The Company leases buildings that are used in the normal course of business which includes offices and facilities in Georgia, Mississippi, and Tennessee. These facilities are used by executive, claims and marketing personnel and are components of the insurance and noninsurance segments. Locations utilized by the Company’s independent exclusive and independent agents are normally leased by those agents as lessees.
Property casualty insurance operations accounted for 80.3% of revenues and 77.4% of net income in 2006. Life insurance operations generated 18.2% of revenues and 27.7% of net income during the same period. Noninsurance net income, combined with corporate expenses for 2006, resulted in a net loss of $5.3 million or 5.1% of net income.
On January 1, 2006, the Company adopted Statement of Financial Accounting Standard (SFAS) No. 123 (revised 2004), Share-Based Payment. SFAS No. 123(R) requires all share-based payments to employees and non-employees, including grants of stock options, to be recognized as compensation expense based on fair value at date of grant. Prior to January 1, 2006, the Company accounted for stock options to employees using the intrinsic value method described in APB Opinion No. 25 and, as such, recognized no compensation cost for employee stock options granted at market value on the date of grant. The Company adopted SFAS No. 123(R) using the modified prospective method, therefore no prior period results have been restated. The valuation model used to value stock options under SFAS No. 123(R) is the Black-Scholes-Merton model, which is the same valuation model that was used prior to January 1, 2006 for pro forma disclosures under SFAS No. 123. Under SFAS No. 123(R) an estimate must be made of the number of awards that are expected to vest and this forfeiture rate is applied to determine the amount of compensation cost to be recognized. The forfeiture rate must be evaluated at each reporting period to determine if any changes should be made which could impact the amount of compensation cost that will be ultimately recognized. In addition, the amount of compensation cost to be recognized is based on non-substantive vesting periods attributable to retirement eligible employees. Alfa’s total fair-value-based compensation expense associated with stock options that were not vested at January 1, 2006 was $3.6 million and the weighted average period over which this expense will be recognized is 0.74 years. The Company shares compensation cost with Mutual based on Alfa’s Management and Operating Agreement (refer to Note 3 - Related Party Transactions).
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America (GAAP) requires the Company’s management to make significant estimates and assumptions based on information available at the time the financial statements are prepared. In addition, management must ascertain the appropriateness and timing of any changes in these estimates and assumptions. Certain accounting estimates are particularly sensitive because of their significance to the Company’s financial statements and because of the possibility that subsequent events and available information may differ markedly from management’s judgments at the time financial statements are prepared. For the Company, the areas most subject to significant management judgments include reserves for property casualty losses and loss adjustment expenses, reserves for future policy benefits, deferred policy acquisition costs, valuation of investments, and reserves for pending litigation. The application of these critical accounting estimates impacts the values at which 70% of the Company’s assets and 60% of the Company’s liabilities are reported at December 31, 2006 and therefore have a direct effect on net earnings and stockholders’ equity. The Company’s “Summary of Significant Accounting Policies” is presented in Note 1 of the Notes to Consolidated Financial Statements.
Index to Financial Statements Management has discussed the Company’s critical accounting policies and estimates, together with any changes therein, with the Audit Committee of the Company’s Board of Directors. The Company’s Audit Committee has also reviewed the disclosures contained herein.
Losses and loss adjustment expenses payable are management’s best estimates at a given point in time of what the Company expects to pay claimants, based on known facts, circumstances, historical trends, emergence patterns and settlement patterns. Reserves for reported losses are established on a case-by-case basis with the amounts determined by claims adjusters based on the Company’s reserving practices, which take into account the type of risk, the circumstances surrounding each claim and policy provisions relating to types of loss. Loss and loss adjustment expense reserves for incurred claims that have not yet been reported (IBNR) are estimated based primarily on historical emergence patterns with consideration given to many variables including statistical information, inflation, legal developments, storm loss estimates, and economic conditions.
Management establishes reserves for loss adjustment expenses that are not attributable to a specific claim. These reserves are referred to as Defense and Cost Containment (DCC) and Adjusting and Other Expenses (AO). DCC and AO reserves are recorded to establish the liability for settling and defending claims that have been incurred, but have not yet been completely settled. For AO, historical ratios of AO to paid losses are developed, and then applied to the current outstanding reserves. The method uses a traditional assumption that 50% of the expenses are realized when the claim is open, and the other 50% are incurred when the claim is closed. The method also assumes that the underlying claims process and mix of business do not change materially over time.
An important assumption underlying the reserve estimation methods for the property casualty lines is that the loss cost trends implicitly built into the loss and LAE patterns will continue into the future. Some of the factors that could influence assumptions arise from a variety of sources including tort law changes, development of new medical procedures, social inflation, and other inflationary changes in costs beyond assumed levels. Inflation changes have much less impact on short-tail personal lines reserves and more impact on long-tail commercial lines. The Company does not have any significant long-tailed lines of business, so the actuarial assumptions and methodologies are consistent across all lines of business, regardless of the expected payout patterns. This is further evidenced by the fact that approximately 90% of ultimate losses for a given accident year are reported in the first year and by the end of the second year more than 99% are reported.
Benefit reserves for traditional life products are determined according to the provisions of SFAS No. 60, Accounting and Reporting by Insurance Enterprises. The methodology used requires that the present value of future benefits to be paid to or on behalf of policyholders less the present value of future net premiums (that portion of the gross premium required to provide for all future benefits and expenses) be determined. Such determination uses assumptions, including provision for adverse deviation, for expected investment yields, mortality, terminations and maintenance expenses applicable at the time the insurance contracts are issued. These assumptions determine the level and the sufficiency of reserves. The Company annually tests the validity of these assumptions.
Reserves for all other benefits are computed in accordance with presently accepted actuarial standards. Management believes that reserve amounts reflected in the Company’s balance sheet related to life products:
are based on actuarial assumptions which are in accordance with contract provisions;
Unrealized investment gains or losses on investments carried at fair value, net of applicable income taxes, are reflected directly in stockholders’ equity as a component of accumulated other comprehensive income (loss) and, accordingly, have no effect on net income. Fair values for fixed maturities are based on quoted market prices. The cost of investment securities sold is determined by using the first-in, first-out methodology. In some instances, the Company may use the specific identification method. The Company monitors its investment portfolio and conducts quarterly reviews of investments that have experienced a decline in fair value below cost to evaluate whether the decline is other than temporary. Such evaluations involve judgment and consider the magnitude and reasons for a decline and the prospects for the fair value to recover in the near term. Declines resulting from broad market conditions or industry-related events, and for which the Company has the intent to hold the investment for a period of time believed to be sufficient to allow a market recovery or to maturity, are considered to be temporary. Future adverse investment market conditions, or poor operating results of underlying investments, could result in an impairment charge in the future. Where a decline in fair value of an investment below its cost is deemed to be other than temporary, a charge is reflected in income for the difference between the cost or amortized cost and the estimated net realizable value. As a result, writedowns of $2.9 million and $20 thousand were recorded in 2006 on equity securities and fixed maturities, respectively. During 2005, writedowns of $1.0 million and $1.0 million were recorded on equity securities and fixed maturities, respectively.
As a result of the Company’s ongoing operating controls and procedures, evidence was discovered during the second quarter of 2006 suggesting irregularities in certain loan transactions within Financial. Management initiated an internal investigation with the assistance of special legal counsel, as well as an outside forensic accountant. The Chairman of the Audit Committee and the Company’s independent registered public accounting firm were notified.
The following table sets forth consolidated summarized income statement information for the years ended December 31, 2006, 2005 and 2004:
Consolidated results of operations have been impacted by the following events in 2005 and 2006:
Index to Financial Statements Property Casualty Insurance: Property casualty insurance earned and written premiums for 2006 increased $47.8 million, or 8.6% and $33.6 million, or 5.7%, respectively. In 2005, earned and written premiums increased $70.9 million and $90.2 million, respectively. The following table shows the Company’s growth in earned and written premium, comparing 2006 and 2005:
The growth in the automobile line is attributable to the addition of AVIC to the pool. AVIC writes nonstandard auto business and contributed $29.0 million of the earned premium increase and $23.8 million of the written premium increase. AIC and AGI, which have a broader line of insurance products, contributed $18.5 million of the personal and commercial lines net increase in earned premiums and $19.8 million of the personal and commercial lines net increase in written premiums. AIC and AGI’s internal growth for the automobile line was $5.5 million for earned premium and $6.4 million for written premium with a slight rate decrease in the first quarter of 2006. The homeowner line earned premium growth of $10.5 million and written premium growth of $10.7 million was impacted by three rate increases across both preferred and standard lines during 2006 and 2005. The farmowner earned and written premium growth of $1.6 million and $1.8 million, respectively, was impacted by a rate increase in the last quarter of 2005. Other personal lines earned premium growth was $467 thousand and commercial lines earned premium growth was $427 thousand.
Reinsurance ceded earned premium increased 55.4% or $1.7 million due to increases in the Company’s catastrophe reinsurance premiums. Reinsurance assumed earned premium increased 9.0% or $2.0 million due to a $2.6 million increase in the assumed premium from the state of Texas through AVIC offset by a $556 thousand decrease in the assumed reinsurance premium from Virginia Mutual’s quota share reinsurance treaty. The 26.9% decrease in reinsurance assumed written premium is related to Virginia Mutual being added to the pool in 2005 offset by increases in assumed written premium in Texas.
The property casualty subsidiaries of the Company are participants in the Pooling Agreement with the Mutual Group and Specialty. Under the Pooling Agreement, the Company’s property casualty subsidiaries along with other members of the Mutual Group cede their direct property casualty business which includes premiums, losses and underwriting expenses to Mutual. Mutual retrocedes to each participant a specified portion of premiums, losses and underwriting expenses based on each participant’s pooling percentage. The Company’s share of the pool was 65% during both 2006 and 2005, therefore pooling did not impact premium growth. Because premiums are allocated according to the Pooling Agreement, policy count data is not applicable to the Company. Refer to Note 2 - Pooling Agreement in the Notes to Consolidated Financial Statements for additional detail of the Pooling Agreement.
Life insurance premiums increased $4.9 million, or 11.9%, in 2006 and $4.0 million, or 10.8%, in 2005. The 2006 increase is primarily the result of an increase in term life premiums of $4.7 million and an increase of 7.8% in term life policies inforce year to date. The introduction of the return of premium level term life product contributed $3.1 million of the $4.9 million increase in life insurance premiums during 2006.
Life insurance policy charges increased $1.3 million, or 3.7%, in 2006 and $1.4 million, or 4.1%, in 2005. The 2006 increase of $1.3 million is primarily due to an increase in universal life policy charges resulting from increases in fund balances that the charges are assessed against along with a slight increase of 0.3% in the number of universal life policies inforce. The persistency ratio for life business was 90.7% and 91.2% at December 31, 2006 and 2005, respectively. Persistency, a non-GAAP financial measure, represents the ratio of the annualized premium of policies inforce at December 31, 2006 and 2005 as a percentage of the annualized premium paid at December 31, 2006 and 2005, respectively. The following table shows the growth in policies inforce and inforce annualized premium, on a statutory accounting basis, comparing 2006 and 2005:
Net investment income decreased $1.7 million, or 1.8%, during 2006. The year to date reduction is due to the $3.5 million increase in net loan losses as a result of collateral loans written off during the second quarter of 2006, increased interest costs on commercial paper and notes payable, declines in partnership income offset by increases in interest income on fixed maturities, dividend income on equity securities and interest income on collateral loans and short-term investments. Net investment income increased $5.6 million, or 6.2%, in 2005 due to increased partnership earnings and a slightly lower yield on increased balances of fixed income securities. Positive cash flows resulted in an increase in invested assets of 6.2% and 7.9% in the years ending December 31, 2006 and 2005.
Operating income for the property casualty subsidiaries increased by $4.8 million, or 6.0%, in 2006 and $11.5 million, or 16.7%, in 2005. In 2006, AVIC and Virginia Mutual operating income decreased $688 thousand as a result of increases in both AVIC’s loss ratio of 4.3% and loss adjustment expense (LAE) ratio of 0.1% and an 8.4% increase in Virginia Mutual’s loss ratio. AVIC’s increased production, a 1.9% improvement in its expense ratio and increases in its net investment income of $2.0 million partially offset these results. AIC and AGI operating income increased $5.5 million as a result of premium growth of 3.3% and a decline in the loss ratio of 3.3% offset by decreases in net investment income of $2.8 million and increases in the LAE ratio of 0.3% and the expense ratio of 2.0%. Upon entering the pool in 2005, AVIC and Virginia Mutual contributed $2.7 million in operating income. AIC and AGI operating income increased $8.8 million in 2005 as a result of decreases in the loss ratio of 0.7% and increases in net investment income of $4.9 million. The return on average equity for 2006 was 17.2% compared to 18.6% in 2005 and 16.7% in 2004. Return on average equity, a non-GAAP financial measure, is defined as net income divided by the simple average of beginning and ending stockholder’s equity.
Index to Financial Statements Net income improved 6.3% on a diluted earnings per share basis in 2006 compared to 2005 and increased 10.4% on a similar basis in 2005 compared to 2004.
Effective January 1, 2005, the property casualty insurance Pooling Agreement (refer to Note 2 - Pooling Agreement in the Notes to Consolidated Financial Statements) was modified as follows:
AVIC’s increase is a result of all nine states being active during 2006 and overall production increases. AVIC and Virginia Mutual premium is reported as $49.3 million of personal lines earned premiums, $481 thousand of reinsurance ceded earned premium and $24.3 million of reinsurance assumed earned premiums in the table above for 2006 and $20.0 million of personal lines, $389 thousand of reinsurance ceded and $22.6 million of reinsurance assumed premiums for 2005.
The loss ratio for 2006 related to AVIC business was 64.6% and Virginia Mutual was 57.9%, which represents 7.6% of the overall loss ratio of 58.0%. For 2005, the loss ratio for AVIC was 60.3% and Virginia Mutual was 49.5%, which represents 4.2% of the overall loss ratio of 60.1%. Also included in the loss ratio are 2.3% of catastrophe losses for 2006 and 2.1% for 2005. The Company had $13.8 million in gross catastrophe losses during 2006 due to severe weather occurring in the first and second quarters compared to $11.6 million in similar losses in the first quarter of 2005. The effect of claims from these events impacted underwriting results by $0.11 and $0.09 per share in 2006 and 2005, respectively, after taxes. The Company’s allocated share of catastrophe losses is described in Note 2 - Pooling Agreement in the Notes to Consolidated Financial Statements under the section Catastrophe Protection Program.
Property casualty insurance premiums increased $70.9 million, or 14.6% during 2005 with $42.2 million of the increase attributable to the new entrants to the pool with AVIC contributing $20.8 million and Virginia Mutual contributing $21.4 million. AIC and AGI contributed $28.7 million of the increase in property casualty premiums, with personal lines increasing $26.0 million and ceded reinsurance premiums declining $2.0 million. The decline in ceded catastrophe reinsurance premiums is related to reinstatement premiums paid in 2004 related to Hurricane Ivan catastrophic activity that were not paid in 2005. The increase in personal lines was attributable to homeowner and manufactured home premiums increasing $16.6 million, or 12.7%, automobile premiums increasing $7.2 million, or 2.4%, and farmowner premiums increasing $1.4 million, or 5.7%.
The loss ratio for the year related to the AVIC business was 60.3% and Virginia Mutual was 49.5%, which represents 4.2% of the overall loss ratio of 60.1%. Also included in the loss ratio are 2.1% of catastrophe losses. The Company had $11.6 million in gross catastrophe losses during 2005 due to severe weather occurring in the first quarter compared to $9.2 million in similar losses in 2004. The effect of claims from these events impacted underwriting results by $0.09 and $0.07 per share in 2005 and 2004, respectively, after taxes. The Company’s allocated share of catastrophe losses is described in Note 2 - Pooling Agreement in the Notes to Consolidated Financial Statements under the section Catastrophe Protection Program.
Index to Financial Statements The LAE ratio has been impacted by the addition of AVIC, which has a different expense structure than AIC and AGI. AVIC pays Vision a fee based on earned premiums to provide loss adjustment activities. This fee structure contributed 0.4% to the LAE ratio.
Net investment income increased 15.7% for 2005, compared to 21.9% for 2004. The slowdown in growth is the result of slightly lower fixed income securities yields with only a 0.5% increase in fixed income balances, offset by increases in partnership income.
Included in other income and fees in 2005 is the addition of $3.5 million of policy fees collected by AVIC.
Pretax operating income increased $4.2 million and operating income, net of tax, increased $2.7 million as a result of the addition of AVIC and Virginia Mutual business.
Net income increased 22.5% for 2005, compared to 27.0% in 2004, with AVIC and Virginia Mutual contributing $2.7 million in 2005. Return on equity was 18.6% for 2005 compared to 16.7% in 2004.
The mortality ratio increased to 104% of expected in 2006 from 96% of expected in 2005. The result was an increase of $5.3 million in benefits and claims expense for 2006. Operating expenses have increased $158 thousand for 2006 with SFAS No. 123(R) adding $289 thousand and the new policy administration system adding $2.4 million offset by decreases in legal costs of $2.5 million due to net legal reserve reductions of $2.2 million. Amortization of deferred policy acquisition costs have increased in 2006 as a result of growth in deferred costs related to consistent new business production increases in prior periods.
Operating income, net of tax, increased 10.1% during 2006 and net income increased 14.6% or $3.7 million. With an increase in realized investment gains in 2006, net income increased 14.6% compared to a decrease in net income of 4.0% in 2005, which was the result of a 51.3% decrease in realized investment gains in 2005.
Total life insurance inforce for 2005 increased $1.4 billion, with term insurance increasing $1.2 billion, or 12.4%. Annualized premiums for inforce business increased 6%, or $7.2 million, for the year, with term insurance increasing 11.6%, or $3.4 million. The persistency ratio remained steady at 91.2%.
Operating income increased 15.9% during 2005 after declining 1.5% in 2004. With a decrease in realized investment gains, net income declined 4.0% in 2005 compared to an increase in net income of 8.1% in 2004, which was the result of an increase in realized investment gains in 2004.
At December 31, 2005, the life subsidiary’s Adjusted Capital calculation in accordance with NAIC RBC guidelines was $189.9 million compared to the Authorized Control Level (Required) RBC amount of $12.9 million.
On January 3, 2005, the Company completed the purchase of Vision, a managing general agency that currently writes nonstandard automobile insurance policies in nine states. In addition, during 2005, Vision wrote a limited amount of homeowner business through other carriers as a general agency. Vision, headquartered in Brentwood, Tennessee, provides all underwriting, claims, actuarial and financial services on behalf of its contracted carriers, which includes AVIC.
On December 31, 2005, the Company completed the sale of a substantial portion of its commercial lease portfolio and other assets, net of related liabilities, to OFC Servicing Corporation, a wholly-owned subsidiary of MidCountry.
Agency operations for the year produced an increase in net income of $2.8 million. In 2006, Vision generated net income of $2.7 million due to increased production for AVIC compared to an operating loss of $86 thousand in 2005 due to infrastructure costs and lower than anticipated premium volume attributable to delays in licensing. During both 2006 and 2005, AAM and AAG produced $72 thousand in operating income.
Loan operations in Financial produced net income of $308 thousand for the year compared to $3.1 million in 2005. During the second quarter of 2006, loans were written off totaling $5.5 million as a result of fraudulent activity by one agent offset by insurance recoveries of $2 million. Despite the net increases in loan losses, loan operations continued to grow with a 3.1% increase in the loan portfolio, an increase in the loan portfolio yield to 7.88% from 7.41%, and an average delinquency ratio of 1.99%. Interest rate increases during the year reduced margins slightly. Equity in net earnings (after internal capital charge) of MidCountry increased 20.0% for the year while the carrying value increased 7.3%.
Noninsurance operating income decreased $2.2 million, or 102%, in 2005. Net loss for the year was $64 thousand.
The following discussion relates to the Company’s corporate operations and intercompany profit eliminations between the Company and its subsidiaries.
The Company has historically produced positive cash flow from operations which has resulted in increasing amounts of funds available for investment and, consequently, higher investment income. Investment income is also affected by investment yields. Information about cash flows, invested assets and yields are presented below for the years ended December 31, 2006, 2005 and 2004:
The overall yield rate, calculated using amortized cost, declined during 2006 to 5.7%. The Company had net realized investment gains before income taxes of $3.4 million in 2006 compared to realized investment gains of $6.1 million during 2005. These gains are primarily from sales of equity securities. Such realized gains on sales of equity securities are the result of market conditions and therefore can fluctuate from period to period.
The composition of the Company’s investment portfolio is as follows at December 31, 2006 and 2005:
The rating of the Company’s portfolio of fixed maturities using the Standard & Poor’s rating categories is as follows at December 31, 2006 and 2005:
Index to Financial Statements At December 31, 2006, all securities in the fixed maturity portfolio, with the exception of a single investment of $3.0 million, were rated by an outside rating service. The Company considers bonds with a quality rating of BB+ and below to be below investment grade or high yield bonds (also called junk bonds).
At December 31, 2006, approximately 37.9% of fixed maturities were mortgage-backed securities. Such securities are comprised of Collateral Mortgage Obligations (CMO’s) and pass through securities. Based on reviews of the Company’s portfolio of mortgage-backed securities, the impact of prepayment risk on the Company’s financial position and results from operation is not believed to be significant. These risks are discussed in more detail in
In our opinion, the 2006 consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of the Alfa Corporation and its subsidiaries at December 31, 2006, and the results of their operations and their cash flows for the year ended December 31, 2006 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the 2006 financial statement schedules listed in the index appearing under Item 15(a)(2) presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audit. We conducted our audit of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit of financial statements includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
As discussed in Note 14 to the consolidated financial statements, the Company changed the manner in which it accounts for share-based compensation effective January 1, 2006.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the
We have audited the accompanying consolidated balance sheet of Alfa Corporation and subsidiaries (the Company) as of December 31, 2005, and the related consolidated statements of income, stockholders’ equity and comprehensive income (loss), and cash flows for each of the years in the two-year period ended December 31, 2005. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
The consolidated financial statements include, after intercompany eliminations, Alfa Corporation and its wholly-owned subsidiaries
Alfa Corporation operates predominantly in the insurance industry. At December 31, 2006, its insurance subsidiaries write life insurance in Alabama, Georgia and Mississippi and property casualty insurance in Arkansas, Florida, Georgia, Indiana, Kentucky, Mississippi, Missouri, Ohio, Tennessee and Virginia. In addition, AVIC assumes business in Texas.
As more fully discussed in Note 2 - Pooling Agreement, the Company’s property casualty insurance business is pooled with that of the Mutual Group, which writes property casualty business in Alabama, and Specialty, which writes nonstandard auto business in Alabama, Georgia, Mississippi and Virginia. The Company’s pooled business is concentrated geographically in Alabama, Georgia and Mississippi with $528 million of premiums and policy charges, or 77%, generated during 2006 from policies written in Alabama. Accordingly, unusually severe storms or other disasters in this state might have a more significant effect on the Company than on a more geographically diversified insurance company and could have an adverse impact on the Company’s financial condition and operating results. Increasing public interest in the availability and affordability of insurance has prompted legislative, regulatory and judicial activity in several states. This includes efforts to contain insurance prices, restrict underwriting practices and risk classifications, mandate rate reductions and refunds, eliminate or reduce exemptions from antitrust laws and generally expand regulation. Because of Alabama’s low automobile rates as compared to rates in most other states, the Company does not expect the type of punitive legislation and initiatives found in some states to be a factor in its primary market in the immediate future.
The Company’s noninsurance subsidiaries are engaged in consumer financing, commercial leasing, agency operations and benefits administration.
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America 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. Estimates and assumptions are particularly important in determining reserves for future policyholder benefits, reserves for losses and loss adjustment expenses payable, evaluation of other-than-temporary impairments on investments, capitalization and amortization of deferred policy acquisition costs, and reserves relating to litigation. Actual results could differ from those estimates.
Universal Life Products: Universal life type products include universal life insurance, other interest-sensitive life insurance policies and annuity products. Universal life revenues, which are considered operating cash flows, consist of policy charges for the cost of insurance, policy administration, and surrender charges that have been assessed against policy account balances during the period. The timing of revenue recognition is determined by the nature of the charge. Cost of insurance and policy administrative charges are assessed on a monthly basis and recognized as revenue when remittances are processed. Percent of premium charges are assessed at the time of payment by the policyholder and recognized as revenue when processed. Surrender charges are recognized as revenue upon surrender of a contract by the policyholder in accordance with contractual terms. Benefit reserves for universal life represent policy account balances before applicable surrender charges. Policy benefits and claims that are charged to expense include interest credited to policy account balances on a monthly basis and death claims reported in the period in excess of related policy account balances.
Compensation cost is recognized ratably over the vesting period of the related share-based compensation award to non-retirement eligible employees. Compensation cost is recognized immediately for grants to retirement eligible employees or over the period from the grant date to the date retirement eligibility is achieved.
Fixed Maturities: Fixed maturities held for investment include investments that the Company has both the ability and positive intent to hold until maturity; such securities are reported at amortized cost. Securities available for sale include bonds and redeemable preferred stocks that the Company may elect to sell prior to maturity and are reported at their current fair value. The unrealized gains or losses on these securities are reflected in accumulated other comprehensive income within stockholders’ equity, net of taxes. Furthermore, deferred policy acquisition costs for universal and other interest sensitive life insurance products are adjusted to reflect the effect that would have been recognized had the unrealized holding gains and losses been realized. This adjustment to deferred acquisition costs results in a corresponding adjustment to comprehensive income. During 2006, the amount of this adjustment before taxes was $2.0 million. Amortization of premium or discount is calculated using the scientific (constant yield) interest method and is recorded as an adjustment to investment income. The interest method results in a constant effective yield equal to the prevailing rate at the time of purchase or at the time of subsequent adjustments to book value. Fixed maturities containing call provisions (where the issue can be called away from the Company at the issuer’s discretion) are amortized to the call or maturity value/date that produces the lowest asset value (yield to worst). For mortgage-backed and asset-backed securities, the amortization period reflects estimates of the period over which repayment of principal is expected to occur, not the stated maturity period.
At December 31, 2006, Vision had a carrier contract requiring them to fund a collateral trust based on a percentage of written premiums. The primary purpose was to provide collateral for the payment of all obligations and performance of all duties set forth in the contract. The amount in the trust is reviewed on an annual basis and adjusted accordingly. The amount of cash restricted at December 31, 2006 and 2005 was $982 thousand and $957 thousand, respectively.
Accounts receivable are primarily comprised of premium installment plan receivables from policyholders and insurance carrier receivables. The allowance for doubtful accounts at December 31, 2006 and 2005 was $1.5 million and $585 thousand, respectively.
Property Casualty Products: Acquisition costs for property casualty insurance are amortized over the period in which the related premiums are earned.
Other Derivative Instruments: Covered call options are contracts that grant the purchaser, for a premium payment, the right, but not the obligation, to purchase a financial instrument at a specified price within a specified period of time. The Company writes (sells)
Index to Financial Statements call options on certain common stocks it already owns to enhance returns to the extent of the premium received. The premium received for a written call option is recorded in other liabilities until the option is exercised, expires, or is otherwise terminated. On disposition, gains (losses) are recognized immediately, with gains (losses) on exercise combined with gains (losses) on the covering asset. The liability is marked to market at each statement date with the changes in the market value of the open options recognized as realized gains (losses) and recorded in the statement of income. The Company had $132 thousand and $50 thousand in options outstanding at December 31, 2006 and 2005, respectively.
The Mutual Group is a direct writer primarily of personal lines property casualty insurance in Alabama. Specialty is a direct writer in Alabama, Georgia, Mississippi, and Virginia. At December 31, 2006, the Company’s subsidiaries similarly are direct writers in: Arkansas, Florida, Georgia, Indiana, Kentucky, Mississippi, Missouri, Ohio, Tennessee and Virginia; and assumes business from Texas. Virginia Mutual is a direct writer in North Carolina and Virginia. Effective January 1, 2007, Alliance is also a direct writer in Tennessee.
Under the Pooling Agreement, each participant cedes premiums, losses, and underwriting expenses on all of their direct property casualty business to Mutual, and Mutual in turn retrocedes to each participant a specified portion of premiums, losses, and underwriting expenses based on each participant’s pooling percentage. The Mutual Group’s and Specialty’s direct property casualty business (together with the property casualty business ceded by the Company) is included in the pool.
As a result of the Pooling Agreement, the Company had receivables of $2.4 million and $9.3 million from the Mutual Group at December 31, 2006 and 2005, respectively, for transactions originating in December and settled the following month.
On October 1, 1996, the Pooling Agreement was amended in conjunction with the restructuring of the Alfa Insurance Group’s catastrophe protection program. Effective November 1, 1996, the allocation of catastrophe costs among the members of the pool was changed to better reflect the economics of catastrophe finance. The amendment limited the Company’s participation in any single catastrophic event or series of disasters to its pool share (65%) of a lower catastrophe pool limit unless the loss exceeded an upper catastrophe pool limit. In cases where the upper catastrophe limit is exceeded on a 100% basis, the Company’s share in the loss would be based upon its amount of surplus relative to other members of the group. Lower and upper catastrophe pool limits are adjusted periodically due to increases in insured property risks. The limits and participation levels since inception of the program are summarized below:
The Company incurred catastrophe losses of $13.8 million, $11.6 million, and $9.2 million in 2006, 2005, and 2004, respectively. These losses resulted in reductions to the Company’s net income of $0.11, $0.09, and $0.07 per diluted share, after reinsurance and taxes in the respective years.
outside of Alabama. The Pooling Agreement is intended to reduce conflicts that could arise in the selection of risks to be insured by the participants by making the results of each participant’s operations dependent on the results of all of the pooled business. Accordingly, the participants should have substantially similar loss ratios for the pooled business excluding catastrophes as long as the Pooling Agreement remains in effect.
Under a Management and Operating Agreement, Mutual provides substantially all facilities, management and other operational services to the Company and its subsidiaries and to other companies associated with Mutual. Most of the personnel providing management services to the Company are full-time employees of, and are directly compensated by, Mutual. The Company’s business is substantially integrated with that of Mutual, Fire and General. Mutual periodically conducts time usage and other special expense allocation studies. Mutual charges the Company for its allocated and direct salaries, employee benefits and other expenses, including those for the use of office facilities. The amounts paid by the Company to Mutual under the Management and Operating Agreement were $65.9 million in 2006, $61.8 million in 2005 and $50.7 million in 2004. The Company reimburses Mutual for the full amount of all its agents’ commissions paid by Mutual for the sale of the Company’s insurance products.
The Mutual Group is a partner in a real estate partnership, which in 2000 established a revolving line of credit with Financial of $4.0 million at a rate of interest equal to the prime lending rate less 1.0%. During 2002, this line of credit was increased to $5.0 million. At December 31, 2006 and 2005, the amount loaned to the partnership under the line of credit was $3.6 million and $4.0 million, respectively. Interest earned by Financial from the partnership was $271 thousand, $235 thousand and $158 thousand in 2006, 2005, and 2004, respectively.
On February 1, 1997, Mutual began covering its employees with a Corporate Owned Life Insurance (COLI) plan utilizing Life’s universal life product. Premiums paid to Life totaled $18.5 million in 2006, $17.9 million in 2005 and $17.9 million in 2004. Policy charges recorded from such premiums totaled $4.0 million in 2006, $3.8 million in 2005 and $3.5 million in 2004. Policy reserves and insurance in force on the COLI plan at December 31, 2006 were $169.9 million and $748.2 million, respectively. Certain of Mutual’s employees and those of the Mutual Group’s sponsoring organization, the Alabama Farmers Federation (Federation), not covered by the COLI plan are covered by group life insurance provided by Life. During 2002, certain retired employees of Virginia Mutual also began being covered by group life insurance provided by Life. Contingency reserves held for this group as of December 31, 2006 and 2005 were $142 thousand and $166 thousand, respectively. Group life insurance premiums paid to Life totaled $493 thousand in 2006, $517 thousand in 2005 and $492 thousand in 2004. Insurance inforce under this plan at December 31, 2006 was $48.0 million. Reserves for group life insurance represent the excess present value of future guaranteed benefits over future premiums plus any unearned premium. Since this one-year term contract renews on January 1 of each year at the discretion of each party, there is no future excess present value of future guaranteed benefits over future premiums at December 31. Since all of the certificates have a renewal date of January 1, the premium for each certificate is fully earned on the following December 31 and no unearned premium liability is present. This reserving method has been used since the Company’s inception. The only change in resulting reserves in recent years occurred when the plan year was adjusted to coincide with the calendar year.
During 1999, the Company formed a subsidiary, ABC, to administer nonqualified employee and director benefit plans on behalf of Mutual. As a result, the accrued benefit liabilities held by the various Alfa property casualty entities and their related assets were transferred to ABC at that time. The amounts of net transfers from ABC to Mutual in 2006 and 2005 for payments of benefits totaled $1.0 million and $763 thousand, respectively.
Financial leases equipment, automobiles, furniture and other property to the Mutual Group and its affiliates. The Mutual Group and its affiliates paid $4.0 million in 2006, $3.4 million in 2005 and $3.4 million in 2004 under these leases. Periodically, the Mutual Group invests in automobile and other installment loans issued and serviced by Financial. The amount invested by the Mutual Group in such loans was $8.3 million at December 31, 2006. The Mutual Group held no such investment in these loans at December 31, 2005. Interest paid by Financial to the Mutual Group on these loans was $334 thousand in 2006, $200 thousand in 2005 and $321 thousand in 2004. The Alabama Farmers Federation (Federation) and Alfa Services, Inc. (Services), a Federation subsidiary, invest in short-term lines of credit with the Company and Financial. The balance outstanding on these lines of credit included in notes payable to affiliates was $19.3 million and $20.9 million at December 31, 2006 and 2005, respectively. Interest paid by the Company and Financial to the Federation and its subsidiary was $1.0 million in 2006, $502 thousand in 2005 and $166 thousand in 2004.
Index to Financial Statements In 2004 prior to its being sold, the Company’s real estate construction subsidiary, Builders, purchased 6 residential lots at fair value for $292 thousand from a partnership in which the Mutual Group is a partner.
The Company’s life subsidiary is a general partner in two investment partnerships with a trust created by Mutual and Fire. The carrying value of the partnerships was $1.1 million and $987 thousand at December 31, 2006 and 2005, respectively.
On December 31, 2005, the Company completed the sale of Financial’s leasing division, OFC Capital, to OFC Servicing Corporation, a subsidiary of MidCountry that continues to service the Company’s retained commercial lease portfolio. Service fees incurred by the Company in 2006 were $908 thousand. Included in other long-term investments in affiliates at December 31, 2006 and 2005, respectively, is a note receivable of $33.0 million and $55.5 million related to the sale transaction. Interest received from OFC Servicing Corporation during 2006 was $1.8 million.
Index to Financial Statements The cost and estimated fair value of investments in equity securities are as follows:
Of the 236 fixed maturities in an unrealized loss position at December 31, 2006, the majority are mortgage-backed securities. Of the $11.7 million in unrealized losses on mortgage-backed securities, the majority was issued by governmental agencies. Therefore, return of principal is not currently an issue. Similarly, the interest rate environment has been the primary cause of the other fixed maturity loss positions in the portfolio. While unrealized gains and losses will fluctuate with interest rate changes, receipt of principal is highly probable if these securities are held to maturity. The Company reviews securities for impairment each quarter and considers its intent and ability to hold any debt securities in a loss position until the fair value recovers. Information used in the assessment for impairment includes industry analyst reports, credit ratings, and the volatility of the security’s market price.
There were 34 equity positions with unrealized losses at December 31, 2006. In the twelve months or more category, one position comprised 20.2% of the total gross unrealized losses. Also included in the twelve months or more category, mutual fund holdings totaling 14.7% of the total gross unrealized losses support a non-qualified deferred compensation plan and it is the Company’s intent to hold through the period of recovery. No other single holding in an unrealized loss position comprised over 15% of the total gross unrealized losses.
The amortized cost and estimated fair value of fixed maturities available for sale at December 31, 2006 by contractual maturity are shown below. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
Proceeds from sales of fixed maturities available for sale were $101.7 million in 2006, $108.4 million in 2005 and $61.4 million in 2004. Gross gains of $1.2 million in 2006, $427 thousand in 2005 and $391 thousand in 2004 and gross losses of $1.3 million in 2006, $2.2 million in 2005 and $952 thousand in 2004 were realized on those sales. In addition, the Company recorded a loss of $20 thousand in 2006, $1.0 million in 2005 and $111 thousand in 2004 for fixed maturities available for sale whose valuation was
deemed to be an other than temporary decline. At December 31, 2006, the Company’s mortgage-backed securities were comprised of CMO’s and pass through securities. The valuation of such securities is subject to significant fluctuations due to changes in interest rates. The Company has a history of positive cash flow and has the ability to hold such investments to maturity. Management performs periodic assessments of the portfolio to monitor interest rate fluctuations. At December 31, 2006, the Company had $4.8 million in fixed maturities available for sale on deposit with regulatory agencies in order to meet statutory requirements.
The Company’s fixed maturity portfolio is predominantly comprised of investment grade securities. At December 31, 2006, $6.4 million in fixed maturities (0.4% of the total fixed maturity portfolio) are considered below investment grade. The Company considers bonds with a quality rating of BB+ and below, based on Standard & Poor’s rating scale, to be below investment grade. A single investment of $3.0 million was not rated at December 31, 2006.
losses on disposal, included in other assets of $551 thousand and $1.5 million subject to individual valuation at December 31, 2006 and 2005, respectively. Leases that are more than 90 days late are placed in a nonaccrual status and totaled $459 thousand and $9.9 million at December 31, 2006 and 2005, respectively.
Partnerships and Equity Method Investments: Investments in partnerships, joint ventures and unconsolidated investee companies are stated at the underlying audited equity value based on accounting principles generally accepted in the United States of America. Income is recognized based on reported earnings by the partnerships, joint ventures and companies. Partnership interests represent 79.3%, or $68.9 million, of other long-term investments at December 31, 2006 and 74.5%, or $48.0 million at December 31, 2005. Similarly, partnership interests represent 19.9%, or $24.0 million, of other long-term investments in affiliates at December 31, 2006 and 15.6%, or approximately $21.6 million at December 31, 2005.
In 2005, the Company recorded goodwill related to the purchase of Vision in the amount of $13.9 million and other intangible assets in the amount of $9.1 million. Vision is reported in the noninsurance segment.
The Company evaluated its final allocation of purchase price and has adjusted its goodwill carrying value by $4.3 million as of December 31, 2006.
Changes in other intangible assets by asset class for 2006 and 2005 are as follows:
For the year ended December 31, 2006, premiums under individual ordinary life insurance participating policies were $5.2 million, or 4% of total premiums collected. The Company accounts for its policyholder dividends based upon dividends apportioned for payment for the next year plus any adjustments for dividends paid differently from those apportioned in the prior year. Total policyholder dividends incurred for 2006 were $4.1 million. The Company paid dividends in the amount of $4.1 million during 2006 to policyholders and did not allocate any additional income to such policyholders. The Company did not issue any participating policies during 2006. The amount of insurance inforce on participating policies represents 1% of ordinary life insurance inforce or $230 million.
Index to Financial Statements The Company is primarily an insurer of private passenger motor vehicles and of single-family homes and has limited exposure for difficult-to-estimate claims such as environmental, product and general liability claims. The Company does not believe that any such claims will have a material impact on the Company’s liquidity, results of operations, cash flows or financial condition. Deducted from the liability for estimated unpaid losses and loss adjustment expenses are the Company’s estimates of salvage and subrogation recoverable of $11.6 million and $9.8 million at December 31, 2006 and 2005, respectively.
Total income tax expense (benefit) for the years ended December 31 was recorded in the financial statements as follows:
At December 31, 2005, the Company established a deferred tax asset for $3.2 million related to future tax benefits in ABC resulting from the transfer of liabilities to ABC when it was formed in 1999. The provision for deferred income taxes was increased by $1.6 million as a result of previously recognized tax benefits in ABC.
The Company has not recognized any deferred taxes for differences between its financial statement carrying amount and its adjusted tax basis of investments in subsidiaries. The amount is not determinable at this time. In the event the Company disposes of one or more of its subsidiaries, it has the ability and intent to liquidate these subsidiaries in a tax-free manner. Therefore, the tax effects of such differences are not required to be recognized. Deferred taxes will be recognized when the Company expects that it will liquidate these subsidiaries in a taxable manner, such as a taxable sale of the investments.
The Company uses variable-rate debt to partially fund its consumer loan and commercial lease portfolios. In particular, it has issued variable-rate long-term debt and commercial paper. These debt obligations expose the Company to variability in interest payments
The Company issued a variable-rate $70 million long-term obligation maturing on June 1, 2017 in the second quarter of 2002 as a means of funding the collateral loan and commercial lease portfolios. Refer to Note 1 - Summary of Significant Accounting Policies for discussions about the Company’s cash flow hedge.
One purported class action lawsuit is pending against both Alfa Builders, Inc. and Fire. Additionally, two purported class action lawsuits are pending against the property casualty companies involving a number of issues and allegations which could affect the Company because of the Pooling Agreement between the companies. No class has been certified in any of these three purported class action cases. In the event a class is certified in any of these purported class actions, reserves may need to be adjusted.
Index to Financial Statements Based upon information presently available, management is unaware of any contingent liabilities arising from other threatened litigation that should be reserved or disclosed.
Unfunded Commitments: The Company periodically invests in affordable housing tax credit partnerships. At December 31, 2006, the Company had legal and binding commitments to fund partnerships of this type in the amount of $37.3 million. These commitments are included in other liabilities in the consolidated balance sheet and are, therefore, excluded from the table below.
Components of comprehensive income are depicted in the Consolidated Statements of Stockholders’ Equity. The reclassification adjustment for net realized investment gains, net of tax, was $2.2 million in 2006, $3.9 million in 2005 and $4.6 million in 2004. Refer to Note 9 - Income Taxes for the income tax expense (benefit) allocated to each component of accumulated other comprehensive income.
The Company’s investment in affiliated equity-method investments have resulted in cumulative earnings of $6.3 million that are included as a part of retained earnings that have not yet been distributed.
Statutory Practices: Generally accepted accounting principles differ in certain respects from the statutory accounting practices prescribed or permitted by insurance regulatory authorities. Prescribed statutory accounting practices include state laws, regulations, and general administrative rules, as well as a variety of publications of the National Association of Insurance Commissioners (NAIC). Permitted statutory accounting practices encompass all accounting practices that are not prescribed. Such practices differ from state-to-state, may differ from company-to-company within a state, and may change in the future. Currently, the Company’s statutory net income is the same and the surplus is not significantly different under the State of Alabama and NAIC accounting practices. The amounts of statutory net income and stockholders’ equity for the Company’s life and property casualty insurance subsidiaries are as follows:
Regulatory Requirements: At December 31, 2006, the life subsidiary’s Adjusted Capital calculated in accordance with NAIC Risk-Based Capital guidelines was $215.3 million, compared to the Authorized Control Level amount of $12.9 million, and the property casualty subsidiaries’ Adjusted Capital was $450.7 million, compared to the Authorized Control Level amount of $35.7 million. The Risk-Based Capital analysis serves as the benchmark for the regulation of insurance enterprises’ solvency by state insurance regulators.
In October 1989, the Company’s Board of Directors approved a stock repurchase program authorizing the repurchase of up to 4,000,000 shares of its outstanding common stock in the open market or in negotiated transactions in such quantities and at such times and prices as management may decide. In March 1999 and in September 2001, the Company’s Board of Directors increased the number of shares authorized to be repurchased by 4,000,000 shares, bringing the total number of shares authorized to be repurchased to 12,000,000. The Company uses the first-in, first-out method when reissuing treasury stock.
The Company’s insurance subsidiaries follow the customary industry practice of reinsuring a portion of their exposures and paying to the reinsurers a portion of the premiums received. Insurance is ceded principally to reduce net liability on individual risks or for individual loss occurrences, including catastrophic losses. Although reinsurance does not legally discharge the individual subsidiary from primary liability for the full amount of limits applicable under their policies, it does make the assuming reinsurer liable to the extent of the reinsurance ceded. The Company evaluates the financial condition of its reinsurers and monitors concentration of credit risk arising from similar geographic regions, activities, or economic characteristics of the reinsurance to minimize exposure to significant losses from reinsurance insolvencies. Failure of reinsurers to honor their obligations could result in losses to the Company; therefore, allowances are established if amounts are believed to be uncollectible. At December 31, 2006 and 2005, there were no amounts deemed uncollectible. At December 31, 2006, the Company does not believe there to be a significant concentration of credit risk related to its reinsurance program.
Effective July 1, 2006, Life entered into a new Accidental Death Catastrophic Reinsurance Agreement. The new agreement covers accidental death exposure in the portfolio by providing attritional and catastrophic protection with Life retaining the first $7.5 million of claims. Coverage includes acts of terrorism, but excludes war, armed forces active duty, professional sports teams, credit card business and liability from any pool.
The Company’s subsidiaries participate in a small number of involuntary pools and underwriting associations on a direct basis and receive a proportional share through the Pooling Agreement. In addition, the Company receives a proportional share of Fire’s quota share reinsurance treaty with Virginia Mutual through the Pooling Agreement. AVIC directly participates in a reinsurance program in the state of Texas assuming non-standard automobile business which is retroceded to the pool.
Effective January 1, 2006, the Company adopted Statement of Financial Accounting Standard (SFAS) No. 123 (revised 2004), Share-Based Payment, using the modified prospective transition method. Under this method, share-based compensation expense is recognized using the fair-value based method for all awards granted on or after the date of adoption. Compensation expense for unvested stock options and awards that were outstanding on December 31, 2005 will be recognized over the requisite service period based on the grant-date fair value of those options and awards as previously calculated under the pro forma disclosures under SFAS No. 123, Accounting for Stock-Based Compensation. The Company determined the fair value of these awards using the Black-Scholes-Merton option pricing model. Under SFAS No. 123(R), an estimate is made for the number of awards that are expected to vest and this forfeiture rate is applied to determine the amount of compensation cost to be recognized. The forfeiture rate must be evaluated at each reporting period to determine if any changes should be made which could impact the amount of compensation cost that will be ultimately recognized. In addition, the non-substantive vesting period approach is used for attributing stock compensation to individual periods for awards to retirement eligible employees, which requires recognition of compensation expense immediately for such grants or over the period from the grant date to the date retirement eligibility is achieved. This change will not affect the overall amount of compensation expense to be recognized but will impact the timing of expense recognition. The effect on the amount of expense the Company recorded in 2006 was an increase of $950 thousand. In accordance with the modified prospective transition method, results for prior periods have not been restated.
Index to Financial Statements Prior to adoption and consistent with the provisions of SFAS No. 123, the Company used the intrinsic value based method to account for stock options issued under the 1993 Plan and provided pro forma disclosures as if the fair value based method had been applied. The Company accounted for the 2005 Plan under SFAS No. 123 using the recognition and measurement principles of the fair value method.
The weighted-average grant-date fair value of options granted for the year was $5.97 in 2006, $6.09 in 2005 and $5.69 in 2004.
At December 31, 2006, there was $1.8 million of unrecognized compensation expense related to nonvested stock options granted that are expected to be charged to expense over a weighted-average period of 1.09 years. This expense will be allocated according to Alfa’s Management and Operating Agreement.
The total fair value of shares vested during 2006, 2005 and 2004, was $199 thousand, $0 and $0, respectively. During 2006, 12,271.4447 shares were released with 12,271 shares issued from treasury shares and fractional shares paid in cash.
The Company leases certain office facilities and equipment from Financial and third parties under various operating leases. Profits from related party leasing transactions are eliminated within the corporate segment. These leases expire at various dates through 2010. Vision’s office facility lease agreement contains scheduled rent increases over the term of the lease. At December 31, 2006, the aggregate minimum rental payments to be made under leases having initial or remaining lease terms in excess of one year are $1.4 million in 2007, $965 thousand in 2008, $789 thousand in 2009, $333 thousand in 2010 and $0 thereafter. Certain leases are subject to allocation under a Management and Operating Agreement (refer to Note 3 - Related Party Transactions) and the Pooling Agreement (refer to Note 2 - Pooling Agreement). Lease expense incurred for these leases, prior to allocation, was $1.3 million in 2006, $1.5 million in 2005 and $549 thousand in 2004.
At December 31, 2006 and 2005, future minimum lease payments to be received on leases are $2.2 million and $11.7 million respectively; with separate deductions for allowance for uncollectible minimum lease payments receivable of $1.2 million and $8.1 million, respectively. Unguaranteed residual values accruing to the benefit of the lessor total $743 thousand and $895 thousand at December 31, 2006 and 2005, respectively. Initial direct costs and unearned income at December 31, 2006 are $0 and $156 thousand, respectively. Initial direct costs and unearned income at December 31, 2005 are $0 and $2.0 million, respectively.
The Company leases certain equipment under agreements that are classified as capital leases. The cost of equipment under capital leases included in other assets was $185 thousand at both December 31, 2006 and 2005. Accumulated amortization of the leased equipment at December 31, 2006 and 2005 was $172 thousand and $61 thousand, respectively. Amortization of assets under capital leases is included in depreciation expense. At December 31, 2006, future minimum lease payments required under the capital leases are $21 thousand in 2007 and $0 thereafter.
Basic earnings per share (EPS) is computed by dividing net income by the weighted average number of shares outstanding. Diluted EPS is computed similarly except that the shares outstanding are increased to give effect to all potentially dilutive shares that would have been outstanding if such shares had been issued. Dilutive shares are the result of stock options outstanding and nonvested restricted stock awards.
The following table presents the Company’s noncash investing and financing activities and required supplemental disclosures to the Statements of Cash Flows for the years ended December 31, 2006, 2005, and 2004:
Financial Statements. SAB 108 requires that public companies use a “dual-approach” in assessing the quantitative effects of financial misstatements. This dual approach includes both an income statement focused assessment and a balance sheet focused assessment. This bulletin must be applied to financial statements for fiscal years ending after November 15, 2006. This bulletin has not had a significant impact on the Company’s financial position or results of operations.
The FASB issued SFAS No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106 and 132(R), in September 2006. This statement requires a company to recognize on a prospective basis an asset for a plan’s overfunded status or a liability for a plan’s underfunded status in its statement of financial position, to measure a plan’s assets and its obligations that determine its funded status as of the end of the employer’s fiscal year, and to recognize changes in the funded status of a defined postretirement plan in the year in which the changes occur as a component of other comprehensive income. The requirement to recognize the funded status of a benefit plan and the disclosure requirements of the statement are effective for fiscal years ending after December 15, 2006. The requirement to measure the plan assets and benefit obligations as of the date of the employer’s fiscal year-end statement of financial position is effective for fiscal years ending after December 15, 2008. The Company has no management or operational employees. Refer to Item 1. for a more detailed discussion of personnel. As discussed in Note 21 - Plan of Conversion of Virginia Mutual Insurance Company, the Company executed a Plan of Conversion of Virginia Mutual Insurance Company during the third quarter of 2006. Virginia Mutual Insurance Company had a frozen defined benefit retirement plan at December 31, 2006. Virginia Mutual Insurance Company has been restructured to form a new subsidiary of the Company effective January 1, 2007. Since the Company did not have any plans impacted by this statement at December 31, 2006, it had no impact on the Company’s financial position or results of operations during 2006. Due to its new subsidiary’s frozen plan, the Company adopted this statement on January 1, 2007 with no significant impact on the Company’s financial position or results of operations.
The FASB issued SFAS No. 156, Accounting for Servicing of Financial Assets, an Amendment of Statement No. 140, in March 2006. This statement will require entities to recognize a servicing asset or liability each time it undertakes an obligation to service a financial asset by entering into a servicing contract in certain situations. It also requires all separately recognized servicing assets and servicing liabilities to be initially measured at fair value and allows a choice of either the amortization or fair value measurement method for subsequent measurement. SFAS No. 156 is effective for annual periods beginning after September 15, 2006. The Company has reviewed the guidance of SFAS No. 156 and believes that the adoption of this statement on January 1, 2007 will not have a significant impact on the Company’s financial position or results of operations.
types of assets and liabilities. The standard also requires additional information to aid financial statement users’ understanding of a reporting entity’s choice to use fair value on its earnings and also requires entities to display on the face of the balance sheet the fair value of those assets and liabilities for which the reporting entity has chosen to measure at fair value. SFAS No. 159 is effective for fiscal years beginning after November 15, 2007. Early adoption is permitted as of the beginning of the previous fiscal year provided the entity makes that choice in the first 120 days of that fiscal year and also elects to apply the provisions of SFAS No. 157. Since application of the standard is optional, any impacts are limited to those financial assets and liabilities to which SFAS No. 159 would be applied. These impacts have yet to be determined, as is any decision concerning the early adoption of the standard.
In September 2005, the American Institute of Certified Public Accountants issued Statement of Position (SOP) 05-1, Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection With Modifications or Exchanges of Insurance Contracts. This statement provides guidance on accounting for deferred acquisition costs on an internal replacement. Transactions are accounted for as an internal replacement, as defined by this statement, when a policyholder requests a change not within the terms of the original contract and the change is deemed by the Company to be significant and integrated. For internal replacements of insurance products, the unamortized balance of acquisition costs previously deferred under the original contracts is charged to income. The new acquisition costs associated with the replacement are deferred and amortized to income. The guidance in this pronouncement is effective for fiscal years beginning after December 15, 2006. The Company adopted SOP 05-1 on January 1, 2007 and estimates that its adoption will not have a significant impact on the Company’s financial position or results of operations.
Effective January 1, 2007, the Pooling Agreement was amended to update the limits and participation levels. The Company’s lower catastrophe pool limit increased $200 thousand to $21.4 million and the upper catastrophe pool limit increased $5.0 million to $530.5 million (refer to Note 2 - Pooling Agreement).