In 1998, Star purchased land located at 26255 American Drive, Southfield, MI, which is in close proximity to its existing offices. The cost of the land was $3.2 million.
In 2000, Savers purchased a building, located at 12641 East 166th Street, Cerritos, CA, for $2.0 million. Crest has its operations in this building.
The Company has a $47.5 million line of credit with its primary lender. As of December 31, 2001, the Company had $47.5 million outstanding on this line of credit. Under the current loan agreement, the Company is required to reduce the amount outstanding by $11.3 million by June 30, 2002 and an additional $12.3 million by December 31, 2002. This line of credit bears interest at a variable margin over the prime rate. As of December 31, 2001, the prime rate was 4.75% and the variable margin was 1.5%.
Absent the sale of assets or other capital raising events, the Company may not have the liquidity in its non-regulated subsidiaries to make the required payments pursuant to the revised pay-down schedule on or after the scheduled payment of $10.8 million on June 30, 2002. Furthermore, if repayment is required due to default, the Company currently does not have sufficient cash to repay the balance. As part of the loan agreement, certain of the Company’s non-regulated subsidiaries guaranteed repayment of the line of credit and the Company pledged the stock of its non-regulated subsidiaries as collateral. In the event of default, the banks would have the right to sell the Company’s non-regulated subsidiaries and apply the proceeds to the balance on the line of credit.
At December 31, 2001, the Company had a deferred tax asset of $24.5 million, $11.8 million of which is related to a net operating loss carryforward (“NOL”). Realization of the deferred tax asset is dependent on generating sufficient taxable income to absorb both the applicable reversing temporary differences and the NOL. Although realization is not assured, management believes that it is more likely than not that current tax strategies, which include potential sale of assets and/or subsidiaries, and the ongoing results from operations excluding the discontinuation of seven specific unprofitable programs, will generate sufficient taxable income to realize the deferred tax asset. If the Company is unable to execute these tax strategies or generate sufficient taxable income, the establishment of a valuation allowance may be required. The NOL of $11.8 million was generated from losses occurring in 1999, 2000, and 2001, which, if unused, will begin to expire in 2019.
On July 31, 1998, the Company acquired Florida Preferred Administrators, Inc. (“Florida Preferred”) and Ameritrust Insurance Corporation (“Ameritrust”), at a purchase price of $12.3 million, resulting in goodwill of $7.0 million. Florida Preferred, a Florida-based third party administrator, provides a broad range of risk management services to purchasers of workers’ compensation insurance from Ameritrust, as well as other insurance carriers. This acquisition was subject to a contingent earn-out provision, which was finalized in 2000. During 2000, the Company paid approximately $4.7 million to the former shareholders under this provision.
Annually, the Company evaluates the net carrying value of goodwill to determine if there has been any impairment in value. The methodology used for this evaluation entails review of current market values of subsidiaries, and annual operating performance along with anticipated results for the ensuing year based on operating budgets and forecasts. At December 31, 2001 the Company concluded that there had been no impairment in the net carrying value of goodwill.
The Company’s investment securities at December 31, 2001 and 2000 are classified as available for sale. Investments classified as available for sale securities are available to be sold in the future in response to the Company’s liquidity needs, changes in market interest rates, tax strategies and asset-liability management strategies, among other reasons. Available for sale securities are reported at fair value, with unrealized gains and losses reported in the accumulated other comprehensive income component of shareholders’ equity, net of deferred taxes.
Realized gains or losses on sale or maturity of investments are determined on the basis of specific costs of the investments. Discount or premium on debt securities purchased at other than par value is amortized using the constant yield method. Investments with other than temporary declines in fair value are written down to estimated fair value and the related realized losses recognized in income. There were $1,293,637 in impaired investments written down in 2001, and none in 2000 and 1999. The Company had gross unrealized losses of $711,000 on investments having a fair value of $21.8 million. These gross unrealized losses were deemed not to be other than temporarily impaired.
Premiums written are recognized as earned on a pro rata basis over the life of the policy term. Unearned premiums represent the portion of premiums written that are applicable to the unexpired terms of policies in force. Provisions for unearned premiums on reinsurance assumed from others are made on the basis of ceding reports when received. Certain premiums are subject to retrospective premium adjustments. The estimated ultimate premium is recognized over the term of the insurance contract.
The Company occasionally guarantees the financing of policies it writes. No material premium financing guarantees were in effect at December 31, 2001.
In December 1998, CSC entered into an agreement with Evergreen National Indemnity Company to transfer most of its contract surety business it wrote on behalf of Star. The agreement provides for the transfer of the underwriting risk on this class of bonds from CSC to Evergreen National Indemnity Company.
Effective May 26, 2000, CSC executed a Subordinated Surplus Note in favor of Star in the principal sum of $195,000. Fifty percent of the principal amount was due on May 26, 2001; the outstanding balance, together with all unpaid interest, is due on May 26, 2002. Interest earns at 9% per annum, with interest payments to be made quarterly, subject to all terms and conditions of the Note. Effective May 26, 2000 and July 14, 2000, Connecticut Surety Corporation executed Promissory Notes in favor of the Company in the amounts of $30,000 and $270,000, due on May 26, 2003 and July 14, 2003, respectively. Interest earns at 9% per annum, payable semi-annually beginning on December 31, 2000, subject to the terms and conditions of the Notes. Furthermore, Star purchased a portion of CSC’s outstanding loan with Fleet Bank for $124,800. Interest and
The underwriting losses associated with these seven programs were $12.8 million, $29.0 million, and $12.0 million for the years ended December 31, 2001, 2000, and 1999, respectively. At December 31, 2001, the amount of unearned premium associated with these programs was $3.2 million.
Meadowbrook-Villari Agency, a Florida-based insurance agency, offered professional liability products and programs, group health and disability, and property and casualty products. Effective July 1, 2001, the Company sold the business of Meadowbrook-Villari Agency. It is anticipated this sale will result in a reduction of annualized agency revenue of approximately $3.2 million, but should not have a material impact on the Company’s overall results of operations. The Company recorded a loss of $1,097,000 in conjunction with the sale.
Results from operations improved $11.0 million from a net loss of $17.5 million in 2000 to a net loss of $6.5 million in 2001. The net loss in 2001 reflects the impact of pre-tax adverse development of $14.4 million on net reserves. The adverse development reflects $5.2 million relating to unprofitable discontinued programs, $4.5 million relating to the provision for uncollectible reinsurance on CSC and HIH America Compensation & Liability Company (“HIH”), a California domiciled insurance company, which was seized by the California Department of Insurance, and the remaining development related to claims activity on the auto liability line of business. In addition, the Company incurred provisions for pre-tax impairments in the investment in CSC surplus notes of $870,000 and recorded a loss of $1.1 million on the sale of the Meadowbrook-Villari Agency. The 2000 results also reflected significant adverse development related to the discontinued programs mentioned above.
The following table sets forth the revenues and results from operations for program business (in thousands):
growth in net earned premiums to $163.7 million in the year ended December 31, 2001 from $146.0 million in the comparable period in 2000, and is the result of growth in existing programs both from increasing policy count and rate increases. These increases were partially offset by the impact of the purchase of a large quota share reinsurance treaty for several workers’ compensation programs and the decline in written premium from programs previously discontinued. Management fees grew $952,000, or 3.9%, to $25.5 million from $24.5 million. Primarily, this increase resulted from a profit sharing fee of $1.6 million related to the good experience achieved on a loss portfolio transfer and new business growth of $1.0 million, which amounts were partially offset by fees related to discontinued or inactive managed programs. The remaining increase reflects a $513,000, or 3.8%, increase in investment income to $14.2 million in 2001 from $13.7 million in 2000.
This increase reflects both a 1.2% increase in average invested assets, from operating cash flows, and a decrease in pre-tax yields to 5.64% in 2001 from 6.23% in 2000.
The principal sources of funds for the Company and its subsidiaries are insurance premiums, investment income, proceeds from the maturity and sale of invested assets, risk management fees, and agency commissions. Funds are primarily used for the payment of claims, commissions, salaries and employee benefits, other operating expenses, shareholder dividends, and debt service. The Company generates operating
cash flow from non-regulated subsidiaries in the form of commission revenue, outside management fees, and intercompany management fees. These sources of income are used to meet debt service, shareholders’ dividends, and other operating expenses of the holding company and non-regulated subsidiaries. Earnings before interest, taxes, depreciation, and amortization from non-regulated subsidiaries were approximately $14.0 million in 2001. These earnings were available for debt service.
Cash flow used in operations was $2.8 million in 2001, compared to cash flow provided by operations of $24.0 million, $23.6 million in 2000, and 1999, respectively. As anticipated by management, the decrease in cash flow in 2001 reflects the acceleration in the payment of previously reserved claims, which more than offset the growth in gross and net written premiums. The positive cash flow in 2000 and 1999 reflects growth in gross and net written premium and the strengthening of case and incurred but not reported (“IBNR”) reserves that did not require immediate cash payments in those years. Absent a capital contribution or the sale of a portion of the Company’s assets, as discussed below, the Company plans to reduce gross and net written premium in 2002 to reduce certain leverage ratios (see “Regulatory and Rating Issues”). As these losses are paid and growth in premium declines, cash and invested assets in the Company’s insurance subsidiaries may decline.
As of December 31, 2001, $47.5 million was outstanding on this line of credit. The line of credit bears interest at a variable margin over the Prime Rate. As of December 31, 2001, the Prime Rate was 4.75% and the variable margin was 1.5%.
At December 31, 2000, the Company was obligated to reduce the credit line to $33.0 million by April 30, 2001. In May 2001, the Company received a permanent waiver of this obligation to reduce the credit line. Concurrent with the permanent waiver, the Company and its banks agreed to waive all prior covenant violations of the existing loan agreement and establish new covenants. In addition, the Company agreed to a revised pay-down schedule, pursuant to which the Company was required to reduce the credit line by $5.0 million per quarter beginning September 30, 2001.
The scheduled payments of $5.0 million due on September 30, 2001 and December 31, 2001 were not made. In February 2002, the Company received a permanent waiver of these obligations to reduce the credit line. Concurrent with the permanent waiver, the Company and its banks agreed to waive all prior covenant violations of the existing loan agreement and establish new covenants effective retroactive to December 31, 2001 related to statutory surplus, GAAP net worth, fixed charge coverage, debt-to-capital ratios and net and gross premium ratios. In addition, the Company agreed to a revised pay-down schedule and a variable margin over the Prime Rate that increases by one quarter point every two months beginning February 1, 2002 until the line of credit is paid down to $33.0 million. Pursuant to the revised pay-down schedule, the Company is required to reduce the credit line by $0.5 million on March 31, 2002, $10.8 million on June 30, 2002, $1.0 million on September 30, 2002, and $11.3 million on December 31, 2002.
Absent the sale of assets or other capital raising events, the Company may not have the liquidity in its non-regulated subsidiaries to make the required payments pursuant to the revised pay down schedule on or after the scheduled payment of $10.8 million on June 30, 2002. Furthermore, if repayment is required due to default, the Company currently does not have sufficient cash to repay the balance. As part of the loan agreement, certain of the Company’s non-regulated subsidiaries guaranteed repayment of the line of credit
The Company has retained an investment-banking firm to file a registration statement with the Securities and Exchange Commission with respect to a public offering of its common stock. The Company executed an engagement letter with an investment-banking firm that will act as financial advisor and lead underwriter for the Company in selling its common stock to the public. The terms will be determined immediately prior to the offering, which is expected to commence in May or June 2002. The offering is subject to certain conditions and no underwriting agreement has yet been executed. If the capital raising is unsuccessful, management believes the Company has the ability to sell certain of its non-regulated subsidiaries to satisfy its debt obligations. There are no restrictions that prohibit the sale of non-regulated subsidiaries. Proceeds from the offering would be used to satisfy all or a portion of the Company’s debt obligations and add to the surplus of its insurance subsidiaries. However, there can be no assurance that these capital-raising efforts will be successful.
As of December 31, 2001 and 2000, the recorded values of the Company’s investment portfolio, including cash and cash equivalents, were $233.8 million and $240.1 million, respectively. The debt securities in the investment portfolio, at December 31, 2001, were 88.2% investment grade A or above bonds as defined by Standard & Poor’s.
Insurance operations are subject to various leverage tests (e.g. premium to statutory surplus ratios), which are evaluated by regulators and rating agencies. The Company’s targets for gross and net written premium to statutory surplus are 3 to 1 and 2 to 1, respectively. Due primarily to net losses in 2000 and in the first half of 2001, statutory surplus is at a level where the premium leverage ratios as of December 31, 2001, on a statutory consolidated basis, were 5.8 to 1 and 3.4 to 1 on a gross and net written premium basis, respectively.
The NAIC’s Insurance Regulatory Information System (“IRIS”) was developed by a committee of state insurance regulators and is primarily intended to assist state insurance departments in executing their statutory mandates to oversee the financial condition of insurance companies operating in their respective states. IRIS identifies 11 industry ratios and specifies “usual values” for each ratio. Unexplained departure from the usual values on four or more ratios generally leads to inquiries or possible further review from individual state insurance commissioners.
In 2001, Star had seven ratios that varied from the “usual value” range. The variations and reasons for these variations are set forth below:
These operating ratios were negatively impacted 	by the underwriting losses recognized in 2000 and 2001, which 	were primarily related to the previously mentioned seven 	discontinued programs.
increase the RBC ratio level and is working closely with OFIS to monitor its progress. While the Company’s gross and net written premium have declined steadily throughout 2001, it has not yet sufficiently reduced its premium leverage ratios and complied with the required RBC level. In addition to continued reductions in premium writings, capital from sources outside the Company may also be necessary to make sufficient progress towards reducing its leverage ratios and increasing the RBC ratio. While the Company has retained an investment-banking firm to execute its selected capital raising alternative, there can be no assurance that the Company will be successful in raising additional capital, or that proceeds therefrom, which would be contributed to the Company’s insurance subsidiaries, would result in sufficient progress towards reducing its leverage ratios and increasing the RBC ratio. If the regulators determine that the Company has made insufficient progress towards reducing its leverage ratios and increasing the RBC ratio, they may take action at any time. While the regulators have taken no actions to date, these actions could include requiring the Company to propose steps to correct the capital deficiency, requiring a further reduction in permitted premium writings, or placing the Company under some form of regulatory control.
In its risk-sharing programs, the Company is also subject to credit risk with respect to the payment of claims by its clients’ captive, rent-a-captive, large deductible programs, indemnification agreements, and on the portion of risk exposure either ceded to the captives, or retained by the clients. The capitalization and credit worthiness of prospective risk-sharing partners is one of the factors considered by the Company in entering into and renewing risk-sharing programs. The Company collateralizes balances due from its risk-sharing partners through Funds Withheld Trusts or letters of credit. At December 31, 2001, the Company had risk exposure in excess of collateral in the amount of $14.1 million on these programs, of which the Company has an allowance of $6.5 million related to these exposures. The Company has historically maintained an allowance for the potential uncollectibility of certain reinsurance balances due from some risk-sharing partners. At the end of each quarter an analysis of these exposures is conducted to determine the potential
Effective January 1, 2001, the Company adopted SFAS No. 133 “Accounting for Derivative Instruments and Hedging Activities” (as amended by SFAS No. 137 and 138). As the Company does not customarily use derivative instruments, the impact of adoption did not impact the results of operations or financial position of the Company.
FASB has issued SFAS No. 141 “Business Combinations”. SFAS No. 141 eliminates the “pooling-of-interests” method for business combinations initiated after June 30, 2001. The Company does not anticipate the adoption of SFAS No. 141 will have a material effect to the result of operations or financial position of the Company.
regulators, rating agencies or lenders; obtainment of certain processing efficiencies; changing rates of inflation; general economic conditions and other risks identified in the Company’s reports and registration statements filed with the Securities and Exchange Commission. The Company is not under any obligation to (and expressly disclaims any such obligation to) update or alter its forward-looking statements whether as a result of new information, future events or otherwise.
See list of Financial Statement Schedules on page 35. The financial statements listed on page 35 including footnote 17 on page 64 of the notes to the consolidated financial statements.