As of December 31, 2008, we leased an aggregate of approximately 426,070 square feet of office space for our agencies, insurance companies and retail stores in various locations throughout the United States. The office space includes two leases for approximately 58,642 aggregate square feet of office space in a common building in Burr Ridge, Illinois. One Burr Ridge lease is for approximately 50,000 square feet of office space, and has a term that expires in November 2016. The other Burr Ridge lease is for approximately 8,642 square feet of office space, and has a term that expires in March 2009. We lease approximately 56,888 square feet of office space in Addison, Texas, and our Addison lease term expires in March 2010. We also lease approximately 26,370 aggregate square feet of office space in a common building in Baton Rouge, Louisiana. One Baton Rouge lease is for approximately 20,117 square feet of office space, and has a term that expires in September 2012. The other Baton Rouge lease is for approximately 6,253 square feet of office space, and has a term that expires in March 2010. In addition, we have 219 owned retail stores that presently lease space on an individual basis at various locations in the states in which we do business. None of these individual retail store leases are material to our operations.
In Baton Rouge, Louisiana, we own a building of approximately 177,469 square feet for investment purposes. The building is under a lease agreement with a federal agency. The lease expires on August 28, 2009. However, the federal agency may terminate the lease upon fifteen days’ written notice after February 28, 2009.
As of December 31, 2008, our subsidiaries included insurance companies licensed to write insurance policies in 40 states, underwriting agencies, and retail agencies with 219 owned stores and 33 operating franchise retail store locations and relationships with two unaffiliated underwriting agencies. We are currently active in offering insurance directly to individual consumers through retail stores in 10 states (Louisiana, Texas, Illinois, Alabama, Florida, Missouri, Indiana, South Carolina, Kansas and Wisconsin) including our franchised stores in Florida and distributing our own insurance policies through 8,000 independent agents or brokers in 10 states (Louisiana, Texas, Illinois, California, Michigan, Florida, Missouri, Indiana, South Carolina and New Mexico).
Retail agencies, which provide multiple points of sale under established local brands with personnel licensed and trained to sell insurance policies and ancillary products to individual consumers.
We believe that our ability to enter into a variety of business relationships with third-parties allows us to maximize sales penetration and profitability through industry cycles better than if we employed a single, vertically integrated operating structure.
At December 31, 2008, our receivables from reinsurers included $17.1 million gross recoverable from VFIC. At December 31, 2008, the VFIC Trust held $17.1 million to collateralize the $17.1 million gross recoverable from VFIC. We have, with the approval of the VFIC Special Deputy Receiver and the District Court, Austin, Texas, withdrawn $7.4 million from the trust securing our reinsurance recoverables from VFIC, which represented 100% of the amount we paid in losses as of the date of the withdrawal covered by the VFIC reinsurance. We have made arrangements with the VFIC Special Deputy Receiver to submit quarterly statements for approval to withdraw additional funds from the trust based upon losses paid.
The variability surrounding the carried loss reserves diminishes for each accident period as the current accident year contains the greatest proportion of losses that have not been reported or settled, and these elements must be estimated as of the current reporting date. The proportion of losses with these characteristics diminishes in subsequent years. Applying a 95% confidence interval based on our paid loss development factors we have determined that the combined effects of adjustments to the initial estimate for loss reserves produce a range of -5.38% to 4.31%.
Applying the above potential variation to the December 31, 2008 estimate of ultimate loss reserves would yield an indication of sensitivity to held reserves from $(8.9) million to $7.1 million, generating an after-tax impact to net income of $(5.8) million to $4.6 million, respectively (assuming a 35% tax rate). The final outcome may fall below or above these amounts.
Valuation of available-for-sale investments. Our investments are recorded at fair value, which is typically based on publicly-available quoted prices. From time to time, the carrying value of our investments may be temporarily impaired because of the inherent volatility of publicly-traded investments. We do not adjust the carrying value of any investment unless management determines that the impairment of an investment’s value is other than temporary.
Gains and losses realized on the disposition of investment securities are determined on the specific identification basis and credited or charged to income. Premium and discount on investment securities are amortized and accreted using the interest method and charged or credited to investment income.
We evaluate goodwill for impairment annually as of September 30, or more frequently if events or circumstances indicate that impairment may have occurred. Goodwill is evaluated for impairment by initially comparing an estimate of the fair value of the Company to its carrying value, including goodwill. If the Company’s estimated fair value exceeds its carrying value, then no impairment exists. When required, the second
Management considers current market conditions and operating results that may affect the estimated fair value of the Company as well as other data such as market capitalization to assess whether any goodwill impairment exists. Continued deteriorating or adverse market conditions may have a significant impact on the estimated fair value of the Company and could result in future impairments of goodwill.
Management believes that the current market displacement caused by the global credit crisis as well as the limited volume of its own shares that trade daily has resulted in the decrease in the Company’s market capitalization that is not representative of a long-term decrease in value.
Key inputs in our valuation model are projected cash flows, future inflationary trends, future tax rates, and the risk-adjusted discount rate. The risk-adjusted discount rate was developed using a capital asset pricing model to estimate our weighted-average cost of capital. The relative mix of capital between debt and equity was estimated at 33.3 pct based on observed industry averages.
Based on the valuation model results, management concluded that goodwill was not impaired as the fair value of the Company exceeded its carrying value. Further, the fair value obtained from the discounted cash flow model was subject to a stress test by decreasing forecasted cash flows by 15%, and at the same time increasing the discount rate by 100 basis points to 15.3%. The indicated stress value was sufficient to cover the book value of the Company.
SFAS No. 142 requires annual testing of goodwill, and does not require interim testing unless, “an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount.” Examples of such events or circumstances include significant adverse changes in the business climate, a decision to sell or dispose of all or a significant portion of a reporting unit, or a significant decline in the Company’s stock price. At December 31, 2008, we evaluated the need to update our analysis of goodwill. Management considered its market capitalization in relation to its book value and believes that the overall decrease in the Company’s current market capitalization is not representative of a long-term decrease in the value of the Company. In arriving at this conclusion, management considered the global economic factors impacting
requirements of Statement 133 in order to provide users of financial statements with enhanced disclosures about an entity’s derivative and hedging activities and thereby improving the transparency of financial reporting. To meet these objectives, SFAS No. 161 requires qualitative disclosure about objectives and strategies for using derivatives, quantitative disclosures about fair value amounts of and gains and losses on derivative instruments, and disclosures about credit-risk-related contingent features in derivative agreements. SFAS No. 161 is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008, with early application encouraged. We do not expect SFAS No. 161 to have a material impact on our consolidated results of operations or financial condition.
In February 2008, the FASB issued FASB Staff Position No. FAS 157-2, Effective Date of FASB Statement No. 157 (FSP 157-2), which delays the effective date of SFAS No. 157 for non-financial assets and non-financial liabilities, except for items that are recognized or disclosed at fair value in the financial statements on a recurring basis, at least annually to fiscal years beginning after November 15, 2008. Any amounts recognized upon adoption as a cumulative effect will be recorded to the opening balance of retained earnings in the year of adoption. We do not expect the adoption of FSP 157-2 to have a material impact on our consolidated results of operations or financial condition.
In December 2007, the FASB issued SFAS No. 141R, Business Combinations, which requires most identifiable assets, liabilities, non-controlling interests, and goodwill acquired in a business combination to be recorded at full fair value. SFAS No. 141R also requires, among other things, the acquisition costs to be expensed in the periods they are incurred, the contingent considerations resulting from events after the acquisition date to be measured and recognized at the acquisition date fair value with subsequent changes recognized in earnings, and the change in deferred tax benefit that are recognizable because of a business combination to be recognized either in income or directly in contributed capital in the period of business combination. SFAS No. 141R is effective for business combinations occurring after December 15, 2008. If we have business combinations after that date, SFAS No. 141R could have a material impact in the future on our consolidated results of operations or financial condition.
As part of our corporate strategy, we treat our owned retail stores as independent agents, encouraging them to sell to their individual customers whatever products are most appropriate for and affordable to those customers. We believe that this offers our retail customers the best combination of service and value, developing stronger customer loyalty and improving customer retention. In practice, this means that in our owned retail stores, the relative proportion of the sales of our own insurance products as compared to the sales of the third-party policies will vary depending upon the competitiveness of our insurance products in the marketplace during the period. This reflects our intention of maintaining the margins in our insurance company subsidiaries, which may occur even at the cost of business lost to third-party carriers.
Total revenues for 2008 decreased $51.1 million, or 10.2%, to $448.9 million from $500.0 million for 2007.
Premiums. One measurement of our performance is the level of gross premiums written and a second measurement is the relative proportion of premiums written through our three distribution channels. The following table displays our gross premiums written by distribution channel for the years ended December 31, 2008, 2007 and 2006 (in thousands):
The following table displays our gross premiums written by state for the years ended December 31, 2008, 2007 and 2006 (in thousands):
Net premiums earned during 2007 on policies sold through our affiliated underwriting agencies (including retail and independent agencies) increased by $108.1 million, or 43.6%. This increase was due to the acquisition of USAgencies. Excluding USAgencies, which was acquired effective January 1, 2007, earned premiums declined by $14.2 million, or 5%, in 2007. Net premiums earned on insurance products sold through the unaffiliated underwriting agencies distribution channel decreased by $0.2 million, or 0.5%, compared with 2006.
Reinsurance. The following table reflects the premiums ceded and assumed under reinsurance agreements in our consolidated financial statements for the years ended December 31, 2008, 2007 and 2006 (in thousands):
In connection with the completion of the acquisition of USAgencies, we reevaluated their reinsurance program in light of the capital structure and risk management programs of the larger combined operations. As a result, terms were renegotiated with the reinsurer and a new quota-share reinsurance agreement was made effective April 1, 2007, under which the net retention increased from 30% to 75% in Louisiana and from 25% to 75% in Alabama on policies issued in those two states. Concurrently, we exercised our option to terminate the prior quota-share contracts on a cut-off basis. In April 2007, we received $31.0 million to settle the unearned premiums less return ceding commissions. Effective January 1, 2009, we terminated our quota-share reinsurance contract on a cut-off basis and received $7.8 million of returned unearned premiums net of returned ceding commissions.
Effective August 1, 2005, we entered into novation agreements with several unaffiliated reinsurers who participated in a quota-share reinsurance agreement in which we also participated. Pursuant to these agreements, we were substituted in place of these reinsurers assuming all rights, interests, liabilities and obligations related to the original quota-share reinsurance agreement. As a result of these novation agreements, our participation in the original reinsurance agreement increased from 5% to 100% effective August 1, 2005. In consideration for our assumption of their liabilities, these reinsurers agreed to pay us an amount equal to their share of the liabilities under the original quota-share agreement as of July 31, 2005. The terms of this reinsurance agreement did not meet the risk transfer requirements according to SFAS No. 113; therefore, this contract was accounted for as deposits according to the guidelines of SOP 98-7, Deposit Accounting for Insurance and Reinsurance Contracts that do not Transfer Insurance Risk. If the estimated deposit liabilities are less than the recorded liabilities, we record excess deposit liabilities as income based on a percentage of actual paid losses. We believe that this methodology approximates the effective interest method prescribed in SOP 98-7. Changes in the carrying amount of the deposit liability should be reported as income or expense as appropriate. We received cash in the amount of $14.2 million in relation to this novation. The deferred gain initially totaled $1.8 million, of which we recognized $0.1 million, $0.4 million, and $0.7 million in income for the years ended December 31, 2008, 2007, and 2006, respectively.
We evaluated the transaction and concluded that we did not assume significant insurance risk because the probability of a significant variation in the amount of payments by the reinsurers was remote. This was primarily due to a sliding scale profit commission payable by the reinsurer to us should there be favorable loss development. This profit commission made the likelihood very remote that the reinsurer would have any significant additional gain or loss on this block of business. The reinsurers will ultimately make the same payments, either to us from profit commission or for the full amount of losses and loss adjustment expenses. The combined cost to the reinsurer is the same. Consequently, since no significant risk was transferred, the use of deposit accounting was required and the use of reinsurance accounting was impermissible under SFAS No. 113. At December 31, 2008, there were no deposit assets and $0.4 million of deposit liabilities recorded on the balance sheet for this contract.
Quota-share reinsurance for business produced through unaffiliated underwriting agencies is specific to each unaffiliated underwriting agency. We maintain control of the selection of reinsurers and the terms and conditions of reinsurance contracts.
Historically, all of our initial quota-share reinsurance agreements contained provisions for sliding scale commissions under which the commission paid to us varies with the loss ratio results under each contract. The effect of this feature in the quota-share reinsurance agreements is to limit the reinsurers’ aggregate exposure to loss and thereby reduce the ultimate cost to us as the ceding company. These features also have the effect of reducing the amount of protection relative to the quota-share amount of premiums ceded by us. Before entering into these reinsurance agreements, and based on our prior operating history, we concluded that each agreement met the risk transfer test of SFAS No. 113 as the reinsurers assume significant risk and have a reasonable possibility of a significant loss.
Commission Income and Fees. The following sets forth the components of consolidated commission income and fees earned for the years ended December 31, 2008, 2007 and 2006 (in thousands):
Commissions are earned on sales of third-party companies’ products sold by our retail agencies. As described above, in our owned retail stores, there can be a shift in the relative proportion of the sales of third-party insurance products as compared to sales of our own carriers’ products due to the relative competitiveness of
Net investment income for 2007 increased $7.6 million, or 86.2%, compared with 2006. The increase was primarily a result of a 45.4% increase in total average invested assets to $332.2 million during 2007 from $228.5 million during 2006, as a result of the acquisition of USAgencies. The average investment yield was 3.59% (5.05% on a taxable equivalent basis) for 2007 as compared to 3.70% (5.33% on a taxable equivalent basis) for 2006.
Losses and Loss Adjustment Expenses. Losses and loss adjustment expenses for 2008 decreased $15.3 million, or 5.3%, compared with 2007. The percentage of losses and loss adjustment expense to net premiums earned was 76.8% in 2008 compared with 73.2% in 2007. The following table displays the impact of hurricane loss and loss development related to prior periods’ business on our loss ratio for the years ended December 31, 2008, 2007 and 2006:
If existing estimates of the ultimate liability for losses and related loss adjustment expenses are lowered, then that favorable development is recognized in the subsequent period in which the reserves are reduced. This has the effect of benefiting that subsequent period, when the aggregate losses and loss adjustment expenses (reflecting the favorable development related to previously reported earned premiums) are reduced relative to that period’s earned premium. Although the favorable development must be included in that subsequent period’s financial statements, it is appropriate for measurement purposes to compare only the losses and loss adjustment expenses related to any specific period’s earned premiums in evaluating performance during that particular period. Excluding the Florida policies previously mentioned, we experienced frequency indications that were flat compared to prior year selections and severity trends of low single digits on an aggregate basis. In a period of stable premium rates, these trends would have resulted in generally stable loss ratios (the ratio of losses and loss adjustment expenses to earned premiums).
estimate. The cumulative redundancy (deficiency) depicted in the table, for any particular calendar year, represents the aggregate change in the initial estimates over all subsequent calendar years.
Deferred policy acquisition costs represent the deferral of expenses that we incur in acquiring new business or renewing existing business. Policy acquisition costs, consisting of primarily commission, advertising, premium taxes, underwriting and retail agency expenses, are initially deferred and then charged against income ratably over the terms of the related policies through amortization of the deferred policy acquisition costs. Thus, the amortization of deferred acquisition costs is correlated with earned premium and the ratio of amortization of deferred acquisition costs to earned premium in an accounting period is another measurement of performance. The cost of policy acquisition (amortization of deferred policy acquisition costs) is the largest component of deferred acquisition costs.
Net expenses, defined as the sum of selling, general and administrative expenses and depreciation and amortization less commission income and fees, as a percentage of net premiums earned (the net expense ratio) decreased to 20.9% in 2008 compared with 21.5% in 2007. The decrease was primarily due to an 11.1% decrease in selling, general and administrative expenses. The following table sets forth the components of the net expenses and the computation of the net expense ratios for the years ended December 31, 2008, 2007 and 2006 (in thousands):
Selling, general and administrative expenses for 2008 decreased $17.9 million, or 11.1%, compared with 2007. The overall decrease in selling, general and administrative expenses was primarily due to a reduction in operating expenses primarily due to the decline in premium value and management’s efforts to reduce expenses in response to the premium decline.
the comparability of the 2007 results to the 2006 results consisted of $1.9 million in IT costs in 2007 related to our strategic systems transformation project, $785,000 in IT expenses related to the migration of our data center and $280,000 for the write-off of software costs deemed to be of no future value. In addition, we expensed $11.5 million in 2007 in connection with the IT outsourcing contract. The combined total of the IT outsourcing expense (which excludes the transformation and data center migration costs) and our continuing IT operating expenses in 2007 exceeded the cost of our IT operations in 2006 by approximately $2.0 million. In the fourth quarter of 2007, a commission liability was reduced by $1.7 million to reflect the appropriate amount of the liability.
During 2006, we developed a comprehensive implementation plan and supporting business case to consolidate and transform our primary business applications onto a new strategic platform. This plan encompasses consolidating and migrating our multiple claims, point-of-sale and policy administration systems onto single strategic platforms, as well as deploying new premium finance, reporting and business analytics capabilities. For all components of this systems transformation plan, we have selected a software package that we will configure and integrate to meet our unique needs. We believe this systems transformation will position us to realize significant strategic benefits including: systemic pricing advantage in our marketplace via consolidated and streamlined systems and operations; faster product time to market; additional retail revenue via premium financing; improved claims and underwriting performance via increased automated application of best practice processing rules; a platform to simplify and hasten post-merger and acquisition integration-reducing integration costs and accelerating synergies realization; and improved customer focus and retention. Through December 31, 2008, we have capitalized $35.8 million of costs related to the transformation. The agency management and premium finance systems were fully implemented in the first quarter of 2008. The insurance systems began to be implemented in June 2008 with the claims system implemented to support all of our operations except for our Louisiana and Alabama operations in 2008. We are in the process of converting all remaining open claims from the legacy system to the new system. For the new policy administration system, we plan to operate the legacy systems through the policies’ renewal dates when they will be converted to the new system. This will result in additional operating expense until the legacy systems can be retired.
Depreciation and amortization expenses for 2007 increased $6.9 million, or 156.0%, compared with 2006. Depreciation expense increased by $2.5 million and amortization expense increased by $4.4 million for 2007, primarily as a result of the acquisition accounting for USAgencies. The USAgencies-related costs consisted of the amortization for the intangible costs of trade name, non-competition agreement and agency relationships determined as required by purchase accounting.
Interest Expense. Interest expense for 2008 decreased $6.7 million, or 26.6%, compared with 2007. The decrease in interest expense was due to the lower level of average debt outstanding. The average balance of our senior secured credit facility was $152.8 million during 2008, a decrease of $46.3 million, or 23.3%, from the average balance during 2007. In 2008, we repaid $66.3 million of the senior secured facility. In January 2008, we entered into an additional interest rate swap with a notional amount of $95.0 million that was also designated a hedge of variable cash flows associated with the senior term loan. The notional amount of the swap gradually declines to $40.0 million prior to its expiration. For this swap, we pay a fixed rate of 3.031% and receive a three-month LIBOR rate. In the second quarter of 2008, the notional amount of the swap was reduced by $5.0 million for a $60,000 gain.
Income tax expense for 2007 was $2.1 million, or an effective rate of 17.9%, compared with income tax expense of $2.7 million, or an effective rate of 21.3%, for 2006. The lower effective tax rate for 2007 was primarily due to the relatively high proportion of the investment income generated by the tax-exempt securities in our investment portfolio.
There are no restrictions on the payment of dividends by our non-insurance company subsidiaries other than state corporate laws regarding solvency. As a result, our non-insurance company subsidiaries generate revenues, profits and net cash flows that are generally unrestricted as to their availability for the payment of dividends and we have and expect to continue to use those revenues to service our corporate financial obligations, such as debt service and stockholder dividends. As of December 31, 2008, we had $2.9 million of cash and equivalents at the holding company level and $4.2 million of cash and cash equivalents at our non-insurance company subsidiaries.
We believe that existing cash and investment balances, as well as new cash flows generated from operations and available borrowings under our other credit facilities, will be adequate to meet our capital and liquidity needs during the 12-month period following the date of this report at both the holding company and insurance company levels. We do not currently know of any events that could cause a material increase or decrease in our long-term liquidity needs other than the capital expenditures related to our strategic systems consolidation and transformation program and the debt service requirements of the senior secured credit facility to fund the acquisition of USAgencies.
Senior secured credit facility. In 2007, we entered into a $220.0 million senior secured credit facility (the facility) provided by a syndicate of lenders, that provide for a $200.0 million senior term loan facility and a revolving facility of up to $20.0 million, depending on our borrowing capacity. The principal amount of the term loan is payable in quarterly installments of $0.3 million, with the remaining balance due January 31, 2014. Beginning in 2008, we were also required to make additional annual principal payments that are calculated based upon our financial performance during the preceding fiscal year. In addition, certain events, such as the sale of material assets or the issuance of significant new equity, necessitate additional required principal repayments. During 2008, we made $66.3 million in principal payments. As of December 31, 2008, we had no borrowings under the revolving portion of the facility.
The interest coverage ratio covenant calculation has been changed to include only interest expense paid in cash. In addition, the quarterly requirements have been changed for the remaining term of the facility.
The revolving facility was reduced from $20 million to $10 million.
The following table summarizes our contractual obligations at December 31, 2008 (in thousands):
(1) As of December 31, 2008, we leased an aggregate of approximately 426,070 square feet of office space for our agencies, insurance companies and retail stores in various locations throughout the United States. These amounts represent our minimum future operating lease commitments.
(3) The principal amount of the Borrowing is payable in quarterly installments of $348,665, with the remaining balance due on the seventh anniversary of the closing of the facility. Beginning in 2008, we are also required to make additional annual principal payments that are to be calculated based upon our financial performance during the preceding fiscal year. In addition, certain events, such as the sale of material assets or the issuance of significant new equity, necessitate additional required principal repayments.
(4) In October 2006, we entered into an IT outsourcing contract with a data processing services provider under which we outsourced substantially all of our IT operations, including our data center, field support and application management. The initial term of the agreement is ten years, although it may be terminated for convenience by us at any time upon six month’s notice after the first two years, subject to the payment of certain stranded costs and other termination fees. These amounts represent our minimum future IT outsourcing commitments.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Affirmative Insurance Holdings, Inc. and subsidiaries’ internal control over financial reporting as of December 31, 2008, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 31, 2009 expressed an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.
We have audited Affirmative Insurance Holdings, Inc. and its subsidiaries’ (the Company) internal control over financial reporting as of December 31, 2008, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). 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 Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.
In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2008, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of the Company as of December 31, 2008 and 2007, and the related consolidated statements of income, stockholders’ equity, comprehensive income (loss), and cash flows for each of the years in the three-year period ended December 31, 2008, and our report dated March 31, 2009 expressed an unqualified opinion on those consolidated financial statements.
Affirmative Insurance Holdings, Inc., formerly known as Instant Insurance Holdings, Inc., was incorporated in Delaware in June 1998. We are a distributor and producer of non-standard personal automobile insurance policies and related products and services for individual consumers in targeted geographic areas. We are currently active in offering insurance directly to individual consumers through retail stores in 10 states (Louisiana, Texas, Illinois, Alabama, Florida, Missouri, Indiana, South Carolina, Kansas and Wisconsin) including our franchised stores in Florida and distributing our own insurance policies through 8,000 independent agents or brokers in 10 states (Louisiana, Texas, Illinois, California, Michigan, Florida, Missouri, Indiana, South Carolina and New Mexico).
Basis of Presentation • Our consolidated financial statements have been prepared in accordance with U.S. Generally Accepted Accounting Principles (GAAP) and include our accounts and the accounts of our operating subsidiaries. All intercompany accounts and transactions have been eliminated in consolidation.
Fiduciary and Restricted Cash • In our capacity as an insurance agency, we collect premiums from insureds and, after deducting our authorized commissions, remit these premiums to the appropriate insurance companies. Unremitted insurance premiums are held in a fiduciary capacity until disbursed by us. In certain states where we operate, the use of investment alternatives for these funds is regulated by various state agencies. We invest these unremitted funds only in cash and money market accounts and report such amounts as restricted cash on our consolidated balance sheets. We report the unremitted liability of these funds as amounts due reinsurers on our consolidated balance sheets. Interest income earned on these unremitted funds is reported as investment income in our consolidated statements of income.
Investments • Investment securities are classified as either available-for-sale investment securities or trading securities and are reported at fair value, generally based on quoted prices in active markets or third-party valuation sources when observable market prices are not available. Unrealized gains and losses are excluded from earnings and reported as a separate component of stockholders’ equity, net of deferred income taxes for available-for-sale investment securities. For trading securities, unrealized gains and losses are reported in the current period’s earnings.
Investments are considered to be impaired when a decline in fair value is judged to be other-than-temporary. On a quarterly basis, we consider available quantitative and qualitative evidence in evaluating potential impairment of our investments. If the cost of an investment exceeds its fair value, we evaluate, among other factors, general market conditions, the duration and extent to which the fair value is less than cost, and our intent and ability to hold the investment to maturity. We also consider potential adverse conditions related to the financial health of the issuer based on rating agency actions. Once a decline in fair value is determined to be other-than-temporary, an impairment charge is recorded in earnings and a new cost basis in the investment is established.
On January 1, 2007, we adopted the provisions of Statement of Financial Accounting Standard (SFAS) No. 155, Accounting for Certain Hybrid Financial Instruments - an amendment of Financial Accounting Standards Board (FASB) Statements No. 133 and 140, which permits the fair value remeasurement of any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation under SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities; clarifies which interest-only strips and principal-only strips are not subject to the requirements of SFAS No. 133; establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or hybrid financial instruments that contain an embedded derivative requiring bifurcation and clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives. The adoption of SFAS No. 155 did not have a material impact on our consolidated financial statements.
Premium Finance Receivable • We recognize interest and origination fees from finance receivables over the term of the finance contract. Late fee revenue is recognized when received.
Other Assets • In November 2008, we elected to participate in a settlement agreement with our broker related to auction-rate securities. We elected to report this settlement as a financial asset at fair value in other assets with changes in fair value reported in other income in accordance with SFAS No. 159.
Claims processing fees - Claims processing fees are received from insurance companies over the premium earning period of the underlying policies. The fees are recognized as revenue over the expected period during which processing services are performed and in amounts appropriate to the processing effort and related costs. The service period and related revenues are based upon historical and expected claims settlement data.
Stock-Based Compensation • Under SFAS No. 123R, Share-Based Payment, we use the modified prospective method and, accordingly, we have not restated prior periods. We recognize stock-based compensation expense using the straight-line method.
Segment Reporting • Our business is the design, sale, underwriting and servicing of non-standard personal automobile insurance policies. Our parent company is a holding company, with no revenues and only interest expense on corporate debt. Our subsidiaries consist of several types of legal entities: insurance companies, underwriting agencies, retail agencies, and a service company where all employees are paid. Our insurance companies possess the certificates of authority and capital necessary to transact insurance business and issue policies, but they rely on both affiliated and unaffiliated underwriting agencies to design, distribute and service those policies. Our underwriting agencies primarily design, distribute and service policies issued or reinsured by our insurance companies and that are distributed by our retail entities and by independent agents. Given the homogeneity of our products, the regulatory environments in which we operate, the nature of our customers and our distribution channels, we monitor, control and manage our business lines as an integrated entity offering non-standard personal automobile insurance products through multiple distribution channels.
Statutory accounting practices • We are required to report our results of operations and financial position to insurance regulatory authorities based upon statutory accounting practices (SAP). One significant difference between SAP and GAAP is that under SAP, we are required to expense all sales and other policy acquisition costs as they are incurred rather than capitalizing and amortizing them over the expected life of the policy as required by GAAP. The immediate charge off of sales and acquisition expenses and other conservative valuations under SAP generally cause a lag between the sale of a policy and the emergence of reported earnings. Since this lag can reduce our income from operations on a SAP basis, it can have the effect of reducing the amount of funds available for dividends from insurance companies. A second significant difference is that under SAP, certain assets are designated as “nonadmitted” and are charged directly to unassigned surplus, whereas under GAAP, such assets are included in the balance sheet net of an appropriate valuation reserve. A third significant difference between SAP and GAAP is that SAP requires available-for-sale investments be carried at amortized book value while GAAP requires available-for-sale investments be carried at fair value.
In December 2007, the FASB issued SFAS No. 141R, Business Combinations, which requires most identifiable assets, liabilities, non-controlling interests, and goodwill acquired in a business combination to be recorded at full fair value. SFAS No. 141R also requires, among other things, the acquisition costs to be expensed in the periods they are incurred, the contingent considerations resulting from events after the
Other Acquisitions • In March 2008, we paid $188,000 for the purchase of one of our franchise stores.
In March 2006, we completed the acquisition of the 27% minority ownership interest of Space Coast Holdings, Inc. We paid approximately $3.2 million to the minority owners and recorded $3.2 million in goodwill. Consequently, our current ownership interest in Space Coast is 100%.
Our trading investment portfolio consists of fixed-income securities, which are carried at fair value with realized gains and losses reported in the current period’s earnings. The Investment Committee periodically reviews investment portfolio results and evaluates strategies to maximize yields, to match maturity durations with anticipated needs, and to maintain compliance with investment guidelines.
Expected maturities may differ from contractual maturities because certain borrowers may have the right to call or prepay obligations with or without penalties. Our amortized cost and estimated fair value of trading securities at December 31, 2008 by contractual maturity are as follows (in thousands):
The amortized cost, gross unrealized gains (losses), and estimated fair value of our investments at December 31 are as follows (in thousands):
At December 31, 2008, we owned approximately $25.4 million of pre-refunded municipal bonds. These pre-refunded municipal bonds have contractual maturities in excess of ten years. However, due to pre-refunding, these securities will be called by the issuer generally within three years or less. Pre-refunded municipal bonds are created when municipalities issue new debt to refinance debt issued when interest rates were higher. Once the refinancing is completed, the issuer uses the proceeds to purchase U.S. Treasury securities and places these securities in an escrow account. These proceeds are then used to pay interest and principal on the original debt until the bond is called.
The following table shows our investments with gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position at December 31, 2008 and 2007 (in thousands):
Our portfolio contains primarily only highly-rated, fixed-income securities. For fixed-income securities with unrealized losses due to market conditions, we have the positive intent and ability to hold the investment for a period of time sufficient to allow a market recovery or to maturity. Management did not believe any unrealized losses represent an other-than-temporary impairment based on our evaluation of available evidence at December 31, 2008.
At both December 31, 2008 and 2007, investments in fixed-maturity securities with an approximate carrying value of $1.9 million were on deposit with regulatory authorities as required by insurance regulations.
In the ordinary course of business, we place reinsurance with other insurance companies in order to provide greater diversification of our business and limit the potential for losses arising from large risks. In addition, we assume reinsurance from other insurance companies.
Under certain of our reinsurance transactions, we have received ceding commissions. The ceding commission rate structure varies based on loss experience. The estimates of loss experience are continually reviewed and adjusted, and the resulting adjustments to ceding commissions are reflected in current operations. The ceding commissions recognized were reflected as a reduction of the following expenses (in thousands):
The amount of loss reserves and unearned premium we would remain liable for in the event our reinsurers are unable to meet their obligations was as follows (in thousands):
On April 1, 2007, we exercised our option to terminate certain quota-share contracts on a “cut-off” basis. In April 2007, we received $31.0 million to settle the unearned premiums less return ceding commissions. Effective January 1, 2009, we terminated our quota-share reinsurance contract on a cut-off basis. On January 29, 2009, we received $7.8 million of returned unearned premiums net of returned ceding commissions.
The Michigan Catastrophic Claims Association (MCCA) is a reinsurance facility that covers no-fault medical losses above a specific retention amount. For policies effective July 1, 2008 to June 30, 2009, the required retention is $0.4 million. As a writer of personal automobile policies in the state of Michigan, we cede premiums and claims to the MCCA. Funding for MCCA comes from assessments against automobile insurers based upon their proportionate market share of the state’s automobile liability insurance market. Insurers are allowed to pass along this cost to Michigan automobile policyholders. Our ceded premiums written to the MCCA were $1.9 million, $3.6 million and $1.8 million in 2008, 2007 and 2006, respectively. We did not issue policies in Michigan prior to 2006.
We evaluated the transaction and concluded that we did not assume significant insurance risk because the probability of a significant variation in the amount of payments by the reinsurers was remote. This was primarily
due to a sliding scale profit commission payable by the reinsurer to us should there be favorable loss development. This profit commission made the likelihood very remote that the reinsurer would have any significant additional gain or loss on this block of business. The reinsurers will ultimately make the same payments, either to us from profit commission or for the full amount of losses and loss adjustment expenses. The combined cost to the reinsurer is the same. Consequently, since no significant risk was transferred, the use of deposit accounting was required and the use of reinsurance accounting was impermissible under SFAS No. 113. At December 31, 2008, there were no deposit assets and $0.4 million of deposit liabilities recorded on the balance sheet for this contract.
Finance receivables, which are secured by unearned premiums from the underlying insurance policies, consisted of the following at December 31, 2008 and 2007 (in thousands):
A summary of property and equipment at December 31, 2008 and 2007 were as follows (in thousands):
Depreciation expense was $7.4 million, $5.4 million, and $2.9 million for the years ended December 31, 2008, 2007 and 2006, respectively.
In 2008, we recognized a realized gain on disposal of assets of $12,000. In 2007 and 2006, we recognized realized losses on disposal of assets of $146,000 and $432,000, respectively.
As of September 30, 2008, the Company completed its annual goodwill and other intangible asset impairment analysis. Consistent with prior assessments, the fair value of goodwill and intangibles was determined using an internally developed discounted cash flow methodology and other relevant indicators of value available in the market place such as market transactions and trading values of similar companies. Based upon the results of the assessment, the Company concluded that the carrying value of other intangible assets related to the Company’s Florida operations exceeded fair value, resulting in an impairment loss of $4.4 million for non-amortizable other intangible assets and $0.2 million for amortizable other intangible assets. The impairment loss is included in impairment of intangible assets in the income statement.
Changes in the carrying value of goodwill for the year ended December 31, 2008 and 2007 were as follows (in thousands):
Amortization expense will be recognized over a weighted-average period of approximately 11.4 years.
Our long-term debt instruments and balances outstanding at December 31, 2008 and 2007 were as follows (in thousands):
The $20.2 million notes payable due 2035 are redeemable in whole or in part anytime after March 15, 2010. Prior to March 15, 2010, the notes may only be redeemed in whole or in part subject to certain specific restrictions and prepayment penalties pursuant to the indenture agreement. The notes were issued in March 2005 and bear an initial interest rate of the three-month Libor rate plus 3.95 percent not exceeding 12.5 percent through March 2010 with no limit thereafter.
In 2007, we entered into a $220.0 million senior secured credit facility (the facility) provided by a syndicate of lenders that provide for a $200.0 million senior term loan facility, which we immediately borrowed under a term loan, and a revolving facility of up to $20.0 million, depending on our borrowing capacity. As of December 31, 2008, we have no borrowings under the revolving portion of the facility. Our obligations under the facility are guaranteed by our material operating subsidiaries (other than our insurance companies) and are secured by a first lien security interest on all of our assets and the assets of our material operating subsidiaries (other than our insurance companies), including a pledge of 100% of the stock of AIC. The facility contains certain financial covenants, which include capital expenditure limitations, minimum interest coverage requirements, maximum leverage ratio requirements, minimum risk-based capital requirements, maximum combined ratio limitations, minimum fixed charge coverage ratios and a minimum consolidated net worth requirement, as well as other restrictive covenants. As time passes, certain of the financial covenants become increasingly more restrictive. At December 31, 2008, we were in compliance with all of our financial and other covenants.
In connection with entering into the facility, we paid $6.6 million in deferred debt acquisition costs that is being amortized over the seven-year term of the facility.
Pricing depends on the amount of the leverage ratio. If the leverage ratio is greater than 2.0, the pricing is LIBOR plus 6.25%. If the leverage ratio is greater than 1.5 and less than or equal to 2.0, the pricing is LIBOR plus 6.00%. If the leverage ratio is less than or equal to 1.5, the pricing is LIBOR plus 5.75%.
The provision for income taxes for the years ended December 31 consisted of the following (in thousands):
Our effective tax rate differed from the statutory rate of 35% for the years ended December 31 as follows:
At December 31, 2008, we have available approximately $2.9 million of capital loss carryforward resulting primarily from sales of securities executed in 2006 and 2007 to adjust the duration of our investment portfolio. This capital loss carryforward, which may be carried forward for five years, may only be used to offset future realized capital gains. We recorded a valuation allowance for the full amount of the deferred tax asset resulting from this capital loss carryforward. We believe the available objective evidence, principally the capital loss carryforward being utilizable to offset only future capital gains, our current investment strategy, and a lack of significant historical realized capital gains creates sufficient uncertainty regarding the realizability of our capital loss carryforward.
In October 2006, we entered into an IT outsourcing contract with a data processing services provider under which we outsourced substantially all of our IT operations, including our data center, field support and application management. The initial term of the agreement was ten years, although it may be terminated for convenience by us at any time upon six month’s notice after the first two years, subject to the payment of certain stranded costs and other termination fees. Our IT outsourcing expenses were $12.7 million, $11.5 million and $6.6 million for the years ended December 31, 2008, 2007 and 2006, respectively.
As of December 31, 2008, we leased office space for our agencies, insurance companies and retail stores in various locations throughout the United States. Our operating lease rental expenses were $9.6 million, $10.2 million and $8.9 million for the years ended December 31, 2008, 2007 and 2006, respectively.
The following table sets forth the reconciliation of numerators and denominators for the basic and diluted earnings per share computation for each of the years ended December 31, 2008, 2007 and 2006 (in thousands, except per share amounts):
In May 2004, our board of directors adopted and our stockholders approved the 2004 Stock Incentive Plan (2004 Plan) to enable us to attract, retain and motivate eligible employees, directors and consultants through equity-based compensatory awards, including stock options, stock bonus awards, restricted and unrestricted stock awards, performance stock awards, stock appreciation rights and dividend equivalent rights. The maximum number of shares of common stock reserved for issuance under the 2004 Plan, as amended, is 3,000,000, subject to adjustment to reflect certain corporate transactions or changes in our capital structure. At December 31, 2008, 1,064,410 shares were reserved for future grants under the 2004 Plan.
We have a 1998 Omnibus Incentive Plan (1998 Plan) under which we may grant options to employees, directors and consultants for up to 803,169 shares of common stock. The exercise prices are determined by the board of directors, but shall not be less than 100% of the fair market value on the grant date or, in the case of any employee who is deemed to own more than 10% of the voting power of all classes of our stock, not less than 110% of the fair market value. The terms of the options are also determined by the board of directors, but shall never exceed ten years or, in the case of any employee who is deemed to own more than 10% of the voting power of all classes of our common stock, shall not exceed five years. We do not expect to grant any further equity awards under the 1998 Plan, but intend to make all future awards under the 2004 Plan. While all awards previously granted under the 1998 Plan will remain outstanding, 1998 Plan shares will not be available for re-grant if these outstanding awards are forfeited or cancelled.
A summary of the stock option activities for each of the three years ended December 31 was as follows (shares in thousands):
We recognized total compensation expense related to the stock options of $727,000, $863,000 and $549,000 during 2008, 2007 and 2006, respectively. Compensation expense is included in selling, general and administrative expenses in the consolidated statement of income. Total unrecognized compensation expense related to unvested stock options was $1.4 million at December 31, 2008, which will be recognized over a weighted-average period of approximately 2.7 years.
Restricted Stock Awards • A summary of activity for our restricted stock grants for each of the years ended December 31 was as follows (shares in thousands):
We sponsor a defined contribution retirement plan under Section 401(k) of the Internal Revenue Code. The plan covers substantially all employees who meet specified service requirements. Under the plan, we may, at our discretion, match 100% of each employee’s contribution, up to 3% of the employee’s earnings, plus 50% of each employee’s contribution for the next 2% of the employee’s salary. Our total contributions to the 401(k) plan were $1.0 million in 2008, 2007 and 2006.
In January 2007, 227 West Monroe Street, Inc., as landlord (Landlord) executed a Consent to Assignment among the Landlord, KR Callahan & Company, LLC (KRCC), an entity whose sole member and manager is Kevin R. Callahan, our Chairman and Chief Executive Officer, and Affirmative Property Holdings, Inc. (Affirmative Property), an indirect wholly-owned subsidiary of ours, and approved the assignment (the Assignment) of the leasehold interest held by KRCC to Affirmative Property with effect from December 2006. Pursuant to the Assignment, KRCC assigned to Affirmative Property all of its right, title and interest in and
to the Lease (the Lease), dated May 8, 2006, between KRCC, as tenant, and the Landlord, and Affirmative Property agreed with KRCC to assume all obligations of KRCC, as tenant, under the Lease. The Lease relates to office space in Chicago, Illinois that will be used by our Claims Staff Counsel. The Lease continues until July 31, 2016 and provides for an average monthly rent of approximately $9,690. In addition, Affirmative Property will be responsible for the payment of taxes, common area maintenance charges and other customary occupancy costs.
We are subject to comprehensive regulation and supervision by government agencies in Illinois, Louisiana, Michigan, and New York, the states in which our insurance company subsidiaries are domiciled, as well as in the states where our subsidiaries sell insurance products, issue policies, handle claims and finance premiums. Certain states impose restrictions or require prior regulatory approval of certain corporate actions, which may adversely affect our ability to operate, innovate, obtain necessary rate adjustments in a timely manner or grow our business profitably. These regulations provide safeguards for policy owners and are not intended to protect the interests of stockholders. Our ability to comply with these laws and regulations, and to obtain necessary regulatory action in a timely manner, is and will continue to be critical to our success.
Our insurance company subsidiaries are subject to risk-based capital standards and other minimum capital and surplus requirements imposed under applicable state laws, including the laws of their state of domicile. The risk-based capital standards, based upon the Risk-Based Capital Model Act adopted by the National Association of Insurance Commissioners, or NAIC, require our insurance company subsidiaries to report their results of risk-based capital calculations to state departments of insurance and the NAIC.
State insurance laws restrict the ability of our insurance company subsidiaries to declare stockholder dividends. These subsidiaries may not make an “extraordinary dividend” until 30 days after the applicable commissioner of insurance has received notice of the intended dividend and has not objected in such time or until the commissioner has approved the payment of the extraordinary dividend within the 30-day period. In most states, an extraordinary dividend is defined as any dividend or distribution of cash or other property whose fair market value, together with that of other dividends and distributions made within the preceding 12 months, exceeds the greater of 10.0% of the insurance company’s surplus as of the preceding year-end or the insurance company’s net income for the preceding year, in each case determined in accordance with statutory accounting
Effective January 1, 2008, the Company adopted SFAS No. 157 which defines fair value, expands disclosure requirements, and specifies a hierarchy of valuation techniques. The disclosure of fair value estimates in the FAS 157 hierarchy is based on whether the significant inputs into the valuation are observable. In determining the level of hierarchy in which the estimate is disclosed, the highest priority is given to unadjusted quoted prices in active markets and the lowest priority to unobservable inputs that reflect the Company’s significant market assumptions. The Company measures certain assets and liabilities at fair value on a recurring basis, including investment securities classified as available-for-sale or trading, cash equivalents, other
receivables and interest rate swaps. Following is a brief description of the type of valuation information (“inputs”) that qualifies a financial asset for each level:
Where possible, the Company utilizes quoted market prices to measure fair value. For assets and liabilities that have quoted market prices in active markets, the Company uses the quoted market prices as fair value and includes these prices in the amounts disclosed in Level 1 of the hierarchy. When quoted market prices in active markets are unavailable, the Company determines fair values based on independent external valuation information, which utilizes various models and valuation techniques based on a range of inputs including pricing models, quoted market price of publicly traded securities with similar duration and yield, time value, yield curve, prepayment speeds, default rates and discounted cash flow. In most cases, these estimates are determined based on independent third-party valuation information, and the amounts are disclosed as Level 2 or Level 3 of the fair value hierarchy depending on the level of observable market inputs.
The following table provides information as of December 31, 2008 about the Company’s financial assets and liabilities measured at fair value on a recurring basis:
The Company’s Level 3 financial assets include certain illiquid auction-rate securities. Observable market inputs for certain auction-rate securities that have experienced failed auctions as a result of liquidity issues in the
The Company’s Level 3 financial assets also include other receivables related to a purchase agreement entered into during November 2008 with our broker to liquidate certain of our auction-rate securities. Under the terms of the agreement, our broker will purchase our eligible auction-rate securities for full par value on or prior to June 30, 2012. As of December 31, 2008, we held $51.3 million (par value) of auction-rate securities that are eligible for such settlement. We have elected to record the settlement as a financial asset at fair value in accordance with SFAS No. 159. Fair value for the settlement was determined using third-party valuation sources and is recorded as other receivables in Level 3 of the fair value hierarchy.
Fair value measurements for liabilities in category Level 3 as of December 31, 2008 were as follows (in thousands):
Gains and losses (realized and unrealized) for Level 3 assets and liabilities included in earnings for the period ended December 31, 2008, are reported in net investment income and other comprehensive income as follows:
Senior secured credit facility - The fair value of the senior secured credit facility based on third-party valuation sources is estimated to be $94.9 million.
Insura, AIC of Michigan and Casualty are wholly-owned subsidiaries of AIC and are included as common stock investments on AIC’s balance sheet in its statutory surplus. The following table summarizes selected statutory information of our insurance subsidiaries ended December 31 (in thousands):