21st Century Holding Company (“21st Century”, “Company”, “we”, “us”) is an insurance holding company, which, through our subsidiaries and our contractual relationships with our independent agents and general agents, controls substantially all aspects of the insurance underwriting, distribution and claims processes. We are authorized to underwrite homeowners’ multi-peril, commercial general liability, personal and commercial automobile, fire, allied lines, surety, commercial multi-peril and inland marine in various states on behalf of our wholly owned subsidiaries, Federated National Insurance Company (“Federated National”) and American Vehicle Insurance Company (“American Vehicle”) and other insurance carriers. We market and distribute our own and third-party insurers’ products and our other services through contractual relationships with a network of approximately 4,200 independent agents, of which approximately 300 actively sell and service our products. We also utilize a select number of general agents for the same purpose.
Federated National is licensed as an admitted carrier in Florida. Through contractual relationships with a network of approximately 4,200 independent agents, of which approximately 300 actively sell and service our products, Federated National is authorized to underwrite homeowners’ multi-peril, fire, allied lines and personal automobile insurance in Florida.
During 2009, 81.2%, 14.6%, 3.4% and 0.8% of the premiums we underwrote were for homeowners’ property and casualty insurance, commercial general liability insurance, federal flood, and personal automobile insurance, respectively. During the year ended December 31, 2008, 68.8%, 27.0%, 3.7% and 0.6% of the premiums we underwrote were for homeowners’ property and casualty insurance, commercial general liability insurance, federal flood, and personal automobile insurance, respectively.
Assurance Managing General Agents, Inc. (“Assurance MGA”) a wholly owned subsidiary of the Company, acts as Federated National’s and American Vehicle’s exclusive managing general agent in the state of Florida and is also licensed as a managing general agent in the states of Alabama, Arkansas, Georgia, Illinois, Louisiana, Mississippi, Missouri, New York, Nevada, South Carolina, Texas and Virginia. During 2009, Assurance MGA contracted with several unaffiliated insurance companies to sell commercial general liability, workers compensation and inland marine through Assurance MGA’s existing network of distributors. This process will continue throughout 2010, as Assurance MGA benefits from the arrangement by receiving commission revenue from policies sold by its insurance partners, while minimizing its risks. As American Vehicle continues its expansion into other states, we intend to retain other general agents to market our commercial general liability insurance products.
The most significant accounting estimates inherent in the preparation of our financial statements include estimates associated with management’s evaluation of the determination of (i) liability for unpaid losses and LAE, (ii) the amount and recoverability of amortization of deferred policy acquisition costs (“DPAC”), and (iii) estimates for our reserves with respect to finance contracts, premiums receivable and deferred income taxes. Various assumptions and other factors underlie the determination of these significant estimates, which are described in greater detail at Footnote 2 in this Form 10-K.
The estimated Ultimate Loss and Defense & Cost Containment Expense (“DCCE”) is based on an analysis by line of business, coverage and by accident quarter performed using data as of December 31, 2009. The analysis relies primarily on four actuarial methods: Incurred Loss & DCCE Development Method, Paid Loss & DCCE Development Method, Bornhuetter-Ferguson Incurred Method, and Bornhuetter-Ferguson Paid Method. Each method relies on company experience, and, where relevant, the analysis includes comparisons to industry experience. The following is a description of each of these methods:
The validity of the results from using a loss development approach can be affected by many conditions, such as internal claim department processing changes, a shift between single and multiple claim payments, legal changes, or variations in a company’s mix of business from year to year. Also, since the percentage of losses paid for immature years is often low, development factors can be volatile. A small variation in the number of claims paid can have a leveraging effect that could lead to significant changes in estimated ultimate values. Accordingly, our reserves are estimates because there are uncertainties inherent in the determination of ultimate losses. Court decisions, regulatory changes and economic conditions can affect the ultimate cost of claims that occurred in the past as well as create uncertainties regarding future loss cost trends. We compute our estimated ultimate liability using the most appropriate principles and procedures applicable to the lines of business written. However, because the establishment of loss reserves is an inherently uncertain process, we cannot be certain that ultimate losses will not exceed the established loss reserves and have a material adverse effect on our results of operations and financial condition.
A key assumption underlying the estimation of the reserve for loss and LAE is that past experience serves as the most reliable estimator of future events. This assumption may materially affect the estimates when the insurance market, the regulatory environment, the legal environment, the economic environment, the book of business, the claims handling department, or other factors (known or unknown) have varied over time during the experience period and / or will vary (expectedly or unexpectedly) in the future. Changes in estimates, or differences between estimates and amounts ultimately paid, are reflected in the operating results of the period during which such adjustments are made. Therefore, the ultimate liability for unpaid losses and LAE will likely differ from the amount recorded at December 31, 2009.
The table below distinguishes total loss reserves between IBNR, as discussed above, and case estimates for specific claims as established by routine claims management.
In April 2009, the FASB issued new accounting guidance related to the recognition and presentation of other-than-temporary impairments. In April 2009, the Securities and Exchange Commission (“SEC”) also adopted similar guidance with Staff Accounting Bulletin (“SAB”) No. 111 (“SAB 111”) on Other-Than Temporary Impairment. This new accounting guidance establishes a new method of recognizing and reporting other-than-temporary impairments of debt securities and contains additional disclosure requirements related to debt and equity securities. For debt securities, the “ability and intent to hold” provision is eliminated, and impairment is considered to be other-than-temporary if an entity (i) intends to sell the security, (ii) more likely than not will be required to sell the security before recovering its cost, or (iii) does not expect to recover the security’s entire amortized cost basis (even if the entity does not intend to sell). This new framework does not apply to equity securities (i.e., impaired equity securities will continue to be evaluated under previously existing guidance). The “probability” standard relating to the collectability of cash flows is eliminated, and impairment is now considered to be other-than-temporary if the present value of cash flows expected to be collected from the debt security is less than the amortized cost basis of the security. The accounting guidance provides that for debt securities which (i) an entity does not intend to sell and (ii) it is not more likely than not that the entity will be required to sell before the anticipated recovery of its remaining amortized cost basis, the impairment is separated into the amount related to estimated credit losses and the amount related to all other factors. The amount of the total impairment related to all other factors is recorded in other comprehensive loss and the amount related to estimated credit loss is recognized as a charge against current period earnings. The new guidance expands disclosure requirements for both debt and equity securities and requires a more detailed, risk-oriented breakdown of security types and related information, and requires that the annual disclosures be made in interim periods. The accounting guidance is effective for interim and annual periods ending after June 15, 2009, with early adoption permitted. At the time of adoption, the Company did not have any Other Than Temporary Impairments for debt securities, and, the adoption of this guidance did not have a material impact on the Company’s consolidated financial statements.
In January 2010, the FASB issued accounting guidance related to fair value measurements and disclosures. The amendments add some new disclosures regarding fair value measurements, including information regarding transfers into and out of Level 1 and Level 2, and information about purchases, sales, issuances and settlements in Level 3 measurements. The amendments also clarify certain existing disclosure requirements. Level 3 amendments are effective for fiscal years beginning after December 15, 2010 and interim periods within those fiscal years; with all other amendments effective for both interim and annual reporting periods beginning after December 15, 2009. The adoption of the guidance will not have a material effect on our financial statements.
The debt and equity securities that are available for sale and carried at fair value represent 98% of total investments as of December 31, 2009, compared with 48% as of December 31, 2008.
In 2008, we reclassified $14.2 million of our bond portfolio as held-to-maturity because we decided that we had the ability to hold them until maturity. During the three months ended December 31, 2008, we reclassified $3.4 million to available-for-sale because a collateralized requirement was reduced.
Deferred income taxes, net, decreased $3.8 million, or 45.2%, to $4.7 million as of December 31, 2009, compared with $8.5 million as of December 31, 2008. Deferred income taxes, net is comprised of approximately $9.1 million and $11.0 million of deferred tax assets, net of approximately $4.4 million and $2.5 million of deferred tax liabilities as of December 31, 2009 and December 31, 2008, respectively.
Income taxes receivable increased $4.8 million, or 210.8%, to $7.1 million as of December 31, 2009, compared with $2.3 million as of December 31, 2008. The change is due to tax payment patterns in connection with our tax liabilities.
The Company’s consolidated federal income tax returns for 2008, 2007, 2006 and 2005 are open for review by the Internal Revenue Service (“IRS”). The federal income tax returns for 2003 and 2002 have been examined by the IRS. The IRS concluded its examination for 2003 and 2002 and there were no material changes in the tax liability for those years. The 2004 income tax return remains open due to net operating loss carryforward to open years.
The Company’s consolidated Florida income tax returns for 2007, 2006 and 2005 are currently under review by the Florida Department of Revenue. The Florida income tax return for 2008 is open for review.
Management revises its estimates based on the results of its analysis. This process assumes that experience, adjusted for the effects of current developments and anticipated trends, is an appropriate basis for estimating the ultimate settlement of all claims. There is no precise method for subsequently evaluating the impact of any specific factor on the adequacy of the reserves, because the eventual redundancy or deficiency is affected by multiple factors.
The incurred loss development method relies on the assumption that, at any given state of maturity, ultimate losses can be predicted by multiplying cumulative reported losses (paid losses plus case reserves) by a cumulative development factor. The validity of the results of this method depends on the stability of claim reporting and settlement rates, as well as the consistency of case reserve levels. Case reserves do not have to be adequately stated for this method to be effective; they only need to have a fairly consistent level of adequacy at all stages of maturity. Historical “age-to-age” loss development factors were calculated to measure the relative development of an accident year from one maturity point to the next. We then selected appropriate age-to-age loss development factors based on these historical factors and use the selected factors to project the ultimate losses.
Unearned premiums increased $10.4 million, or 25.5%, to $50.9 million as of December 31, 2009, compared with $40.5 million as of December 31, 2008. The change was due to a $13.6 million increase in unearned homeowners’ insurance premiums of which $7.4 million is associated with our assumption of policies from Citizens, a $3.8 million decrease in unearned commercial general liability premiums, a $0.2 million increase in unearned flood insurance premiums, and a $0.4 million increase in unearned automobile premiums. Generally, as is in this case, an increase in unearned premium directly relates to an increase in written premium on a rolling twelve-month basis. Competition could negatively affect our unearned premium.
Deferred gain from sale of property decreased $0.5 million, or 32.7%, to $1.0 million as of December 31, 2009, compared with $1.5 million as of December 31, 2008. In accordance with the provisions of FASB issued guidance, we are amortizing the deferred gain over the term of the leaseback, which is scheduled to end in December 2011.
The Florida Legislature required a rate decrease that resulted in an average 15.2% decrease statewide on homeowners' policies that was integrated into our rates on June 1, 2007. The effect of this rate decrease on existing policies and the corresponding premium decrease in direct written premium was fully recognized in policies by May 31, 2008. In addition, a rate decrease of 11.3% statewide for homeowners' policies was approved by the Florida Office of Insurance Regulation (“Florida OIR”) and implemented with an effective date of May 1, 2008 for new business and June 1, 2008 for renewal business for the homeowners' program. The effect of this rate decrease is flowing through the Company’s homeowners’ book of business such that a full impact of the premium decreases on direct written premium was realized by April 2009 for the homeowners' program. These rate decreases have had an adverse effect on gross and earned premium.
The withdrawal of our ratings could limit or prevent us from writing or renewing desirable insurance policies, from competing with insurers who have higher ratings, from obtaining adequate reinsurance, or from borrowing on a line of credit. The withdrawal of our ratings could have a material adverse effect on the Company’s results of operations and financial position because the Company’s insurance products might no longer be acceptable to the secondary marketplace and mortgage lenders. Furthermore, a withdrawal of our ratings could prevent independent agents from selling and servicing our insurance products.
The change in homeowners’ net premiums earned is partially due to a $13.5 million increase in unearned premiums, of which $7.4 million is associated with our assumption of policies from Citizens in December 2009, and a $24.0 million increase in premium volume. Please see above Gross Premiums Ceded discussion.
Other income increased $0.1 million, or 15.4%, to $0.8 million in 2009, compared with $0.7 million in 2008.
Management revises its estimates based on the results of its analysis. This process assumes that experience, adjusted for the effects of current developments and anticipated trends, is an appropriate basis for estimating the ultimate settlement of all claims. There is no precise method for subsequently evaluating the impact of any specific factor on the adequacy of the reserves, because the eventual redundancy or deficiency is affected by multiple factors. Because of our process, reserves were increased by approximately $5.8 million during 2009.
In accordance with GAAP, our loss ratio is computed as losses and LAE divided by net premiums earned. A lower loss ratio generally results in higher operating income. Our loss ratio for 2009 was 86.9% compared with 64.3% for 2008. The table below reflects the loss ratios by product line.
The charge to operations for stock based compensation, in accordance with the provisions of FASB issued guidance, was approximately $0.4 million during 2009 compared with approximately $0.5 million for 2008.
Policy acquisition costs, net of amortization decreased $1.1 million, or 6.9%, to $13.7 million for 2009, compared with $14.8 million for 2008. Policy acquisition costs, net of amortization, consists of the actual policy acquisition costs, including commissions, payroll and premium taxes, less commissions earned on reinsurance ceded and policy fees earned. The change is due to increased homeowner’s written premium and the less than 20% related commissions, net of decreased commercial general liability premium and the approximately 25% related commissions.
The provision for income tax benefit was $5.9 million for 2009, compared with $1.3 million for 2008.
As previously discussed, a rate decrease required by the Florida Legislature resulted in a rate decrease averaging 15.2% statewide on homeowners' policies that was integrated into our rates on June 1, 2007. The effect of this rate decrease on existing policies and the corresponding premium decrease in direct written premium was fully recognized in policies by May 31, 2008. In addition, a rate decrease of 11.3% statewide for homeowners' policies was approved by the Florida OIR and implemented with an effective date of May 1, 2008 for new business and June 1, 2008 for renewal business for the homeowners' program. The effect of this rate decrease is flowing through the Company’s book of business such that a full impact of the premium decreases on direct written premium should be realized by April 2009 for the homeowners' program. These rate decreases have had an adverse effect on premium volume.
In addition, we implemented higher premium discounts in response to wind mitigation efforts by policyholders. Such discounts, which were required by the Florida Legislature and became effective on December 15, 2007 for new business and renewal business, have also had a significant effect on premium. As of December 31, 2007, 30.0% of our homeowners’ policyholders were receiving wind mitigation credits totaling $2.0 million, (a 2.0% reduction of in-force premium), while 50.0% of our homeowners’ policyholders were receiving wind mitigation credits totaling $17.0 million, (a 27.6% reduction of in-force premium), at December 31, 2008.
Pursuant to the Florida OIR regulations, we are required to report write-your-own-flood premiums on a direct and ceded basis for 2008 and subsequent years. Prior to 2008, we reported only the commissions income associated with this program.
The Company’s sale of auto insurance policies decreased by $1.4 million, or 73.9%, to $0.5 million in 2008, compared with $1.9 million in 2007. American Vehicle markets automobile insurance in Florida only to its existing policyholders by offering to renew the existing policy. Federated National markets its automobile insurance in Florida to both existing and new policyholders.
The decrease in prepaid reinsurance premiums was $4.5 million in 2008, compared with $11.3 million in 2007. The change in this account was primarily associated with the timing of our reinsurance payments measured against the term of the underling reinsurance policies.
The decrease in unearned premiums was $15.9 million in 2008, compared with $21.4 million in 2007. The change was due to a $13.2 million decrease in unearned homeowners’ insurance premiums, a $4.0 million decrease in unearned commercial general liability premiums, a $1.7 million increase in federal flood unearned premiums and a $0.4 million decrease in unearned automobile premiums. These changes are a result of our decreased premium volume during this period. See Gross Premiums Written.
Net premiums earned decreased $34.1 million, or 34.4%, to $65.1 million in 2008, compared with $99.2 million in 2007. The following table denotes net premiums earned by major product line.
Commission income decreased $5.6 million, to $1.6 million in 2008, compared with $7.2 million in 2007. The 2008 commission income was primarily in connection with our reinsurance treaties.
Net investment income decreased $1.5 million, or 19.6%, to $6.5 million in 2008, compared with $8.0 million in 2007. Net investment income on corporate bonds, which generally provide a higher yield than United States government bonds, increased $2.4 million, to $3.1 million in 2008, compared with $0.7 million in 2007. Net investment income on United States government bonds decreased $3.6 million, to $0.9 million in 2008, compared with $4.5 million in 2007.
Regulatory assessments recovered increased $0.4 million, or 27.2%, to $2.1 million in 2008, compared with $1.7 million in 2007.
We continue to revise our estimates of the ultimate financial impact of past storms. The revisions to our estimates are based on our analysis of subsequent information that we receive regarding various factors, including: (i) per claim information; (ii) company and industry historical loss experience; (iii) legislative enactments, judicial decisions, legal developments in the awarding of damages, and (iv) trends in general economic conditions, including the effects of inflation.
Operating and underwriting expenses decreased $5.6 million, or 43.5%, to $7.2 million in 2008, compared with $12.8 million in 2007. The change was primarily due to a $2.9 million decrease in fees paid to boards, bureaus and associations, a $1.8 million decrease in premium taxes and a $1.2 million decrease in bad debts.
Salaries and wages increased $0.7 million, or 10.3%, to $7.4 million in 2008, compared with $6.7 million in 2007. In 2008, we had a $0.3 million severance payment. The charge to operations for stock based compensation, in accordance with the provisions of FASB issued guidance, was approximately $0.5 million in 2008 compared with approximately $0.6 million in 2007.
Policy acquisition costs, net of amortization, decreased $4.7 million, or 24.0%, to $14.8 million in 2008, compared with $19.4 million in 2007. Policy acquisition costs, net of amortization, consisted of the actual policy acquisition costs, including commissions, payroll and premium taxes, less commissions earned on reinsurance ceded and policy fees earned. The decreased production volume for both the homeowners’ and commercial general liability product lines was the reason for the decrease in this asset.
A summary of long-term contractual obligations as of December 31, 2009 follows. The amounts represent estimates of gross undiscounted amounts payable over time.
In 2009, our primary sources of capital included proceeds from the sale of investment securities, increased unearned premiums, increased unpaid losses and LAE, increased deferred income tax expense, net realized investment gains, increased premium deposits and customer credit balances, non-cash compensation, and depreciation and amortization. Also contributing to our liquidity were a tax benefit related to non-cash compensation, a provision for uncollectible premiums receivable, and a provision for credit losses, net. Because we are a holding company, we are largely dependent upon fees and commissions from our subsidiaries for cash flow.
In 2009 and 2008, operations used net operating cash flow of $11.6 million and $1.5 million, respectively, and provided net operating cash flow of $33.6 million in 2007.
In 2009, operations generated $21.4 million of gross cash flow, due to a $10.4 million increase in unearned premiums, a $5.8 million increase in unpaid losses and LAE, a $1.9 million increase in deferred income tax expense, a $0.4 million increase in premium deposits and customer credit balances, $0.3 million of non-cash compensation, $0.2 million of depreciation and amortization, a $0.1 million increase in the provision for uncollectible premiums receivable, a $1.6 million decrease in reinsurance recoverable, net and $0.7 million of amortization of investment discount.
In 2009, operations used $33.0 million of gross cash flow primarily due to a $4.8 million increase in income taxes recoverable, a $4.8 million increase in prepaid reinsurance premiums, a $1.7 million increase in other assets, a $1.7 million increase in policy acquisition costs, net of amortization, a $7.1 million increase in premiums receivable, a $1.1 million decrease in accounts payable and accrued expenses, a $0.4 million decrease in bank overdraft, and $1.1 million of net realized investment gains, all in conjunction with a net loss of $10.3 million.
In 2009, net cash used in investing activities was $82.7 million, compared with net cash provided by investment activities of $107.9 million in 2008 and net cash used in investing activities of $19.7 million in 2007. Our available for sale investment portfolio is highly liquid as it consists entirely of readily marketable securities. In 2009, investing activities generated $59.2 million and used $141.9 million. Our debt portfolio contained callable features exercised in 2008. The proceeds from our called securities were in cash and short-term investments as of December 31, 2008. During 2008, the Company engaged an outside investment advisor and during 2009 the funds were invested in long and short term investments with yields that best match our liquidity needs.
Federated National’s and American Vehicle’s statutory capital surplus levels as of December 31, 2009 were approximately $21.0 million and $25.8 million, respectively, and their statutory net losses in 2009 were $12.2 million and $1.1 million, respectively.
We have audited the accompanying balance sheets of 21st Century Holding Company as of December 31, 2009 and 2008, and the related consolidated statements of operations, stockholders’ equity and comprehensive income, and cash flows for each of the years in the three-year period ended December 31, 2009. We also have audited 21st Century Holding Company’s internal control over financial reporting as of December 31, 2009, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). 21st Century Holding Company’s management is responsible for these financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Certification Report included in the Company’s 2009 Form 10-K. Our responsibility is to express an opinion on these financial statements and an opinion on the company’s internal control over financial reporting based on our audits.
American Vehicle is licensed as an admitted carrier in Florida, and underwrites commercial general liability, and personal and commercial automobile insurance. American Vehicle is also licensed as an admitted carrier in Alabama, Louisiana and Texas, and underwrites commercial general liability insurance in those states. American Vehicle operates as a non-admitted carrier in Arkansas, California, Georgia, Kentucky, Maryland, Missouri, Nevada, Oklahoma, South Carolina, Tennessee, and Virginia, and can underwrite commercial general liability insurance in all of these states.
A non-admitted carrier is not licensed by the state, but is allowed to do business in that state and is strictly regulated to protect policyholders from a variety of illegal and unethical practices, including fraud. Sometimes, non-admitted carriers are referred to as “excess and surplus” lines carriers. Non-admitted carriers are subject to considerably less regulation with respect to policy rates and forms. Non-admitted carriers are not required to financially contribute to and benefit from the state guarantee fund, which is used to pay for losses if an insurance carrier becomes insolvent or unable to pay the losses due their policyholders.
During 2008 Federated National applied for and was granted, by the Florida OIR, a license to underwrite fire and allied lines insurance as an admitted carrier. Operations under Federated National’s newly granted allied lines began in 2008 as a cedant for the insurance policies it underwrites to the federal flood program. Operations under Federated National’s granted fire line of business began in 2009.
Assurance MGA, a wholly owned subsidiary of the Company, acts as Federated National’s and American Vehicle’s exclusive managing general agent in the state of Florida and is also licensed as a managing general agent in the states of Alabama, Arkansas, Georgia, Illinois, Louisiana, Mississippi, Missouri, New York, Nevada, South Carolina, Texas and Virginia. During 2009, Assurance MGA contracted with several unaffiliated insurance companies to sell commercial general liability, workers compensation and inland marine through Assurance MGA’s existing network of distributors. This process will continue throughout 2010 as Assurance MGA benefits from the arrangement by receiving commission revenue from policies sold by its insurance partners, while minimizing its risks. As American Vehicle continues its expansion into other states, we intend to retain other general agents to market our commercial general liability insurance products.
Deferred acquisition costs primarily represent commissions paid to outside agents at the time of policy issuance (to the extent they are recoverable from future premium income) net of ceded premium commission earned from reinsurers, salaries and premium taxes net of policy fees, and are amortized over the life of the related policy in relation to the amount of premiums earned. The method followed in computing deferred acquisition costs limits the amount of such deferred costs to their estimated realizable value, which gives effect to the premium to be earned, related investment income, unpaid losses and LAE and certain other costs expected to be incurred as the premium is earned. There is no indication that these costs will not be fully recoverable in the near term.
Unpaid losses and LAE are determined by establishing liabilities in amounts estimated to cover incurred losses and LAE. Such liabilities are determined based upon our assessment of claims pending and the development of prior years' loss liability. These amounts include liabilities based upon individual case estimates for reported losses and LAE and estimates of such amounts that are IBNR. Changes in the estimated liability are charged or credited to operations as the losses and LAE are settled.
If all the costs substantially associated with the MGA contracts, which do not involve affiliated insurers, are incurred during the underwriting process, then the MGA fees and the related acquisition costs are recognized at the time the policy is underwritten, net of estimated cancellations. If the MGA contract requires significant involvement subsequent to the completion of the underwriting process, then the MGA fees and related acquisition costs are deferred and recognized over the life of the policy. Included in Managing General Agent Fees are policy fees charged by the insurance companies and passed through to Assurance MGA. Policy fees are discussed below.
We recognize the income and expense on reinsurance contracts principally on a pro-rata basis over the term of the reinsurance contracts or until the reinsurers maximum liability is exhausted, whichever comes first. We are reinsured under separate reinsurance agreements for the different lines of business underwritten. Reinsurance contracts do not relieve us from our obligations to policyholders. We continually monitor our reinsurers to minimize our exposure to significant losses from reinsurer insolvencies. We only cede risks to reinsurers whom we believe to be financially sound. At December 31, 2009, all reinsurance recoverables are considered current and deemed collectable.
the circumstances under which an entity should recognize events or transactions occurring after the balance sheet date in its financial statements, and,
In September 2006, FASB issued new accounting guidance that enhances existing guidance for measuring assets and liabilities using fair value and requires additional disclosure about the use of fair value for measurement. The adoption of this guidance did not have a material impact on the Company’s financial statements or condition.
In March 2008, the FASB issued new accounting guidance related to disclosures about derivative instruments and hedging activities. This guidance requires companies with derivative instruments to disclose information that should enable financial-statement users to understand how and why a company uses derivative instruments, how derivative instruments and related hedged items are accounted for and how derivative instruments and related hedged items affect a company’s financial position, financial performance and cash flows. This guidance is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008. The Company does not utilize derivative instruments, and, accordingly the adoption of this guidance did not have an impact on the Company’s consolidated financial statements.
We face a risk of non-collectibility of reinsurance, which could materially and adversely affect our business, results of operations and/or financial condition.
The fair value of our investments is estimated based on prices published by financial services or quotations received from securities dealers and is reflective of the interest rate environment that existed as of the close of business on December 31, 2009 and 2008. Changes in interest rates subsequent to December 31, 2009 may affect the fair value of our investments. Refer to Footnote 3(a) of the Notes to Consolidated Financial Statements for details.
The carrying amounts for the following financial instrument categories approximate their fair values at December 31, 2009 and 2008 because of their short-term nature: cash and short term investments, premiums receivable, finance contracts, due from reinsurers, revolving credit outstanding, bank overdraft, accounts payable and accrued expenses.
Property, plant and equipment is stated at cost less accumulated depreciation. Depreciation on property, plant and equipment is calculated on a straight-line basis over the following estimated useful lives: building and improvements - 30 years and furniture and fixtures - 7 years. We capitalize betterments and any other expenditure in excess of $500 if the asset is expected to have a useful life greater than one year. The carrying value of property, plant and equipment is periodically reviewed based on the expected future undiscounted operating cash flows of the related item. Based upon our most recent analysis, we believe that no impairment of property, plant and equipment exists at December 31, 2009.
FASB issued guidance addresses accounting and reporting for (a) investments in equity securities that have readily determinable fair values and (b) all investments in debt securities. FASB issued guidance requires that these securities be classified into one of three categories: (i) held-to-maturity, (ii) trading securities or (iii) available-for-sale.
Total Investments increased $88.1 million, or 338.2%, to $114.2 million as of December 31, 2009, compared with $26.1 million as of December 31, 2008. Our debt portfolio contained callable features exercised in 2008. The proceeds from our called securities were in cash and short-term investments as of December 31, 2008. During 2009, the Company engaged external asset managers and the funds were invested in long and short term investments with yields that best match our liquidity needs.
intent and ability of the Company to retain the investment for a period of time sufficient to allow for anticipated recovery in market value;
In reaching a conclusion that a security is either other than temporary or permanently impaired we consider such factors as the timeliness and completeness of expected dividends, principal and interest payments, ratings from nationally recognized statistical rating organizations such as Standard and Poor’s and Moody’s, as well as information released via the general media channels. During 2009, in connection with this process, we have not charged any net realized investment loss to operations.
As of December 31, 2009, 36.9% of the investment portfolio is in corporate bonds, 34.4% is in obligations of states and political subdivisions, and 11.2% is in United States government bonds. Approximately 17.5% of the holdings are in equities related to diverse industries.
The following table shows the realized gains (losses) for debt and equity securities for the years ended December 31, 2009 and 2008.
The Company holds collateral under related reinsurance agreements in the form of letters of credit totaling $2.8 million that can be drawn on for amounts that remain unpaid for more than 120 days.
As a result of our review of liability for losses and LAE, which includes a re-evaluation of the adequacy of reserve levels for prior year’s claims, we increased the liability for losses and LAE for claims occurring in prior years by $1.7 million, $4.5 million and $9.2 million for the years ended December 31, 2009, 2008 and 2007, respectively.
Federated Premium’s operations were funded by the revolving loan agreement with FlatIron Funding Company LLC (“FlatIron”). The Revolving Agreement was structured as a sale of contracts receivable under a sale and assignment agreement with Weschester Premium Acceptance Corporation (“WPAC”), which gave them the right to sell or assign these contracts receivable. Federated Premium, which serviced these contracts, recorded transactions under the Revolving Agreement as secured borrowings. There were no outstanding borrowings under the Revolving Agreement as of December 31, 2009, 2008 or 2007. This credit facility terminated, at our request, during 2007.
In assessing the net realizable value of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income and tax planning strategies in making this assessment. At December 31, 2009 and 2008, based upon the level of historical taxable income and projections for future taxable income over the periods in which the deferred tax assets are deductible, management believes it is more likely than not that the Company will realize the benefits of these deductible differences.
To retain our certificate of authority, the Florida Insurance Code (the "Code") requires Federated National and American Vehicle to maintain capital and surplus equal to the greater of 10% of their liabilities or a statutory minimum capital and surplus as defined in the Code. Federated National and American Vehicle are required to have a minimum capital surplus of $4.0 million. At December 31, 2009, 2008 and 2007, Federated National’s statutory capital surplus was $21.0 million, $31.5 million and $32.3 million, respectively. At December 31, 2009, 2008 and 2007, American Vehicle had statutory capital surplus of $25.8 million, $25.1 million and $27.6 million, respectively.
The insurance companies are also required to adhere to prescribed premium-to-capital surplus ratios. As of December 31, 2009, 2008 and 2007, both Federated National and American Vehicle were in compliance with the prescribed premium-to-surplus ratio.
Based upon the 2009 and 2008 statutory financial statements for Federated National and American Vehicle, statutory surplus exceeded all regulatory action levels established by the NAIC’s risk-based capital requirements.
Based on risk-based capital requirements, the extent of regulatory intervention and action increases as the ratio of an insurer’s statutory surplus to its Authorized Control Level (“ACL”), as calculated under the NAIC’s requirements, decreases. The first action level, the Company Action Level, requires an insurer to submit a plan of corrective actions to the insurance regulators if statutory surplus falls below 200.0% of the ACL amount. The second action level, the Regulatory Action Level, requires an insurer to submit a plan containing corrective actions and permits the insurance regulators to perform an examination or other analysis and issue a corrective order if statutory surplus falls below 150.0% of the ACL amount. The third action level, ACL, allows the regulators to rehabilitate or liquidate an insurer in addition to the aforementioned actions if statutory surplus falls below the ACL amount. The fourth action level is the Mandatory Control Level, which requires the regulators to rehabilitate or liquidate the insurer if statutory surplus falls below 70.0% of the ACL amount. Federated National’s ratio of statutory surplus to its ACL was 245.1%, 739.4 % and 653.0% at December 31, 2009, 2008 and 2007, respectively. American Vehicle’s ratio of statutory surplus to its ACL was 426.9%, 402.5% and 448.5% at December 31, 2009, 2008 and 2007, respectively.
The NAIC has also developed Insurance Regulatory Information Systems (“IRIS”) ratios to assist state insurance departments in identifying companies which may be developing performance or solvency problems, as signaled by significant changes in the companies’ operations. Such changes may not necessarily result from any problems with an insurance company, but may merely indicate changes in certain ratios outside the ranges defined as normal by the NAIC. When an insurance company has four or more ratios falling outside “usual ranges,” state regulators may investigate to determine the reasons for the variance and whether corrective action is warranted.
As of December 31, 2009, American Vehicle was outside NAIC’s usual range for three of thirteen IRIS ratios. These ratios reflect the decline in premium volume and operating results. The third ratio related to lower than expected investment yields. As of December 31, 2008, American Vehicle was outside NAIC’s usual range for two of thirteen IRIS ratios. There was one exception in connection with the two year overall operating ratio and one in connection with two year reserve development to policyholders’ surplus.
American Vehicle’s statutory capital and surplus was $25.8 million and $25.1 million as of December 31, 2009 and 2008, respectively. American Vehicle’s statutory net income (loss) was approximately ($1.1) million, ($2.4) million and $1.3 million for the years ended December 31, 2009, 2008 and 2007 respectively. American Vehicle’s statutory non-admitted assets were approximately $0.9 million and $1.5 million as of December 31, 2009 and 2008, respectively.
Management has a responsibility to continually measure and monitor its commitments and its contingencies. The nature of the Company’s commitments and contingencies can be grouped into three major categories; insured claim activity, assessment related activities and operational matters.
Pursuant to Florida Statutes Section 627.3512, insurers are permitted to recoup the assessment by adding a surcharge to policies in an amount not to exceed the amount paid by the insurer to Citizens. Federated National is currently underwriting the recoupment in connection with the Citizens assessments and has since recouped approximately $2.3 million. Federated National subrogated approximately $1.8 million to the reinsurers.
The Florida OIR issued Information Memorandum OIR-06-008M, titled Notice of Anticipated Florida Hurricane Catastrophe Fund Assessment, and dated May 4, 2006, to all property and casualty insurers, surplus lines insurers, and surplus lines agents in the state of Florida placing them on notice of an anticipated FHCF assessment. Sighting the unprecedented hurricane seasons of 2004 and 2005, the FHCF exhausted nearly all of the $6 billion in reserves it had accumulated since its inception in 1993. The Florida State Board of Administration, the body that oversees the FHCF, issued its directive to levy an emergency assessment upon all property and casualty business in the state of Florida. There is no statutory requirement that policyholders be notified of the FHCF assessment. The FHCF and Florida OIR are, however, recommending that insurers include the FHCF assessment in a line item on the declaration page for two reasons: (1) this is a multi-year assessment and (2) there may be concurrent assessments and the insureds should know what amount is for which assessment. The assessment became effective on all policies effective after January 1, 2007 and will be remitted to the administrator of the assessment as collected.
From July 27, 2007, to August 7, 2007, several securities class action lawsuits were filed against the Company and certain of its executive officers in the United States District Court for the Southern District of Florida (“District Court”) on behalf of all persons and entities (the “plaintiff’s”) who purchased the Company's securities during the various class periods specified in the complaints. A consolidated amended complaint (“Class Litigation”) was filed on behalf of the class on January 22, 2008, Case No. 07-61057. The complaint alleges that the defendants made false and misleading statements and failed to accurately project the Company's business and financial performance during the putative class period. The plaintiffs seek an unspecified amount of damages and claim violations of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5. On March 18, 2008, a verified shareholder derivative complaint Case No. 08-cv-60374 (“Derivative Litigation”) was filed against certain current or former officers and directors of the Company in the District Court.
At a settlement hearing held on January 29, 2010, the Court approved the terms of the Stipulation of Settlement. See Note 25- Subsequent Events.
One of our directors is a partner at a law firm that handles some of the Company’s claims litigation. Fees paid to this law firm amounted to approximately $90,000, $145,000 and $80,000 in 2009, 2008 and 2007, respectively, and is included in LAE.
A summary of the numerator and denominator of the basic and fully diluted 2009, 2008 and 2007 net income (loss) per share is presented below.
Operating profit or loss is 10% or more of the greater, in absolute amount, of the combined operating profit (or loss) of all industry segments with operating profits (or losses).
We implemented a stock option plan in September 1998, which expired in September 2008, and provided for the granting of stock options to officers, key employees and consultants. The objectives of this plan included attracting and retaining the best personnel, providing for additional performance incentives, and promoting our success by providing employees the opportunity to acquire common stock. Options outstanding under this plan were granted at prices either equal to or above the market value of the stock on the date of grant, typically vest over a four-year or five-year period and expire six or ten years after the grant date. Under this plan, we were authorized to grant options to purchase up to 900,000 common shares, and, as of December 31, 2009 and December 31, 2008, we had outstanding exercisable options to purchase 124,599 and 130,099 shares, respectively.
In 2001, we implemented a franchisee stock option plan that was terminated during September 2008, and provided for the granting of stock options to individuals purchasing Company owned agencies that were then converted to franchised agencies. The purpose of the plan was to advance our interests by providing an additional incentive to encourage managers of Company owned agencies to purchase the agencies and convert them to franchises. Options outstanding under the plan were granted at prices, which were above the market value of the stock on the date of grant, vested over a ten-year period, and expired ten years after the grant date. Under this plan, we were authorized to grant options to purchase up to 988,500 common shares, and, as of December 31, 2009, we had no outstanding exercisable options to purchase shares.
In 2002, we implemented the 2002 Stock Option Plan. The purpose of this plan is to advance our interests by providing an additional incentive to attract, retain and motivate highly qualified and competent persons who are key to the Company, including employees, consultants, independent contractors, officers and directors. Our success is largely dependent upon their efforts and judgment; therefore, by authorizing the grant of options to purchase common stock, we encourage stock ownership. Options outstanding under the plan were granted at prices either equal to or above the market value of the stock on the date of grant, typically vest over a five-year period, and expire six years after the grant date. Under this plan, we are authorized to grant options to purchase up to 1,800,000 common shares, and, as of December 31, 2009 and December 31, 2008, we had outstanding exercisable options to purchase 736,951 and 658,151 shares, respectively.
Options outstanding as of December 31, 2009 are exercisable as follows.
Prior to January 1, 2006, we accounted for the plans under the recognition and measurement provisions of stock-based compensation using the intrinsic value method prescribed by the Accounting Principles Board (“APB”) and related Interpretation , as permitted by FASB issued guidance. Under these provisions, no stock-based employee compensation cost was recognized in the Statement of Operations as all options granted under those plans had an exercise price equal to or less than the market value of the underlying common stock on the date of grant.
Compensation cost for all share-based payments granted prior to, but not yet vested as of January 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of FASB issued guidance, and
As a result of adopting FASB issued guidance on January 1, 2006, the Company’s income from continuing operations before provision for income taxes and net income for 2008, are lower by approximately $483,000 and $301,000, respectively, than if it had continued to account for share-based compensation under ABP guidance.
Basic and diluted earnings per share for 2009 would have been ($1.25), if the Company had not adopted FASB issued guidance, compared with reported basic and diluted earnings per share of ($1.29).
Because the change in income taxes payable includes the effect of excess tax benefits, those excess tax benefits also must be shown as a separate operating cash outflow so that operating cash flows exclude the effect of excess tax benefits. FASB issued guidance requires the cash flows resulting from the tax benefits resulting from tax deductions in excess of the compensation cost recognized for those options (excess tax benefits) to be classified as financing cash flows.
The weighted average fair value of options granted during 2009, 2008 and 2007 estimated on the date of grant using the Black-Scholes option-pricing model was $0.61 to $1.29; $0.59 to $3.63 and $2.92 to $5.59, respectively.
Our Amended and Restated Articles of Incorporation authorize the issuance of one million shares of preferred stock with designations, rights and preferences determined from time to time by our board of directors. Accordingly, our Board of Directors is empowered, without shareholder approval, to issue preferred stock with dividends, liquidation, conversion, voting or other rights that could adversely affect the voting power or other rights of the holders of common stock. We have not issued preferred shares as of December 31, 2009.
In April 2009, the FASB issued accounting guidance that if an entity determines that either the volume and/or level of activity for an investment security has significantly decreased (from normal conditions for that investment security) or price quotations or observable inputs are not associated with orderly transactions, increased analysis and management judgment will be required to estimate fair value. This guidance was effective for interim and annual periods ending after June 15, 2009, with early adoption permitted. This guidance was applied prospectively. The adoption of this guidance did not have an impact on the Company’s financial statements or condition.
In September 2006, FASB issued accounting guidance that defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for an asset or liability in an orderly transaction between market participants on the measurement date. This guidance also establishes a fair value hierarchy that requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The guidance also categorizes assets and liabilities at fair value into one of three different levels depending on the observation of the inputs employed in the measurement, as follows: