by ceding insurer are as follows (in thousands):
At December 31, 2007, $17.3 million was included in reserves for losses and loss adjustment expenses that represented the amounts owed from AIC and Insura under reinsurance agreements with the VIG affiliated companies, including Hawaiian Insurance and Guaranty Company, Ltd (Hawaiian). Affirmative established a trust account to collateralize this payable, which currently holds $22.9 million (including accrued interest) in securities (the AFIC Trust). The AFIC Trust has not been drawn upon by the SDR in Texas or the SDR in Hawaii. It is the expectation that the terms for withdrawal of funds from the AFIC trust will be similar to those we expect to be agreed to in regards to the VFIC Trust.
We are not aware of any novation or commutation activity that is reasonably likely to occur in future periods.
A summary of property and equipment at December 31, 2007 and 2006 is as follows (in thousands):
Other intangible assets at December 31, 2007 and 2006 are as follows (in thousands):
The following table provides a reconciliation of the beginning and ending reserves for unpaid losses and loss adjustment expenses for the periods indicated (in thousands):
The $31 million notes payable due 2035 are redeemable in whole or in part by the issuer after five years. The notes were issued in December 2004 and bear an initial interest rate of 7.545 percent until December 15, 2009, at which time the securities will adjust quarterly to the three-month LIBOR rate plus 3.6 percent.
The $26 million notes payable due 2035 are redeemable in whole or in part by the issuer after five years. The notes were issued in June 2005 and bear an initial interest rate of 7.792% until June 15, 2010, at which time they will adjust quarterly to the three-month LIBOR rate plus 3.55 percent.
The $20 million notes payable due 2035 are redeemable in whole or in part anytime after March 15, 2010. Prior to March 15, 2010, the notes may only be redeemed in whole or in part subject to certain specific restrictions and prepayment penalties pursuant to the indenture agreement. The notes were issued in March 2005 and bear an initial interest rate of the three-month Libor rate plus 3.95 percent not exceeding 12.5 percent through March 2010 with no limit thereafter.
In connection with entering into the Facility, we paid $6.6 million in deferred debt acquisition costs that is being amortized over the seven-year term of the Facility.
The principal amount of the term loan is payable in quarterly installments of $500,000, with the remaining balance due on the seventh anniversary of the closing of the Facility. Beginning in 2008, we are also required to make additional annual principal payments that are to be calculated based upon our financial performance during the preceding fiscal year. In addition, certain events, such as the sale of material assets or the issuance of significant new equity, necessitate additional required principal repayments. As of the date of this filing, we have not borrowed any funds under the revolving portion of the Facility.
The provision for income taxes for the years ended December 31 consists of the following (in thousands):
Our effective tax rate differs from the statutory rate of 35% for the years ended December 31 as follows:
In October 2006, we entered into an IT outsourcing contract with a data processing services provider under which we outsourced substantially all of our IT operations, including our data center, field support and application management. The initial term of the agreement is ten years, although it may be terminated for convenience by us at any time upon six month’s notice after the first two years, subject to the payment of certain stranded costs and other termination fees. Our IT outsourcing expenses were $11.5 million and $6.6 million for the years ended December 31, 2007 and 2006, respectively.
As of December 31, 2007, we leased an aggregate of approximately 423,074 square feet of office space for our agencies, insurance companies and retail stores in various locations throughout the United States. Our operating lease rental expenses were $10.2 million, $8.9 million and $8.3 million for the years ended December 31, 2007, 2006 and 2005, respectively.
The following table summarizes our minimum future IT outsourcing and operating lease commitments at December 31, 2007 (in thousands):
Affirmative’s funds used improperly by Defendants to satisfy a debt of one of VIG’s subsidiaries. In February 2007, by consent of the parties, the Court referred the action to the United States Bankruptcy Court for the Northern District of Alabama, where bankruptcy proceedings are pending with respect to VIG. Later in February 2007, the Bankruptcy Court entered an order, upon consent of the parties, temporarily staying the action. The court has continued this matter until April 2008.
In December 2003, InsureOne Independent Agency, LLC (InsureOne), American Agencies, General Agency, Inc. and Affirmative Insurance Holdings, Inc. brought action in the Circuit Court of Cook County, Illinois to enforce non-compete and non-solicitation agreements entered into with James Hallberg, the former president of InsureOne, a wholly-owned subsidiary, and eight former employees of InsureOne and two of Hallberg’s family trusts. The court entered interim orders prohibiting all defendants, including Hallberg, from hiring any employees of InsureOne or of plaintiffs’ other underwriting agencies. We are seeking between $15 and $23 million in damages for lost profits and diminution in value. James Hallberg and the Hallberg family gift trust have asserted counterclaims seeking combined damages of approximately $4.5 million. The bench trial of this matter has concluded and the parties are currently waiting for the court to render judgment.
either (a) in accordance with a joint written instruction by us and the Seller or (b) pursuant to a court order or judgment that is final and nonappealable sent to the escrow agent by us or the Seller, and any portion of the Marsh Litigation Reserve not so required to be paid to us shall be promptly paid by the escrow agent to the Seller. Although we believe it is unlikely, it is nevertheless possible that the aggregate amount payable at the conclusion of the Marsh litigation may exceed the Marsh Litigation Reserve, and the Seller may not have the financial ability to indemnify us for any losses in excess of said reserve.
Affirmative Insurance Company is a party to a 100% quota share reinsurance agreement with Hawaiian Insurance and Guaranty Company, Ltd (Hawaiian), which is ultimately a wholly-owned subsidiary of VIG. In November 2004, Hawaiian was named among a group of four other named defendants and twenty unnamed defendants in a complaint filed in the Superior Court of the State of California for the County of Los Angeles alleging causes of action as follows: enforcement of coverage under Hawaiian’s policy of an underlying default judgment plaintiff obtained against Hawaiian’s former insured, who was denied a defense in the underlying lawsuit due to his failure to timely pay the Hawaiian policy premium; ratification and waiver of policy lapse and declaratory relief against Hawaiian; breach of implied covenant of good faith and fair dealing against Hawaiian with the plaintiff as the assignee of the insured; intentional misconduct as to the defendant SCJ Insurance Services (SCJ); and professional negligence as to the defendants Prompt Insurance Services, Paul Ruelas, and Anthony David Medina. SCJ, Prompt Insurance Services, Paul Ruelas, and Anthony David Medina are not affiliated with AIC. The plaintiff sought to enforce an underlying default judgment obtained against Hawaiian’s insured in September 2004 in the amount of $35.0 million and additional bad faith damages including punitive damages in the amount of $35.0 million. In August 2005, plaintiff served a copy of its Second Amended Complaint, which added a cause of action for fraud and deceit against all defendants, and a cause of action for negligent misrepresentation against Hawaiian and SCJ.
In January 2006, Judge Bigelow absolved Hawaiian and SCJ of all counts plaintiff filed against them in this litigation on the trial court level by virtue of court order on motions for summary judgment that were submitted by both Hawaiian and SCJ. A partial dismissal without prejudice was entered as to defendant Paul Ruelas.
Plaintiff filed a notice of appeal in April 2006. In September 2006, Hawaiian moved to stay appellate proceedings pursuant to an Order of Liquidation entered in August 2006, in the Circuit Court for the State of Hawaii.
In October 2006, The Court of Appeal of the State of California, Second Appellate District, Division Five, granted the stay order requested by Hawaiian. In December 2006, the court modified its October 2006 stay order by lifting it as to SCJ, causing the suit to proceed with SCJ as the sole defendant. Hawaiian filed a status update with the court in March 2007, indicating that the liquidation proceeding for Hawaiian remained pending and in full force and effect. On March 15, 2007, plaintiff moved the Court of Appeal to lift the stay and that motion was denied. On March 27, 2007, plaintiff filed a petition with the Supreme Court of California for review of the Court of Appeal’s order denying plaintiff’s motion to lift the stay, and in July 2007, the Supreme Court of California denied that petition.
The following table sets forth the reconciliation of numerators and denominators for the basic and diluted earnings per share computation for each of the years ended December 31, 2007, 2006 and 2005 (in thousands, except per share amounts):
A summary of the stock option activities for each of the three years ended December 31 is as follows (shares in thousands):
We recognized total compensation expense related to the stock options of $863,000 and $549,000 during 2007 and 2006, respectively. Compensation expense is included in selling, general and administrative expenses in the statement of income. Total unrecognized compensation expense related to unvested stock options was $2.1 million at December 31, 2007, which will be recognized over a weighted-average period of approximately 3.5 years.
Restricted Stock Awards • A summary of activity for our restricted stock grants for each of the years ended December 31 is as follows (shares in thousands):
We recognized total compensation expense related to the restricted stock awards of $375,000 and $46,000 during 2007 and 2006, respectively. Compensation expense is included in selling, general and administrative expenses in the income statement. As of December 31, 2007, there was approximately $1.2 million of total unrecognized compensation cost related to unvested restricted stock awards which will be recognized over a weighted average period of approximately 3.8 years.
We sponsor a defined contribution retirement plan under Section 401(k) of the Internal Revenue Code. The plan covers substantially all employees who meet specified service requirements. Under the plan, we may, at our
Prior to August 30, 2005, we provided various services for VIG and its subsidiaries, including underwriting, premium processing, and claims processing and recorded $594,000 of income related to these services for 2005.
In January 2007, 227 West Monroe Street, Inc., as landlord (Landlord) executed a Consent to Assignment among the Landlord, KR Callahan & Company, LLC (KRCC), an entity whose sole member and manager is Kevin R. Callahan, our Chairman and Chief Executive Officer, and Affirmative Property Holdings, Inc. (Affirmative Property), an indirect wholly-owned subsidiary of ours, and approved the assignment (the Assignment) of the leasehold interest held by KRCC to Affirmative Property with effect from December 2006. Pursuant to the Assignment, KRCC assigned to Affirmative Property all of its right, title and interest in and to the Lease (the Lease), dated May 8, 2006, between KRCC, as tenant, and the Landlord, and Affirmative Property agreed with KRCC to assume all obligations of KRCC, as tenant, under the Lease. The Lease relates to approximately 4,000 square feet of office space in Chicago, Illinois that will be used by our Claims Staff Counsel. The Lease continues until July 31, 2016 and provides for an average monthly rent of approximately $9,690. In addition, Affirmative Property will be responsible for the payment of taxes, common area maintenance charges and other customary occupancy costs.
In connection with the Lease, KRCC had procured a Letter of Credit in favor of the Landlord in the amount of $293,257 as a security deposit against KRCC’s obligations under the Lease. In connection with the Assignment, Affirmative Property agreed to replace KRCC’s Letter of Credit at a future date with a Letter of
We are subject to comprehensive regulation and supervision by government agencies in Illinois, the state in which our insurance company subsidiaries are domiciled, as well as in the states where our subsidiaries sell insurance products, issue policies and handle claims. Certain states impose restrictions or require prior regulatory approval of certain corporate actions, which may adversely affect our ability to operate, innovate, obtain necessary rate adjustments in a timely manner or grow our business profitably. These regulations provide safeguards for policy owners and are not intended to protect the interests of stockholders. Our ability to comply with these laws and regulations, and to obtain necessary regulatory action in a timely manner, is and will continue to be critical to our success.
The following table identifies the states in which we operate and the gross premiums written by state (in thousands):
The carrying amounts and estimated fair values of our financial instruments at December 31, 2007 and 2006 were as follows (in thousands):
Available-for-sale investment securities - The available-for-sale investment securities maturities are calculated using quoted market prices.
Notes payable - The fair value of the notes payable is estimated based on current rates available on similar debt.
Senior secured credit facility - The fair value of the senior secured credit facility is assumed to equal the book value because the facility is a floating rate instrument.
The following table summarizes selected statutory information of our insurance subsidiaries ended December 31 (in thousands):
Insura, AIC of Michigan and Casualty are wholly-owned by AIC and are included as common stock investments on AIC’s balance sheet in its statutory surplus.
At December 31, 2007, we served as the franchisor for thirty-five operating franchise stores located in Florida under the FED USA brand name. Our franchising operations generate minimal revenues and therefore do not have a significant impact on our consolidated operating results. We are engaged in our franchise business primarily for the purpose of creating additional sales locations for our insurance companies’ products, as opposed to seeking revenues from franchise or royalty fees. In short, our business strategy relative to our franchises is to generate revenues from the sale of insurance policies by our franchise stores rather than from the receipt of any initial franchise fees or royalty income from those stores. We include initial franchise fees and royalty payments that we collect and receive from our franchisees as part of our reported revenues relating to commission income and fees in our financial statements.