We are principally a retailer, servicer and underwriter of non-standard personal automobile insurance. We also own two tracts of land in San Antonio, Texas that are held for sale. Non-standard personal automobile insurance is made available to individuals because of their inability or unwillingness to obtain standard insurance coverage due to various factors, including payment history, payment preference, and failure in the past to maintain continuous insurance coverage, driving record and/or vehicle type.
At March 10, 2015, we leased and operated 355 retail locations (or “stores”) and a call center staffed by employee-agents who primarily sell non-standard personal automobile insurance products underwritten by us as well as certain commissionable ancillary products. In most states, our employee-agents also sell a complementary insurance product providing personal property and liability coverage for renters underwritten by us. In addition, select retail locations in highly competitive markets in Illinois and Texas offer non-standard personal automobile insurance serviced and underwritten by other third-party insurance carriers. At March 10, 2015, we wrote non-standard personal automobile insurance in 13 states (Virginia commenced in January 2015) and were licensed in 12 additional states.
The following table shows the number of our retail locations. Retail location counts are based upon the date that a location commenced or ceased writing business.
The following table shows the number of our retail locations by state.
investment income earned on the invested assets of the insurance company subsidiaries.
The following table presents the change in the total number of policies in force (“PIF”) for the insurance operations. PIF increases as a result of new policies issued and decreases as a result of policies that are canceled or expire and are not renewed. At December 31, 2014, PIF was 14.4% higher than at the same date in the prior year.
Since the beginning of 2012, we renewed our focus on improving the customer experience and value through several initiatives. Through February 2015, our progress has included:
Moving forward, we continue to believe that our retail stores are the foundation of our business, providing an opportunity for us to directly interact with our customers on a regular basis. We also recognize that customer preferences have changed and that we need to adapt to meet those needs. For that reason, we will continue to invest in our people, retail stores, website and call center initiatives, and our customer interaction efforts in order to improve the customer experience.
At December 31, 2014, 94% of the fair value of our fixed maturity portfolio was rated “investment grade” (a credit rating of AAA to BBB-) by nationally recognized statistical rating organizations. Investment grade securities generally bear lower yields and have lower degrees of risk than those that are unrated or non-investment grade. We believe that a high quality investment portfolio is more likely to generate a stable and predictable investment return.
Commission and fee income increased 13% to $39.7 million for the year ended December 31, 2014, from $35.1 million for the year ended December 31, 2013. This increase in commission and fee income was a result of higher fee income related to commissionable ancillary products sold and the increase in PIF noted above.
Net realized gains on investments, available-for-sale during the year ended December 31, 2014 included $23 thousand of net realized gains on redemptions. Net realized losses on investments, available-for-sale during the year ended December 31, 2013 included $61 thousand of charges related to OTTI on certain non-agency backed CMOs offset by $32 thousand of net realized gains on redemptions.
The loss ratio was 73.9% for the year ended December 31, 2014, compared with 71.5% for the year ended December 31, 2013. We experienced favorable development related to prior fiscal years of $4.9 million for the year ended December 31, 2014, compared with favorable development of $3.0 million for the year ended December 31, 2013. The favorable loss development for the year ended December 31, 2014 was primarily related to bodily injury claims occurring in accident years 2010 through 2013. The favorable loss development for the year ending December 31, 2013 was primarily related to bodily injury claims occurring in accident years 2010 through 2012, partially offset by unfavorable loss and loss adjustment expense development on Florida personal injury protection claims.
Insurance operating expenses increased 6% to $87.6 million for the year ended December 31, 2014 from $82.8 million for the year ended December 31, 2013. The increase was primarily attributable to additional variable costs associated with higher PIF, as well as additional salaries and benefits for the sales organization.
The benefit for income taxes was $18.3 million for the year ended December 31, 2014, compared with a provision for income taxes of $0.7 million at the year ended December 31, 2013. The benefit for income taxes for the year ended December 31, 2014 included a decrease in the valuation allowance for the deferred tax asset of $22.4 million resulting from a change in management’s judgment regarding the realizability of the deferred tax asset. A valuation allowance is established to reduce the deferred tax asset to the amount that is more likely than not to be realized. In assessing our ability to support the realizability of our deferred tax asset, we consider both positive and negative evidence and we place greater weight on historical results rather than on our outlook for future profitability. In recent years, the Company incurred losses resulting in a source of negative evidence. With the conclusion of 2014, the Company’s historical results now reflect a twelve quarter cumulative taxable income which management considered to be a trend of positive evidence in accessing the realizability of its deferred tax asset. Based on this fact and our outlook for future profitability, the deferred tax asset valuation allowance was adjusted this period and resulted in the aforementioned income tax benefit. A valuation allowance of $1.8 million remains at December 31, 2014 for certain amounts that are not more likely than not expected to be realized. The provision for income taxes for the year ended December 31, 2013 related to current state income taxes for certain subsidiaries with taxable income.
Net realized losses on investments, available-for-sale during the year ended December 31, 2013 primarily included $61 thousand of charges related to OTTI on certain non-agency backed CMOs. Net realized gains on investments, available-for-sale during the year ended December 31, 2012 primarily included $3.2 million in net realized gain from the sales of $29.6 million of corporate bonds which were sold in September 2012 in order to increase the statutory capital and surplus of the insurance company subsidiaries. For additional information with respect to the determination of OTTI losses on investment securities, see “Critical Accounting Estimates - Investments” below and Note 3 to our consolidated financial statements.
Insurance operating expenses increased 1% to $82.8 million for the year ended December 31, 2013 from $82.1 million for the year ended December 31, 2012. The increase was primarily a result of additional advertising costs and management performance bonuses incurred.
Overall, the combined ratio decreased to 96.4% for the year ended December 31, 2013 from 107.7% for the year ended December 31, 2012.
The provision for income taxes was $0.7 million for the year ended December 31, 2013, compared with the benefit for income taxes of $5 thousand at the year ended December 31, 2012. The provision for income taxes related to current state income taxes for certain subsidiaries with taxable income. The provision (benefit) for income taxes for year ended December 31, 2012 included adjustments that reduced certain state income taxes.
Our primary sources of funds are premiums, fees and investment income from our insurance company subsidiaries and commissions and fee income from our non-insurance company subsidiaries. Our primary uses of funds are the payment of claims and operating expenses. Net cash provided by operating activities for the year ended December 31, 2014 was $27.0 million, compared with net cash provided by operating activities of $17.8 million for the year ended December 31, 2013. This increase was primarily as a result of the increase in net income and in policy liabilities for losses and unearned premiums as a result of the increase in premiums written. Net cash provided by investing activities for the year ended December 31, 2014 was $3.3 million, compared with net cash used in investing activities of $4.9 million for the year ended December 31, 2013. The year ended December 31, 2014 included net reductions to our investment portfolio of $4.5 million, while the prior year included net additions to our investment portfolio of $4.0 million. The net reductions in the current year were primarily the result of maturities and redemptions in excess of purchases. Investing activities during the year ended December 31, 2014 also included capital expenditures primarily related to system enhancements of $1.4 million as compared to $0.9 million of the same in the prior year.
State insurance laws limit the amount of dividends that may be paid from our insurance company subsidiaries. At December 31, 2014, our insurance company subsidiaries could pay $2.0 million in ordinary dividends without prior regulatory approval.
The following table summarizes our contractual obligations by period at December 31, 2014 (in thousands).
Payments due by period assume a contractual variable interest rate of LIBOR plus 375 basis points, or 4.005% at January 31, 2015.
Income taxes are accounted for under the liability method, whereby deferred income tax assets and liabilities result from temporary differences. Temporary differences are differences between the tax basis of assets and liabilities and operating loss and tax credit carryforwards and their reported amounts in the consolidated financial statements that will result in taxable or deductible amounts in future years. Valuation of the deferred tax asset is considered a critical accounting estimate because the determination of our ability to utilize the asset involves a number of management assumptions relating to future operations that could materially affect the determination of the ultimate value and, therefore, the carrying amount of our deferred tax asset.
Identifiable intangible assets are attributable to our insurance operations and were initially recorded at their estimated fair values at the date of acquisition. They have an indefinite useful life and are not amortized for financial statement purposes. We perform our required annual impairment test as of each June 30th.
In the event that facts and circumstances indicate that the identifiable intangible assets may be impaired, an interim impairment test would be required. Our evaluation includes multiple assumptions that may change over time. If unfavorable events or trends occur, further identifiable intangible assets impairment charges may become necessary that could have a materially adverse impact on our results of operations in the period in which the write-off occurs.
We are directly liable for loss and loss adjustment expenses under the terms of the insurance policies underwritten by our insurance company subsidiaries. Each of our insurance company subsidiaries establishes a reserve for all of its unpaid losses, including case reserves and IBNR reserves, and estimates for the cost to settle the claims. We estimate our IBNR reserves by estimating our ultimate liability for loss and loss adjustment expense reserves first, and then reducing that amount by the amount of cumulative paid claims and by the amount of our case reserves. We rely primarily on historical loss experience in determining reserve levels, on the assumption that historical loss experience provides a good indication of future loss experience. We also consider various other factors, such as inflation, claims settlement patterns, legislative activity and litigation trends. Our actuarial staff continually monitors these estimates on a state and coverage level. We utilize our actuarial staff to determine appropriate reserve levels. As experience develops or new information becomes known, we increase or decrease the level of our reserves in the period in which changes to the estimates are determined. Accordingly, the actual losses and loss adjustment expenses may differ materially from the estimates we have recorded. See “Business - Loss and Loss Adjustment Expense Reserves” in Item 1 of this report and Note 9 to our consolidated financial statements for additional information.
We have audited the accompanying consolidated balance sheets of First Acceptance Corporation and subsidiaries (the “Company”) as of December 31, 2014 and 2013, and the related consolidated statements of operations and comprehensive income (loss), stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2014. Our audits also included the financial statement schedule listed in the index at Item 15(a) (2). These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements and schedule based on our audits.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of First Acceptance Corporation and subsidiaries at December 31, 2014 and 2013, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2014, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule referred to above, when considered in relation to the basic financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.
We have audited First Acceptance Corporation and subsidiaries’ (the “Company”) internal control over financial reporting as of December 31, 2014, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 Framework) (the “COSO criteria”). The Company’s management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Annual Report on Internal Control Over Financial Reporting listed as item 9A. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.
Other investments consist of limited partnership interests and an investment in the common stock of a real estate investment trust (“REIT”). Limited partnership interests are recorded at net asset value or the equity method of accounting if the Company is deemed to have significant influence as a result of its ownership percentage. Based on the underlying investments of the limited partnerships, their carrying value approximates fair value. Valuations are based upon the GAAP financial statements of the partnerships which are required to be audited annually. The common stock of the REIT is recorded at a fair value with the corresponding unrealized appreciation or depreciation, net of deferred income taxes, reported in other comprehensive income (loss).
Insurance premiums earned include policy and renewal fees and are recognized on a pro-rata basis over the respective terms of the policies. Written premiums are recorded as of the effective date of the policies for the full policy premium, although most policyholders elect to pay on a monthly installment basis. Premiums and fees are generally collected in advance of providing risk coverage, minimizing the Company’s exposure to credit risk. Premiums receivable are recorded net of an estimated allowance for uncollectible amounts.
Deferred acquisition costs include premium taxes and other variable underwriting and direct sales costs incurred in connection with writing successful new and renewal business. These costs are deferred and amortized over the policy period in which the related premiums are earned, to the extent that such costs are deemed recoverable from future unearned premiums and anticipated investment income. Advertising costs are expensed when incurred and are not a part of deferred acquisition costs. Amortization expense for the years ended December 31, 2014, 2013 and 2012 was $11.4 million, $11.1 million and $11.4 million, respectively, and is included within insurance operating expenses in the accompanying consolidated statements of operations and comprehensive income (loss).
Identifiable intangible assets are attributable to the Company’s insurance operations and were initially recorded at their estimated fair values at the date of acquisition. Identifiable intangible assets, primarily comprised of trade names, having an indefinite useful life, are not amortized for financial statement purposes. The Company performs required annual impairment tests of its identifiable intangible assets as of June 30th of each fiscal year. In the event that facts and circumstances indicate that the identifiable intangible assets may be impaired, an interim impairment test would be required.
The Company follows the guidelines of ASU 2012-02, Intangibles - Goodwill and Other (Topic 350), which allows companies to waive comparing the fair value of indefinite-lived intangible assets to their carrying amounts in assessing the recoverability of these assets if, based on qualitative factors, it is more likely than not that the fair value of the indefinite-lived intangible assets is greater than their carrying amounts.
In May 2011, the FASB issued ASU No. 2011-04, Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs, which amends certain measurement and disclosure requirements related to fair value measurements to improve consistency with international reporting standards. The Company adopted the provisions of this guidance in the quarter ended March 31, 2012. The adoption of this guidance did not have an impact on the Company’s financial position or results of operations.
The Company categorizes valuation methods used in its identifiable intangible assets impairment tests as Level 3. To determine the fair value of acquired trademarks and trade names, the Company uses the relief-from-royalty method, which requires the Company to estimate the future revenue for the related brands, the appropriate royalty rate and the weighted average cost of capital. The Company also categorizes valuation methods used to fair value its investments in other investments as Level 3, since these investments have redemption and transfer restrictions and are therefore not readily marketable.
The fair values as presented represent the Company’s best estimates and may not be substantiated by comparisons to independent markets. The fair value of the debentures payable is categorized as Level 3, since it was based on current market rates offered for debt with similar risks and maturities an unobservable input categorized as Level 3. Carrying values of certain financial instruments, such as cash and cash equivalents and premiums and fees receivable, approximate fair value due to the short-term nature of the instruments and are not required to be disclosed. Therefore, the aggregate of the fair values presented in the preceding table does not purport to represent the Company’s underlying value.
The Company holds available-for-sale investments and other investments. Other investments include limited partnership interests which are carried at either net asset value or under the equity method which approximate fair value, and an investment in the common stock of a REIT. The following tables present the fair-value measurements for each major category of assets that are measured on a recurring basis (in thousands).
The following table represents the quantitative disclosure for those assets classified as Level 3 during the year ended December 31, 2014 (in thousands).
Other investments consist of the common stock of a real estate investment trust and limited partnership interests in three funds that invest in (i) commercial real estate and secured commercial real estate loans acquired from financial intuitions, (ii) small balance distressed secured loans and debt securities and (iii) undervalued international publicly-traded equities. These investments have redemption and transfer restrictions; however, the Company does not intend to sell these investments, and it is more likely than not that the Company will not be required to sell them before the expiration of such restrictions. At December 31, 2014, the Company had unfunded commitments of $2.3 million with two of these investments.
At December 31, 2014, fixed maturities and cash equivalents with a fair value and amortized cost of $5.3 million were on deposit with various insurance departments as a requirement of doing business in those states. Cash equivalents with a fair value and amortized cost of $9.4 million were on deposit with another insurance company as collateral for an assumed reinsurance contract.
Compensation expense related to Stock Option Awards is calculated under the fair value method and is recorded on a straight-line basis over the vesting period. There were no Stock Option Awards granted during the years ended December 31, 2014 and 2013. At December 31, 2014, the weighted average remaining contractual life of options outstanding and exercisable/vested was approximately 2.4 years for both.
A summary of the activity for the Company’s Restricted Stock Awards is presented below (in thousands, except per share data).
Depreciation and amortization expense related to property and equipment was $1.8 million, $2.1 million and $2.2 million for the years ended December 31, 2014, 2013 and 2012, respectively. Included within the furniture and equipment and the leasehold improvements categories at December 31, 2014 above are capitalized assets totaling $0.2 million not yet in service. These assets are related to the Company’s strategic investments in its retail stores and the website.
The Company is committed under various operating lease agreements for office space. Certain lease agreements contain renewal options and rent escalation clauses. Rental expense for the year ended December 31, 2014, 2013 and 2012 was $8.9 million, $9.2 million and $9.5 million, respectively, and is included within insurance operating expenses in the accompanying consolidated statements of operations and comprehensive income (loss). Future minimum lease payments under these agreements follow (in thousands).
December 31, 2014, the unamortized debt discount of $0.9 million is being amortized to interest expense over the term of the debentures.
The tax effects of temporary differences that give rise to the net deferred tax assets and liabilities are presented below (in thousands).
The Company had a valuation allowance of $1.8 million and $24.2 million at December 31, 2014 and 2013, respectively, to reduce the net deferred tax asset to the amount that is more likely than not to be realized. The change in the total valuation allowance for the year ended December 31, 2014 was a decrease of $22.4 million resulting from a change in management’s judgment regarding the realizability of the deferred tax asset. For the year ended December 31, 2014, a $1.2 million adjustment to the valuation allowance related to the unrealized change on investments was included in net income. The change in the valuation allowance was also net of the utilization of $9.8 million in NOL carryforwards.
At December 31, 2014, the Company had gross state NOL carryforwards of $7.1 million that begin to expire in 2020. At December 31, 2014, the Company had gross federal NOL carryforwards of $17.7 million that begin to expire in 2031. In addition, the Company had AMT credit carryforwards of $2.0 million that have no expiration date. At December 31, 2014, the Company had gross state NOL carryforwards of $7.1 million that begin to expire in 2020.
The following table sets forth the computation of basic and diluted net income (loss) per share (in thousands, except per share data).
For the year ended December 31, 2014, the computation of diluted net income per share included exercisable options to purchase approximately 0.8 million shares that had a dilutive effect of 298 thousand shares. Options to purchase 295 thousand shares for the year ended December 31, 2014 were not included in the computation of diluted net income (loss) per share as their exercise prices were in excess of the average stock prices for the periods.
The Company is named as a defendant in various lawsuits, arising in the ordinary course of business, generally relating to its insurance operations. All legal actions relating to claims made under insurance policies are considered by the Company in establishing its loss and loss adjustment expense reserves. The Company also faces lawsuits from time to time that seek damages beyond policy limits, commonly known as bad faith claims, as well as class action and individual lawsuits that involve issues arising in the course of the Company’s business. The Company continually evaluates potential liabilities and reserves for litigation of these types using the criteria established by FASB ASC 450, Contingencies (“FASB ASC 450”). Pursuant to FASB ASC 450, reserves for a loss may only be recognized if the likelihood of occurrence is probable and the amount can be reasonably estimated. If a loss, while not probable, is judged to be reasonably possible, management will disclose, if it can be estimated, a possible range of loss or state that an estimate cannot be made. Management evaluates each legal action and records reserves for losses as warranted by establishing a reserve in its consolidated balance sheets in loss and loss adjustment expense reserves for bad faith claims and in other liabilities for other lawsuits. Legal fees are expensed as incurred. Amounts incurred are recorded in the Company’s consolidated statements of operations and comprehensive income (loss) in losses and loss adjustment expenses for bad faith claims and in insurance operating expenses for other lawsuits unless otherwise disclosed.
The following table presents selected financial data by business segment (in thousands).
The statutory-basis financial statements of the Insurance Companies are prepared in accordance with accounting practices prescribed or permitted by the Department of Insurance in each respective state of domicile. Each state of domicile requires that insurance companies domiciled in the state prepare their statutory-basis financial statements in accordance with the National Association of Insurance Commissioners Accounting Practices and Procedures Manual subject to any deviations prescribed or permitted by the insurance commissioner in each state of domicile. The Insurance Companies are required to report their risk-based capital (“RBC”) each December 31. Failure to maintain an adequate RBC could subject the Insurance Companies to regulatory action and could restrict the payment of dividends. At December 31, 2014, the RBC levels of the Insurance Companies did not subject them to any regulatory action.
Income before income taxes for the quarter ended December 31, 2014 of $3.1 million included $2.6 million of favorable development in the Company’s estimate of unpaid loss and loss adjustment expenses.