We lease office space in Nashville, Tennessee for our corporate offices (approximately 21,000 square feet) and for our claims and customer service center (approximately 51,000 square feet). We also lease office space in Chicago, Illinois, Tampa, Florida and Irving, Texas for our regional claims offices and in Chicago, Illinois and Houston, Texas for our regional customer service centers. Our retail locations are all leased and typically are located in storefronts in retail shopping centers, and each location typically contains less than 1,000 square feet of space. See Note 9 to our consolidated financial statements for further information about leases.
The unaudited pro forma results should not be considered indicative of actual results that would have been achieved had the USAuto acquisition and related transactions been consummated on July 1, 2003 and do not purport to indicate results of operations for any future period.
The following discussion should be read in conjunction with our consolidated financial statements and accompanying notes included in this report. This discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of various factors, including those discussed below and elsewhere in this report, particularly under the caption “Risk Factors.”
As of September 1, 2008, we leased and operated 431 retail locations (or “stores”), staffed by employee-agents. Our employee-agents exclusively sell non-standard insurance products either underwritten or serviced by us. As of September 1, 2008, we wrote non-standard personal automobile insurance in 12 states and were licensed in 13 additional states.
Our insurance operations generate revenues from selling, servicing and underwriting non-standard personal automobile insurance policies in 12 states. We conduct our underwriting operations through three insurance company subsidiaries: First Acceptance Insurance Company, Inc., First Acceptance Insurance Company of Georgia, Inc. and First Acceptance Insurance Company of Tennessee, Inc. Our insurance revenues are primarily generated from:
The following table presents the change in the total number of policies in force for the insurance operations for the periods presented. Policies in force increase as a result of new policies issued and decrease as a result of policies that are canceled or expire and are not renewed.
Expense Ratio - Expense ratio is the ratio (expressed as a percentage) of operating expenses to premiums earned. This is a measurement that illustrates relative management efficiency in administering our operations. Insurance operating expenses are reduced by fee income from insureds and, for the period from January 1, 2006 through December 31, 2006, a transaction service fee we received for servicing the run-off business previously written by the Chicago non-standard insurance agencies whose business we acquired in January 2006 (“Chicago acquisition”).
The expense ratio for the year ended June 30, 2008 includes expenses of $1.3 million related to (i) severance and related benefits charges of $1.0 million incurred in connection with separation agreements with certain officers and retail management personnel and (ii) costs of $0.3 million associated with the closure of poor performing stores. The effect of these expenses had a negative impact of 40 basis points on the expense ratio for the year ended June 30, 2008.
At June 30, 2008, 99.8% of our investment portfolio was rated “investment grade” (a credit rating of AAA to BBB) by nationally recognized rating agencies. The average credit rating of our fixed maturity portfolio was AA+ at June 30, 2008. Investment grade securities generally bear lower yields and lower degrees of risk than those that are unrated or non-investment grade. Management believes that a high quality investment portfolio is more likely to generate a stable and predictable investment return.
The following table summarizes our fixed maturity securities at June 30, 2008 (in thousands).
Revenues for the year ended June 30, 2008 decreased 4% to $332.4 million from $347.6 million in the prior year. Net loss for the year ended June 30, 2008 was $17.8 million, compared with a net loss of $16.7 million for the year ended June 30, 2007. Basic and diluted net loss per share was $0.37 for the year ended June 30, 2008, compared with $0.35 for the year ended June 30, 2007.
Premiums earned decreased by $14.7 million, or 5%, to $285.9 million for the year ended June 30, 2008, from $300.7 million for the year ended June 30, 2007. This decline was due to the decrease in the number of policies written, which was partially offset by higher average premiums per policy as a result of rate increases taken in a number of states to improve underwriting profitability. The decrease in the policies written was due to the current weak economic conditions impacting our customers, rate increases taken in a number of states to improve underwriting profitability and the closure of 45 poor performing stores since January 2007.
Premiums earned in Florida, Georgia and Tennessee for the year ended June 30, 2008 declined by $24.5 million over the prior year. These markets collectively accounted for 44% of premiums earned during fiscal 2008, down from 50% in the prior year. Our premiums earned in these states were adversely affected by a decline in used car sales, which have historically been a significant contributor to new policy growth in these markets. Additionally, the decline in our Florida market was due to a January 1, 2008 rate increase to improve our underwriting profitability and the decline in our Georgia market was due to state legislation intended to curb illegal immigration. The decline in premiums earned was partially offset by premium growth of $11.9 million in our emerging markets of South Carolina and Pennsylvania.
The expense ratio increased from 19.8% for the year ended June 30, 2007 to 21.7% for the year ended June 30, 2008. This increase was primarily due to the year-over-year decline in premiums earned and the net effect of the expenses discussed above which had a negative impact of 40 basis points on the expense ratio during the year ended June 30, 2008 and the positive impact on the expense ratio during the year ended June 30, 2007 from the transaction service fee of $0.9 million, or 30 basis points, earned through December 31, 2006 in connection with the Chicago acquisition.
At this time, we are unable to estimate the total costs associated with the Georgia and Alabama litigation settlements. The costs of the settlements will depend, among other factors, upon whether class members receive premium credits or reimbursement certificates pursuant to the terms of the settlements and the rate of redemption of the premium credits and reimbursement certificates. The litigation settlement costs are set forth separately in the consolidated statements of operations. We anticipate that our payment of the $6.3 million in plaintiffs’ attorneys’ fees and expenses and the $0.4 million in estimated costs associated with the administration of the settlement, both of which were accrued at June 30, 2008, will occur in calendar year 2009, after the final approvals from the courts.
The provision for income taxes for the year ended June 30, 2008 includes a charge of $11.4 million related to the expiration of certain federal net operating loss carryforwards as well as an increase in the valuation allowance for the deferred tax asset of $3.6 million resulting in a charge totaling $15.0 million. The provision for income taxes for the year ended June 30, 2007 includes an increase in the valuation allowance for the deferred tax asset of $6.9 million as well as $10.0 million related to the expiration of certain net operating loss carryforwards resulting in a deferred tax asset charge totaling $16.9 million. The changes during the years ended June 30, 2008 and 2007 related to the valuation allowance were due to revisions in estimates for our future taxable income based on the most recent fiscal year results. The charges during the years ended June 30, 2008 and 2007 related to the expiration of net operating loss carryforwards were due to taxable income for the most recent fiscal year being less than our prior estimates.
Loss before income taxes for the year ended June 30, 2008 was $8.7 million, compared with $5.3 million for the year ended June 30, 2007. Segment losses consist of other operating expenses not directly related to the insurance operations, interest expense and stock-based compensation offset by investment income on corporate invested assets. During the year ended June 30, 2008, interest expense in connection with borrowings under our credit facility decreased to $0.7 million from $1.7 million during the year ended June 30, 2007 as a result of lower outstanding indebtedness. In addition, we incurred $3.9 million and $0.2 million of interest expense during the years ended June 30, 2008 and 2007, respectively, related to the debentures issued in June 2007. Other operating expenses for the year ended June 30, 2008 also included a $0.5 million accrual for disputed Texas franchise taxes on sales of foreclosed real estate held for sale and $0.2 million in costs associated with amendments made to our credit agreement.
Revenues for the year ended June 30, 2007 increased 40% to $347.6 million from $249.0 million in the prior year. Net loss for the year ended June 30, 2007 was $16.7 million, compared with net income of $28.1 million for the year ended June 30, 2006. Basic and diluted net income (loss) per share was $(0.35) for the year ended June 30, 2007, compared with $0.59 and $0.57, respectively, for the year ended June 30, 2006.
Revenues from insurance operations were $347.4 million for the year ended June 30, 2007, compared with $244.6 million for the year ended June 30, 2006. Income before income taxes from insurance operations for the year ended June 30, 2007 was $6.3 million, compared with $26.5 million for the year ended June 30, 2006.
For the year ended June 30, 2007, premiums earned increased by $91.9 million, or 44%, to $300.7 million from $208.8 million for the year ended June 30, 2006. The increase was due primarily to the expansion of our business. Approximately 87% of the premium growth was in Florida, Texas and South Carolina, where we opened 102 locations in fiscal 2006, and Chicago, where we acquired 72 locations in January 2006. The total number of insured policies in force at June 30, 2007 increased 13% over the same date in 2006 from 200,401 to 226,974. At June 30, 2007, we operated 462 stores, compared with 460 stores at June 30, 2006.
The loss and loss adjustment expense ratio was 80.4% for the year ended June 30, 2007, compared with 67.5% for the same period last year. For the year ended June 30, 2007, we experienced a negative development for losses occurring in prior accident periods of approximately $3.9 million. For the premiums earned during this fiscal year, the loss and loss adjustment expense ratio was 79.2%. During fiscal 2007, we experienced significant unanticipated increases in (1) the frequency of PIP losses in Florida, (2) the severity of bodily injury losses in Florida and Georgia, and (3) the severity of property damage losses in Georgia and other states. The higher than anticipated severity in Georgia bodily injury losses in fiscal 2007 was somewhat driven by a higher than anticipated occurrence of large losses (losses of $10,000 or above). To a lesser extent, the increase in the loss and loss adjustment expense ratio for fiscal 2007 was the result of a change in our business mix resulting from premium growth in our emerging states of Florida and Texas where we anticipated higher loss ratios. Our loss ratio (exclusive of loss adjustment expenses) for Florida’s PIP coverage was 105.1% for the year ended June 30, 2007 on premiums earned of $15.5 million.
In January 2007, we hired a new head of product management with significant experience in rate making for the non-standard automobile insurance sector. In addition, we filed new rates in Florida (December 2006), South Carolina and Georgia (March 2007) and Pennsylvania (September 2007).
Insurance operating expenses increased 29% to $97.6 million for the year ended June 30, 2007 from $75.8 million for the year ended June 30, 2006. This increase was primarily due to the fiscal 2006 addition of new stores (including those acquired in Chicago) and expenses, such as advertising, employee-agent compensation, rent and premium taxes that vary along with the increase in premiums earned.
related to the expiration of net operating loss carryforwards was due to taxable income during fiscal 2007 being less than prior estimates. The decrease in the valuation allowance for the year ended June 30, 2006 was the result of our taxable income exceeding the previous estimate used in establishing the valuation allowances in addition to revisions in estimates for our future taxable income.
Loss before income taxes from real estate and corporate for the year ended June 30, 2007 was $5.3 million versus income before income taxes of $0.6 million for the year ended June 30, 2006. The year ended June 30, 2006 included gains on sales of foreclosed real estate held for sale of $3.6 million. There were no gains on sales of foreclosed real estate held for sale during the year ended June 30, 2007. In addition, during the year ended June 30, 2007, we incurred $1.7 million of interest expense in connection with borrowings related to the credit facility compared with $0.9 million for the year ended June 30, 2006.
Our primary sources of funds are premiums, fee income and investment income. Our primary uses of funds are the payment of claims and operating expenses. Operating activities for the year ended June 30, 2008 provided $18.4 million of cash, compared with $36.7 million provided in the same period in fiscal 2007. The decrease in cash provided by operating activities was the result of an increase in paid loss and loss adjustment expenses and a decrease in cash collected on premiums written. Net cash provided by investing activities for the year ended June 30, 2008 was $5.4 million, compared with net cash used in investing activities of $75.5 million in fiscal 2007. Both periods reflect net additions to our investment portfolio, while the year ended June 30, 2008 includes the settlement of a $20.0 million receivable for securities in July 2007. Financing activities for the year ended June 30, 2008 included debt principal repayments of $16.0 million which were comprised of (i) the repayment of $5.0 million on our revolving credit facility in July 2007, (ii) the required principal prepayment of $6.0 million on our term loan facility in October 2007 made in accordance with an amendment to the credit agreement, and (iii) an additional prepayment of $5.0 million on our term loan facility in January 2008. During the years ended June 30, 2008 and 2007, we made scheduled quarterly principal payments on our term loan facility of $3.1 million and $5.6 million, respectively. We also made an additional principal prepayment of $1.0 million on our term loan facility in August 2008 and we are required to repay the remaining $2.5 million principal balance of our term loan facility by October 31, 2008.
During the year ended June 30, 2008, the insurance company subsidiaries paid ordinary dividends to the holding company of $6.5 million in October 2007 and $5.5 million in December 2007. These dividends were used to repay the $11.0 million in unscheduled debt payments noted above as well as for general corporate activities.
At June 30, 2008, we had $2.9 million available in unrestricted cash and investments outside of the insurance company subsidiaries. These funds and the additional unrestricted cash from the sources described in the next paragraph were used to pay the principal prepayment of $1.0 million noted above and will be used to pay the final payment on our term loan facility of $2.5 million on October 31, 2008 and the amounts to be paid by the Company related to the litigation settlements. For additional information with respect to the litigation settlements, see “Item 3. Legal Proceedings.”
We are part of an insurance holding company system with substantially all of our operations conducted by our insurance company subsidiaries. Accordingly, the holding company’s primary sources of cash are dividends from our insurance company subsidiaries and from our non-insurance company subsidiaries that sell ancillary products to our insureds. The holding company will also receive cash from operating activities as a result of investment income and the ultimate liquidation of our foreclosed real estate held for sale. In addition, as a result of our NOL carryforwards, taxable income generated by the insurance company subsidiaries through June 30, 2009 will provide cash to the holding company through an intercompany tax allocation agreement through which the insurance company subsidiaries reimburse the holding company for current tax benefits utilized through recognition of the NOL carryforwards. Cash could also be made available through the issuance of securities and loans from financial institutions.
Based on our December 31, 2007 statutory capital and surplus, our ordinary dividend capacity for calendar 2008 is approximately $11 million. Such amount is limited however to the amount of earned surplus of FAIC. At June 30, 2008, our ordinary dividend capacity was approximately $3 million. However, available ordinary dividends from FAIC’s wholly-owned insurance company subsidiaries can increase the earned surplus of FAIC to $7 million. The timing of ordinary dividend payments during calendar 2008 is affected by the amount of dividend payments made in the preceding twelve-month period. Therefore, subject to the sufficiency of earned surplus, FAIC is permitted to pay an ordinary dividend of $6.5 million in October 2008 and an additional $4.5 million in December 2008.
We believe that existing cash and investment balances, when combined with anticipated cash flows as noted above, will be adequate to meet our expected liquidity needs in both the short-term and the reasonably foreseeable future. Our growth strategy may require external financing, and we may from time to time seek to obtain external financing. We cannot assure you that additional sources of financing will be available to us on favorable terms, or at all, or that any such financing would not negatively impact our results of operations.
At June 30, 2008, we were not in compliance with our financial covenants in the credit agreement regarding a minimum fixed charge coverage ratio, a minimum consolidated tangible net worth ratio and a minimum net income requirement. Our lenders waived this non-compliance as of June 30, 2008 and we entered into an amendment to the credit agreement dated September 10, 2008. The amended terms (i) required us to make a prepayment of $1.0 million in principal on August 8, 2008, (ii) accelerated the maturity date of the term loan facility to October 31, 2008, (iii) eliminated the revolving credit facility and (iv) removed all financial covenants for the remaining term.
Consists of the provision associated with the settlement agreement relating to the Georgia litigation and the preliminary settlement terms relating to the Alabama litigation. Other costs associated with the litigation cannot be reasonably estimated at this time. For additional information with respect to the litigation settlements, see “Item 3. Legal Proceedings.”
The preparation of consolidated financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect amounts reported in the consolidated financial statements. As more information becomes known, these estimates and assumptions could change, thus having an impact on the amounts reported in the future. The following are considered to be our critical accounting policies.
Goodwill and other identifiable intangible assets are attributable to our insurance operations and are recorded at their estimated fair values at the date of acquisition. Goodwill and other intangible assets having an indefinite useful life are not amortized for financial statement purposes. We perform an annual impairment test. In the event that facts and circumstances indicate that the goodwill and other identifiable intangible assets may be impaired, an interim impairment test would be required. Intangible assets with finite lives are amortized over their useful lives and are periodically reviewed to ensure that no conditions exist indicating the recorded amount is not recoverable from future undiscounted cash flows.
As a part of our annual impairment test to evaluate the recoverability of such assets, recent trends in our results, including premiums written, premiums earned and policies in force as well as the estimated future discounted cash flows associated with these assets, were compared with their carrying amounts to determine if a write down to market value or discounted cash flow value was necessary. Based on this evaluation, we concluded that goodwill and other identifiable intangible assets were fully realizable as of June 30, 2008. However, our evaluation includes multiple assumptions, including estimated discounted cash flows and estimates that may change over time. If future discounted cash flows become less than those projected by the Company, an impairment charge may become necessary that could have a materially adverse impact on our results of operations and financial position.
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. Management reviews investments for impairment on a quarterly basis. A decline in the fair value of any available-for-sale security below cost that is deemed to be other-than-temporary would result in a charge against income.
Securities with declines attributable to issuer-specific fundamentals are reviewed to identify all available evidence to estimate the potential for impairment. Resources used include historical financial data included in SEC filings for corporate bonds and performance data regarding the underlying loans for collateralized mortgage obligations. Securities with declines attributable to market or sector declines where we have the intent and ability to hold these securities for a period of time sufficient to allow for any anticipated recovery in fair value are not deemed to be other-than-temporary.
Commission income and related policy fees, written for affiliated and unaffiliated insurance companies, are recognized at the date the customer is initially billed or as of the effective date of the insurance policy, whichever is later. Commissions on premium endorsements are recognized when premiums are processed. Motor club fees written by an affiliate are earned on a pro-rata basis over the respective terms of the contracts and included within commission and fee income. Fees are paid monthly by motor club members and are generally collected in advance of providing coverage, minimizing our exposure to credit risk.
Fee income includes agency and installment fees to compensate us for the costs of providing installment payment plans, as well as late payment, policy cancellation, policy rewrite and reinstatement fees. We recognize these fees on a collected basis. Installment billing fees paid by policyholders are recognized as revenue when each installment is billed.
This report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. All statements made in the report, other than statements of historical fact, are forward-looking statements. You can identify these statements from our use of the words “may,” “should,” “could,” “potential,” “continue,” “plan,” “forecast,” “estimate,” “project,” “believe,” “intent,” “anticipate,” “expect,” “target,” “is likely,” “will,” or the negative of these terms and similar expressions. These statements are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. These forward-looking statements may include, among other things:
We have audited the accompanying consolidated balance sheets of First Acceptance Corporation and subsidiaries (the “Company”) as of June 30, 2008 and 2007, and the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the three years in the period ended June 30, 2008. Our audits also included the financial statement schedules listed in the index at Item 15(a). These financial statements and schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements and schedules based on our audits.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of First Acceptance Corporation and subsidiaries’ internal control over financial reporting as of June 30, 2008, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated September 10, 2008 expressed an unqualified opinion thereon.
First Acceptance Corporation (the “Company”) is a holding company based in Nashville, Tennessee with operating subsidiaries whose primary operations include the selling, servicing and underwriting of non-standard personal automobile insurance. The Company writes non-standard personal automobile insurance in 12 states and is licensed as an insurer in 13 additional states. The Company issues policies of insurance through three wholly-owned subsidiaries, First Acceptance Insurance Company, Inc., First Acceptance Insurance Company of Georgia, Inc. and First Acceptance Insurance Company of Tennessee, Inc. (the “Insurance Companies”). The Company has limited activities related to its attempts to market and dispose of foreclosed real estate held for sale.
The preparation of financial statements in conformity with generally accepted accounting principles (“GAAP”) requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. It also requires disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenue and expenses during the period. Actual results could differ from those estimates.
Fixed maturities, available-for-sale, include bonds with fixed principal payment schedules and loan-backed securities which are amortized using the retrospective method. These securities are carried at fair value with the corresponding unrealized appreciation or depreciation, net of deferred income taxes, reported in other comprehensive income or loss.
Investment securities are exposed to various risks such as interest rate, market and credit risk. Fair values of securities fluctuate based on the magnitude of changing market conditions; significant changes in market conditions could materially affect portfolio value in the near term. Management reviews investments for impairment on a quarterly basis. Fair values of investments are based on prices quoted in the most active market for each security. If quoted prices are not available, fair value is estimated based on the fair value of comparable securities, discounted
Goodwill and other identifiable intangible assets are attributable to the Company’s insurance operations and are recorded at their estimated fair values at the date of acquisition. Goodwill and other intangible assets having an indefinite useful life are not amortized for financial statement purposes. The Company performs an annual impairment test. In the event that facts and circumstances indicate that the goodwill and other identifiable intangible assets may be impaired, an interim impairment test would be required. Intangible assets with finite lives are amortized over their useful lives and are periodically reviewed to ensure that no conditions exist indicating the recorded amount is not recoverable from future undiscounted cash flows.
In February 2007, the FASB issued Statement No. 159, Establishing the Fair Value Option for Financial Assets and Liabilities (“SFAS 159”), which includes an amendment to FASB Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities (“SFAS 115”). SFAS 159 permits entities to choose to measure many financial instruments and certain other items at fair value. The election is made on an instrument-by-instrument basis and is irrevocable. If the fair value is elected for an instrument, SFAS 159 specifies that unrealized gains and losses are reported at each subsequent reporting date. This statement applies to all entities and most of the provisions of this statement apply only to entities that elect the fair value option. However, the amendment to SFAS 115 applies to all entities with available-for-sale and trading securities. SFAS 159 is effective for fiscal years beginning after November 15, 2007. The Company does not expect the adoption of SFAS 159 to have a material impact on the Company’s results of operations or financial position given that the Company does not anticipate making the election set forth in the pronouncement.
In March 2008, the FASB issued Statement No. 161, Disclosures about Derivative Instruments and Hedging Activities (“SFAS 161”), which includes an amendment to FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities (“SFAS 133”). SFAS 161 applies to all derivative instruments and related hedged items accounted for under SFAS 133. SFAS 161 requires entities to provide greater transparency about (i) how and why an entity uses derivative instruments, (ii) how derivative instruments and related hedged items are accounted for under SFAS 133 and its related interpretations, and (iii) how derivative instruments and related hedged items affect an entity’s financial position, results of operations, and cash flows. SFAS 161 is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008. The
Company has not evaluated the requirements of SFAS 161 and has not yet determined if SFAS 161 will have a material impact on its future consolidated financial statements.
During the years ended June 30, 2008, 2007 and 2006, the Company paid $0.5 million, $0.8 million and $0.9 million, respectively, in income taxes and $4.3 million, $1.7 million and $0.6 million, respectively, in interest.
Basic net income (loss) per share is computed by dividing net income (loss) available to common shareholders by the weighted average number of common shares, while diluted net income (loss) per share is computed by dividing net income (loss) available to common shareholders by the weighted average number of such common shares and dilutive share equivalents. Dilutive share equivalents result from the assumed conversion of employee stock options and restricted common stock and are calculated using the treasury stock method.
Effective January 1, 2005, the Company acquired the assets (principally the book of business and 15 retail locations) of a non-standard automobile insurance agency in Texas for $4.0 million in cash. Goodwill and identifiable intangible assets from this acquisition are deductible for tax purposes. As a result of this acquisition, the Company is now writing business through company-operated retail locations in Texas. Of the total purchase price, $3.8 million has been recorded as goodwill and $0.2 million has been assigned to an identifiable intangible asset related to the value of policy renewals, which was amortized over a 7-month period in proportion to anticipated policy expirations.
Pro forma financial information has not been presented for this acquisition since the nature of the revenue-producing activity of this business has changed from a managing general agency to the underwriting results of an insurance company. The results of operations of the business acquired are included in the Company’s statements of operations beginning on January 1, 2005, the date of acquisition.
targets. As a result of this acquisition, the Company is now writing business from these locations. The Company also received a monthly fee from the seller through December 31, 2006 totaling $5.0 million as compensation for servicing the run-off of business previously written by the agencies through other insurance companies. Fees of $0.9 million and $4.1 million were recognized and included within other revenues during the years ended June 30, 2007 and 2006, respectively.
The following table summarizes the estimated fair values of the assets acquired at the date of acquisition (in thousands).
For the years ended June 30, 2008, 2007 and 2006, amortization related to all identifiable intangible assets was $0.1 million, $0.4 million and $0.6 million, respectively. At June 30, 2008, there were no remaining identifiable intangible assets subject to amortization.
The following table sets forth the amount of gross unrealized loss by severity (as compared to amortized cost) and length of time that individual securities have been in a continuous unrealized loss position at June 30, 2008 (in thousands).
Securities with declines attributable to issuer-specific fundamentals are reviewed to identify all available evidence to estimate the potential for impairment. Resources used include historical financial data included in SEC filings for corporate bonds and performance data regarding the underlying loans for collateralized mortgage obligations. Securities with declines attributable to market or sector declines where the Company has the intent and ability to hold these securities for a period of time sufficient to allow for any anticipated recovery in fair value are not deemed to be other-than-temporary.
The Insurance Companies had unsecured aggregate reinsurance receivables from a single reinsurance entity which are summarized as follows (in thousands).
Ceded premiums earned and reinsurance receivables on losses and loss adjustment expenses (“LAE”) were as follows (in thousands).
Net premiums written and earned are summarized as follows (in thousands).
The percentages of premiums assumed to net premiums written for the years ended June 30, 2008, 2007 and 2006 were 7%, 6% and 9%, respectively.
Compensation expense related to stock options is calculated under the fair value method and is recorded on a straight-line basis over the vesting period. Fair value of the stock options was estimated at the grant dates using the Black-Scholes option pricing model based on the following assumptions.
A summary of the status of the Plan as of June 30, 2008, 2007 and 2006 and changes during the years then ended is presented below (in thousands, except per share data).
The Company’s Board of Directors has adopted the First Acceptance Corporation Employee Stock Purchase Plan (“ESPP”) whereby eligible employees may purchase shares of the Company’s common stock at a price equal to the lower of the closing market price on the first or last trading day of a six-month period. ESPP participants can authorize payroll deductions, administered through an independent plan custodian, of up to 15% of their salary to purchase semi-annually (June 30 and December 31) up to $25,000 of the Company’s common stock during each calendar year. The Company has reserved 200,000 shares of common stock for issuance under the ESPP. Employees purchased approximately 34,000, 25,000 and 22,000 shares during the years ended June 30, 2008, 2007 and 2006, respectively. Compensation expense attributable to subscriptions to purchase shares under the ESPP was $27,000, $25,000 and $22,000 for the years ended June 30, 2008, 2007 and 2006. At June 30, 2008, 106,771 shares remain available for issuance under the ESPP.
The Company sponsors a defined contribution retirement plan (“401k Plan”) under Section 401(k) of the Internal Revenue Code. The 401k Plan covers substantially all employees who meet specified service requirements. Under the 401k Plan, the Company may, at its discretion, match 100% of the first 3% of an employee’s salary plus 50% of the next 2% up to the maximum allowed by the Internal Revenue Code. The Company’s contributions to the 401k Plan for the years ended June 30, 2008, 2007 and 2006 were $0.7 million, $0.7 million and $0.4 million, respectively.
The unfavorable change in the estimate of unpaid loss and loss adjustment expenses of $3.9 million for the year ended June 30, 2007 was impacted by the limited historical loss experience in the Company’s newer states which required more judgment in determining loss reserve estimates for those states. Such unfavorable change was primarily related to the bodily injury and Personal Injury Protection coverages in Florida.
In connection with the acquisition of the Chicago, Illinois non-standard automobile insurance agencies, on January 12, 2006, the Company entered into, and borrowed under, a credit agreement with two banks consisting of a $5.0 million revolving facility and a $25.0 million term loan facility, both maturing on June 30, 2010. At June 30, 2008, the Company had no outstanding borrowings under the revolving facility. Through September 13, 2007, outstanding borrowings under the term loan facility bore interest at LIBOR plus 175 basis points per annum. The Company entered into an interest rate swap agreement on January 17, 2006 that fixed the interest rate on the term loan facility at 6.63% through June 30, 2010. The term loan facility was due in equal quarterly installments through June 30, 2010. Both facilities are secured by the common stock and certain assets of selected subsidiaries.
As a result of non-compliance with regards to certain financial covenants, the Company entered into amendments to the credit agreement, dated September 13, 2007 and February 6, 2008. The amended terms have less restrictive financial covenants, increased the interest rate by 75 basis points and required the Company to make a prepayment of at least $6.0 million in principal before December 31, 2007. In addition, the availability under the revolving credit facility was permanently reduced from $5.0 million to $2.0 million. The amended credit agreement contained certain financial covenants regarding (i) a minimum fixed charge coverage ratio, (ii) a minimum consolidated tangible net worth, (iii) a maximum net premiums written to surplus ratio, (iv) a maximum combined ratio, (v) a minimum RBC and (vi) a minimum net income requirement.
During the year ended June 30, 2008, the Company made prepayments on its term loan facility including the required principal prepayment of $6.0 million in October 2007 made in accordance with the amendment to the credit agreement in September 2007 and an additional principal prepayment of $5.0 million in January 2008.
At June 30, 2008, the Company was not in compliance with the financial covenants in the amended credit agreement regarding a minimum fixed charge coverage ratio, a minimum consolidated tangible net worth ratio and a minimum net income requirement. The lenders waived this non-compliance as of June 30, 2008 and the Company entered into an amendment to the credit agreement dated September 10, 2008. The amended terms (i) required the Company to make a prepayment of $1.0 million in principal on August 8, 2008, (ii) accelerated the maturity date of the term loan facility to October 31, 2008, (iii) eliminated the revolving credit facility and (iv) removed all financial covenants for the remaining term.
The maturities of the notes payable and capitalized lease obligations secured by equipment as of June 30, 2008 are as follows (in thousands).
At June 30, 2008 and 2007, $0.2 million and $0.9 million, respectively, of the valuation allowance was related to the net unrealized change on investments as the Company believes that it is more likely than not that this tax benefit will not be realized. For the years ended June 30, 2008, 2007 and 2006, the change in the valuation allowance related to the net unrealized change on investments of $0.8 million, $0.3 million and $1.2 million, respectively, is included as part of other comprehensive loss. In addition, at June 30, 2008, the Company had state NOL carryforwards of $5.3 million that begin to expire in 2019 and AMT credit carryforwards of $1.3 million that have no expiration date.
The gross federal NOL carryforwards will expire in 2009 through 2023, as shown in the following table (in thousands).
For the year ended June 30, 2008, options to purchase approximately 5.5 million shares of common stock, a dilutive effect of approximately 1.5 million shares, and 0.4 million shares of restricted common stock were not included in the computation of diluted loss per share as their inclusion would have been anti-dilutive.
For the year ended June 30, 2007, options to purchase approximately 4.7 million shares of common stock, a dilutive effect of approximately 2.1 million shares were not included in the computation of diluted loss per share as their inclusion would have been anti-dilutive.
The Company primarily transacts business either directly with its policyholders or through four independently-owned insurance agencies in Tennessee who exclusively write insurance policies on behalf of the Company. Direct policyholders make payments directly to the Company. Balances due from policyholders are generally secured by the related unearned premium. The Company requires a down payment at the time the policy is originated and subsequent scheduled payments are monitored in order to prevent the Company from providing coverage beyond the date for which payment has been received. If subsequent payments are not made timely, the policy is generally canceled at no loss to the Company. Policyholders whose premiums are written through the independent agencies make their payments to these agencies that in turn remit these payments to the Company. Balances due to the Company resulting from premium payments made to these agencies are unsecured.
Effective May 2004, the Company entered into an advisory services agreement with an entity controlled by a current director of the Company to render advisory services in connection with financings, mergers and acquisitions and other related matters involving the Company. In consideration for the advisory services to be provided, the Company paid the advisor a quarterly fee of $62,500 for a four-year period through April 2008. There
are no further amounts due related to the advisory services agreement. See Note 9 to the consolidated financial statements regarding the terms of a related severance agreement and future lease obligations.
Certain claims and legal actions have been brought against the Company for which an accrual of a loss has been made under SFAS 5. The Company is a party to litigation in Alabama and Georgia in which allegations are made with respect to its sales practices, primarily the sale of motor club memberships currently or formerly sold in those states. Annette Rush v. Village Auto Insurance Company, Inc. (now known as First Acceptance Insurance Company of Georgia, Inc.) was filed on October 26, 2005, as a putative class action in the Superior Court of Fulton County, Georgia. Margaret Franklin v. Vesta Insurance Corp., et al. was filed on July 14, 2006, as a putative class action in the Circuit Court of Bullock County, Alabama. Keisha Milbry Monday, et al. v. First Acceptance Corp., et al. was filed on February 13, 2007, in the Circuit Court of Bullock County, Alabama. Carrie Jackson v. Alabama Acceptance Insurance Agency, Inc. was filed on July 24, 2007, as a putative class action in the Circuit Court of Bullock County, Alabama. Solomon and Catherine Warren, et al. v. First Acceptance Corp., et al. was filed on November 9, 2007, in the Circuit Court of Barbour County, Alabama. The suits generally allege that the Company implemented a program to convince its consumers who purchased automobile insurance policies to also purchase motor club memberships or that the Company charged its consumers billing fees associated with its products that were not properly disclosed, and seek unspecified damages and attorneys’ fees. The Georgia Superior Court certified the class in the Georgia lawsuit in December 2006. The Georgia Court of Appeals affirmed the class certification decision and the Georgia Supreme Court denied the Company’s Petition for Certiorari in January 2008. The court has not certified classes of plaintiffs in the two Alabama putative class actions. The Company has denied all allegations of wrongdoing, has vigorously defended itself against these actions, and believes the Company has meritorious defenses to these claims.
Notwithstanding the foregoing, to avoid the uncertainty, risks and costs of further litigation, the Company has determined to settle this litigation. Pursuant to the terms of the settlement agreement, the plaintiffs in the Georgia litigation will be divided into two classes: (i) persons who were insured by the Company on September 1, 2008 who purchased an automobile club membership with their automobile insurance and (ii) persons who were insured by the Company prior to September 1, 2008 who purchased an automobile club membership with their automobile insurance. Pursuant to the terms of the settlement, each class member who was insured by the Company on September 1, 2008 will receive a premium credit equal to 100% of the amounts he or she paid for automobile club memberships and deferred billing fees against the premium for new or renewal automobile insurance policies for up to twelve months of liability or uninsured motorist coverage issued by the Company prior to December 31, 2009, unless he or she elects, prior to December 31, 2008, to receive instead of the premium credit a reimbursement certificate that provides for cash reimbursement of up to a maximum total payment of $50 for any rental or towing expenses incurred by the class member on or before December 31, 2009 as a result of the disablement of his or her vehicle because of an accident. Each class member who was insured by the Company prior to September 1, 2008 will receive a reimbursement certificate that provides for cash reimbursement of up to a maximum total payment of $50 for any rental or towing expenses incurred by the class member on or before December 31, 2009 as a result of the disablement of his or her vehicle because of an accident, unless he or she elects, prior to December 31, 2008, to receive instead of the reimbursement certificate, a premium credit equal to 100% of the amounts he or she paid for automobile club memberships and deferred billing fees against the premium for new automobile insurance policies for up to twelve months of liability or uninsured motorist coverage issued by the Company prior to June 30, 2010. Any premium credits issued to class members as described above will be prorated over a twelve-month term not to extend beyond June 30, 2010, and the class member will be entitled to the prorated premium credit only so long as he or she keeps their insurance premiums current during the twelve-month term. No benefits will be available to class members until January 1, 2009. The Company has also agreed to strengthen its disclosures to customers of all relevant fees, charges and coverages. In addition, the Company has agreed to pay $3.8 million in fees and expenses for the attorneys for the Georgia plaintiffs and pay all costs associated with the administration of the settlement. The settlement agreement is subject to approval by the court, and the Company expects the court to hold a hearing to consider the settlement in November 2008.
At this time, the Company is unable to estimate the total costs associated with the Georgia and Alabama litigation settlements. The costs of the settlements will depend, among other factors, upon whether class members receive premium credits or reimbursement certificates pursuant to the terms of the settlements and the rate of redemption of the premium credits and reimbursement certificates. The Company estimates that there are approximately 11,000 persons who were insured by the Company on September 1, 2008 and approximately 155,000 persons who were insured by the Company prior to September 1, 2008 that, pursuant to the terms of the settlement agreement, are members of the plaintiff class in the Georgia litigation. The Company estimates that there are approximately 55,000 persons who were insured by the Company prior to September 1, 2008 that, pursuant to the proposed settlement terms, would be eligible to be members of the plaintiff class in the Alabama litigation. The total amount received by the Company relating to motor club memberships and deferred billing fees is $24.7 million for the State of Georgia and $5.8 million for the State of Alabama.
The carrying values and fair values of certain of the Company’s financial instruments as of June 30, 2008 and 2007 were as follows (in thousands).
The statutory-basis financial statements of the Insurance Companies are prepared in accordance with accounting practices prescribed or permitted by the Department of Insurance in each respective state of domicile. Each state of domicile requires that insurance companies domiciled in those states prepare their statutory-basis financial statements in accordance with the National Association of Insurance Commissioners Accounting Practices and Procedures Manual subject to any deviations prescribed or permitted by the insurance commissioner in each state of domicile. In addition, the Insurance Companies are required to report their risk-based capital (“RBC”) each December 31. Failure to maintain an adequate RBC could subject the Insurance Companies to regulatory action and could restrict the payment of dividends. As of December 31, 2007, the RBC levels of the Insurance Companies did not subject them to any regulatory action.
At June 30, 2008 and 2007, on an unaudited consolidated statutory basis, capital and surplus as calculated was $113.1 million and $120.2 million, respectively. For the twelve months ended June 30, 2008, 2007 and 2006, unaudited consolidated statutory net income (loss) as filed was $3.8 million, $(1.9) million and $10.6 million, respectively.
The maximum amount of dividends which can be paid by FAIC to the Company, without the prior approval of the Texas insurance commissioner, is limited to the greater of 10% of statutory capital and surplus as of December 31 of the next preceding year or net income for the year. Accordingly, as of December 31, 2007, the maximum amount of dividends available to be paid to the Company from FAIC without prior approval within any preceding twelve-month period is approximately $11 million. The amount of the dividend is further limited by the amount of FAIC’s “earned surplus” which at June 30, 2008 was $2.8 million.
FAIC-GA and FAIC-TN are wholly-owned subsidiaries of FAIC and the maximum amount of dividends which they can pay to FAIC, without the prior approval of the respective insurance commissioner, is limited to the greater of 10% of their statutory capital and surplus as of December 31 of the next preceding year or net income (not including realized capital gains) for the year. Available ordinary dividends from these wholly-owned insurance company subsidiaries would increase the earned surplus of FAIC to $7.0 million.
Net loss before income taxes for the quarter ended June 30, 2007 included an unfavorable change in the estimate of unpaid loss and loss adjustment expenses which resulted in a charge of $15.6 million. Of this amount, $12.6 million related to prior accident quarters and $3.0 million related to an unanticipated increase in the loss and loss adjustment expense ratio for the current quarter. Net loss for the quarter ended June 30, 2007 included an increase in the provision for income taxes of $16.9 million due to (i) an increase in the valuation allowance for the deferred tax asset of $6.9 million resulting from revisions in management’s estimates for the Company’s future taxable income based on the results for fiscal 2007 and (ii) a $10.0 million charge due to the expiration of certain NOL carryforwards due to taxable income for fiscal 2007 being less than management’s most recent estimates.