Our insurance companies, underwriting agencies and retail agencies often function as a vertically integrated unit, capturing the premium (and associated risk) and commission and fee revenue generated from the sale of each insurance policy. However, each of these operations also works with unaffiliated entities on an unbundled basis, either functioning independently or with one or both of the other two operations. We believe that our ability to enter into a variety of business relationships with third parties allows us to maximize sales penetration and profitability through industry cycles better than if we employed a single, vertically integrated operating structure.
For the years ended December 31, 2003, 2002 and 2001, our consolidated revenues were derived principally from commissions and fees, investment income and investment gains and losses. For the years ended December 31, 2003, 2002 and 2001, our consolidated expenses consisted primarily of expenses associated with underwriting activities, agents’ commissions and operations. Beginning January 1, 2004, our consolidated revenues also include net premiums earned and net investment income and our consolidated expenses also include losses, loss adjustment expenses and policy acquisition costs. We report consolidated financial information in three business segments: our agency segment, our insurance company segment and our corporate and other segment.
Effective December 31, 2003, Vesta sold to us two insurance companies - Affirmative Insurance Company and Insura - and also transferred to us all future economic interest in the NSA Business through a series of reinsurance transactions. We accounted for our acquisition of these insurance companies as a pooling of interests under SFAS No. 141, and our historical consolidated financial statements have been presented to reflect our historical results of operations and the historical results of Affirmative Insurance Company and Insura on a combined basis. Prior to December 31, 2003, our insurance companies ceded 100% of their premiums, losses and loss adjustment expenses to Vesta Fire. Accordingly, our insurance companies’ historical statements of operations prior to January 1, 2004 do not include any of the premiums, losses or loss adjustment expenses on policies written by our insurance companies.
• A-Affordable. On October 31, 2001, we acquired substantially all of the assets of A-Affordable Insurance Agency, Inc. A-Affordable is a Dallas-based underwriting agency and retail agency operation.
• InsureOne. On December 31, 2002, we acquired from Vesta substantially all of the business and operations comprising InsureOne, a Chicago-based retail agency and underwriting agency. The acquisition included an 80.0% equity interest in the retail agency. Vesta had purchased the assets of these businesses from an unaffiliated third party on January 1, 2002. We accounted for these acquisitions at Vesta’s historical carrying amounts as transfers of net assets between entities under common control in accordance with SFAS No. 141. The transaction was accounted for as a pooling of interests and, therefore, our historical financial statements have been presented to reflect our results of operations with those of the InsureOne underwriting and retail businesses on a combined basis effective January 1, 2002.
• Affirmative Insurance Company and Insura. Effective December 31, 2003, we acquired Affirmative Insurance Company and Insura from Vesta. We accounted for our acquisition of the insurance companies at Vesta’s historical carrying amounts as transfers of net assets between entities under common control in accordance with SFAS No. 141. The acquisitions were accounted for as a pooling of interests, and all historical financial statements presented reflect our results of operations on a combined basis with those of Affirmative Insurance Company and Insura.
• Fed USA. In December 2004, we acquired certain assets of Fed USA Retail, Inc., which owns retail agencies that produce and service non-standard personal automobile policies sold in Florida by 24 owned and branded retail stores in three DMAs as of December 31, 2004. We also acquired certain assets of Fed USA Franchising, Inc., which produces and services policies sold in Florida through 42 franchised retail stores in four DMAs as of December 31, 2004.
Our consolidated financial statements are based upon the selection and application of accounting policies that require management to make estimates and assumptions that can significantly affect amounts reported in the financial statements. As more information becomes known, these estimates and assumptions could change and therefore impact amounts reported in the future. We believe the following are some of the areas where the degree of judgment in determining amounts recorded in our historical consolidated financial statements make the accounting policies critical:
We receive commissions for policies that are written through our underwriting agencies or are sold by our retail agencies. These policies are subject to cancellation by the policyholder prior to the policy expiration date. We estimate the future cancellations in determining the amount of commission and fee income that is recorded in our consolidated financial statements. Our allowance for policy cancellations, presented as deferred revenue in our consolidated balance sheet, is periodically evaluated and adjusted as necessary. All commission and policy fee revenue and our related allowance for policy cancellations from our insurance companies are eliminated in consolidation.
The commission rate paid to our underwriting agencies is established annually in contractual agreements between our underwriting agencies and our insurance companies and the unaffiliated insurance company our underwriting agencies represent. Provisional commissions are paid to our underwriting agencies based upon a contractually established provisional commission rate multiplied by the premiums that they produce. Our underwriting agencies also can earn profit-sharing commissions from our insurance companies and the unaffiliated insurance company they represent if the loss ratio on the business they produce is lower than a contractually established provisional loss ratio. Profit-sharing is recorded when we conclude it is probable that estimates of losses will result in loss ratios that are lower than the provisional loss ratios. These loss ratio estimates are based on various actuarial assumptions and determinations by our internal actuaries regarding potential future losses. If the actual loss experience is less favorable than the
When we determine that a claim for loss and other costs associated with the loss made under one of our insurance policies is owed, we initially pay the full amount owed to the insured or claimant. Subsequently, we seek to recover any amounts due from reinsurers in accordance with the terms of the applicable reinsurance contract. We record the amounts we expect to receive from reinsurers pursuant to these contracts as assets on our balance sheet. Our insurance companies report as assets the estimated reinsurance recoverable on paid losses and unpaid losses, including an estimate for losses incurred but not reported, and premium amounts paid to reinsurers applicable to unexpired terms of policies in force. These amounts are estimated based on our interpretation of each reinsurer’s obligations pursuant to the individual reinsurance contracts between us and each reinsurer, as well as judgments we make regarding the financial viability of each reinsurer and its ability to pay us what is owed under the reinsurance contract. In evaluating the financial viability of each reinsurer, we rely upon financial statements, credit reports and other publicly available information applicable to each reinsurer, as well as management’s experience and industry knowledge.
Reserving for unpaid 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. Management’s 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. The liabilities stated for unpaid claims and for expenses of investigation and adjustment of unpaid claims are based on the following: (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
We conduct regular reviews to assess whether the amortized cost of our investments are impaired and if any impairment is other than temporary. Factors considered by us in assessing whether an impairment is other than temporary include the credit quality of the investment, the duration of the impairment, our ability and intent to hold the investment until recovery and overall economic conditions. If we determine that the value of any investment is other than temporarily impaired, we record a charge against earnings in the amount of the impairment.
companies. For the year ended December 31, 2004, the total commissions and fees earned by our retail agencies were $44.9 million, of which approximately $9.3 million, or 20.6%, was paid to us by unaffiliated companies and not eliminated in consolidation.
• commissions our underwriting agencies pay to unaffiliated independent agencies; and
• net premiums earned, which is the sum of the premiums earned on direct and assumed premiums written less premiums earned on premiums we cede to reinsurers;
• policy fee revenues, which are comprised primarily of origination and installment fees charged to our policyholders.
• losses and loss adjustment expenses, including estimates for losses and loss adjustment expenses incurred during a period and the changes in estimates for prior periods, less the portion of those losses and loss adjustment expenses that we cede to reinsurers;
The majority of these expenses are variable. Changes in expenses are closely correlated with changes in premium volume. Commission expenses and claims administration expenses are determined as a percentage of gross premiums earned according to contractual agreements with individual underwriting agencies.
The following table summarizes our historical results of operations by reporting segment. For more detailed information concerning the components of revenues and expenses by segment, please refer to Note 23 to our consolidated financial statements at page 67 of this report.
Consolidated. Total revenues for the year ended December 31, 2004 were $288.7 million, an increase of $184.7 million, or 177.6%, as compared to total revenues of $104.0 million for the prior year. The increase in total revenues was principally due our retention of gross premiums written in our insurance companies following the termination of the reinsurance agreements with Vesta, which allowed us to start retaining premiums beginning January 1, 2004 that were previously ceded to Vesta.
For the year ended December 31, 2004, minority interest net of income taxes was $804,000 as compared to $403,000 in the prior year. The increase in minority interest was a result of improved profitability of our Space Coast underwriting agency, where our ownership interest is 73.0%.
Agency segment. Total revenues for the year ended December 31, 2004 were $165.8 million, an increase of $19.3 million, or 13.1%, as compared to total revenues of $146.5 million in the prior year. Revenues for the years ended December 31, 2004 and 2003 were generated primarily through commissions, policy fees and claims processing fees, as follows:
Provisional commission for our underwriting agencies for the year ended December 31, 2004 were $76.1 million, an increase of $8.7 million, or 12.9%, as compared to provisional commissions of $67.4 million in the prior year. The $67.4 million in provisional commissions recorded in the prior year were favorably impacted by a $2.4 million reduction in a deferred revenue accrual. Excluding the impact of this adjustment, provisional commission for the year ended December 31, 2004 would have increased $11.1 million or 17.2%, as compared to the prior year. The increase in provisional commission was attributable to increases in total controlled premium produced by our underwriting agencies, which increased 8.7% over prior year, as well as increases in provisional commission rates which increased to 25.5% for the year ended December 31, 2004 from 23.6% in the prior year.
Commissions related to our retail agencies’ sales of unaffiliated insurance companies’ products were $6.7 million for the year ended December 31, 2004, a decrease of $211,000, or 3.0%, as compared commissions related to our retail agencies’ sales of unaffiliated insurance companies’ products of $6.9 million for the prior year.
Policy and other fees for the year ended December 31, 2004 were $42.7 million, an increase of $4.2 million, or 10.8%, as compared to policy and other fees of $38.5 million for the prior year. The $38.5 million recorded in policy and other fees in the prior year were unfavorably impacted by a $1.2 million increase in a deferred revenue accrual. Excluding the impact of this adjustment, policy and other fees for the year ended December 31, 2004 would have increased $3.0 million, or 7.4%, as compared to prior year. The increase in policy and other fees is principally due to the growth in policies in force partially offset by a decrease in agency fees charged by our Texas retail operations.
Claims processing fees for the year ended December 31, 2004 were $27.8 million, an increase of $922,000, or 3.4%, as compared to claims processing fees of $26.9 million in the prior year. The increase in claims processing fees is primarily due to the increases in earned premiums. Claims processing fees are paid to us based on a contractual rate relative to the amount of gross premiums earned on business that underwriting agencies produce. We recognize these fees over the expected service period based on the historical amount and timing of claims settlement expenses relative to the revenue we receive for performing claims settlement services.
• Depreciation and amortization expenses for the year ended December 31, 2004 were $4.2 million, an increase of $643,000, as compared to $3.6 million in the prior year. The increases in depreciation and amortization expenses were principally due to the acceleration of the depreciable lives of certain policy and claims processing systems to match their remaining expected lives due to the expected implementation of a new policy and claims system in 2005 as well as increases in depreciation as a result of increases in software and hardware purchases related to the integration of our acquisitions.
Pretax income for the year ended December 31, 2004 was $26.1 million, an increase of $5.2 million, or 25.1%, as compared to pretax income of $20.9 million in the prior year. For the year ended December 31, 2004 the pretax margin was 15.8%, an increase from the 14.3% pretax margin recorded in the prior year.
Pre-tax income for the year ended December 31, 2004 was $16.4 million, an increase of $5.7 million, or 52.5%, as compared to pre-tax income of $10.8 million in the prior year. The increase in pre-tax income was principally a result of the profitability of the business being retained starting January 1, 2004 as compared to policy fees retained in our insurance companies in the prior year. Our combined ratio for the year ended December 31, 2004 was 93.6%.
Corporate and other segment. The pre-tax loss for the year ended December 31, 2004 was $1.1 million as compared to a pre-tax loss of $821,000 for the prior year.
Operating expenses for the year ended December 31, 2004 was $492,000 compared to zero for the prior year. The increase is attributable to public company expenses such as directors and officers insurance, investor relations expenses and directors fees.
Consolidated. Total revenues for the year ended December 31, 2003 were $104.0 million, an increase of $18.6 million, or 21.8%, as compared to total revenues of $85.4 million for the prior year.
Pretax income for the year ended December 31, 2003 was $30.8 million, an increase of $7.8 million or 33.9% as compared to pre-tax income of $23.0 million for the prior year. For the year ended December 31, 2003 the pretax margin, or pretax income divided by total revenue, expressed as a percentage, was 29.5% an increase from the 27.0% pretax margin recorded in the prior year.
The principal reason for the decrease in 2003 was our purchase on May 7, 2003 of the 20.0% interest in InsureOne that we did not own.
Agency segment. Total revenues for the year ended December 31, 2003 were $146.5 million, an increase of $14.8 million, or 11.2%, as compared to total revenues of $131.8 million in the prior year. Revenues for the years ended December 31, 2003 and 2002 were generated primarily through commissions, policy fees and claims processing fees, as follows:
Commissions for the year ended December 31, 2003 were $81.1 million, an increase of $13.1 million, or 19.4%, as compared to commissions of $68.0 million in the prior year. We earned commissions in both our underwriting agencies and retail agencies. Commissions for our underwriting agencies, which include both provisional and profit-sharing commissions, for the year ended December 31, 2003 was $74.2 million, an increase of $11.1 million, or 17.5%, as compared to $63.1 million in the prior year.
• Depreciation and amortization expenses for the year ended December 31, 2003 were $3.6 million, an increase of $1.2 million, as compared to $2.4 million in the prior year. The increases in depreciation and amortization expenses were principally due to an increase of $1.0 million in amortization of intangibles related to acquisitions and increases in amortization and depreciation as a result of increases in software and hardware purchases related to the integration of our acquisitions.
• Operating expenses for the year ended December 31, 2003 were $41.1 million, an increase of $5.9 million, or 16.8%, as compared to $35.2 million in the prior year. The increase in operating expenses was primarily a result of increases in advertising expenditures of $1.1 million, increases in claims processing expenses of $3.0 million and recording a full year of operating expenses for Driver’s Choice which we acquired effective August 1, 2002.
Net investment income for the year ended December 31, 2003 was $159,000, a decrease of $212,000 from net investment income of $371,000 in the prior year. Net realized capital gains for the year ended December 31, 2003 were $457,000 and no gains were realized in the prior year.
Total expenses for the year ended December 31, 2003 were a negative $544,000, an increase of $91,000 as compared to total expenses of negative $635,000 in the prior year. Our insurance companies received ceding commissions from Vesta Fire related to the premiums ceded in accordance with the reinsurance agreement. The negative expense recorded for the years ended December 31, 2002 and 2003 is a result of our insurance companies receiving ceding commissions in an amount greater than their policy acquisition and operating expenses.
Corporate and other segment. Interest expense for the year ended December 31, 2003 was $821,000, as compared to interest expense of $1.0 million for the prior year. The interest expense in 2003 represents interest payments on a note payable related to the Harbor Insurance Group, Inc. acquisition, starting in January of 2003 when the final determination of the contingent payments was made. The interest expense in 2002 was related to notes payable to Vesta that were repaid in full and cancelled on September 30, 2002.
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, 2004, we had $2.8 million of cash and invested assets at the holding company level and $5.9 million of cash and invested assets at our non-insurance company subsidiaries.
State insurance laws restrict the ability of our insurance company subsidiaries to declare stockholder dividends. These subsidiaries may not make an “extraordinary dividend” until 30 days after the applicable commissioner of insurance has received notice of the intended dividend and has not objected in such time or until the commissioner has approved the payment of the extraordinary dividend within the 30-day period. An extraordinary dividend is defined as any dividend or distribution of cash or other property whose fair market value, together with that of other dividends and distributions made within the preceding 12 months, exceeds the greater of 10.0% of the insurance company’s surplus as of the preceding December 31 or the insurance company’s net income for the 12-month period ending the preceding December 31, in each case determined in accordance with statutory accounting practices. In addition, an insurance company’s remaining surplus after payment of a dividend or other distribution to stockholder affiliates must be both reasonable in relation to its outstanding liabilities and adequate to its financial needs. In 2005, our insurance companies may pay up to $13.9 million in ordinary dividends without prior regulatory approval, although we do not anticipate that our insurance company subsidiaries will pay dividends in the foreseeable future because we intend to reduce our reinsurance purchases and seek stronger financial strength ratings for our 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, 2004, the capital ratios of both of our insurance companies substantially exceeded the risk-based capital requirements. As of December 31, 2004, the capital ratios of both of our insurance companies exceeded the highest level for regulatory action under the risk-based capital guidelines.
Net cash provided by operating activities was $52.1 million for the year ended December 31, 2004, as compared to $40.7 million for the year ended December 31, 2003, and net cash used in operating activities of $898,000 for the year ended December 31, 2002. The increase in cash flow generated from operations for the year ended December 31, 2004 compared to the prior year was principally due to an increase in our net income as well as increases in cash flows due to the timing of collections and payments of losses and unearned revenue as well as increased collections on amounts due reinsurers. The increase in cash flow generated from operations for the year ended December 31, 2003 compared to the prior year was principally due to an increase in our net income, our increased collection of premiums and commissions receivable, amounts due reinsurers and the collection of two intercompany receivables. Our cash flows from operations are derived mainly from the activities discussed in the preceding paragraph. Our cash collection and payment processes have not changed materially and we do not expect changes to these procedures in the future. The primary driver of our inconsistent historical cash flows from operations has been the timing of clearing our intercompany receivable and payable balances with Vesta.
Credit facility. On August 6, 2004, we entered into a senior secured credit facility with The Frost National Bank. Under this credit facility, the maximum amount available to us from time to time is $15.0 million, which may include up to $15.0 million under a two-year revolving line of credit, up to $10.0 million in five-year term loans and up to $10.0 million in five-year stand-by letters of credit. The borrowings under our credit facility will initially accrue interest at an annual rate of LIBOR plus 1.50% and we will pay letter of credit fees based on an initial annual rate of 0.75%. Our obligations under the facility are guaranteed by our material operating subsidiaries (other than our insurance companies) and are secured by a first lien security interest on all of our assets and the assets of our material operating subsidiaries (other than our insurance companies), including a pledge of 100% of the stock of Affirmative Insurance Company. The facility contains certain financial covenants, which include combined ratio, risk-based capital requirement, fixed charge coverage ratio, consolidated net worth and consolidated net income requirements, and other restrictive covenants governing distributions and management changes. The proceeds are available to issue letters of credit securing our obligations under reinsurance agreements, to fund general working capital for our agency operations, capital surplus for our insurance companies and to finance acquisitions activities. As of December 31, 2004 we had not borrowed against our facility. As of December 31, 2004, we are in compliance with all of our financial and other restrictive covenants.
Trust Preferred Securities. On December 31, 2004, our newly formed trust subsidiary completed a private placement of $30.0 million of 30 year floating rate trust preferred securities. Simultaneously, we borrowed $30.9 million from the trust subsidiary and contributed $29.0 million to Affirmative Insurance Company’s policyholder’s surplus. The note bears an initial interest rate of 7.545 percent until December 15, 2009, at which time the securities will adjust quarterly to the 90-day LIBOR rate plus 3.6 percentage points. As of December 31, 2004, the note balance was $30.9 million.
(2) Consists primarily of rental obligations under real estate leases related to our retail operations and our corporate offices.
Affirmative Insurance Company, a wholly-owned subsidiary of Affirmative, is a party to a 100% quota share reinsurance agreement with Hawaiian and is sharing in the defense of this matter. Hawaiian is ultimately a wholly-owned subsidiary of Vesta Insurance Group, Inc. which is a 42.9% stockholder of Affirmative. The other named defendants SCJ Insurance Services, Prompt Insurance Services, Paul Ruelas, and Anthony David Medina are unaffiliated persons to Affirmative.
Interest rate risk. Our investment portfolio consists principally of investment-grade, fixed income securities, all of which are classified as available for sale. Accordingly, the primary market risk exposure to our debt securities is interest rate risk. In general the fair market value of a portfolio of fixed income securities increases or decreases inversely with changes in market interest rates, while net investment income realized from future investments in fixed income securities increases or decreases along with interest rates. In addition, some of our fixed income securities have call or prepayment options. This could subject us to reinvestment risk should interest rates fall and issuers call their securities and we reinvest at lower interest rates. We attempt to mitigate this interest rate risk by investing in securities with varied maturity dates and by managing the duration of our investment portfolio to a defined range of three to four years. The fair value of our fixed income securities as of December 31, 2004 was $159.7 million. The effective duration of the portfolio as of December 31, 2004 was 3.8 years. Should the market interest rates increase 1.0%, our fixed income investment portfolio would be expected to decline in market value by 3.8%, or $6.1 million, representing the effective duration multiplied by the change in market interest rates. Conversely, a 1.0% decline in interest rates would result in a 3.8%, or $6.1 million, increase in the market value of our fixed income investment portfolio.
At December 31, 2004, we had recorded $75.4 million as amounts recoverable from reinsurers, including $10.3 million net recoverable from Vesta Fire. Our reinsurance agreement with Vesta Fire allow us and Vesta Fire to offset amounts due to one another under the agreement. Vesta Fire is currently rated “B” (Fair) by A.M. Best. . According to our reinsurance agreement, if Vesta Fire’s
Effects of inflation. We do not believe that inflation has a material effect on our results of operations, except for the effect that inflation may have on interest rates and claims costs. The effects of inflation are considered in pricing and estimating reserves for unpaid claims and claim expenses. The actual effects of inflation on our results are not known until claims are ultimately settled. In addition to general price inflation, we are exposed to a persisting long-term upward trend in the cost of judicial awards for damages. We attempt to mitigate the effects of inflation in our pricing and establishing of loss and loss adjustment expense reserves.
In November 2002, the FASB issued Interpretation No. 45, or FIN 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others, which covers guarantees such as standby letters of credit, performance guarantees, and direct and indirect guarantees of indebtedness of others, but not guarantees of funding. FIN 45 requires a guarantor to recognize, at the inception of a guarantee, a liability in an amount equal to the fair value of the obligation undertaken in issuing the guarantee, and requires disclosure about the maximum potential payments that might be required, as well as the collateral or other recourse obtainable. The recognition and measurement provisions of FIN 45 were effective on a prospective basis after December 31, 2002.We adopted FIN 45 on January 1, 2003, without a material impact on our financial condition or results of operations.
In January 2003, the FASB issued Interpretation No. 46, or FIN 46, Consolidation of Variable Interest Entities. FIN 46 states that if a business enterprise is the primary beneficiary of a variable interest entity, the assets, liabilities and results of the activities of the variable interest entity should be included in the consolidated financial statements of the business enterprise. This Interpretation explains how to identify variable interest entities and how an enterprise assesses its interests in a variable interest entity to decide whether to consolidate that entity. FIN 46 also requires existing unconsolidated variable interest entities to be consolidated by their primary beneficiaries if the entities do not effectively disperse risks among parties involved. Variable interest entities that effectively disperse risks will not be consolidated unless a single party holds an interest or combination of interests that effectively recombines risks that were previously dispersed. Due to significant implementation concerns, the FASB modified the wording of FIN 46 and issued FIN 46R in December 2003. FIN 46R deferred the effective date for the provisions of FIN 46 to entities other than Special Purpose Entities, or SPEs, until financial statements are issued for periods ending after March 15, 2004. SPEs are subject to the provisions of either FIN 46 or FIN 46R as of December 15, 2003. The adoption of FIN 46 and FIN 46R did not have a material impact on our consolidated financial position or consolidated results of operations.
Any statement contained in this report which is not a historical fact, or which might otherwise be considered an opinion or projection concerning the Company or its business, whether express or implied, is meant as and should be considered a forward-looking statement as that term is defined in the Private Securities Litigation Reform Act of 1996. Forward-looking statements are based on assumptions and opinions concerning a variety of known and unknown risks, including but not necessarily limited to changes in market conditions, natural disasters and other catastrophic events, increased competition, changes in availability and cost of reinsurance, changes in governmental regulations, and general economic conditions, as well as other risks more completely described in our filings with the Securities and Exchange Commission. If any of these assumptions or opinions prove incorrect, any forward-looking statements made on the basis of such assumptions or opinions may also prove materially incorrect in one or more respects.
As a result of a series of transactions commencing on December 21, 2000, Vesta Insurance Group, Inc. and its subsidiaries (“Vesta”) owned approximately 98.1% of our issued and outstanding common stock at June 30, 2004, which were acquired from former stockholders and the purchase of new common stock directly from us.
Commission income - Commission income and related policy fees, written for affiliated and unaffiliated insurance companies, are recognized at the date the customer is initially billed or as of the effective date of the insurance policy, whichever is later. Commissions on premium endorsements are recognized when processed. Our allowance for policy cancellations, presented as deferred revenue in our consolidated balance sheet, is periodically evaluated and adjusted as necessary. All commission and policy fee revenue and our related allowance for policy cancellations from our insurance companies is eliminated in consolidation.
We disclose the fair values of financial instruments for which it is practicable to estimate the value. Fair value disclosures exclude certain financial instruments such as premium receivables, commission receivables, and premium payables when carrying values approximate our fair value.
In December 2002, the FASB issued SFAS No. 148 (“SFAS 148”), Accounting for Stock-Based Compensation - Transition and Disclosure. This statement provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. It also amends the disclosure requirements of SFAS No. 123 (“SFAS 123”), Accounting for Stock-Based Compensation to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method on reported results. We have elected to continue to apply APB Opinion No. 25 (“APB 25”) Accounting for Stock Issued to Employees and related interpretations in accounting for stock options.
On September 30, 2002, we redeemed $2.0 million of notes payable to The Shelby Insurance Company, a subsidiary of Vesta, plus accrued interest of $0.4 million and a note receivable of $0.3 million, in exchange for Instant Auto Insurance Company, our wholly owned subsidiary.
During the first quarter of 2004, we received $35.6 million in fixed income securities from Vesta in lieu of cash, to settle the collection of premiums and fees, receivables from reinsurers, exchange of other invested assets, and miscellaneous intercompany balances.
In November 2002, the FASB issued Interpretation No. 45, or FIN 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others, which covers guarantees such as standby letters of credit, performance guarantees, and direct and indirect guarantees of indebtedness of others, but not guarantees of funding. FIN 45 requires a guarantor to recognize, at the inception of a guarantee, a liability in an amount equal to the fair value of the obligation undertaken in issuing the guarantee, and requires disclosure about the maximum potential payments that
In January 2003, the FASB issued Interpretation No. 46 (“FIN 46”), Consolidation of Variable Interest Entities. FIN 46 states that if a business enterprise is the primary beneficiary of a variable interest entity, the assets, liabilities and results of the activities of the variable interest entity should be included in the consolidated financial statements of the business enterprise. This Interpretation explains how to identify variable interest entities and how an enterprise assesses its interests in a variable interest entity to decide whether to consolidate that entity. FIN 46 also requires existing unconsolidated variable interest entities to be consolidated by their primary beneficiaries if the entities do not effectively disperse risks among parties involved. Variable interest entities that effectively disperse risks will not be consolidated unless a single party holds an interest or combination of interests that effectively recombines risks that were previously dispersed. Due to significant implementation concerns, the FASB modified the wording of FIN 46 and issued FIN 46R in December 2003. FIN 46R deferred the effective date for the provisions of FIN 46 to pre-existing entities other than Special Purpose Entities (“SPEs”) until financial statements are issued for periods ending after March 15, 2004. SPEs are subject to the provisions of either FIN 46 or FIN 46R as of December 15, 2003. Our adoption of FIN 46 and FIN 46R did not have a material impact on our consolidated financial position or consolidated results of operations.
If a decline in the fair market value of investments is determined to be other than temporary, the investment is written down to fair value and the amount of the write-down is accounted for as a realized loss. We had no declines in fair value that were determined to be other than temporary.
At December 31, 2004 and 2003, investments in fixed maturity securities with an approximate carrying value of $15.1 million and $6.6 million were on deposit with regulatory authorities as required by insurance regulations.
Effective July 9, 2004, the date of our initial public offering, we have terminated our tax allocation agreement with Vesta and will file separate federal income tax returns on a go forward basis. Prior to July 9, 2004, we were included in a consolidated income tax return filed by Vesta. Under the tax allocation agreement with Vesta, a company with taxable income pays tax equal to an amount that would have been paid had the company filed a separate return. A company with a taxable loss is paid a tax benefit currently to the extent that affiliated companies within the consolidated group utilizes that loss. Prior to January 1, 2002, except for our insurance subsidiaries that we acquired effective December 31, 2003, we filed a separate consolidated federal income tax return.
The $305,000 of other intangible assets acquired was allocated to brand name, which is not subject to amortization.
The $4,397,000 of other intangible assets acquired was allocated to brand name, which is not subject to amortization.
Effective December 31, 2003, we acquired Affirmative Insurance Company and Insura from a subsidiary of Vesta for 3,408,382 shares of our common stock. Affirmative Insurance Company and Insura are Illinois domiciled insurance companies and are licensed to write business in 26 states. We accounted for the acquisition of our insurance companies at Vesta’s historical carrying value amounts as transfers of net assets between entities under common control in accordance with SFAS 141. The transactions are accounted for as a pooling of interests. Pursuant to pooling of interest accounting treatment, our historical consolidated financial statements have been presented to reflect the results of operations of Affirmative Insurance Company, Insura and us on a combined basis.
Vesta transferred our insurance company subsidiaries to us on December 31, 2003. Before this time, these insurance companies had ceded 100% of the business that they wrote to Vesta Fire as part of an intercompany reinsurance agreement. In connection with a reinsurance restructuring agreement, Vesta Fire retained all liability with respect to any losses and allocated loss adjustment expenses occurring on or prior to December 31, 2003 on policies issued by our insurance companies, and retained all corresponding loss and loss adjustment expense reserves as of December 31, 2003. As a result, as of December 31, 2003, our insurance companies had no net loss or loss adjustment expense reserves. In connection with the acquisition of our insurance companies from Vesta, this reinsurance agreement was terminated as of December 31, 2003, and our insurance companies began accruing losses and loss adjustment expenses, subject only to third-party reinsurance arrangements, for reported and incurred but not reported losses for insurance policies issued or assumed by our insurance companies after December 31, 2003. Therefore, due to the termination of this 100% reinsurance agreement as of December 31, 2003, our insurance companies have recorded losses and loss adjustment expenses in their respective statements of operations beginning January 1, 2004. Although Vesta Fire remains liable as a reinsurer for all of our insurance companies’ losses and loss adjustment expenses associated with these
policies occurring on or prior to December 31, 2003, we are subject to primary liability with respect to these policies. Consequently, we face exposure to credit risk with respect to Vesta Fire’s ability to satisfy its obligations to us. Vesta Fire is currently rated “B” (Fair) by A.M. Best. According to our reinsurance agreement, if Vesta Fire’s A.M. Best financial strength rating remains below “B+” we have the right to require Vesta Fire to provide a letter of credit or establish a trust account to collateralize the net amounts due to us from Vesta Fire under these reinsurance agreements. On July 27, 2004, we notified Vesta to establish a trust account collateralizing the net amount due to us, due to the fact that Vesta Fire’s A.M. Best rating was below a “B+”. We have $8.9 million currently in a trust account and have requested Vesta to increase the collateral held in this account to $10.3 million to fully collateralize the net amount due to us as of December 31, 2004.
Effective December 31, 2003, Affirmative Insurance Company and Insura cancelled their quota share contract with Vesta on a “cut off” basis, meaning that Vesta as reinsurer retained its loss and loss adjustment expense reserves as of December 31, 2003 and remains liable for any losses incurred on or prior to December 31, 2003 on policies issued by the other Vesta affiliated insurance companies as well as any subsequent development of loss and loss adjustment reserves related to those losses. As a result, we retained unearned premiums of $19.7 million related to this business as of December 31, 2003.
For the year ended, December 31, 2004, we have ceded $47.5 million of paid losses and $49.1 million of incurred losses and loss adjustment expense to various reinsurers.
• New Mexico and South Carolina. This agreement covers substantially all of our business written through our underwriting agencies in these states from January 1, 2004 and continues in force until terminated by us or our reinsurers at any December 31 with not less than 90 days’ prior notice. We ceded 75.0% of gross premiums written in the first six months of 2004, and effective July 1, 2004, we reduced the amount of business we cede to our reinsurers on all business written through our underwriting agencies in these states from 75.0% to 30.0% for the second half of 2004. We terminated this agreement effective December 31, 2004 on a run-off basis. The reinsurance under this agreement is provided by Chubb Re, which reinsures 86.7% of the premiums we ceded, and AXA Re which reinsures 13.3% of the premiums we ceded. Chubb Re and AXA Re are rated “A++” and “A-” respectively, by A.M. Best.
The following table provides a reconciliation of the beginning and ending reserves for unpaid losses and loss adjustment expenses, presented in conformity with generally accepted accounting principles, or GAAP, for the periods indicated:
Amortization expense was $738,000, $1.0 million, and $275,000 for the years ended December 31, 2004, 2003 and 2002.
We provide various services for Vesta and its subsidiaries, including underwriting, premium processing, and claims processing. Accordingly, for the years ended December 31, the accompanying consolidated statements of operations reflect these services as follows (dollars in thousands):
We issued a note payable to Vesta of $2.5 million on December 26, 2001, $0.5 million on January 1, 2002, $2.3 million on February 1, 2002, $1.2 million on April 1, 2002 and $1.5 million on September 1, 2002. These notes were issued to facilitate our acquisition activities. These notes bore interest at 12%, with interest due at maturity. On September 30, 2002, we issued 1,140,522 shares of common stock to Vesta as repayment of these notes, including $0.6 million in accrued interest.
On December 31, 2004, our newly formed trust subsidiary completed a private placement of $30.0 million of 30 year floating rate trust preferred securities. Simultaneously, we borrowed $30.9 million from the trust subsidiary and contributed $29.0 million to Affirmative Insurance Company’s policyholder’s surplus. The note bears an initial interest rate of 7.545 percent until December 15, 2009, at which time the securities will adjust quarterly to the 90-day LIBOR rate plus 3.6 percentage points. As of December 31, 2004, the note balance was $30.9 million.
We leased a portion of our furniture, equipment and computer software under a non-cancelable financing lease expiring in 2005. The lease carried an implicit interest rate of 8.06%. During 2004, this lease was paid in full.
Consists of rental obligations under real estate leases related to our retail operations and our corporate offices.
InsureOne’s former president is also a defendant, along with nine former employees of InsureOne and two of Hallberg’s family trusts, in actions we brought in the Circuit Court of Cook County, Illinois in December 2003 and in the United States District Court for the Eastern District of Missouri in February 2004 to enforce non-compete and non-solicitation agreements entered into with those employees. Both courts have entered interim orders prohibiting the defendants from hiring any employees of InsureOne or one of AIHI’s other underwriting agencies. The order expired in the Missouri action in November of 2004, but is still in effect in the Illinois action and prohibits all defendants, including Hallberg, from hiring any employees of InsureOne et al. until the conclusion of the trial of the Illinois action. The trial in the Illinois action is currently scheduled to begin in August of 2005. On May 17, 2004, the former president of InsureOne filed a counterclaim in the Illinois case seeking unspecified compensatory damages, specific performance, attorneys’ fees and court costs based on causes of action for breach of contract, fraud, negligent misrepresentation and breach of fiduciary duty in connection with Vesta’s original acquisition of the InsureOne business in 2002, the claimant’s employment with InsureOne and our purchase of the 20% minority interest in InsureOne in 2003. InsureOne et al. filed a motion to dismiss these counterclaims, which was granted in part and denied in part. Hallberg filed amended counterclaims based on causes of action for breach of contract, fraud, and breach of fiduciary duty. InsureOne et al. have answered those counterclaims, and believe the counterclaims are without merit. We are vigorously contesting the counterclaims and are exercising all rights and remedies available to us.
On May 6, 2004, the former minority owners of our InsureOne retail agency, including InsureOne’s former president, filed a complaint in the United States District Court for the Northern District of Illinois alleging causes of action against us and three of our executive officers under Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder, as well as causes of action for fraudulent misrepresentation, negligent misrepresentation and breach of fiduciary duty in connection with our purchase of the plaintiffs’ 20% minority interest in this retail agency in 2003. The plaintiffs sought damages equal to the difference between the amount paid for the 20% interest and the court’s determination of the value of this interest,
plus attorneys’ fees and court costs. Defendants filed a motion to dismiss this case which was granted by the Court on March 8, 2005. The Court’s March 8, 2005 Order dismisses all claims without prejudice and grants plaintiffs 20 days from the date of the order to attempt to replead their claims. We anticipate that the plaintiffs will attempt to replead some or all of those claims. We believe these claims are without merit, and we will vigorously contest the claims, and exercise all available rights and remedies against them should plaintiffs choose to replead those claims.
This matter is currently proceeding through pre-trial discovery and depositions of pertinent witnesses in preparation for a September 6, 2005 trial date. Hawaiian and the other defendants thereto believe these allegations are without merit and are vigorously contesting the claims brought by the plaintiffs and exercising all available rights and remedies against them; however, the ultimate outcome of this matter is uncertain.
Effective December 31, 2003, we acquired Affirmative Insurance Company and Insura from an indirect wholly owned subsidiary of Vesta in exchange for 3,408,382 shares of our common stock. In addition, we paid a ceding commission to various insurance subsidiaries of Vesta in the amount of 1,471,984 shares of our common stock as the result of the reinsurance transactions related to Vesta’s transfer to us of the future economic interest in the non-standard automobile business (Note 7).
On March 12, 2004 we filed an Amendment and Restated Certificate of Incorporation increasing the number of shares of authorized common stock from 40 million to 75 million.
On July 9, 2004, we completed our initial public offering of our common stock. We issued 4,420,000 additional shares of our common stock and Vesta sold 3,750,000 shares of our common stock that they owned, at an initial public offering price of $14 per share. On July 26, 2004, our underwriters exercised their option to purchase an additional 663,000 shares from us, and an additional 562,500 shares from Vesta. Our net proceeds from the offering were $65.3 million, after deducting our estimated offering expenses. We contributed $64.3 million of the net proceeds to our insurance companies in order to increase their statutory surplus. This additional capital allowed us to reduce our reinsurance purchases and retain more gross premiums. The remaining $1.0 million of net proceeds were held for general corporate purposes.
The provisions of SFAS No. 128 (“SFAS 128”) Earnings per Share require presentation of both basic and diluted earnings per share. A reconciliation of the numerators and denominators of the basic and diluted earnings per share computations as required by SFAS 128 is presented below:
We have an 1998 Omnibus Incentive Plan (“1998 Plan”) under which we may grant options to employees, directors and consultants for up to 803,169 shares of common stock. The exercise prices are determined by the Board of Directors, but shall not be less than 100% of the fair value on the grant date or, in the case of any employee who is deemed to own more than 10% of the voting power of all classes of our stock, not less than 110% of the fair value. The terms of the options are also determined by the Board of Directors, but shall never exceed ten years or, in the case of any employee who is deemed to own more than 10% of the voting power of all classes of our common stock, shall not exceed five years.
The board or committee may fix the term and vesting schedule of each stock option, but no incentive stock option will be exercisable more than ten years after the date of grant. Vested stock options generally remain exercisable for up to three months after a participant’s termination of service or up to 12 months after a participant’s death or disability. Typically, the exercise price of each incentive stock option must not be less than 100% of the fair market value of our common stock on the grant date, and the exercise price of a nonqualified stock option must not be less than 20% of the fair market value of our common stock on the grant date. In the event that an incentive stock option is granted to a 10% stockholder, the term of such stock option may not be more than five years and the exercise price may not be less than 110% of the fair market value on the grant date. The exercise price of each stock option granted under the 2004 Plan may be paid in cash or in other forms of consideration in certain circumstances, including shares of common stock, deferred payment arrangements or pursuant to cashless exercise programs. A stock option award may provide that if shares of our common stock are used to pay the exercise price, an additional option will be granted to the participant to purchase that number of shares used to pay the exercise price. Generally, stock options are not transferable except by will or the laws of descent and distribution, unless the board or committee provides that a nonqualified stock option may be transferred.
A summary of expiration dates and weighted average exercise price for all outstanding options and options currently exercisable at December 31, 2004 is as follows:
As discussed in Note 11, we receive a significant amount of commissions and fees directly from Vesta.
Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure
The information relating to this Item 10 is incorporated by reference to the Proxy Statement for our 2005 Annual Meeting of Stockholders, which will be filed with the Securities and Exchange Commission no later than 120 days after December 31, 2004
The information relating to this Item 14 is incorporated by reference to the Proxy Statement for our 2005 Annual Meeting of Stockholders, which will be filed with the Securities and Exchange Commission no later than 120 days after December 31, 2004.
Consolidated Statements of Operations - For the Years Ended December 31, 2004, 2003 and 2002
Consolidated Statements of Stockholders Equity and Comprehensive Income for the Years Ended December 31, 2004, 2003 and 2002
Amended and Restated Certificate of Incorporation of Affirmative Insurance Holdings, Inc. (incorporated by reference to Exhibit 3.1 to our Registration Statement on Form S-1 filed with the SEC on March 22, 2004, File No. 333-113793).
Amended and Restated Bylaws of Affirmative Insurance Holdings, Inc. (incorporated by reference to Exhibit 3.2 to our Registration Statement on Form S-1 filed with the SEC on March 22, 2004, File No. 333-113793).
Form of Common Stock Certificate (incorporated by reference to Exhibit 4.1 to Amendment No. 3 to our Registration Statement on Form S-1 filed with the SEC on June 14, 2004, File No. 333-113793).
Affirmative Insurance Holdings, Inc. 1998 Omnibus Incentive Plan, as amended (incorporated by reference to Exhibit 10.1 to our Registration Statement on Form S-1 filed with the SEC on March 22, 2004, File No. 333-113793).
Employment Agreement between Affirmative Insurance Holdings, Inc. and Katherine C. Nolan (incorporated by reference to Exhibit 10.5 to Amendment No. 2 to our Registration Statement on Form S-1 filed with the SEC on May 27, 2004, File No. 333-113793).
Private Passenger Automobile Quota Share Reinsurance Contract issued to Affirmative Insurance Company and Insura Property & Casualty Insurance Company, covering Florida business, effective January 1, 2004 (incorporated by reference to Exhibit 10.11 to Amendment No. 3 to our Registration Statement on Form S-1 filed with the SEC on June 14, 2004, File No. 333-113793).
Private Passenger Automobile Quota Share Reinsurance Contract issued to Old American County Mutual Fire Insurance Company, covering business produced by the Texas-based A-Affordable underwriting agency, effective January 1, 2004 (incorporated by reference to Exhibit 10.12 to Amendment No. 3 to our Registration Statement on Form S-1 filed with the SEC on June 14, 2004, File No. 333-113793).
First Amended and Restated Managing General Agency Agreement between Old American County Mutual Fire Insurance Company and A-Affordable Managing General Agency, Inc. dated as of January 1, 2004 (incorporated by reference to Exhibit 10.13 to Amendment No. 2 to our Registration Statement on Form S-1 filed with the SEC on May 27, 2004, File No. 333-113793).
First Amended and Restated Managing General Agency Agreement between Old American County Mutual Fire Insurance Company and American Agencies General Agency, Inc. dated as of January 1, 2004 (incorporated by reference to Exhibit 10.14 to Amendment No. 2 to our Registration Statement on Form S-1 filed with the SEC on May 27, 2004, File No. 333-113793).
Investment Management Agreement, dated as of February 20,2004, between Synovus Trust Company, N.A. Prime Advisors, Inc., Affirmative Insurance Company and Insura Property & Casualty Company (incorporated by reference to Exhibit 10.15 to our Registration Statement on Form S-1 filed with the SEC on March 22, 2004, File No. 333-113793).
Form of Separation Agreement between Affirmative Insurance Holdings, Inc. and Vesta Insurance Group, Inc. (incorporated by reference to Exhibit 10.16 to Amendment No. 2 to our Registration Statement on Form S-1 filed with the SEC on May 27, 2004, File No. 333-113793).
Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
We completed an initial public offering of our common stock effective July 9, 2004. We issued 4,420,000 additional shares of our common stock and Vesta sold 3,750,000 shares of our common stock that they owned, at an initial public offering price of $14.00 per share. On July 26, 2004, our underwriters exercised their option to purchase an additional 663,000 shares from us, and an additional 562,500 shares from Vesta. As of December 31, 2004, Vesta beneficially owned approximately 41.4% of our issued and outstanding capital stock.
Our consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America and include our accounts and the accounts of our operating subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation.
Management believes the accompanying financial statements are representative of our costs of doing business on a stand-alone basis. The accompanying income statements include charges for expenses allocated to us by Vesta for various services. These charges were based upon specific identification when available or were allocated based upon estimated usage. Management believes the methods used to identify and allocate these costs are reasonable. Vesta acquired approximately 52% of our common and convertible preferred stock on December 21, 2000 and acquired an additional approximately 40% of our common and convertible preferred stock on December 28, 2001.
Our preparation of financial statements in conformity with accounting principles generally accepted in the United States of America 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 and impairment of assets.
We account for our equity interest in unconsolidated subsidiaries under the equity method of accounting. Under the equity method of accounting, we record our proportionate share of the income (losses), net of income taxes in our consolidated statements of operations. As of December 31, 2004, our equity in unconsolidated subsidiaries was written down to zero.
The Company is required to report its results of operations and financial position to Insurance Departments of Insurance based upon Statutory accounting practices (“SAP”). Certain key differences under SAP, unlike GAAP are as follow: the Company is required to expense all sales and other policy acquisition costs as they are incurred rather than capitalizing and amortizing them over the expected life of the policy. The immediate charge off of sales and acquisition expenses and other conservative valuations under SAP generally cause a lag between the sale of a policy and the emergence of reported earnings. Because this lag can reduce the Company’s gain from operations on a SAP basis, it can have the effect of reducing the amount of funds available for dividend from insurance companies.
Property and equipment is stated at cost, less accumulated depreciation, and consists primarily of capitalized third-party system development costs, telephone equipment and furniture and fixtures. Depreciation is computed using the straight-line method over the estimated useful lives of our assets, typically ranging from three to five years.
In connection with certain acquisitions, we are liable for additional purchase price in the event specified earning levels or other contractual targets are met. These obligations are recorded as consideration due for acquisitions in our consolidated balance sheet upon the determination by us that such payments are both estimable and payable beyond a reasonable doubt.
We paid the following amounts for the years ended December 31(dollars in thousands):
might be required, as well as the collateral or other recourse obtainable. The recognition and measurement provisions of FIN 45 were effective on a prospective basis after December 31, 2002.We adopted FIN 45 on January 1, 2003, without a material impact on our financial condition or results of operations.
In May 2003, the FASB issued SFAS No. 150 (“SFAS 150”), Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity”. SFAS 150 established standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability because that financial instrument embodies an obligation of the issuer. SFAS 150 requires mandatory redeemable financial instruments to be classifies as a liability unless the redemption is required to occur only upon the liquidation or termination of the reporting entity. Our adoption of SFAS 150 did not have a material impact on our consolidated financial position or consolidated results of operations.
On January 1, 2002, we purchased American Agency General Agency, Inc. (“American Agencies”) and certain non-standard personal automobile assets of Harbor Insurance Group, Inc. for $21.5 million. Our purchase price consisted of $1.5 million cash at closing, $1.4 million notes payable, $500,000 assumption of certain liabilities, and $18.1 million due upon the occurrence of certain future events which were resolved in 2003. American Agencies is a non-standard personal automobile managing general agency located in Addison, Texas. Summarized below is an allocation of assets and liabilities acquired (dollars in thousands):
On August 1, 2002, we purchased all the issued and outstanding stock of Drivers’ Choice, LLC for $1.9 million. Our purchase price consisted of $45,000 cash at closing and $1.9 million assumption of certain liabilities. Drivers’ Choice is a non-standard personal automobile agency located in Columbia, South Carolina. Summarized below is an allocation of assets and liabilities acquired (dollars in thousands):
As a result of the transactions above, we paid a ceding commission to Vesta of 1,471,984 shares of our common stock, valued at $14.4 million for the assumed unearned premium as of December 31, 2003. There was no gain or loss reported as a result of the intercompany reinsurance restructuring with Vesta recorded at December 31, 2003.
We are currently transitioning the non-standard personal automobile business written on all Vesta insurance company subsidiaries to Affirmative Insurance Company and Insura. During this transitional period Affirmative Insurance Company or Insura will reinsure the new and renewal policies written by the Vesta insurance company subsidiaries through a 100% quota share reinsurance agreement, whereby Affirmative Insurance Company will assume 100% of the underwriting results of the Vesta insurance subsidiaries related to non-standard personal automobile polices produced by our underwriting agencies.
Effective January 1, 2004, we entered into two quota share reinsurance agreements with unaffiliated reinsurers with variable cession percentages, which provided us with an option to cede less of the business produced by our underwriting agencies to these reinsurers in the last two quarters of 2004.
We adopted SFAS No. 142, Goodwill and Other Intangible Assets, effective January 1, 2002. With the exception of the pooling of historical financial results relative to acquisitions of businesses under common control, we have accounted for all other business combinations using the purchase method of accounting. In business combinations using the purchase method of accounting, the excess cost of the acquisition is allocated to the assets acquired (including identified intangible assets) and liabilities assumed based on their estimated values. The excess of cost of an acquired entity over the net of the amounts assigned to assets acquired and liabilities assumed is an asset referred to as “excess of cost over net assets acquired” or “goodwill.” Indirect and general expenses related to business combinations are expensed as incurred.
On January 1, 2002, we ceased goodwill amortization and will test for impairment annually, or more frequently if impairment indicators arise. Intangible assets with finite lives are amortized over their useful lives and are periodically reviewed to ensure that no conditions exist indicating the recorded amount of intangible assets is not recoverable from future undiscounted cash flows.
We evaluate impairment of goodwill and indefinite life intangibles in our agency reporting unit, as the insurance company reporting unit has no associated goodwill or 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. We will perform an impairment test annually on September 30. The test performed as of September 30, 2004 indicated there was no goodwill impairment.
The changes in the carrying amount of goodwill as of December 31, 2004 and 2003 and for the years ended December 31, 2004 and 2003 are as follows (in thousands):
Other adjustments to goodwill include changes to the contingent purchase consideration on certain acquisitions and final adjustments to purchase price allocations.
Property and equipment is stated at cost, less accumulated depreciation, and consists primarily of capitalized third-party system development costs, telephone equipment, and furniture and fixtures. Depreciation is computed using the straight-line method over the estimated useful lives of the assets, typically ranging from three to five years.
Depreciation expense was $3.5 million, $2.6 million, and $2.1 million for the years ended December 31, 2004, 2003 and 2002, respectively.
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 policyowners 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.
Our insurance company subsidiaries are subject to risk-based capital standards and other minimum capital and surplus requirements imposed under applicable state laws, including the laws of their state of domicile, Illinois. The risk-based capital standards, based upon the Risk-Based Capital Model Act adopted by the National Association of Insurance Commissioners, or NAIC, require our insurance company subsidiaries to report their results of risk-based capital calculations to state departments of insurance and the NAIC.
One of our subsidiaries had a note payable with a bank, which was obtained for operating purposes prior to our acquisition of such subsidiary. The note carried interest at 8.5% annually, with monthly payments of $7,800 through June 2006. During 2004, this note was paid in full. As of December 31, 2003, the note balance was $219,000.
Consists of payments due in 2005 related to the asset purchase of InsureOne Independent Agency, LLC.
On August 6, 2004, we entered into a senior secured credit facility with The Frost National Bank. Under this credit facility, the maximum amount available to us from time to time is $15.0 million, which may include up to $15.0 million under a two-year revolving line of credit, up to $10.0 million in five-year term loans and up to $10.0 million in five-year stand-by letters of credit. The borrowings under our credit facility will initially accrue interest at an annual rate of LIBOR plus 1.50% and we will pay letter of credit fees based on an initial annual rate of 0.75%. Our obligations under the facility are guaranteed by our material operating subsidiaries (other than our insurance companies) and are secured by a first lien security interest on all of our assets and the assets of our material operating subsidiaries (other than our insurance companies), including a pledge of 100% of the stock of Affirmative Insurance Company. The facility contains certain financial covenants, which include combined ratio, risk-based capital requirement, fixed charge coverage ratio, consolidated net worth and consolidated net income requirements and other restrictive covenants governing distributions and management changes. The proceeds are available to issue letters of credit securing our obligations under reinsurance agreements, to fund general working capital for our agency operations, capital surplus for our insurance companies and to finance acquisition activities. Currently, we have not borrowed against our facility. As of December 31, 2004, we are in compliance with all of our financial and other restrictive covenants. As of December 31, 2004, we had not borrowed against our facility
On February 14, 2003, we issued 53,615 shares of our common stock to E.B. Lyone, III, a minority stockholder for $407,000.
On March 12, 2004, we issued 35,216 shares of our common stock to E.B. Lyon, III, a minority stockholder, at a purchase price of $9.76 per share, for aggregate consideration of $343,809 in cash.
On September 28, 2004, we issued 80,837 shares of our common stock to Vesta Insurance Group, Inc. in connection with the exercise of options, with an exercise price of $7.59 per share, which we originally issued to Vesta on June 30, 2000.
We account for our stock-based compensation in accordance with SFAS No. 123 (“SFAS 123”), Accounting for Stock-Based Compensation. SFAS 123 defines a fair value based method of accounting for an employee stock option. It also allows an entity to continue using the intrinsic value based accounting method prescribed by APB Opinion No. 25 (“APB 25”), Accounting for Stock Issued to Employee. We have continued to use APB 25 to account for our stock options. Accordingly, we have adopted the disclosure requirements of SFAS 148, which requires presentation of pro forma net income and earnings per share information under SFAS 123.
In December 2004, the Financial Accounting Standards Board, or FASB, issued SFAS No. 123R (“SFAS 123R”), Share-Based Compensation, which is a revision of FASB Statement No. 123, Accounting for Stock-Based Compensation, and supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees, and its related implementation guidance. SFAS 123R focuses primarily on accounting for transactions in which an entity obtains employee services in share-based payment transactions. This statement requires a public entity to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award (with limited exceptions). That cost will be recognized over the period during which an employee is required to provide service in exchange for the award, the requisite service period. No compensation cost is recognized for equity instruments for which employees do not render the requisite service. SFAS 123R is effective for public entities that do not file as small business issuers as of the beginning of the first interim or annual reporting period that begins after June 15, 2005. We anticipate adopting the provisions of SFAS 123R in July 2005. We are currently evaluating the requirements and the potential impact of SFAS 123R and have not yet determined if SFAS 123R will have a material impact on our future operations.
In addition, the 2004 Plan provides for awards for restricted stock, unrestricted stock, performance stock, and dividend equivalent rights. As of December 31, 2004, no awards have been issued under the 1998 Plan, except as discussed above.
The following table identifies the eleven states in which we operate and the gross premiums written produced by our underwriting agencies and by unaffiliated agencies by state for the year ended December 31, 2004 (dollars in thousands):
The carrying amount of and estimated fair values of our financial instruments at December 31, 2004 and 2003 are as follows (dollars in thousands):