As of December 31, 2014, we leased an aggregate of 160,420 square feet of office space in various locations throughout the United States. These leased properties included the following:
We are a provider of non-standard personal automobile insurance policies for individual consumers in targeted geographic markets. Non-standard personal automobile insurance policies provide coverage to drivers who find it difficult to obtain insurance from standard automobile insurance companies due to their lack of prior insurance, age, driving record, limited financial resources or other factors. Non-standard personal automobile insurance policies generally require higher premiums than standard automobile insurance policies for comparable coverage.
We incurred losses from operations over the last six years, including an operating loss of $31.0 million for the year ended December 31, 2014. Losses over this period were primarily due to underwriting losses, significant revenue declines, expenses declining less than the amount of revenue declines, and goodwill impairments. The losses from operations were the result of significant new business written in 2012 and 2013, prior pricing issues in some states in which we have taken significant pricing and underwriting actions to address profitability, losses from states that we have exited, such as Florida and Michigan, and goodwill impairment charges as a result of such losses.
Our insurance 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 insurance companies to report their results of risk-based capital calculations to state departments of insurance and the NAIC. At December 31, 2014, the risk-based capital level of Affirmative Insurance Company (AIC) triggered a regulatory action level event under the NAIC standard. As a result, AIC is required to submit a plan to the Illinois Department of Insurance (IDOI) in April 2015 detailing corrective actions it will take to return its risk-based capital ratio to an acceptable level. Upon receipt of the plan, the IDOI may accept the plan, require further amendments to the plan or take additional regulatory action including, but not limited to, placing AIC in receivership. Such additional regulatory action by the Illinois Department of Insurance would have a material adverse effect on our operations and the interest of our creditors and stockholders. Such additional regulatory action by the Illinois Department of Insurance also would trigger a further event of default under our senior secured credit facility and subordinated credit facility allowing our lenders to declare all amounts outstanding under the facilities to be immediately due and payable, and if such amounts were declared immediately due and payable by the lenders, it would have a material adverse effect on our operations and the interests of our creditors and stockholders.
We have taken and will continue to pursue appropriate actions to improve the underwriting result. We are also pursuing various other actions to address these issues. However, there can be no assurance that these actions will be effective.
Reserving for unpaid losses and loss adjustment expenses. On a quarterly basis at the end of each financial reporting period, we record management’s best estimate of our overall reserve for both current and prior accident years. The amount recorded represents the remaining amount we expect to pay for all covered losses, including case reserves, reserves for unreported losses, and supplemental development on losses with reserves as of the statement date, as well as the amount we expect to pay for all claim settlement expenses. The overall reserve estimate for loss and loss adjustment expenses (LAE) is the difference between management’s best estimate of the ultimate loss and LAE and the paid loss and LAE through the current financial statement date. Management’s best estimate consists of separate estimates for loss, defense and cost containment expenses, and adjusting and other expenses.
Frequency and Severity - We use historical claim count development over discrete periods of time to estimate future claim counts. We divide projected ultimate claim counts by an exposure base (earned car-years), select expected claim frequencies from the results, and adjust them for trends based on internal and external information. Concurrently, we divide projected ultimate losses by the projected ultimate claim counts to select expected loss severities. We use internal and external information to trend the severities and combine them with the trended, projected frequencies to develop ultimate loss projections.
We monitor the actual emergence of loss and LAE data and compare it to the expected emergence implied by our central point estimates. Differences in these are part of our considerations for whether it’s appropriate to modify our assumptions for developing loss and LAE reserve estimates.
We conduct regular reviews to assess whether our investments are impaired and if any impairment is other than temporary. Factors considered by us in assessing whether an impairment is other than temporary include the credit quality of the investment, the duration of the impairment, our ability and intent to hold the investment until recovery or maturity and overall economic conditions. An other-than-temporary impairment is triggered in circumstances where (1) an entity has an intent to sell the security, (2) it is more likely than not that the entity will be required to sell the security before recovery of its amortized cost basis, or (3) the entity does not expect to recover the entire amortized cost basis of the security (that is, a credit loss exists). Other-than-temporary impairments are separated into amounts representing credit losses which are recognized in earnings and amounts related to all other factors which are recognized in other comprehensive income (loss), a component of stockholders’ equity (deficit). All impairments on our available-for-
On September 30, 2013, we sold our retail agency distribution business to Confie Seguros (Confie). Our retail agency distribution business consisted of 195 retail locations in Louisiana, Alabama, Texas, Illinois, Indiana, Missouri, Kansas, South Carolina and Wisconsin and two premium finance companies (the retail business). Proceeds from the sale were $101.9 million in cash with the potential to receive an additional $20.0 million of cash proceeds. The initial cash proceeds included a working capital adjustment of $1.9 million that was received in 2013 and $20.0 million placed in an escrow account. The funds held in escrow were available, dependent upon the quarterly risk-based capital status of Affirmative Insurance Company (AIC), to be utilized to either infuse capital into AIC or pay down debt. As of the first risk-based measurement date of September 30, 2013, AIC met the risk-based capital target and in November 2013, $5.0 million was released from the escrow account and was used to pay down the senior secured credit facility. As of December 31, 2013, AIC met the risk-based capital target and in April 2014, an additional $5.0 million was released from the escrow account and was used to pay down the senior secured credit facility. In March 2014, the purchase agreement was amended to eliminate the measurement of risk-based capital as of March 31, 2014. In June 2014, the remaining $10.0 million in the escrow account was utilized to infuse capital into AIC.
In connection with the sale of the retail business, we also entered into a distribution agreement pursuant to which the purchaser will continue to produce insurance business for our insurance subsidiaries at least until the earlier of December 15, 2015, or when Confie’s obligation to pay the contingent proceeds pursuant to the purchase agreement is discharged. Among other things, the distribution agreement sets forth the terms and conditions under which Confie will produce insurance business for the Company after the closing and includes terms designed to preserve the volume of business produced by the retail business for the Company as of the closing. In turn, the distribution agreement obligates our insurance subsidiaries to maintain reinsurance and their underwriting capacity in the markets where the retail business operates for the duration of the distribution agreement, including certain restrictions on increasing fees and rates beyond certain thresholds without Confie’s consent. Additionally, Confie will continue to provide premium financing capability for the Company’s policies, including for business written through other independent agencies in certain markets, and the parties will share equally in any increased profits from premium financing other independent agency business during the term of the distribution agreement. Due to the Company’s significant continuing involvement as the underwriter for business produced by the retail agency distribution business and the ongoing premium finance arrangements, the operating activities of the retail agency distribution are not reflected as discontinued operations.
Total net premiums written for 2014 decreased $26.9 million, or 20.9%, compared with 2013. The decrease was primarily due to changes in the amount of quota-share reinsurance, which was partially offset by the growth in direct premiums written. Net premiums written was impacted by the termination of the March 2013 quota-share reinsurance contract on January 1, 2014 with the return of $47.2 million in unearned premiums and the termination of the December 2013 quota-share reinsurance contract on June 30, 2014 with the return of $51.7 million in unearned premiums. Offsetting this increase was the new reinsurance agreement entered into on June 30, 2014 to cede 85% of business written in our five largest states.
Total net premiums written for 2013 decreased $41.9 million, or 24.6%, compared with 2012. The decrease was due to an increase in reinsurance. Net written premium was impacted by the 40% quota-share reinsurance contract that was effective March 31, 2013 with the initial cession of $27.2 million unearned premiums, the amendment ceding an additional 40% effective June 30, 2013, ceding additional $24.4 million of unearned premium, and impacted by the termination of a reinsurance agreement with a county mutual that was terminated on January 1, 2013, which reduced gross written premiums by $11.8 million.
Reinsurance. In 2011, we entered into a quota-share agreement with a third-party reinsurance company under which we ceded 10% of business produced in Louisiana, Alabama, Texas and Illinois from September 1, 2011 through December 31, 2011. At December 31, 2011, this contract converted to a 40% quota-share reinsurance contract on the in-force business for the applicable states throughout 2012. Written premiums ceded under this agreement totaled $82.0 million during the year ended December 31, 2012, and this agreement was extended under the same terms through March 31, 2013 and terminated on a cutoff basis as of April 1, 2013. Upon termination, we recorded $27.2 million of returned premium, net of $7.7 million of deferred ceding commissions. Written premiums under this agreement during 2013 represented a return of previously ceded premiums totaling $5.5 million. Written premiums ceded under this agreement totaled $99.3 million. This agreement was commuted in March 2015.
In 2013, we entered into a new quota-share agreement with the same third-party reinsurance company effective March 31, 2013, under which we ceded 40% for the same four states as the expiring agreement. This agreement was amended effective June 30, 2013, under which we ceded an additional 40% for the same four states for the remainder of 2013. This agreement was further amended to provide a $10.0 million reduction in ceded premiums in the fourth quarter. Written premiums ceded under this agreement totaled $145.8 million during the year ended December 31, 2013. This agreement terminated on January 1, 2014, resulting in the return of $47.2 million unearned premiums, net of $13.9 million of ceding commissions. Written premiums ceded under the agreement totaled $98.6 million.
Commission income, fees and managing general agent revenue for 2014 decreased $34.1 million, or 44.0%, compared with 2013. The decrease was due to the sale of our former retail business in September 2013. Policyholder fees increased $2.1 million, or 5.9%, due to the higher overall volume of premiums written and an increase in California fees. Managing general agent revenue decreased $4.1 million, or 43.3%, compared with the prior year period. Managing general agent revenue is related to the Texas county mutual book of business that we manage, but no longer assume the underwriting risk beginning January 1, 2013. This business has declined as we are writing more of the Texas business within our insurance company.
Net Investment Income and Other Income. Net investment income includes income on our portfolio of debt securities and net rental income from our investment in real property. Net investment income for 2014 increased $0.3 million, or 10.6%, compared with 2013. The increase was primarily due to an increase in the annualized average investment yield of 7.1% to 1.5% in 2014, compared with 1.4% in 2013. This was partially offset by the 4.6% decrease in total average invested assets to $46.5 million during 2014 from $48.7 million during 2013.
At December 31, 2014, our fixed-income investments were invested in the following: corporate debt securities 52.2%; U.S. Treasury and government agencies securities 25.0%; certificates of deposit 8.3%; mortgage-backed securities 10.0%; and states and political subdivisions securities 4.5%. The average quality of our portfolio was A- at December 31, 2014. We attempt to mitigate interest rate risk by managing the duration of our fixed-income portfolio to the duration of our reserves. As of December 31, 2014, the effective duration of our fixed-income investment portfolio was 2.5 years.
In 2014, the percentage of net losses and loss adjustment expense to net premiums earned (the net loss ratio) was 119.2% compared with 89.2% in 2013. The current year included $21.2 million of unfavorable prior period development primarily related to Louisiana, Texas, and California losses from 2013 and 2012, which was primarily due to increases in estimated severity of liability claims. Excluding the prior year development, the current accident year net loss ratio was 97.4% compared with 81.8% in 2013. The use of quota-share reinsurance overstates the net loss ratio. Loss adjustment expenses include all of the business subject to the quota-share treaties with ceding commission income booked as an offset to selling, general and administrative expenses. Excluding the impact of the quota-share, the loss ratio for the 2014 accident year was 75.2% and 74.6% for the 2013 accident year. The increase in the current year was due to our increasing of 2014 losses based on the prior period development.
In 2013, the percentage of net losses and loss adjustment expense to net premiums earned (the net loss ratio) was 89.2% compared with 77.8% in 2012. The current year included $7.0 million of unfavorable prior period development primarily related to the 2011 accident year for our Louisiana business, $3.6 million related to the 2011 and 2012 Texas business, and $1.3 million for the accident year 2012 California business. Excluding the prior year development, the current accident year net loss ratio was 81.8%
compared with 74.0% in 2012. The use of quota-share reinsurance overstates the net loss ratio. Loss adjustment expenses include all of the business subject to the quota-share treaties with ceding commission income booked as an offset to selling, general and administrative expenses. Excluding the impact of the quota-share, the loss ratio for the 2013 accident year was 74.6% and 69.4% for the 2012 accident year. The increase in the current year was primarily due to a significant increase in new business, which tends to have a higher loss ratio than renewal business. Also reflected in the above numbers is the effect of catastrophes. In the current accident year we have incurred catastrophes, net of reinsurance, equal to 2.0% for 2013 and 2012. Both of these numbers are higher than our long term average expectation of 0.5%.
Our losses and loss adjustment expense reserves of $132.8 million on a gross basis and $46.3 million on a net basis are our best estimates as of December 31, 2014. The analysis provided by our internal valuation methods indicated that the expected range for the ultimate liability for our losses and loss adjustment expense reserves, as of December 31, 2014, was between $127.5 million and $152.7 million on a gross basis and between $42.6 million and $56.0 million on a net basis.
The following table summarizes the development of reserves for unpaid losses and loss adjustment expenses (in thousands):
Selling, General and Administrative Expenses. Another measurement of our performance that addresses our overall efficiency is the level of selling, general and administrative expenses. We recognize that our customers are primarily motivated by low prices. As a result, we strive to keep our costs as low as possible to be able to keep our prices affordable and thus to maximize our sales while still maintaining profitability. Our selling, general and administrative expenses include not only the cost of acquiring the insurance policies through our insurance carriers (the amortization of the deferred acquisition costs) and managing our insurance carriers and former retail stores, but also the costs of the holding company. The largest component of selling, general and administrative expenses is personnel costs, including compensation and benefits. Selling, general and administrative expenses for 2014 decreased by $46.9 million, or 47.0%, compared to 2013. A decrease of $25.9 million resulted from the sale of the retail business which, in the prior year period, accounted for $15.6 million in personnel costs and $10.3 million in overhead costs such as rent, advertising, postage and other expenses. Excluding the impact of the direct costs of the retail operations, SG&A expenses decreased $21.0 million, or 28.0%, compared with the 2013 due to the decrease of $7.1 million in professional fees, $6.5 million in bad debt allowance reversal, $3.7 million in personnel costs, and $3.7 million in other overhead costs due to management actions to reduce expenses.
Selling, general and administrative expenses for 2013 increased $3.7 million, or 3.8%, compared with 2012, primarily due to a $26.8 million increase in policy acquisition expenses due to the increase in gross written premiums. This was partially offset by a $7.0 million decline in employee compensation and benefits, $6.7 million decline in professional fees, $4.2 million decline in advertising costs and $5.3 million in other overhead costs due to management actions to reduce expenses and the departure of employees with the sale of the retail business.
Additions to deferred acquisition costs in 2014 increased by $5.3 million, and additions to the related amortization increased by $5.7 million compared with 2013. The increase in additions is primarily due to the increase in policy acquisition expenses incurred for independent agents due to the increase in premiums written as well as the increase in policy acquisition costs of our former retail business which previously was eliminated in the consolidated financial statements. This increase is partially offset by the increase of $15.5 million of deferred acquisition costs ceded to our reinsurers.
Additions to deferred acquisition costs in 2013 decreased by $10.9 million, and additions to the related amortization decreased by $3.3 million compared with 2012. The decrease in additions is primarily due to the increase of $13.1 million of deferred acquisition costs ceded to our reinsurers, partially offset by the policy acquisition expenses incurred for independent agents due to the increase in premiums written as well as the increase in policy acquisition costs in the fourth quarter of our former retail business which previously was eliminated in the consolidated financial statements.
Net expenses, defined as the sum of selling, general and administrative expenses and depreciation and amortization less commission income, fees and managing general agent revenue, as a percentage of net premiums earned (the net expense ratio) decreased to 15.8% in 2014 compared with 17.7% in 2013. The decrease was primarily due a 47.0% decrease in selling, general and administrative expenses, a 44.0% decrease in commission income, fees and managing general agent revenue, and a 15.9% decrease in depreciation and amortization, partially offset by a 41.4% decrease in net premiums earned. Net expenses as a percentage of net premiums earned (the net expense ratio) decreased to 17.7% in 2013 compared with 31.0% in 2012. The decrease was primarily due to a 15.3% increase in net premiums earned, a 26.1% increase in commission income, fees and managing general agent revenue, and a 29.6% decrease in depreciation and amortization. The following table sets forth the components of the net expenses and the computation of the net expense ratios (in thousands):
Interest expense for 2013 increased $0.9 million, or 4.7%, compared with 2012. This increase was primarily due to an increase in amortization of debt discount, which was $4.9 million in 2013 as compared with $4.1 million for 2012 due to the incremental term loan that was borrowed in November 2012 and the new debt arrangement effective September 2013.
Income Taxes. Income tax benefit for 2014 was $1.7 million as compared with income tax expense of $0.9 million for 2013. Income tax benefit for 2014 was primarily due to the state tax benefit.
Our gross deferred tax assets prior to recognition of valuation allowance were $98.5 million and $90.0 million at December 31, 2014 and 2013, respectively. In assessing the realizability of our deferred tax assets, we considered whether it was more likely than not that our deferred tax assets will be realized based upon all available evidence, including scheduled reversal of deferred tax liabilities, historical operating results, projected future operating results, tax carry-back availability, and limitations pursuant to Section 382 of the Internal Revenue Code, among others. Based on this assessment, we began recording a valuation allowance against deferred taxes in December 2009. The valuation allowance was $97.2 million and $84.8 million at December 31, 2014 and 2013, respectively.
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 (NAIC), require our insurance company subsidiaries to report their results of risk-based capital calculations to state departments of insurance and the NAIC. Failure to meet applicable risk-based capital requirements or minimum statutory capital requirements could subject us to further examination or corrective action imposed by state regulators, including limitations on our writing of additional business, state supervision or liquidation. Any changes in existing risk-based capital requirements or minimum statutory capital requirements may require us to increase our statutory capital levels. At December 31, 2014, three of our insurance subsidiaries maintained a risk-based capital level that was in excess of an amount that would require any corrective actions. The risk-based capital level of Affirmative Insurance Company (AIC) triggered a regulatory action level event under the NAIC standard. As a result, AIC is required to submit a plan to the Illinois Department of Insurance (IDOI) in April 2015 detailing corrective actions it will take to return its risk-based capital ratio to an acceptable level. Upon receipt of the plan, the IDOI may accept the plan, require further amendments to the plan or take additional regulatory action including, but not limited to, placing AIC in receivership.
Effective January 1, 2012, the State of Illinois adopted the revised NAIC Risk-Based Capital Model Act that includes a risk-based capital trend test as another manner under which the company action level could be triggered and will be applied beginning December 31, 2012. The test is applicable when an insurance company has a risk-based capital ratio between 200% and 300% and a combined ratio of more than 120%. At December 31, 2014, three of our insurance subsidiaries maintained a risk-based capital level
that was in excess of an amount that would require any corrective actions. Affirmative Insurance Company (AIC) was at the Regulatory Action Level, thus, this test does not apply.
We believe that existing cash and investment balances, as well as cash flows generated from operations, and other actions taken by the Company will be adequate to meet our liquidity needs, planned capital expenditures and the debt service requirements of the senior secured credit facility and notes payable, during the 12-month period following the date of this report at both the holding company and insurance company levels. For the year ended December 31, 2014, cash and cash equivalents decreased $20.7 million in 2014 as compared with an increase of $6.4 million in 2013. Our net cash used in operations was $51.3 million in 2014 as compared to net cash used in operations of $3.1 million in 2013. This increase was primarily due to the increase in gross written premiums ceded to reinsurers and net loss from operations in 2014. Net cash provided by investing activities was $41.1 million in 2014 as compared to net cash provided by investing activities of $77.3 million in 2013. The decrease in cash flows was primarily due to the proceeds from the sale of the retail business recorded during the periods. In 2014, $25.0 million of proceeds were recognized compared to $84.3 million for 2013. Net cash used in financing activities was $10.6 million in 2014 as compared to net cash used in financing activities of $67.8 million in 2013. This primarily resulted from the refinancing of the Company’s senior secured credit facility effective January 2007, partially offset by the net cash proceeds received from the capital lease entered into during the current year.
The pricing under the senior secured credit facility was amended effective September 30, 2014 to an adjusted LIBOR rate floor of 1.25%, plus 9.25%. The interest rate as of December 31, 2014 was 10.50%. We made principal payments of $6.5 million and $5.0 million in 2014 and 2013, respectively. As of December 31, 2014, the principal balance of the senior secured credit facility was $28.5 million. The senior secured credit facility was issued at a discount of $2.0 million that is amortized as interest expense over the expected term of the loan using the effective interest method. Repayment of the facility is due quarterly with $2.0 million payable for each quarter through September 30, 2014, $3.5 million payable each quarter through September 30, 2015, $4.5 million payable on December 31, 2015 and the remaining balance of $13.5 million due in full on March 30, 2016. Prepayments under this agreement are applied to the earliest payments due. Effective December 31, 2014, the senior secured credit facility was amended to postpone the principal payment of $3.5 million due March 31, 2015. The next payment due is $7.0 million on June 30, 2015.
The pricing under the subordinated secured credit facility is currently subject to an adjusted LIBOR rate floor of 1.25%, plus 18.00%. The interest rate as of December 31, 2014 was 19.25%. The subordinated secured credit facility included a commitment fee of $3.0 million that was added to the principal balance outstanding. Accrued interest is added to the outstanding principal balance until the senior secured credit facility is paid. Capitalized interest totaling $2.9 million was added to the principal balance during 2014. As of December 31, 2014, the principal balance of the subordinated secured credit facility was $16.6 million.
On December 31, 2013, we entered into a capital lease transaction with an equipment finance company wherein we sold $4.9 million of computer software, software licenses and hardware used in our insurance operations and simultaneously entered into a capital lease for the EDP Equipment. We entered into a similar capital lease in 2010.
In March 2013, we entered into a $4.8 million loan secured by commercial real estate. The mortgage requires monthly payments of principal and interest with the final payment due on the maturity date of December 15, 2015. For this disclosure, it is assumed that the mortgage will not be redeemed before the contractual maturity and the interest rate will remain at its current level.
The principal amount of the senior secured credit facility is payable in quarterly installments with the remaining balance due on March 30, 2016. The principal amount of the subordinated secured credit facility is due on March 30, 2017. For this disclosure, it is assumed that none of these secured credit facilities will be redeemed before their contractual maturities and interest rates on these secured credit facilities will remain at their current levels.
The payout pattern for reserves for losses and loss adjustment expenses is based upon historical payment patterns and does not represent actual contractual obligations. The timing and amount ultimately paid can and will vary from these estimates.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Affirmative Insurance Holdings, Inc. and subsidiaries as of December 31, 2014 and 2013, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2014, in conformity with U.S. generally accepted accounting principles.
The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 2 to the consolidated financial statements, the Company’s recent history of recurring losses from operations, its failure to comply with certain financial covenants in the senior secured and subordinated credit facilities, its need to meet debt repayment requirements and its failure to comply with the Illinois Department of Insurance minimum risk-based capital requirements raise substantial doubt about its ability to continue as a going concern. Management’s plans in regard to these matters are also described in Note 2. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty.
Affirmative Insurance Holdings, Inc. (the Company), was incorporated in Delaware in June 1998. The Company is a provider of non-standard personal automobile insurance policies for individual consumers in targeted geographic areas. The Company is a party to an agreement with an unaffiliated underwriting agency in the state of California and provides non-standard insurance policies written by a Texas county mutual. The Company is currently distributing insurance policies through approximately 5,000 independent agents or brokers in 7 states (Louisiana, Texas, California, Alabama, Illinois, Indiana and Missouri).
The Company incurred losses from operations over the last six years, including an operating loss of $31.0 million for the year ended December 31, 2014. Losses over this period were primarily due to underwriting losses, significant revenue declines, expenses declining less than the amount of revenue declines, and goodwill impairments. The losses from operations were the result of significant new business written in 2012 and 2013, prior pricing issues in some states in which the Company has taken significant pricing and underwriting actions to address profitability, losses from states that the Company has exited, such as Florida and Michigan, and goodwill impairment charges as a result of such losses.
The senior secured and subordinated credit facilities contain quarterly debt covenants that set forth, among other things, minimum risk-based capital requirements for the Company’s insurance subsidiaries as well as minimum cash flow requirements for the Company’s non-regulated businesses. The credit facilities have been amended to waive compliance with the risk-based capital measurement requirement as of December 31, 2014 and as of March 31, 2015, and to postpone the principal payment of $3.5 million due March 31, 2015 to June 30, 2015. Except for the minimum risk-based capital requirement for which the Company obtained a waiver, the Company was in compliance with these covenants as of December 31, 2014. However, it is probable the Company will not meet certain of these covenants in future periods. If the Company is unable to achieve compliance with the covenants or obtain a forbearance or waiver of any non-compliance or amend the agreements to change such covenants, the lenders could declare all amounts outstanding under the facilities to be immediately due and payable. Even if the Company is compliant with the covenants or, if not compliant, obtains additional forbearance or waivers from its lenders, there is still substantial uncertainty that the Company will be able to refinance or extend the maturity of the senior secured facility when it becomes due in March 2016. If the Company’s lenders declare the amounts outstanding to be immediately due and payable or if the Company is unable to refinance or extend the maturity of the senior secured credit facility when it becomes due, it would have a material adverse effect on the Company’s operations and the Company’s creditors and stockholders.
Investments • Investment securities consist of debt securities, and are recorded at fair value on the consolidated balance sheet. These investments are classified as available-for-sale with unrealized gains and losses recorded in accumulated other comprehensive income (loss), a separate component of stockholders’ deficit. No income tax effect of unrealized gains and losses is reflected in other comprehensive income (loss) due to the Company carrying a full deferred tax valuation allowance. 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.
Amounts Due from/to Reinsurers • The Company collects premiums from insureds and after deducting its authorized commissions, the Company remits these premiums to the appropriate reinsurance companies. The Company’s obligation to remit these premiums is recorded as amounts due reinsurers in its consolidated balance sheet. The Company records the amounts it expects to receive from reinsurers for paid and unpaid losses as an asset on its consolidated balance sheet.
Identifiable intangible assets consist of state insurance company licenses. The Company reviews such intangibles for impairment whenever an impairment indicator exists. Management continually monitors events and changes in circumstances that could indicate carrying amounts of long-lived assets, including intangible assets, may not be recoverable. When such events or changes in circumstances occur, management assesses recoverability by determining whether the carrying value of such assets will be recovered through the undiscounted expected future cash flows. If the future undiscounted cash flows are less than the carrying amount of these assets, an impairment loss is recognized based on the excess of the carrying amount over the fair value of the assets.
Management evaluates on an ongoing basis the Company’s investments in Trust I and II (collectively the “Trusts”) and continue to conclude that, while the Trusts continue to be variable interest entities (“VIE’s”), the Company is not the primary beneficiary. Therefore, the Trusts are not included in the Company’s consolidated financial statements.
Reserves for Losses and Loss Adjustment Expenses • The Company maintains reserves for the estimated ultimate liability for unpaid losses and loss adjustment expenses related to incurred claims and estimates of unreported claims. The estimation of the ultimate liability for unpaid losses and loss adjustment expenses is based on projections developed by the Company’s actuaries using analytical methodologies commonly used in the property-casualty insurance industry. Liabilities for unpaid claims and for expenses of investigation and adjustment of unpaid claims are based on: (1) the accumulation of estimates of individual claims for losses reported prior to the close of the accounting period; (2) estimates received from ceding companies, reinsurers and insurance pools and associations; (3) estimates of unreported losses based on past experience; (4) estimates based on past experience of expenses for investigating and adjusting claims; and (5) estimates of subrogation and salvage collections. Management periodically adjusts the losses and loss adjustment expense reserves for changes in product mix, underwriting standards, loss cost trends and other factors. Losses and loss adjustment expense reserves may also be impacted by factors such as the rate of inflation, claims settlement patterns, litigation and legislative and regulatory activities. Unpaid losses and loss adjustment expenses have not been reduced for amounts recoverable from reinsurers. Changes in estimates of liabilities for unpaid losses and loss adjustment expenses are reflected in the consolidated statement of operations in the period in which determined. Ultimately, the actual losses and loss adjustment expenses may differ materially from recorded estimates.
Managing general agent revenue - Revenues earned for business produced for a Texas county mutual insurance agency beginning January 1, 2013. The Company receives compensation for distribution and underwriting services and providing claims handling on the business. Revenue for distribution and underwriting services are recognized, net of an allowance for estimated policy cancellations, at the date the customer is initially billed or as of the effective date of the insurance policy, whichever is later. Claims handling revenue is recognized as the services are provided.
Accounting and Reporting for Reinsurance • Income and expense on reinsurance contracts are recognized principally over the term of the reinsurance contracts or until the reinsurers maximum liability is exhausted, whichever comes first. Reinsurance contracts do not relieve the Company from its obligations to policyholders. The Company continually monitors reinsurers to minimize the exposure to significant losses from reinsurer insolvencies. The Company only cedes risks to reinsurers whom it believes to be financially sound.
Stock-Based Compensation • Compensation cost is measured based on the grant-date fair value of an award utilizing the assumptions discussed in Note 17. Compensation cost is recognized for financial reporting purposes on a straight-line basis over the period in which the employee is required to provide service in exchange for the award.
Income Taxes • The Company accounts for income taxes under the asset and liability method. Under this method, deferred income taxes are recognized for temporary differences between the financial statement and tax return bases of assets and liabilities. Recorded amounts are adjusted to reflect changes in income tax rates for the period in which the change is enacted. Any resulting future tax benefits are recognized to the extent that realization of such benefits is more likely than not, and a valuation allowance is established for any portion of a deferred tax asset that management believes will not be realized. While the Company typically does not incur significant interest or penalties on income tax liabilities, the Company’s policy is to classify such amounts as income tax expense on the consolidated statement of operations.
Recently Issued Accounting Standards • Accounting Standards Update (ASU) 2014-09, Revenue from Contracts with Customers issued in May 2014 supersedes the revenue recognition requirements in Topic 605, Revenue Recognition and most industry-specific guidance. Insurance contracts have been excluded from the scope of the guidance, which is effective for fiscal years beginning after December 15, 2016. The Company does not expect the adoption of this standard to have a material impact on the consolidated financial position, results of operations, or cash flows.
Accounting Standards Update (ASU) No. 2014-15, Presentation of Financial Statements-Going Concern (Subtopic 205-40): Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern issued in August 2014 is intended to define management’s responsibility to evaluate whether there is substantial doubt about an organization’s ability to continue as a going concern and to provide related footnote disclosures. Specifically, this ASU provides guidance to an organization’s management, with principles and definitions that are intended to reduce diversity in the timing and content of disclosures that are commonly provided by organizations today in the financial statement footnotes. The amendments are effective for annual periods ending after December 15, 2016, and interim periods within annual periods beginning after December 15, 2016. Early application is permitted for annual or interim reporting periods for which the financial statements have not previously been issued. The Company does not expect the adoption of this standard to have a material impact on the consolidated financial position, results of operations, or cash flows.
The additional $20.0 million of proceeds may be used to pay down debt or infuse capital into Affirmative Insurance Company (AIC). The additional proceeds are contingent on AIC meeting certain risk-based capital thresholds and maintaining the obligations of the distribution agreement. The risk-based capital measurement begun as of June 30, 2014 for up to $10.0 million of additional proceeds and the remaining balance up to $20.0 million can be achieved on any following quarterly measurement date through December 31, 2015. These contingent proceeds are recognized as risk-based capital measurement thresholds are achieved. In September 2014, $10.0 million of additional proceeds were received of which, $9.9 million was used to infuse capital into AIC and $0.1 million was used to pay down the senior secured credit facility.
The Company realized a pretax gain on the sale of $10.0 million and $65.0 million for the years ended December 31, 2014 and 2013, respectively. The Company’s consolidated results of operations as of December 31, 2013 include the retail business’s results of operations through the date of the sale, September 30, 2013. The net assets sold consisted of (in thousands):
The amortized cost, gross unrealized gains (losses), and estimated fair value of the Company’s available-for-sale securities at December 31, 2014 and 2013, were as follows (in thousands):
The Company had $10.0 million of unsettled investment purchases as of December 31, 2013.
The unrealized losses at December 31, 2014 were primarily attributable to changes in market interest rates since the securities were purchased. Management systematically evaluates investment securities for other-than-temporary declines in fair value on a quarterly basis. Investments are considered to be impaired when a decline in fair value is judged to be other-than-temporary. On a quarterly basis, the Company considers available quantitative and qualitative evidence in evaluating potential impairment of its investments. If the cost of an investment exceeds its fair value, the Company evaluates, among other factors, general market conditions, duration and extent to which the fair value is less than cost. If the fair value of a debt security is less than its amortized cost basis, an other-than-temporary impairment may be triggered in circumstances where (1) an entity has an intent to sell the security, (2) it is more likely than not that the entity will be required to sell the security before recovery of its amortized cost basis, or (3) the entity does not expect to recover the entire amortized cost basis of the security (that is, a credit loss exists). Other-than-temporary impairments are separated into amounts representing credit losses which are recognized in earnings and amounts related to all other factors which are recognized in other comprehensive income (loss). The Company also considers potential adverse conditions related to the financial health of the issuer based on rating agency actions. As a result of management’s quarterly analyses for the years ended December 31, 2014 and 2013, no individual securities were considered other-than-temporarily impaired.
In the ordinary course of business, the Company places reinsurance with other insurance companies in order to provide greater diversification of its business and limit the potential for losses arising from large risks. The Company’s reinsurance agreements provide for recovery of a portion of losses and loss expenses from reinsurers and reinsurance recoverables are recorded as assets. The Company is liable if the reinsurers are unable to satisfy their obligations under the agreements. The Company seeks to cede business to reinsurers generally with a financial strength rating of “A-” or better.
In 2011, the Company entered into a quota-share agreement with a third-party reinsurance company under which the Company ceded 10% of business produced in Louisiana, Alabama, Texas and Illinois from September 1, 2011 through December 31, 2011. At December 31, 2011, this contract converted to a 40% quota-share reinsurance contract on the in-force business for the applicable states throughout 2012. Written premiums ceded under this agreement totaled $82.0 million during the year ended December 31, 2012, and this agreement was extended under the same terms through March 31, 2013 and terminated on a cutoff basis as of April 1, 2013. Upon termination, the Company recorded $27.2 million of returned premium, net of $7.7 million of deferred ceding commissions. Written premiums under this agreement during 2013 represented a return of previously ceded premiums totaling $5.5 million. Written premiums ceded under this agreement totaled $99.3 million. This agreement commuted in March 2015.
Effective December 31, 2013, the Company entered into a new reinsurance agreement with four third-party reinsurance companies. Under this agreement, the Company ceded 20% of premiums and losses in Alabama, Illinois, Louisiana and Texas, and 60% in California on policies in force on December 31, 2013 or written or renewed on and after that date. Written premiums ceded under this agreement totaled $22.2 million as of December 31, 2013. On January 1, 2014, the quota-share rate increased to 60% for all business in force in these same states and for new and renewal business. On June 30, 2014, the reinsurance agreement was terminated, resulting in the return of $51.7 million of unearned premiums, net of $14.5 million of ceding commissions. Written premiums ceded under the agreement totaled $95.9 million. In March 2015, two of the quota share reinsurers commuted their participation on this agreement.
At December 31, 2014, $0.2 million was included in reserves for losses and loss adjustment expenses that represented the amounts owed by AIC under a reinsurance agreement with a VIG-affiliated company. Affirmative established a trust account to secure the Company’s obligations under this reinsurance contract, which currently holds $10.7 million in a money market cash equivalent account (the AIC Trust). The Special Deputy Receiver in Texas had cumulative withdrawals from the AIC Trust of $0.4 million through December 2014, and the Special Deputy Receiver in Hawaii had cumulative withdrawals from the AIC Trust of $1.7 million through December 2014.
Policy acquisition costs, consisting of primarily commissions and premium taxes, net of ceding commission income, are deferred and charged against income ratably over the terms of the related policies. The components of deferred policy acquisition costs and the related amortization were as follows (in thousands):
The Company’s depreciation expense was $6.0 million, $7.1 million, and $10.0 million for the years ended December 31, 2014, 2013 and 2012, respectively.
Consistent with prior assessments, the fair value of the Company was determined using an internally developed discounted cash flow method. Management made significant assumptions and estimates about the extent and timing of future cash flows, growth rates, and discount rates that represent unobservable inputs into the valuation methodologies used to calculate fair value. A discount rate of 19% was used at September 30, 2012, which the Company believes adequately reflected an appropriate risk-adjusted discount rate based on its overall cost of capital and company-specific risk factors related to cash flow, debt covenants compliance, and regulatory risk. The cash flows were estimated over a significant future period of time, which made those estimates and assumptions subject to a high degree of uncertainty. In step two of the goodwill impairment analysis, the Company determined the fair values of the Company’s assets and liabilities (including any unrecognized intangible assets) as if the Company had been acquired in a business combination. Determining the implied fair value of goodwill was judgmental in nature and involved the use of significant estimates and assumptions. The resulting implied fair value of goodwill was compared to the carrying value of goodwill, resulting in the write-off of the remaining goodwill balance of $23.4 million in 2012.
The Company sold $12.8 million of trade name intangibles as part of the retail sale in 2013, as discussed in Note 4.
The $20.1 million notes payable due 2035 are redeemable in whole or in part by the Company. The notes adjust quarterly to the three-month LIBOR rate plus 3.95%. The interest rate as of December 31, 2014 was 4.19%.
A waiver under both the senior secured and subordinated credit facility of all defaults or events of default arising out of the breach of the Company’s risk-based capital ratio for the quarters ended December 31, 2014 and March 31, 2015.
The principal payment of $3.5 million due March 31, 2015 under the senior secured facility postponed to June 30, 2015. The next principal payment due is $7.0 million on June 30, 2015.
A fee of 2.5% is due to the senior secured facility lenders upon approving the amendment. The fee shall be added to the principal amount of the credit facility as of March 31, 2015. Commencing on July 31, 2015, a fee of 0.50% is due on the last day of each month thereafter, which may, at the Company’s option, be added to the principal amount of the credit facility then outstanding.
Effective September 30, 2014, the pricing under the senior secured facility changed from adjusted LIBOR rate floor plus 7.25% to the adjusted LIBOR rate floor plus 9.25%. The new interest rate on the senior secured facility beginning September 30, 2014 is 10.50%.
Debt issuance costs of $5.2 million were capitalized and will be amortized to interest expense over the expected term of the new credit agreements.
In May 2010, the Company entered into two capital lease obligations related to certain computer software, software licenses, and hardware used in the Company’s insurance operations. The Company received cash proceeds from the financing in the amount of $28.2 million. As required by the lease agreements, the Company purchased $28.2 million of certificates of deposit held in brokerage accounts and pledged such securities as collateral against all of the Company’s obligations under the lease. The dollar amount of collateral pledged is set to decline over the term of the lease as the Company makes the scheduled lease payments. At the end of the initial term, the Company will have the right to purchase the software for a nominal fee, after which all rights, title and interest would transfer to the Company.
Property under capital lease consisted of the following as of December 31, 2014 and 2013 (in thousands):
Estimated future lease payments for the year ending December 31 (in thousands):
The Company’s effective tax rate differed from the statutory rate of 35% for the years ended December 31 as follows (in thousands):
As of December 31, 2014, the Company has available for income tax purposes federal net operating loss carryforwards (NOL’s), which may be used to offset future taxable income. The Company’s NOL’s expire as follows (in thousands):
The Company leases office space for its insurance companies in various locations throughout the United States. The Company’s operating lease rental expenses were $2.5 million, $6.8 million and $8.8 million for the years ended December 31, 2014, 2013 and 2012, respectively.
The following table summarizes the Company’s minimum commitments at December 31, 2014 (in thousands):
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, 2014, 2013 and 2012 (in thousands, except per share amounts):
In May 2004, the Company’s board of directors adopted and its stockholders approved the 2004 Stock Incentive Plan (2004 Plan) to enable the Company 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 the Company’s capital structure. At December 31, 2014, 807,195 shares were reserved for future grants under the 2004 Plan.
expected term of options granted represents the period of time that the options are expected to be outstanding. The expected volatility assumption is derived from the historical volatility of the Company’s common stock over the most recent period commensurate with the estimated expected life of the Company’s stock options, adjusted for periods of significant volatility not expected to recur. The dividend yield was based on expected dividends at the time of grant.
The Company recognized compensation expense related to the stock options of $50,000, $300,000 and $403,000 during 2014, 2013 and 2012, respectively. The 2014 expense is further reduced by $57,000 to account for forfeited options recorded in the current period. Compensation expense is included in selling, general and administrative expenses in the consolidated statements of operations. Total unrecognized compensation expense related to unvested stock options was $4,002 at December 31, 2014, which will be recognized over a weighted-average period of approximately 1.5 months.
The outstanding restricted stock awards of 472,000 at December 31, 2014 had an aggregate intrinsic value of $585,200. The aggregate fair value of restricted stock awards vested during 2012 was $1,000 at the date of vesting.
The Company sponsors 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, the Company may, at its 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. There were no employer matching contributions to the 401(k) plan in 2012 or 2013. The Company reinstated matching contributions to the 401(k) plan beginning January 1, 2014. Total costs incurred by the Company in 2014 was $0.6 million.
On September 30, 2013, the Company entered into a $10.0 million subordinated secured credit facility with JCF AFFM Debt Holdings, L.P., as Administrative Agent and Collateral Agent. JCF AFFM Debt Holdings, L.P. is an affiliate of J.C. Flowers & Co. LLC and New Affirmative LLC, the Company’s majority shareholder.
The following table sets forth the components of accumulated other comprehensive income (loss), including reclassification adjustments (in thousands):
Net gain in accumulated other comprehensive income (loss) reclassifications for previously unrealized net gains on available-for-sale securities was $46,000 and $49,000 for the years ended December 31, 2014 and 2013, respectively. The gain was not net of any taxes due to the valuation allowance for deferred income taxes.
Effective January 1, 2012, the State of Illinois adopted the revised NAIC Risk-Based Capital Model Act that includes a risk-based capital trend test as another manner under which the company action level could be triggered. The test is applicable when an insurance company has a risk-based capital ratio between 200% and 300% and a combined ratio of more than 120%. At December 31, 2014, three of our insurance subsidiaries maintained a risk-based capital level that was in excess of an amount that would require any corrective actions. Affirmative Insurance Company (AIC) was at the Regulatory Action Level, thus, this test does not apply.
State insurance laws restrict the ability of the Company’s insurance company subsidiaries to declare stockholder dividends. These subsidiaries may not issue 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 practices. In addition, dividends may only be paid from unassigned earnings and an insurance company’s remaining surplus must be both reasonable in relation to its outstanding liabilities and adequate to its financial needs. As of December 31, 2014, the Company’s insurance companies could not pay ordinary dividends to the Company without prior regulatory approval due to a negative unassigned surplus position of Affirmative Insurance Company.
The following table displays the Company’s gross written premiums managed and assumed by state (in thousands):
The Company’s Level 3 financial assets include an investment in a hedge fund, which is presented as other invested assets in the consolidated balance sheets. The Company elected the fair value option for its investment in the hedge fund and measures the fair value of the hedge fund on the basis of the net asset value of the fund as reported by the fund manager. The hedge fund is primarily invested in residential mortgage-backed securities and other asset-backed securities which are recorded at fair value as determined by the fund manager. Such fair value determination is based on quoted marked prices, bid prices, or the fund manager’s proprietary valuation models where quoted prices are unavailable or deemed to be inadequately representative of fair value. Significant decreases in the fair value of the underlying securities in the hedge fund would result in a significantly lower fair value measurement of other invested assets as reported in the consolidated balance sheets.
Fair value measurements for assets in Level 3 for the year ended December 31, 2014 were as follows (in thousands):
Fair value measurements for assets in Level 3 for the year ended December 31, 2013 were as follows (in thousands):
The Company did not have any transfers between Levels 1 and 2 during the years ended December 31, 2014 or 2013.
The fair values of the notes payable, the senior secured credit facility and the subordinated secured credit facility were estimated using discounted cash flow analyses prepared by a third-party valuation source based on inputs and assumptions, such as credit and default risk associated with the debt. The mortgage payable is reported at par value which approximates its fair value due to its short-term nature.