The selected consolidated financial data presented below for, and as of the end of each of the years ended December 31, have been derived from the consolidated financial statements of the Company which have been audited by KPMG LLP, independent certified public accountants. The consolidated balance sheets as of December 31, 2001 and 2000, and the consolidated statements of operations, shareholders' equity and comprehensive income and cash flows for each of the years in the three-year period ended December 31, 2001, and the independent auditors report thereon are included elsewhere in this document. The information presented below should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations", consolidated financial statements and the notes thereto, and the other financial information included herein.
The discussion and analysis of the Company's financial condition and results of operations are based upon the Company's consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates under different assumptions or conditions.
In July 2001, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 141, "Business Combinations" (Statement 141) and Statement of Financial Accounting Standards No. 142, "Goodwill and Other Intangible Assets" (Statement 142). Statement 141 requires that the purchase method of accounting be used for all business combinations initiated after June 30, 2001 as well as all purchase method business combinations completed after June 30, 2001. Statement 141 also specifies criteria intangible assets acquired in a purchase method business combination must meet to be recognized and reported apart from goodwill, noting that any purchase price allocable to an assembled workforce may not be accounted for separately. Statement 142 requires that goodwill and intangible assets with indefinite useful lives no longer be amortized, but instead tested for impairment at least annually in accordance with the provisions of Statement 142. Statement 142 also requires that intangible assets with definite useful lives be amortized over their respective estimated useful lives to their estimated residual
values, and reviewed for impairment in accordance with Statement of Financial Accounting Standards No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of."
The Company adopted the provisions of Statement 141 effective July 1, 2001 and Statement 142 effective January 1, 2002. The adoption of Statement 141 had no impact on the consolidated financial statements. The adoption of Statement 142 will result in the Company no longer amortizing the remaining goodwill.
Liabilities for unpaid claims and claim adjustment expenses are based on estimates of the ultimate cost of settlement. Changes in claim estimates resulting from the review process and differences between estimates and ultimate payments are reflected in expense for the year in which the revision of these estimates first become known.
The process of establishing claim reserves is an imprecise science and reflects significant judgmental factors. In many liability cases, significant periods of time, ranging up to several years or more, may elapse between the occurrence of an insured claim and the settlement of the claim. Some judicial decisions and legislative actions, even after coverage is written and reserves are initially set, broaden liability and policy definitions and increase the severity of claim payments. As a result of this and other societal and economic developments, the uncertainties inherent in estimating ultimate claim costs on the basis of past experience have increased significantly, further complicating the already difficult claim reserving process.
Ultimate liability may be greater or lower than current reserves. Reserves are monitored by the Company using new information on reported claims and a variety of statistical techniques. The reserves are reviewed annually by an independent actuarial firm. The Company does not discount to present value that portion of its claim reserves expected to be paid in future periods.
In assessing the realization of its deferred tax assets, management considers whether it is more likely than not that a portion or all of the deferred tax assets will be realized. The Company recorded a valuation allowance in an amount equal to its net deferred tax asset at December 31, 2001. 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.
On February 7, 2002, the Company announced its decision to discontinue writing commercial lines insurance business due to continued adverse claims development and unprofitable results. The Company's commercial lines business segment produced approximately $70 million in gross premiums written in 2001. The Company plans to reduce its cost structure commensurate with the business reduction. Since February 7, 2002, the Company has reduced its employee count by 35 and notified all of its commercial lines agents of its intent to cancel their agency contracts. The Company has notified all states, where required by statute, of its intent to cease writing commercial lines of insurance in their state. The Company has ceased writing new commercial business and has taken certain steps allowed under the statutes to not renew commercial business. The discontinuance of writing commercial lines will likely result in the Company ceasing to be approved to write insurance in a number of states. The Company continues to operate a personal lines insurance operation in Florida that produced approximately $40 million in gross premiums written in 2001. See "Results of Operations."
The Company will be in a period of transition as it exits from its commercial lines insurance business. During the transition process, the Company may consider the sale of subsidiaries associated with that business. The Company also intends to continue to review current trends and profitability prospects for its nonstandard personal automobile business, and may endeavor to increase, decrease or dispose of all or part of it.
1999 GMSP Transaction. On October 4, 1999, GNA sold to GMSP, for an aggregate purchase price of $31,620,000, (i) 31,620 shares of Series A Preferred Stock, which are convertible into 6,200,000 shares of Common Stock at a conversion price of $5.10 per share (subject to adjustment for certain events), (ii) the Series A Warrant to purchase an aggregate of 1,550,000 shares of Common Stock at an exercise price of $6.375 per share and (iii) the Series B Warrant to purchase an aggregate of 1,550,000 shares of Common Stock at an exercise of $8.50 per share. At closing GNA and its insurance company subsidiaries entered into Investment Management Agreements with GMSP, pursuant to which GMSP manages their respective investment portfolios. Completion of these transactions (the "1999 GMSP Transaction") concluded the strategic alternatives review process that the Company initiated in 1998. Proceeds from the 1999 GMSP Transaction were available for acquisitions, investments and other corporate purposes. See "Item 1. Business -- Investment Strategy".
The agreement with GMSP was conditioned upon the following changes in the securities currently held by GMSP. The exercise prices of the Series A Warrant and the Series B Warrant held by GMSP were amended to $2.25 per share and $2.5875 per share, respectively. Each of these warrants provides for the purchase of 1,550,000 million shares of Common Stock, subject to adjustment. Further, the Company is required to redeem the outstanding shares of its Series A Preferred Stock on January 1, 2006, subject to certain conditions at a price of $1,000 per share plus accrued and unpaid dividends. Any Series A Preferred Stock unredeemed for any reason after that date would accrue interest, payable quarterly at a rate equal to eight percent per year with any unpaid interest compounded annually. The Series A Preferred Stock is convertible into 6,200,000 shares of Common Stock at a conversion price of $5.10 per share.
The agreement with GMSP provided an opportunity to convert the Company's illiquid investments with a cost of $4.2 million to cash as of November 2002, as follows: the Company could at its option require GMSP to purchase the illiquid investments for $2.1 million, less any future cash received prior to November 2002 from the investments. GMSP could at its option require the Company to sell the illiquid investments to GMSP for $4.2 million, less any future cash received prior to November 2002 from the investments. During the second quarter of 2001, the Company recognized a permanent impairment of these investments and wrote down the carrying value to the amount recoverable from GMSP under the put option. In February 2002, GMSP consented to the early exercise of the Company's option, and the Company exercised its option to require GMSP purchase the illiquid investments for approximately $2.1 million.
Effective December 31, 2000, the Company entered into a quota share reinsurance agreement whereby the Company ceded 100% of its commercial auto liability unearned premiums and 50% of all other commercial business unearned premiums at December 31, 2000 to a non-affiliated reinsurer. For policies with an effective date of January 1, 2001 through December 31, 2001, the Company entered into a quota share reinsurance agreement whereby the Company will cede 20% of its commercial business to a non-affiliated reinsurer. Also effective December 31, 2000, the Company entered into a reserve reinsurance cover agreement with a non-affiliated reinsurer. This agreement reinsures the Company's ultimate net aggregate liability in excess of $32,500,000 up to an aggregate limit of $89,650,000 for net commercial auto liability losses and loss adjustment expense incurred but unpaid as of December 31, 2000. The Company established a reinsurance balance receivable and a liability for funds held under reinsurance agreements for the reserves transferred at December 31, 2000 and December 31, 2001. Also in connection with this agreement, the Company is required to maintain assets in a trust fund with a fair value at least equal to the funds held liability. The trust fund was established during the third quarter of 2001 and at December 31, 2001 the assets in the trust had a fair value of $49,553,698. Because the Company's statutory policyholders' surplus fell below certain levels specified in the agreement, the reinsurer has the option to direct the trustee to transfer the assets of the trust to the reinsurer. If the reinsurer were to exercise its option, based upon December 31, 2001 balances, investments and funds held under reinsurance agreements would each be reduced by approximately $47,800,000. The reinsurer would continue to be responsible for reimbursing the Company for claim payments covered under this agreement.
Gross premiums written in 2001 of $117,183,182 are 30% below the $168,285,832 recorded in 2000 primarily due to the Company's decision in the fourth quarter of 2000 to cease writing certain identified non-profitable commercial trucking business. Gross premiums written in 2000 of $168,285,832 were 26% above the $133,898,001 recorded in 1999 primarily because of increases in commercial specialty lines, personal auto business written in Florida and personal umbrella business written in 2000. The following table compares the major product lines between the years for gross premiums written:
Insurance service revenues decreased $727,443 in 2001 from 2000 and $794,453 in 2000 from 1999. The decreases were primarily a result of the decrease in claim adjusting service revenues.
The ratio of commissions and the change in deferred policy acquisition costs and deferred ceding commission income to net premiums earned is 21% in 2001, 22% in 2000 and 21% in 1999.
Amortization of goodwill decreased in 2001 as a result of the sale of Tri-State and the second quarter 2001 write-off of its goodwill. Amortization of goodwill increased in 2000 as a result of the goodwill related to the Tri-State acquisition in January 2000.
The Federal income tax expense for 2001 is a result of the Company recording a valuation allowance of $31,534,712 against its deferred Federal income tax asset offset by the income tax benefit generated by the net loss from operations. Establishing the valuation allowance was necessary because of the uncertainty of future profitability levels. The Company does not lose the right to utilization of its net operating loss carry forwards for Federal income tax purposes in the future. For 2000 the Company generated a current tax benefit, with an effective tax benefit rate of 37%, as a result of a net loss from operations. The effective tax rate of 15% for 1999 was primarily the result of tax-exempt income comprising a major portion of income before taxes. A reconciliation between income taxes computed at the Federal statutory rates and the provision for income taxes is included in Note (6) of Notes to Consolidated Financial Statements.
The cumulative effect of change in accounting principle was recorded as a result of EITF 99-20, which became effective April 1, 2001. This amount represents the write down of an investment that was considered temporarily impaired and was written down in the first quarter of 2001 through accumulated other comprehensive income. EITF 99-20 changed the definition of impairment which resulted in this asset being reclassified as an impairment other than temporary which requires recognition through the statement of operations.
The Company had Federal income tax loss carry forwards at December 31, 2001 of approximately $19,864,000 that could be applied against any future earnings of the Company, subject to certain limitations. Thus, the Company does not currently require funds to satisfy Federal income tax obligations.
GNA entered into an amendment dated as of February 27, 2002 to its bank credit agreement which cured GNA's covenant breaches and provided for principal prepayments. Pursuant to the amendment, GNA prepaid $6,100,000 of the indebtedness outstanding under the credit agreement. Several covenants in the existing credit agreement were eliminated or modified by the amendment and the interest rate was changed to a base rate (which approximates prime) plus 175 basis points. The remaining $4,200,000 principal balance under the Credit Agreement is payable in 2003. The credit agreement precludes payment of dividends on common or preferred stock and restricts the kinds of investments that GNA may make.
Subject to bank credit agreement restrictions, GNA may also obtain cash through the sale of subsidiaries or assets and through the issuance of common or preferred stock. The bank credit agreement generally requires a note prepayment in the event of the sale of GNA of any subsidiary or assets (except certain ordinary course of business sales), or any issuance of stock, equal to 50% of the proceeds received.
The primary sources of the insurance subsidiaries' liquidity are funds generated from insurance premiums, net investment income and maturing investments. The short-term investments and cash are intended to provide adequate funds to pay claims without selling fixed maturity investments. At December 31, 2001, the insurance subsidiaries held short-term investments and cash that the insurance subsidiaries believe are adequate liquidity for the payment of claims and other short-term commitments.
Effective December 31, 2000, the insurance subsidiaries entered into a quota share reinsurance agreement whereby the Company ceded 100% of its commercial auto liability unearned premiums and 50% of all other commercial business unearned premiums at December 31, 2000 to a non-affiliated reinsurer. For policies with an effective date of January 1, 2001 through December 31, 2001, the Company entered into a quota share reinsurance agreement whereby the Company ceded approximately 20% of its commercial business to a non-affiliated reinsurer. Also effective December 31, 2000, the Company entered into a reserve reinsurance cover agreement with a non-affiliated reinsurer. This agreement reinsures the Company's ultimate net aggregate liability in excess of $32,500,000 up to an aggregate limit of $57,150,000 for net commercial auto liability losses and loss adjustment expense incurred but unpaid as of December 31, 2000. The Company established a reinsurance balance receivable and a liability for funds held under reinsurance agreements for the reserves transferred at December 31, 2000. Also in connection with this agreement, the Company is required to maintain assets in a trust fund with a fair value at least equal to the funds held liability. The trust fund was established during the third quarter of 2001 and at December 31, 2001 the assets in the trust had a fair value of $49,553,698. Because the Company's statutory policyholders' surplus fell below certain levels specified in the agreement, the reinsurer has the option to direct the trustee to transfer the assets of the trust to the reinsurer. If the reinsurer were to exercise its option, based upon December 31, 2001 balances, investments and funds held under reinsurance agreements would each be reduced by approximately $47,800,000. The reinsurer would continue to be responsible for reimbursing the Company for claim payments covered under this agreement.
Investments decreased primarily for the reasons mentioned regarding net cash used for operating activities. At December 31, 2001, 98% of the Company's investments were investment grade with an average duration of approximately 3.3 years, including approximately 25% that were held in short-term investments. On a taxable equivalent basis the return on average investments was 4.3% in 2001, 6.5% in 2000, and 5.7% in 1999. The Company classifies its bond securities as available for sale. In February 2002 GMSP purchased the equity investments and the note receivable, classified as "Other investments", for approximately $2,087,000 which was their carrying value at December 31, 2001. In March 2002, the Company reduced the carrying value of a non-rated security to $0 resulting in a write down of approximately $2,010,000 as a result of a significant increase in the default rate in January and February of 2002 in the underlying collateral, which has disrupted the cash flow stream sufficiently to virtually eliminate future cash flows. This write down is not reflected in the Statement of Operations for 2001, but will be included in the first quarter 2002 Statement of Operations. The unrealized gain associated with the investment portfolio was $3,580,690 (net of tax effects) at December 31, 2001. The duration of the bonds available for sale approximates the average expected payout of claims. Certain investments are held in trust under the terms of the reserve reinsurance cover agreement. Because the Company's statutory policyholders' surplus fell below certain levels specified in the agreement, the reinsurer has the option to direct the trustee to transfer the investments of the trust to the reinsurer. If the reinsurer were to exercise its option, based upon December 31, 2001 balances, investments would be reduced by approximately $47,800,000.
Premiums receivable decreased as a result of the decrease in writings caused primarily by the exiting of commercial auto during 2001. This balance is comprised of premiums due from general agents for commercial lines and premiums due from insureds for personal lines. The commercial lines premiums are generally received within forty-five days of
the month end in which coverage was bound, whereas the personal lines premiums are written with a down payment and monthly payment terms of up to nine months. At December 31, 2001, approximately 42% of the balance was due under the deferred payment terms. The Company has recorded an allowance for doubtful accounts of $200,000 which it considers adequate at the present time.
Reinsurance balances receivable increased primarily as a result of C & CAE claims paid under the reserve reinsurance cover agreement and the quota share reinsurance agreements for both commercial and personal lines of business written in 2001. This balance is primarily comprised of claims and claim adjustment expenses paid by the Company and due from reinsurers under the Company's various reinsurance agreements. During the fourth quarter of 2001, the Company recorded an allowance for doubtful accounts of $2,653,597 as a result of concern regarding the collectibility of amounts due from specific reinsurers. Balances written off in previous years have been immaterial. The Company considers the allowance adequate at the present time.
Deferred policy acquisition costs increased primarily as a result of a decrease in deferred ceding commission income primarily generated from the 2000 commercial quota share reinsurance agreements. This balance represents commissions, premium taxes and certain marketing and underwriting expenses which are deferred and charged to operations over periods in which the related premiums are earned. Ceding commission income, which is realized on a written basis, is deferred and recognized over periods in which the related premiums are earned. Deferred ceding commission income is netted against deferred policy acquisition costs. The change in the resulting deferred asset is charged (credited) to operations. The Company recorded impairments on its deferred policy acquisition costs at December 31, 2001 of $2,487,009 related to the property and commercial auto lines of business and at December 31, 2000 of $501,930 related to the property and nonstandard personal auto lines of business. With the Company's exit from commercial lines, deferred policy acquisition costs are expected to decrease rapidly during 2002 as the commercial lines writings decrease.
Property and equipment decreased primarily as a result of information technology software write-offs in the second quarter of 2001 and equipment disposed of in conjunction with the sale of Tri-State. Approximately $4,400,000 of this balance consists of the office building located in Fort Worth, Texas housing the Company's principal offices. The Company has entered into a contract to sell the building at a purchase price equal to $5,000,000. The sale is subject to certain conditions, including the buyer's satisfaction with its due diligence. The sale of the building, if consummated at all, could be consummated in August 2002. The Company plans to lease space in the Dallas/Fort Worth area and will move in August subject to the closing of the sale. The remaining portion of property and equipment is computer hardware, computer software, furniture and an office building the Company previously occupied which is under lease until May, 2003. As the Company exits commercial lines, future write-offs of software and equipment will likely occur.
Management contract is the unamortized purchase price of GAINSCO County Mutual Insurance Company's management contract which expires in 2042 and is being amortized over a forty year period ending 2032. The Company believes that the fair value of this asset is significantly above its amortized cost.
Other assets are comprised of funds held by reinsurers where the Company has assumed business from the reinsurers and the funds are collateral for the reinsurer. Also contained in this balance are prepaid commissions on personal lines business and prepaid insurance premiums on policies the Company has purchased for its protection.
Unearned premiums decreased because of the decrease in writings. This balance represents the portion of premiums written which are applicable to the unexpired terms of policies in force. Because of the Company's decision to exit commercial lines, this balance is expected to decrease rapidly in future periods.
Commissions payable increased primarily due to a decrease in estimated commission income from the 2000 commercial quota share reinsurance agreements. This balance is primarily commissions payable to reinsurers based on claim experience.
Drafts payable decreased primarily as a result of a decrease in claims paid for the fourth quarter of 2001 versus the fourth quarter of 2000. This balance is comprised of outstanding drafts which have been issued to pay for claims and claim adjustment expenses, but which have not cleared the bank account of the Company.
Note payable decreased due to scheduled principal repayments made during 2001 and unscheduled principal prepayments of $2,500,000 and $200,000 made during the first and fourth quarter of 2001, respectively, in conjunction an amendments to the credit agreement (see Note (4) of Notes to Consolidated Financial Statements). In the first quarter of 2002, the Company made a scheduled repayment of $500,000 and an unscheduled prepayment of $6,100,000. The unscheduled prepayment was made in conjunction with an amendment to the credit agreement which cured covenant breaches. The remaining $4,200,000 principal balance under the credit agreement is payable in 2003. (see Note (4) of Notes to Consolidated Financial Statements).
As a result of the 2001 GMSP Transaction and the Stallings Transaction, the Company has three series of redeemable preferred stock, which are classified as mezzanine financing. The Series A Convertible Redeemable Preferred Stock was previously classified in shareholders' equity because it was not subject to mandatory redemption. The Series B and the Series C preferred stock each include accrued dividends in the amount of $230,672 as of December 31, 2001.
At December 31, 2001, total assets less total liabilities (excluding redeemable preferred stock) of the Company was $52,546,273, and there were outstanding three series of preferred stock with an aggregate liquidation value of $38,081,344 ($37,620,000 stated value plus accrued dividends of $461,344). In the event of a liquidation of the Company (which is not contemplated) based upon consolidated shareholders' equity at December 31, 2001, there would be $14,464,929 available for distribution to the holders of the common stock ($0.68 per common share) after the payment of creditors and the liquidation value of the preferred stock. The amount ultimately available to the shareholders would vary with changes in the assets and liabilities of the Company.
Statements made in this report that are not strictly historical may be forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Investors are cautioned that important factors, representing certain risks and uncertainties, could cause actual results to differ materially from those contained in the forward-looking statements. These factors include, but are not limited to, (a) the Company's ability to effect the successful exit from unprofitable lines and businesses that the Company believes cannot be counted on to produce future profit, (b) heightened competition from existing competitors and new competitor entrants into the Company's markets, (c) the extent to which market conditions firm up, the acceptance of higher prices in the market place and the Company's ability to realize and sustain higher rates, (d) contraction of the markets for the Company's business, (e) the Company's ability to secure an A.M. Best rating acceptable to its end markets and meet its obligations under its capital and debt agreements, (f) the ongoing level of claims and claims-related expenses and the adequacy of claim reserves, (g) the effectiveness of investment strategies implemented by the Company's investment manager, (h) continued justification of recoverability of goodwill in the future, (i) the availability of reinsurance and the ability to collect reinsurance recoverables, (j) the Company's ability to invest in new endeavors that are successful, (k) the limitation on the Company's ability to use net operating loss carry forwards as a result of constraints caused by ownership changes within the meaning of Internal Revenue Code Section 382, (l) continued listing of the Company's common stock on the NYSE or, if such listing is not continued, the qualification of the Company's common stock for trading on a different market which would allow acceptable liquidity and trading for the Company's common stock, and (m) general economic conditions including fluctuations in interest rates. A forward-looking statement is relevant as of the date the statement is made. The Company undertakes no obligation to update any forward-looking statements to reflect events or circumstances arising after the date on which the statements are made.
The following Consolidated Financial Statements Schedules are on pages 82 through 93: